Giddy/Investments

The Markets /1

New York University/ING Barings

The Capital Markets

Prof. Ian Giddy New York University

The Money and Capital Markets The players l Stocks and bonds: the instruments and markets l The economy and the market l Constructing a portfolio l Picking stocks l

The The Portfolio Portfolio Project Project Copyright ©1999 Ian H. Giddy

Capital Markets 2

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The Markets /2

The Project Part I: Construct a well balanced portfolio for a client l Part II: Analyze a company to add to the portfolio l

Copyright ©1999 Ian H. Giddy

Capital Markets 3

Finance Theory... Time Is Money l Same Thing, Same Price l Risk Is Rewarded l

Copyright ©1999 Ian H. Giddy

Capital Markets 4

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The Markets /3

Applied Finance Theory...

Price versus

Value

Copyright ©1999 Ian H. Giddy

Capital Markets 5

Buy, Sell or Hold? How and where do I trade? l What should I buy? When? Why? l How can I estimate the value of a bond? A stock? An IPO? An option or other derivative? l How should I combine investments? l When is it time to sell? l

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Capital Markets 6

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The Markets /4

Stock and Bond Issues

Stocks Stocks && Bonds Bonds

Primary Primary Market Market Secondary Secondary Market Market

Copyright ©1999 Ian H. Giddy

Capital Markets 7

Primary Market for Equities Private Equity Placement

Initial Public Offering (IPO)

Subsequent Offering

Stock Buyback?

Management Buyout? Copyright ©1999 Ian H. Giddy

Capital Markets 8

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The Markets /5

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Capital Markets 9

Investment Banking Arrangements l

l

Underwritten vs. “Best Efforts” u Underwritten: firm commitment on proceeds to the issuing firm u Best Efforts: no firm commitment Negotiated vs. Competitive Bid u Negotiated: issuing firm negotiates terms with investment banker u Competitive bid: issuer structures the offering and secures bids

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Capital Markets 10

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The Markets /6

Secondary Market for Equities Private Equity Placement

Initial Public Offering (IPO)

Subsequent Offering

Secondary Market Trading

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Capital Markets 11

Institutional Investors and Money Managers Institutional Investors

Money Managers

Mutual Funds Insurance Companies

Money Moneymanagers managers

Pension Funds Hedge funds, Central banks, etc.

Copyright ©1999 Ian H. Giddy

Stocks and bonds

Capital Markets 12

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The Markets /7

Mutual Funds Open-End

Stocks and bonds

n n

Closed-End

Variable number of shares

Not traded on an exchange Price = NAV (less fees)

Stocks and bonds

n n

Variable number of shares

Traded on a stock exchange Price may not = NAV

Copyright ©1999 Ian H. Giddy

Capital Markets 13

Active vs. Passive Management Active Management l Finding undervalued securities l Timing the market Passive Management l No attempt to find undervalued securities l No attempt to time l Holding an efficient portfolio Copyright ©1999 Ian H. Giddy

Capital Markets 14

Giddy/Investments

The Markets /8

Instruments and Markets

What What Investments? Investments? Treasury Treasury Bills? Bills? (risk-free) (risk-free)

Stocks Stocks and and Bonds? Bonds? (risky) (risky)

Copyright ©1999 Ian H. Giddy

Capital Markets 15

Risky Investments?

Return

Risk

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Capital Markets 16

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The Markets /9

Capital Allocation Possibilities: Treasuries or an Equity Fund? Expected Return THE THEEQUITY EQUITYFUND FUND Return Return17% 17% Risk Risk27% 27%

THE THEUS USTREASURY TREASURYBOND BOND Return 7% Return 7% Risk RiskZero Zero

Risk Copyright ©1999 Ian H. Giddy

Capital Markets 17

Capital Allocation Possibilities: Treasuries or an Equity Fund? Expected Return

E(rP) =17%

THE EQUITY FUND

P

10% rf=7% 7% σ = 27% Copyright ©1999 Ian H. Giddy

Risk Capital Markets 18

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The Markets /10

We Can Buy Some T-bills and Some of the Risky Fund E(R) ONE PORTFOLIO: 30% Bills, 70% Fund E(R)=.3X7+.7X17=14% SD=.7X27=18.9%

17%

SLOPE=0.37

14%

rf=7%

18.9%

27%

Risk (Standard Deviation)

Copyright ©1999 Ian H. Giddy

Capital Markets 19

Financial Institutions and Markets l

The Money Market u The

operation of the Money Market u Participants in the Money Market u The Eurocurrency Market l

The Capital Market u Domestic

bonds, Eurobonds

u Equities

l

Foreign Exchange

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Capital Markets 20

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The Markets /11

How do Securities Trade?

Key Securities Money market instruments - Short-term debt instruments, like deposits and bills l Bonds - used by businesses and governments to raise money l Common Stock - Units of ownership, interest, or equity l Preferred Stock, Convertibles - A form of ownership with features of both debt and common stock

l

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The Markets /12

How do Securities Trade? Efficient

Unregulated

Inefficient

Regulated

Foreign Exchange: How Much Does a Dollar Buy? Cost?

