Business Finance II

Part ! : Intro , Instruments , Market structure

Taught by:
Syed Irfan Ahmed CFA FRM

Business Finance II- IBA Graduate program

Investments & Financial

Assets

Essential nature of investment

Reduced current consumption
Planned later consumption

Real Assets
Assets used to produce goods

and services

Financial Assets
Claims on real assets

1-2

Business Finance II- IBA Graduate program

Role of Financial Assets and

Markets in the Economy

Consumption Timing
Allocation of Risk
Separation of Ownership

Business
1-3

Finance II- IBA Graduate program

Financial System Clients

and Their Needs

Household Sector
Primary Need: Invest Funds

Business Sector
Primary Need: Raise Funds

Government Sector
Primary Need: Raise Funds

Business
1-4

Finance II- IBA Graduate program

Major Classes of Financial Assets

or Securities

Debt
Money market instruments
Bonds

Common stock
Preferred stock
Derivative securities

Business Finance II- IBA Graduate program

Markets and Instruments

Money Market
Debt Instruments
Derivatives

Capital Market
Bonds
Equity
Derivatives

Business Finance II- IBA Graduate program

Money Market Instruments

Treasury bills
Certificates of deposit
Commercial Paper
Bankers Acceptances
Eurodollars
Repurchase Agreements (RPs) and
Reverse RPs
Federal Funds
Business Finance II- IBA Graduate program

Capital Market Fixed Income Instruments

Publicly Issued Instruments

US Treasury Bonds and Notes
Agency Issues (Fed Gov)
Municipal Bonds

Privately Issued Instruments

Corporate Bonds
Mortgage-Backed Securities

Business Finance II- IBA Graduate program

Capital Market - Equity

Common stock
Residual claim
Limited liability

Preferred stock
Fixed dividends - limited
Priority over common
Tax treatment

Business Finance II- IBA Graduate program

Stock Indexes

Uses
Track average returns
Comparing performance of managers
Base of derivatives

Factors in constructing or using an

Index
Representative?
Broad or narrow?
How is it constructed?
Business Finance II- IBA Graduate program

Examples of Indexes

PSX All, 100 & 30

PMI 30
Dow Jones Industrial Average (30 Stocks)
Standard & Poors 500 Composite
NASDAQ Composite
NYSE Composite
PMEX
CBOT

Business Finance II- IBA Graduate program

Construction of Indexes

How are stocks weighted?

Price weighted (DJIA)
Market-value weighted (S&P500, NASDAQ)
Equally weighted (Value Line Index)

How returns are averaged?

Arithmetic (DJIA and S&P500)
Geometric (Value Line Index)

Business Finance II- IBA Graduate program

Averaging Methods
Component Return
A=10%
B= (-5%)
C = 20%
Arithmetic Average
[.10 + (-.05) + .2] / 3 = 8.33%
Geometric Average
[(1.1) (.95) (1.2)]1/3 - 1 = 7.84%

Business Finance II- IBA Graduate program

Primary vs. Secondary

Security Sales

Primary
New issue
Key factor: issuer receives the proceeds

from the sale

Secondary
Existing owner sells to another party
Issuing firm doesnt receive proceeds and

is not directly involved

Business Finance II- IBA Graduate program

Investment Banking
Arrangements

Underwritten vs. Best Efforts

Underwritten: firm commitment on

proceeds to the issuing firm

Best Efforts: no firm commitment

Negotiated vs. Competitive Bid

Negotiated: issuing firm negotiates terms

with investment banker

Competitive bid: issuer structures the
offering and secures bids
Business Finance II- IBA Graduate program

Public Offerings

Public offerings: registered with the

SEC and sale is made to the investing
public
Shelf registration (Rule 415, since 1982)

Initial Public Offerings (IPOs)

Evidence of underpricing
Performance

Business Finance II- IBA Graduate program

Private Placements

Private placement: sale to a limited

number of sophisticated investors not
requiring the protection of registration
Dominated by institutions
Very active market for debt securities
Not active for stock offerings

Business Finance II- IBA Graduate program

Organization of Secondary
Markets

Organized exchanges
OTC market
Third market & Fourth market

Business Finance II- IBA Graduate program

Organized Exchanges

Auction markets with centralized order

flow
Dealership function: can be
competitive or assigned by the
exchange (Specialists)
Securities: stock, futures contracts,
options, and to a lesser extent, bonds
Examples: PSX , PMEX
Business Finance II- IBA Graduate program

OTC Market

Dealer market without centralized

order flow
Securities: stocks, bonds and some
derivatives
Most secondary bonds transactions

Business Finance II- IBA Graduate program

Third & fourth Market

In third Markets, Trading of listed

securities away from the exchange
Institutional market: to facilitate trades
of larger blocks of securities
Involves services of dealers and brokers
In fourth market, Institutions trade
directly with institutions
No middleman involved in the
transaction
Business Finance II- IBA Graduate program

Costs of Trading

Commission: fee paid to broker for

making the transaction
Spread: cost of trading with dealer
Bid: price dealer will buy from you
Ask: price dealer will sell to you
Spread: ask - bid

Combination: on some trades both are

paid
Business Finance II- IBA Graduate program

Types of Orders

Instructions to the brokers on how to

complete the order
Market
Limit
Stop loss

Business Finance II- IBA Graduate program

Margin Trading

Using only a portion of the proceeds for

an investment
Borrow remaining component
Margin arrangements differ for stocks
and futures

Business Finance II- IBA Graduate program

Short Sales
Purpose: to profit from a decline in the
price of a stock or security
Mechanics
Borrow stock through a dealer
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

Business Finance II- IBA Graduate program

Regulation of Securities
Markets

Government Regulation
Self-Regulation
Circuit Breakers
Insider Trading

Business Finance II- IBA Graduate program

Types of Investment
Organizations

Unit Trusts
Managed Investment Companies
Open-End
Closed-End

Other investment organizations

Commingled funds
REITs

Business Finance II- IBA Graduate program

Investment Policies

Money Market
Fixed Income
Equity
Balance & Income
Asset Allocation
Indexed
Specialized Sector
Business Finance II- IBA Graduate program