Selecting Investments in a

Financial Instruments Global Market

Week 2 Questions to be answered:
• Why should investors have a global perspective
regarding their investments?
PART 1: Global Markets
• What has happened to the relative size of U.S.
and foreign stock and bond markets?
Reilly & Brown • What are the differences in the rates of return
Chapter 3 on U.S. and foreign securities markets?

Reasons for the expansion of

Selecting Investments in a investment opportunities
Global Market
Questions to be answered: 1. Growth and development of foreign
• How can changes in currency exchange rates financial markets
affect the returns that “local” investors
experience on foreign securities? 2. Advances in telecommunications
• Is there an additional advantage of diversifying technology
in international markets beyond the benefits of 3. Mergers of firms and security exchanges
domestic diversification?
• What alternative securities are available?
What are their cash flow and risk properties?

The Case for Constructing Relative Size of U.S. Financial Markets

Global Investment Portfolios
• The share of the U.S. in world capital markets has
dropped from about 65 percent of the total in 1969
1. Ignoring foreign markets can substantially to about 47 percent in 2010
reduce the investment choices for “local” • The growing importance of foreign securities in
(let’s say US) investors world capital markets is likely to continue
2. The rates of return on non-U.S. securities • Overall value of the total investable capital market
often have substantially exceeded those for has increased from $2.3 Trillion in 1969 to $113.6
U.S.-only securities Trillion in 2000 and the U.S. portion has declined
3. The low correlation between U.S. stock to less than half.
markets and many foreign markets can • This trend is likely to continue
help to substantially reduce portfolio risk

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 The Case for Global Investments Global Investment Choices

• Fixed-income investments
• Rates of return available on non-U.S. securities
often exceed U.S. Securities due to higher growth – bonds and preferred stocks
rates in foreign countries, especially the emerging • Equity investments
markets
• Special equity instruments
• Diversification with foreign securities can help – warrants and options
reduce portfolio risk because foreign markets have • Futures contracts
low correlation with U.S. capital markets
• Investment companies
• Real estate

Fixed-Income Investments Capital Market Instruments

• Contractual payment schedule
• Recourse varies by instrument • Fixed income obligations that trade in
• Bonds secondary market
– investors are lenders – U.S. Treasury securities
– expect interest payment and return of principal
– U.S. Government agency securities
• Preferred stocks
– dividends are typically guaranteed and must be paid – Municipal bonds
before common share holders get theirs – Corporate bonds
– In case of bankruptcy, preferred stock holders are
paid before common stock holders

International Bond Investing International Bond Investing

• There is a substantial fixed income market outside • Eurobond
the United States that offers additional opportunity – An international bond denominated in a currency not
for diversification native to the country where it is issued
• Bond identification characteristics • Yankee bonds
– Country of origin – Sold in the United States and denominated in U.S.
– Location of primary trading market dollars, but issued by foreign corporations or
governments
– Home country of the major buyers
– Currency of the security denomination – Eliminates exchange risk to U.S. investors
• International domestic bonds
– Sold by issuer within its own country in that
country’s currency

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 Equity Investments Acquiring Foreign Equities
• Returns are not contractual and may be better or
worse than on a bond 1. Purchase of American Depository Receipts
(ADRs)
Common Stock
2. Purchase of American shares
– Represents ownership of a firm
3. Direct purchase of foreign shares listed on a
– Investor’s return tied to performance of the U.S. or foreign stock exchange
company and may result in loss or gain 4. Purchase of international mutual funds

American Depository Receipts Purchase or Sale of American shares

(ADRs) • Issued in the United States by transfer agent on
behalf of a foreign firm
• Easiest way to directly acquire foreign shares
• Higher expenses
• Certificates of ownership issued by a U.S. bank that
represents indirect ownership of a certain number of • Limited availability
shares of a specific foreign firm on deposit in a U.S. Direct Purchase of Foreign Shares
bank
• Buy and sell in U.S. dollars • Direct investment in foreign equity markets-
• Dividends in U.S. dollars difficult and complicated due to administrative,
• May represent multiple shares information, taxation, and market efficiency
• Listed on U.S. exchanges problems
• Very popular • Purchase foreign stocks listed on a U.S. exchange
– limited choice