An An over-the-counter over-the-counter market market

Spot Spot

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Forward Forwards Forward Forwards Forward Forward Futures, Futures, Options Options

Capital Markets 24

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The Markets /13

Major Securities Markets Organized Securities Exchanges are organizations that act as markets for previously issued securities l They are secondary markets - for stocks traded after they have been issued in the public market l Trading is accomplished through an auction process l Once placed, an order to buy or sell is usually executed in a matter of minutes l Examples: NYSE, American, London, Tokyo Copyright ©1999 Ian H. Giddy

Capital Markets 25

World Stock Exchanges Market Value of Shares of Domestic Listed Companies, June 1997 9,000,000 8,000,000 7,000,000

US$ millions

6,000,000 5,000,000 4,000,000 3,000,000 2,000,000 1,000,000

Copyright ©1999 Ian H. Giddy

Thailand

Philippines

Korea

Singapore

Kuala Lumpur

Taiwan

Australia

Amsterdam

Toronto

Switzerland

Paris

Hongkong

Germany

Tokyo

London

New York

0

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The Markets /14

The Role of Securities Exchanges l

l l

l

Create a continuous, liquid market in which demanders of funds can obtain needed financing Design and enforce rules of conduct so that trading is fair Create an efficient market that allocates funds to their most productive uses A key to the efficient allocation of funds is the rate of return on an investment

Copyright ©1999 Ian H. Giddy

Capital Markets 27

Let’s Play the Game Costs of trading l Commission: fee paid to broker for making the transaction l Spread: cost of trading with dealer u Bid:

price dealer will buy from you u Ask: price dealer will sell to you u Spread: ask - bid l

Combination: on some trades both are paid

Copyright ©1999 Ian H. Giddy

Capital Markets 28

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The Markets /15

Costs of Trading Commission: fee paid to broker for making the transaction l Spread: cost of trading with dealer l

u Bid:

price dealer will buy from you u Ask: price dealer will sell to you u Spread: ask - bid l

Combination: on some trades both are paid

Copyright ©1999 Ian H. Giddy

Capital Markets 29

Types of Orders Instructions to the brokers on how to complete the order l Market l Limit l Stop loss

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Capital Markets 30

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The Markets /16

Margin Trading Using only a portion of the proceeds for an investment l Borrow remaining component l Margin arrangements differ for stocks and futures l

Copyright ©1999 Ian H. Giddy

Capital Markets 31

Stock Margin Trading

l l l

l

Maximum margin is currently 50%; you can borrow up to 50% of the stock value Set by the Fed Maintenance margin: minimum amount equity in trading can be before additional funds must be put into the account Margin call: notification from broker you must put up additional funds

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Capital Markets 32

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The Markets /17

Margin Trading - Initial Conditions X Corp $70 50% Initial Margin 40% Maintenance Margin 1000 Shares Purchased Initial Position Stock $70,000 Borrowed $35,000 Equity 35,000

Copyright ©1999 Ian H. Giddy

Capital Markets 33

Margin Trading - Maintenance Margin Stock price falls to $60 per share New Position Stock $60,000 Borrowed $35,000 Equity 25,000 Margin% = $25,000/$60,000 = 41.67%

Copyright ©1999 Ian H. Giddy

Capital Markets 34

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The Markets /18

Margin Trading - Margin Call How far can the stock price fall before a margin call? (1000P - $35,000)* / 1000P = 40% P = $58.33 * 1000P - Amt Borrowed = Equity

Copyright ©1999 Ian H. Giddy

Capital Markets 35

Short Sales Purpose: to profit from a decline in the price of a stock or security Mechanics l Borrow stock through a dealer l Sell it and deposit proceeds and margin in an account l Closing out the position: buy the stock and return to the party from which is was borrowed

Copyright ©1999 Ian H. Giddy

Capital Markets 36

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The Markets /19

Short Sale - Initial Conditions Z Corp 50% 30% $100

100 Shares Initial Margin Maintenance Margin Initial Price

Sale Proceeds $10,000 Margin & Equity 5,000 Stock Owed 10,000

Copyright ©1999 Ian H. Giddy

Capital Markets 37

Short Sale - Maintenance Margin Stock Price Rises to $110 Sale Proceeds $10,000 Initial Margin 5,000 Stock Owed 11,000 Net Equity 4,000 Margin % (4000/11000) 36%

Copyright ©1999 Ian H. Giddy

Capital Markets 38

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The Markets /20

Short Sale - Margin Call How much can the stock price rise before a margin call? ($15,000* - 100P) / (100P) = 30% P = $115.38 * Initial margin plus sale proceeds

