12/02/2023

Econ 122 Financial Economics I

Lecture 1: Financial Assets

Jianxin Wang

Investment Analysis
How much should I invest in risky (e.g. stocks)
versus risk-free (e.g. bank deposits) assets?
How many risky assets should I hold?
How much should I invest in different risky assets?
Is a risky asset mispriced?
Fair value today?
Expected return next year?
How well do asset pricing models work?

1
 12/02/2023

Investment Analysis
Passive versus active investing
Does the asset price reflect what I know? What other
investors know? What the company CEO knows?
How to improve my investment returns?
How should I manage risk?
How to hedge and how much to hedge?
What is the fair value of a derivative contract?
How should I trade?
Daily? Weekly? Monthly? Quarterly? Yearly? Multiple-years?
Trading cost, liquidity, private information.
Sources of my performance?
Choice of asset classes, e.g. stocks vs bonds
Choice of sectors, e.g. resource vs tech companies
Choice of companies, e.g. BYD vs Tesla
Market timing

What Do You Learn in This Subject?

Topics
Financial assets and markets.
Mean-variance portfolio construction.
Basic theories of equity pricing.
Issues relating to market efficiency and investor behaviour.
Performance attribution
Models and theories
Assumptions: critical vs convenience
Conclusion
Underlying economic mechanisms
Math expression

2
 12/02/2023

Assessments
In-class Q&A: 5% based on random calls, 5% based
on voluntary answers
The midterm exam: 20%; Covers Lectures 1 – 7
Team project: 30%
Teams of 3-5 students
Analysis of stock return and risk; details in Lecture 3
The final exam: 50%; Covers all topics
Exams have multiple-choice and short-answer
questions, and are similar to the back-of-chapter
exercises.

Approach to Learning
Read relevant chapters prior to lectures
Attempt to identify and understand the key
messages: Concepts? Issues? Connections?
Answer/ask questions during lecture.
Take notes during lecture: logics and gaps
Internalize the lecture content:
Think & reflect.
Summarizing & memorizing are not internalizing.
PRACTICE the back-of-chapter questions.
It takes regular exercises to build up the mental muscle.
Answers are provided and discussed in tutorial sessions.

3
 12/02/2023

Approach to Learning
不闻不若闻之 Hearing is better than not hearing;
Seeing is better than hearing;
闻之不若见之
Understanding is better than seeing;
见之不若知之 Doing is better than understanding.
知之不若行之 --- Xun Zi
---《荀子修身》 Just do it!
--- Nike

Today’s Topics
Financial assets
Equities, bonds, currencies, indices, and derivatives
Trading mechanisms
Auction
Dealership
Search
Financial markets
By asset
By function
By trading mechanism

4
 12/02/2023

Asset Classes
Equities
Common; preferred; voting rights.
Bonds
Loan; bond; treasury; corporate; money market.
Others:
Real estate; currency; commodity; gold.
Indices:
Equity; bond; commodity; real estate.
Sector; industry; green/ESG.
Derivative securities
Options and futures

Equity
Common stocks
Ownership, dividends, residual claim, and limited liability
voting rights: more than one vote per share; one vote per
share; no voting right, only dividend.
Preferred stocks
Fixed dividends: missing dividends are paid later.
Priority over common stocks
Often have lower tax on dividends
Depository receipts
American (ADR), European (EDR), and global (GDR)
ADR: a US investment bank receives shares from a Philippine-
listed firm and sells ADRs of this firm to US investors.

12/02/2023 10

5
 12/02/2023

Equity Indices
Tend to have a small number of stocks in an
index, e.g. Dow 30, FT 100, S&P 500.
Calculation
Price weighted: stocks with higher prices have greater
weights, e.g. DJIA, Nikkei 225.
Market-value weighted: stocks with higher market values
have greater weights, e.g. S&P500, NASDAQ.
Equally weighted: all stocks have the same weights, e.g.
Wilshire 5000, Value-Line.

12/02/2023 11

Price-Weighted Index
Price on Price on Shares
Stock Aug 17 Aug 18 Return Outstanding

A 100 110 10% 10m

B 10 8 -20% 500m

Index on Aug 17 = (100+10)/2 = 55

Index on Aug 18 = (110+8)/2 = 59
Index return = 59/55 – 1 = 7.3%
Also return = (100/110) x 10% + (10/110) x (–20%) = 7.3%
Index return is dominated by stocks with high prices.
Tracking portfolio: equal number of shares in each
stock.
12/02/2023 12

6
 12/02/2023

Stock Split
Stock A has a 2 for 1 split after closing on Aug 17:
P0 = $50, shares outstanding = 20 million, P1 = $55
Before the split, index = (100+10)/2 = 55
After the split, index should be the same:
(50+10)/d = 55 → d = 1.09
Index on Aug 18: (55 + 8)/1.09 = 57.8
Index return = 57.8/55 – 1 = 5.1%
Stock A’s price, therefore weight in the index, is
lower. Stock B has a higher weight and a negative
return. The index return is lower after the split.