Purchase International Mutual Funds Special Equity Instruments

• Global funds - invest in both U.S. and foreign • Equity-derivative securities have a claim on
stocks
common stock of a firm
• International funds - invest mostly outside the
U.S. • Options are rights to buy or sell at a stated
price for a period of time
• Funds can specialize
– Diversification across many countries • Warrants are options to buy from the
– Concentrate in a segment of the world company
– Concentrate in a specific country • Puts are options to sell to an investor
– Concentrate in types of markets • Calls are options to buy from a stockholder

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 Futures Contracts Financial Futures

• Exchange of a particular asset at a specified • Recent development of contracts on financial

delivery date for a stated price paid at the time instruments such as T-bills, Treasury bonds, and
of delivery Eurobonds
• Traded mostly on Chicago Mercantile Exchange
• Deposit (10% margin) is made by buyer at
(CME) and Chicago Board of Trade (CBOT)
contract to protect the seller (futures only)
• Allow investors and portfolio managers to protect
• Commodities trading is largely in futures against volatile interest rates
contracts
• Currency futures allow protection against changes
• Current price depends on expectations in exchange rates

Investment Companies Direct Real Estate Investment

• Purchase of a home
• Rather than buy individual securities
– High cost / requires down payment
directly from the issuer they can be acquired
indirectly through shares in an investment • Purchase of raw land
company – Risky / low liquidity
• Investment companies sell shares in itself • Land Development
and uses proceeds to buy securities
– Requires capital, time, and expertise
• Investors own part of the portfolio of
– Returns from successful development can be
investments
significant

Low-Liquidity Investments 2. Coins and Stamps

• Enjoyed by many as hobby and as an investment
• Some investments don’t trade on securities markets
• Market fragmented, but more liquid than antiques
• Lack of liquidity keeps many investors away • Price lists are published weekly and monthly
• Auction sales create wide fluctuations in prices
• Grading specifications aid sales
• Without markets, dealers incur high transaction costs
• Wide spread between bid and ask prices
1. Antiques/Art
3. Gold/Silver/Diamonds
• Serious collectors may enjoy good returns • Can be illiquid
• Investment requires knowledge of art and the art world • Grading determines value, but is subjective
• Acquisition of work from a well-known artist requires • Investment-grade gems require substantial investments
large capital commitments and patience • No positive cash flow until sold
• High transaction costs; uncertainty and illiquidity • Costs of insurance, storage, and appraisal

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 Organization and Functioning of
Securities Markets
Financial Instruments
Week 2 Questions to be answered:
• What is the purpose and function of a market?
• What are the characteristics that determine the
PART 2: Securities Markets quality of a market?
• What is the difference between a primary and
Reilly & Brown secondary capital market and how do these markets
Chapter 4 support each other?
• What are the major types of orders available to
investors and market makers?

What is a market? Characteristics of a Good Market

• Availability of past transaction information
– must be timely and accurate
• Brings buyers and sellers together to aid in
the transfer of goods and services • Liquidity
– marketability
• Does not require a physical location
– price continuity
• Both buyers and sellers benefit from the – depth (many buyers and sellers)
market • Low Transaction costs
• Rapid adjustment of prices to new information

Organization of the Securities Market Government Bond Issues

• Primary markets • Treasury Bills – negotiable, non-interest bearing
– Market where new securities are sold and funds securities with original maturities of one year or
go to issuing unit less
• Secondary markets • Treasury Notes – original maturities of 2 to 10
– Market where outstanding securities are bought years
and sold by investors. The issuing unit does not
receive any funds in a secondary market • Treasury Bonds – original maturities of more than
transaction 10 years
• Third/Fourth markets (see later)

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 Municipal Bond Issues Bond Issues
• Sold by three methods • The investment banker purchases the entire
– Competitive bid issue from the issuer and resells the security
– Negotiation to the investing public.
– Private placement • The firm charges a commission for
providing this service.
• Underwriters sell the bonds to investors.
Their contribution is mainly in terms of • For municipal bonds, the underwriting
– Origination function is performed by both investment
banking firms and commercial banks
– Risk-bearing
– Distribution

Corporate Stock Issues Underwriting Relationships with

Investment Bankers
New issues are divided into two groups 1. Negotiated
1. Seasoned equity issues - new shares – Most common
offered by firms that already have stock – Full services of underwriter
outstanding 2. Competitive bids
2. Initial public offerings (IPOs) - a firm – Corporation specifies securities offered
selling its common stock to the public for – Lower costs
the first time – Reduced services of underwriter
3. Best-efforts
– Investment banker acts as broker

