Chapter Objectives To identify the basic investment alternatives Chapter 9. Financial Markets To understand the nature of securities market, distinguishing between organized and Institutions exchanges and over-the-counter market To recognize important legislations that protests investors To learn how to select a stockbroker and how to choose an investment account To know how to take an investment position and how to place investment orders What are the two major classes of Why invest? investment alternatives? Current enjoyment Tangible Intangibles (financial Home or jewelry assets or paper Provide enjoyment in Current income use as well as an assets) investment return Interest or Dividends Provide claims to Examples: houses, Future needs tangible assets or the antiques, land, earnings they provide Down payment for a home jewelry Examples: stocks, Educating children bonds Retirement Bequest What are the major factors to What are the basic investment alternatives? consider with any investment? Investments Held for Liquidity Do You Want Current or Future Return? Current return: Dividends, interest, or other types Securities with Long or No Maturities of asset income received on a regular basis. Future return: A return expected in the future Pooling Arrangements resulting from the potential sale of an asset that has appreciated in value. Contractual Claims Total return: Sum of current and future return Tangible Assets What Is Your Income Tax Situation? What Is Your Attitude Towards Risk? Risk Averse (Low Tolerance for Risk) Risk Seeking (High Tolerance for Risk)
What are the securities with long What are investment held for liquidity? or no maturities? Types Types Bank Accounts Bonds and Notes by Different Issuers Money Market Mutual Funds Preferred Stock Issued by Corporations Series EE and Series HH Bonds Common Stock Issued by Corporations Characteristics Characteristics Low risk, low return Bonds tend to have lower risks than common stocks. Preferred stocks are in between. What are pooling arrangements? What are contractual claims? Types Types Mutual Funds Warrants and Rights Investment Trusts Put and Call Options Limited Partnerships Commodity and Financial Futures Characteristics Characteristics Risk will depend on the objective of the High risk investments pooling instrument. What are tangible assets? What are organized exchanges? A Physical Place Where Buyers and Sellers Types Meet to Trade Securities Real Estate Examples: • Personal Residence • Others (Rental Properties) New York Stock Exchange (NYSE) Gold and Other Metals/Minerals • The largest exchange in the world - “Big Board” • http://www.nyse.com/home.html Jewelry and Collectibles The American Stock Exchange Characteristics • Smaller, now affiliated with NASDAQ Other than personal residence, investment in this • http://www.amex.com/ category is rather risky 14 regional stock exchanges
How does the NYSE work? What is the over-the-counter market? Securities Traded at “Posts” Largest Exchange (Number of Issues You Must Have a “Seat” To Trade on the Floor Traded) Commission Brokers Through a Communication System Floor Brokers Called NASDAQ Floor Traders Specialists Small Companies and High-Tech Trade: investor -> broker -> specialist Companies (auction) Intel Microsoft What are organized options and What are the major regulations regarding security exchanges? futures exchanges? Five options exchanges The Securities Act of 1933 Chicago Board Options Exchange The Securities Exchange Act of 1934 American Options Exchange The Securities Investor Protection Act of Philadelphia Options Exchange 1970 (SIPC) Pacific Coast Exchange Other Regulation New York Stock Exchange State and local Over a dozen commodities exchanges in Self- regulation the U.S. and Canada What is the Securities Exchange What is the Securities Act of 1933? Act of 1934? Much Broader than the 1933 Act First Federal Law Regulating the Outlaws Fraud and Misrepresentation by Securities Industry Anyone, Including Insiders Applies to New Issues Established the Annual Report (10-K) Requires a Securities Issuer to Provide and the Quarterly Report (10-Q) A Prospectus - A Very Detailed Created an Enforcement Agency (SEC) Document Describing All Material Information Related to the Issue