13

Market-Value Weighted Index

On Aug 17, index value is set to “100”
Market value of A = $100 x 10m = $1,000m
Market value of B = $10 x 500m = $5,000m
Portfolio value is $6,000m, with 1/6 in A and 5/6 in B.
𝟏 𝟓
On Aug 18, index return is x10%+ x(–20%) = –15%
𝟔 𝟔
Portfolio value is 110x10m + 8x500m = $5,100m.
Portfolio return is 5100/6000 – 1 = -15%
Index return is dominated by stocks with high market value.
Index value = 100 x (1–15%) = 85
Tracking portfolio: proportional to market values.
How would a stock split affect value-weighted index?

12/02/2023 14

7
 12/02/2023

Equally-Weighted Index
Index on 17/8/22 = “100”
Return on index is (10% –10%)/2 = 0%
Index on 18/8/22 = 100 x (1+0%) = 100
Tracking portfolio: equal $ values in A and B
As stock prices change, frequent portfolio
rebalancing is required to maintain equal $ values
How would a stock split affect equally-weighted
index?

12/02/2023 15

Basics of Bonds
Debt: issuer borrows from bond investors.
Similarities and differences with bank loans?
Face or par value, e.g. $1000
Maturity/expiration date, e.g. Nov 15, 2045
The par value and a coupon are paid on the expiration date.
Coupon rate is a percentage of the par value
Coupon payment period: annual or semi-annual
Annual coupon = 3% x $1000 = $30
Semi-annual coupon = $30/2 = $15
Coupons are paid (semi-)annually going backward from the
expiration date.

16

8
 12/02/2023

Bond versus Equity

Risk
Corporate control
Tax
Flotation costs:

Proceeds Equity Bonds

(US$m) IPOs SEOs Conv. Bonds Stra. Bonds
$2–9.99 17.0% 13.3% 8.7% 4.4%
100–199.99 7.1 4.2 2.8 2.3
500 and up 5.7 3.1 2.1 1.6
Average 11.0% 7.1% 3.8% 2.2%

17

Short-term Debt: Money Market Instruments

Maturity  1 year.
Face (par) value, e.g. $100,000.
Traded at a discount from the par value.
No coupon payment. Receive par value at maturity.
Examples:
T-bills: common maturities are 4, 8, 13, 26, and 52 weeks.
Commercial papers: issued by large corporations, average
maturity 30 days.
Repurchase agreements (repos): short-term funding, e.g.
by stock dealers: The dealer sells treasuries and buys back
at higher price, often after overnight or several days.
Reverse repos: The dealer buys treasures and sells back at
higher price.

12/02/2023 18

9
 12/02/2023

Longer-term Debt: Notes and Bonds

We assume par value = $1000.
When issued, notes have maturity from 1 to 10
years, bonds have maturity > 10 years.
Government: treasury bonds and notes, agency
issues, municipal bonds
Private: corporate bonds, asset-backed securities
Default: borrower/bond issuer fails to pay coupon
or the par value.
Treasuries have no default risk. Why?
Do other government bonds have default risk?

12/02/2023 19

Bond Quotes
Quotes are in % of the face value
Most treasuries: par value $1000, semi-annual coupons.
Wall Street Journal, 3 January 2019

20

10
 12/02/2023

Bond Cash Flows and Return

For the bond expiring on 15-Aug-2029, it pays
x6.125% coupon, i.e. $30.625 every 6 months.
The bid price is 132.7266%x$1000 = $1327.27. The
ask price is $1327.89. It increased 1.1406% of par
value, i.e. $11.406, from yesterday.
It has 11 years and 22 coupons left. If coupons are
reinvested at annual yield of 2.575%, the value at
maturity is 30.625× ∑ (1 + 0.02575/𝟐) = $773.15
Receive par value at maturity = $1000
Total return over 11 years = 1773.15/1327.27 – 1 =
33.6%.