Why Secondary Financial Secondary Bond Market

• U.S. government and municipal bonds
Markets Are Important – U.S. government bonds traded by bond dealers
– Banks and investment firms make up municipal market
• Provide liquidity to investors who makers
acquire securities in the primary market • Secondary corporate bond market
– Traded through an OTC market
• Result in lower required returns than if Secondary Equity Markets
issuers had to compensate for lower 1. Major national stock exchanges
– New York, Tokyo, and London stock exchanges
liquidity
2. Regional stock exchanges
– Chicago, San Francisco, Boston, Osaka, Nagoya, Dublin,
• Help determine market pricing for new Cincinnati
issues 3. Over-the-counter (OTC) market
– Stocks not listed on organized exchange

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 Trading Systems Call Versus Continuous Markets
• Pure auction market • Call markets trade individual stocks at
– Buyers and sellers are matched by a broker at a specified times to gather all orders and
central location determine a single price to satisfy the most
– Price-driven market orders
• Dealer market • Used for opening prices on NYSE if orders
– Dealers provide liquidity by buying and selling build up overnight or after trading is
shares suspended
– Dealers may compete against other dealers • In a continuous market, trades occur at any
time the market is open

Third Market Exchange Membership

• OTC trading of shares listed on an exchange
• Mostly well known stocks • Specialists (market makers) [see next slide]
– GM, IBM, AT&T, Xerox
• Commission brokers
• Competes with trades on exchange
• May be open when exchange is closed or trading – Employees of a member firm who buy or sell for the
suspended customers of the firm
Fourth Market • Floor brokers
• Direct trading of securities between two parties with no – Independent members of an exchange who act as
broker intermediary
broker for other members
• Usually both parties are institutions
• Can save transaction costs • Registered traders
• No data are available regarding its specific size and – Use their membership to buy and sell for their own
growth accounts

Market Makers (Specialists) Major Types of Orders

• Market orders
• Specialist is an exchange member assigned to – Buy or sell at the best current price
handle particular stocks – Provides immediate liquidity
– Has two roles: • Limit orders
• Broker to match buyers and sellers – Order specifies the buy or sell price
• Dealer to maintain fair and orderly market – Time specifications for order may vary

• Specialist has two income sources • Instantaneous - “fill or kill”, part of a day, a full day,
several days, a week, a month, or good until canceled
– Broker commission, without risk (GTC)
– Dealer trading income from profit, with risk

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 Major Types of Orders Major Types of Orders
• Special Orders • Short sales
– Stop loss – Sell overpriced stock that you don’t own and
• Conditional order to sell stock if it drops to a given purchase it back later (at a lower price)
price
– Borrow the stock from another investor (through
• Does not guarantee price you will get upon sale
your broker)
• Market disruptions can cancel such orders
– Can only be made on an uptick trade
– Stop buy order – Must pay any dividends to lender
• Investor who sold short may want to limit loss if
– Margin requirements apply
stock increases in price

Margin Transactions Margin Transactions

• On any type order, instead of paying 100% Buy 200 shares at $50 = $10,000 position
cash, borrow a portion of the transaction, Borrow 50%, investment of $5,000
using the stock as collateral If price increases to $60, position
• Interest rate on margin credit may be below – Value is $12,000
prime rate – Less - $5,000 borrowed
– Leaves $7,000 equity for a
• Regulations limit proportion borrowed
– $7,000/$12,000 = 58% equity position
– Margin requirements are from 50% up
• Changes in price affect investor’s equity

Margin Transactions Margin Transactions

Buy 200 shares at $50 = $10,000 position • Initial margin requirement at least 50%. Set up by
the Fed (regulator).
Borrow 50%, investment of $5,000 • Maintenance margin
If price decreases to $40, position – Requirement proportion of equity to stock
– Value is $8,000 – Protects broker if stock price declines
– Minimum requirement is 25%
– Less - $5,000 borrowed – Margin call on under-margined account to meet
– Leaves $3,000 equity for a margin requirement
– $3,000/$8,000 = 37.5% equity position – If margin call not met, stock will be sold to pay off
the loan