What is the Securities Investor What are the federal acts requiring Protection Act of 1970 (SIPC)? registration with the SEC? Act Group Regulated Protects investors if their stockbrokers The Maloney Act of Trade Associations have financial problems 1938 Account insured to $500,000 of The Investment Investment securities and $100,000 in cash Company Act of Companies 1940 Guarantees only that your securities The Investment Investment Advisors (not prices) eventually will be delivered Advisors Act of 1940 to you or another broker. How to select a stockbroker? What are some other regulations? Full-service vs. discount brokers: Full-Service brokers States Have “Blue Sky” Laws • Features: Research, representatives to help with portfolio Similar to the Federal Laws planning, access to new stock offerings, personal contact with customers, high commissions Apply to Intrastate Security Sales • Visit a full-service broker Website: Merrill Lynch at Self Regulation Is Provided by the National http://www.ml.com/ Association of Securities Dealers (NASD) Discount Brokers • Features: Possibly no personal contact, 800 number or Through: the Internet, low commissions Dealers Rules of Fair Practice • Visit a discount broker Website: Ameritrade at http://www.ameritrade.com/ Code of Procedure If you are experienced, choose discount Uniform Practice Code brokers to save commission. What are investment positions? What kinds of accounts are available? Long--You buy securities – most common Cash Account Short--You sell securities that you do not own Similar to a Bank’s Charge Account You think the price of a security will fall Must Pay for Purchases in 3 Days The Broker loans shares to you so you can sell Can Receive Share Certificates them at the current high price Margin Account If the price does fall, then you can buy these Allows You to Borrow $ from Your Broker to Buy shares back at lower prices and return the Securities borrowed shares to the broker. Interest is Charged on Such Loans A short can be risky since long-run trend in prices If such leverage is used, risk is increased is up.
Where to find investment What are the different kinds of orders? information? Market Order - Buys/Sells at Best Company Sources Available Price The Annual (10-K) and Quarterly (10-Q) Limit Order - Sets the Highest/Lowest Reports from SEC site Price You Will Accept An example of 10-k report: Stop Order - An Order That Is Triggered http://www.sec.gov/Archives/edgar/data/354950/0000 by a Security Reaching a Certain Price; 95014402004155/g75478e10-k.txt Often Used to Protect a Profit in a Stock Investment Advisory Services Value Line, Moody’s , Standard & Poor’s Chapter 10. Investment Newspapers and Magazines Basics Wall Street Journal, Barron’s, Investor’s Business Daily Internet Data Sources Yahoo: http://finance.yahoo.com/ FT: http://news.ft.com/home/us/ What is risk? - Return variability as Chapter Objectives a measure 10% 8% 6% To grasp the nature of risk and its sources, and to relate risk to investment return 5% To see the importance of diversification, and to understand how it reduces investment risk To understand how to accomplish adequate A B C diversification, both among asset groups and -8% within an asset group To become familiar with methods and issues Investment A: no Investment B: Investment C: in establishing a portfolio and changing it return variation, some return wide return over time no risk variation, some variation, much risk risk
What’s the relationship between What are the sources of risk? risk and return? Changing Economic Conditions Inflation Risk The higher the risk, the higher the expected return (no guarantee) in the long run. Business Cycle Risk Example: Annual return from 1970 to2003 Interest-Rate Risk Risk: Common Stocks – high risk Changing Conditions of the Security • Highest 37.4% (1995), lowest -26.5% (1974), range 63.9% Issuer 90-Day U.S. Treasury Bills – low risk • Highest 14.1% (1981), lowest 1.0% (2003), range 13.1% Management Risk Average annual return: Business Risk Common stocks – higher average return • 11.30% ($1000 in 1970 becomes $38,078 IN 2003) Financial Risk 90-Day U.S. Treasury Bills – lower average return • 7.23% ($1000 invested in 1970 becomes $10,739 IN 2003) What is an investment’s required What is investment risk premium? return? Risk Premium: An investment’s required return is the The difference between an investment’s return and the return on U.S. T-Bill return it must earn to compensate Market Risk Premium: investors for undertaking its inherent Using 1970-2003 Historical Data, this Premium is risks. 4.07% (11.30% - 7.23% ) Riskier investments have higher Using long-term data, the premium is close to 8% required return than less risky Controversy Exists over Value for the Premium investments What is a portfolio? What are the two types of risks? A Portfolio is Simply Random Risks a Group of Assets Associated with specific companies Stocks Can be reduced by holding more stocks Held at the Same (About 20 at least) Time Market Risk Bills Associated with the Overall Market Bonds Cannot be reduced by holding more stocks
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