Copyright ©1999 Ian H. Giddy

Capital Markets 39

Instruments and Markets

Governments Governments

Treasuries Treasuries

Copyright ©1999 Ian H. Giddy

Agencies, Agencies, Mortgage-backed Mortgage-backed Securities Securities

Capital Markets 40

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The Markets /21

Instruments and Markets

Governments Governments

Treasuries Treasuries

Copyright ©1999 Ian H. Giddy

Agencies, Agencies, Mortgage-backed Mortgage-backed Securities Securities

Capital Markets 41

Benchmark Bonds

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Capital Markets 42

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The Markets /22

Corporate Bonds: Spread over Benchmark

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Capital Markets 43

US Bond Markets

MortgageBacked 29%

Asset-Backed 2%

Governments 53% Corporates 16%

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Capital Markets 44

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The Markets /23

Instruments and Markets

Corporate Corporate Bonds Bonds

Domestic Domestic

International International

Copyright ©1999 Ian H. Giddy

Capital Markets 45

Major Securities Markets International Capital Markets l l

l

The Eurobond Market is the market for bonds issued outside the country of the currency The Foreign Bond Market is one in which a foreign corporation or government issues bonds in a domestic market in the local currency An International Equity Market has emerged that allows corporations to sell large blocks of shares simultaneously to investors in several different countries

Copyright ©1999 Ian H. Giddy

Capital Markets 46

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The Markets /24

International Bond Markets are Linked l

Issuers and investors compare terms in the domestic and Eurobond markets, which are linked across currencies via currency swaps BOND MARKETS WITHIN COUNTRY OF CURRENCY

BOND MARKETS OUTSIDE COUNTRY OF CURRENCY

Domestic Japanese

Domestic US - Gov't - Corporate

- Gov't - Corporate

Foreign Bonds "Yankee"

Foreign Bonds "Samurai"

Currency Swaps Eurodollar Bond Market

Euroyen Bond Market Long-dated Forward Exchange

Copyright ©1999 Ian H. Giddy

Capital Markets 47

Interest Rate Swap The typical interest-rate swap is an exchange of a fixed for a floating interest rate for a period of time. Effectively, it involves paying the difference between a fixed rate and a floating rate like Libor: 8% Fixed GE GE

Chase Chase 3-mo Libor, floating

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Capital Markets 48

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The Markets /25

Derivatives Derivatives are, by definition, derived from cash instruments, like bonds, stocks, currencies or commodities l Example: foreign exchangel FX Forwards, futures, swaps l

SPOT FOREX CONTRACTS

l Currency

options l Knock-ins,

Copyright ©1999 Ian H. Giddy

PERLS

Capital Markets 49

The Chicago Mercantile Exchange

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Capital Markets 50

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The Markets /26

Managing a Portfolio Capital Allocation

Risk-Free Asset

Risky Assets

Asset Allocation

Bonds

Real Estate

Stocks

Commodities

FX

Security Selection

ConEd

Viacom

Chase

Siemens

Copyright ©1999 Ian H. Giddy

Capital Markets 51

Long-Term Returns on Investments Stocks, Bonds, Bills and Inflation

12

Stocks total return 4

Bonds total return

5

Bills total return 4

Consumer prices

8

Stocks capital gains

8

Stocks after inflation 4

Dividends and reinvestment 0

Copyright ©1999 Ian H. Giddy

2

4

6

8

10

12

14

Capital Markets 52

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The Markets /27

The Economy and the Markets How much should I pay for a bond? l Interest rates and inflation l Growth and employment l How much should I pay for a stock? l Corporate profits and equity values l

Copyright ©1999 Ian H. Giddy

Capital Markets 53

Emerging Equity Markets

Copyright ©1999 Ian H. Giddy

Capital Markets 54

Giddy/Investments

The Markets /28

Corporate Profits Drives Stock Prices Corporate profits

4,000.0

$ billions (1992 dollars)

3,500.0 3,000.0 2,500.0 2,000.0 1,500.0 1,000.0 500.0

19 95

19 93

19 91

19 89

19 87

19 85

19 83

19 81

19 79

19 77

19 75

19 71 19 73

19 69

19 67

19 65

19 63

19 61

19 59

0.0

Year

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Capital Markets 55

Performance Benchmarking: Buy Kellogg?

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Capital Markets 56

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The Markets /29

Performance Benchmarking: Buy Kellogg?

Copyright ©1999 Ian H. Giddy

Capital Markets 57

Performance Benchmarking: Buy Kellogg?

Copyright ©1999 Ian H. Giddy

Capital Markets 58

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The Markets /30

Performance Benchmarking: Buy Kellogg?

Copyright ©1999 Ian H. Giddy

Capital Markets 59

Performance Benchmarking: Buy Kellogg?

Copyright ©1999 Ian H. Giddy

Capital Markets 60

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The Markets /31

Performance Benchmarking: Buy Kellogg?

Conclusion: Conclusion: Benchmarks Benchmarks are are needed because performance needed because performance is is relative relative

Copyright ©1999 Ian H. Giddy

Capital Markets 61

How Can We Know About a Company? Financial statements l Web resources l Forecasting and comparative l

Example: n J&J company report n Pharma industry report

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Capital Markets 62

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The Markets /32

Ian H. Giddy Ian Giddy NYU Stern School of Business Tel 212-998-0332; Fax 212-995-4233 [email protected] http://giddy.org

Copyright ©1999 Ian H. Giddy

Capital Markets 66