21

Asset-Backed Securities (ABS)

Bonds collateralized by a pool of assets.
Mortgages, car loans, credit card payments, leases, movie
proceeds, etc.
Mortgage-back securities (MBS)
A mortgage lender (M) sells bonds to bondholders (B)
with coupon C and face value F.
M lends the bond proceeds to homebuyers (H) and
receives mortgage payment P.
P is used to pay M (fee for securitizing the mortgage) and
B (C, F, and mortgage insurance I), and other expenses
(e.g. accounting and legal).

22

11
 12/02/2023

The U.S. Fixed-income Market ($b, 2018)

23

Bond Indices
A broad portfolio of bonds representing different
coupon, rating, maturity, etc.
Number in thousands
Market-value weighted
Track the average return of bonds in a particular
character or sector:
Indices for treasury bonds, agency bonds,
corporate bonds, asset-backed securities,
international bonds, high-yield bonds, etc.

12/02/2023 24

12
 12/02/2023

Major Bond Indices

Global
BAML Global Bond Index
Bloomberg Barclays Global Aggregate Bond Index
Citi World Broad Investment-Grade Bond Index (WorldBIG)
US
Bloomberg indices for US government and corporate bonds.
Europe
https://au.investing.com/indices/bond-indices
Asia
Australia, China, India, Japan, Korea, New Zealand, Taiwan

25

Currencies
Risk-free assets denominated in foreign currencies
E.g. USD cash or treasury bills
Spot, forward, futures, and options
Over-the-counter (OTC) trading: spot and futures
Exchange trading: futures and options
Quotes: AUD/PHP = 37.689/774
AUD: base currency; PHP: quote currency
1 unit base currency = X units of quote currency
Dealer buys AUD at PHP37.689, sells AUD at PHP37.774.
Most quotes and trades are against USD.
Non-USD quotes are calculated from USD quotes.

26

13
 12/02/2023

Currency Trading

27

Derivative Contracts/Contingent Claims

Contracts to trade the underlying asset at a future
date at the agreed price.
Forwards: both sides are obligated to trade
Futures: forwards with standardized terms set by the
exchange
Options: the buyer decides whether to trade. Contract
terms are standardized by the exchange.
Payoff depends on the price of the underlying asset.
Long history of agriculture futures contracts.
Option pricing models are developed in 1970s.

28

14
 12/02/2023

Forwards and Futures

Forward contract
Mutual obligation for the buyer and the seller to trade at
the pre-specified price on the expiration date.
Futures contract
Standardized forward contracts with specific prices and
expiration dates
Product, quality, and location to be delivered
Futures price: the agreed transaction (strike) price
Expiration date and date to be delivered
Settlement method: cash or physical delivery

12/02/2023 29

Underlying Assets
Agricultural commodities
Corn, coffee, cattle, frozen orange juice, wheat, sugar, etc.
Metals and minerals
Gold, silver, platinum, copper, tin, zinc, etc.
Foreign exchanges
Major currencies against USD.
Financials
Stock and bond indices, single stocks.

30

15
 12/02/2023

SPI 200 Futures on ASX

Contract Unit A$25the S&P/ASX 200 Index Value
Contract Months: March/June/September/December up to six
quarters months ahead.
Trading Ends: The third Thursday the settlement month. On this
day, trading ceases at 12.00pm
Settlement Date: The second business day following the last
permitted day of trading.
Cash Settlement The Special Opening Quotation of the underlying
Price: S&P/ ASX 200 Index on the last trading day.

31

10-Year T-bond Futures on ASX

Contract Unit Treasury bonds with a face value of A$100,000, a coupon rate of
6% per annum and a term to maturity of ten years.
Contract March/June/September/December up to two quarters ahead.
Months:
Trading Ends: The 15th day of the contract month (or the next business day
where the 15th day is not a business day). Trading ceases at 12.00
noon.
Minimum Prices shall be quoted in yield per cent per annum in multiples of
Price Move: 0.005 per cent. For quotation purposes the yield shall be
deducted from an index of 100.
Cash The arithmetic mean, taken at 9.45 am, 10.30 am and 11.15 am
Settlement on the last day of trading by 10 dealers, randomly selected for
Price: each time, at which they would buy and sell a series of bonds
previously declared by the Exchange for that contract month,
excluding the two highest and two lowest buying quotations and
the two highest and two lowest selling quotations for each bond.
32

16
 12/02/2023

Option Contracts
The underlying asset, e.g. IBM stock
Call/put: the right (but not obligation) to buy/sell at
an agreed price on or before the expiration date.
Contract size: 100 shares
Exercise/strike prices, e.g. $45, $50, $55,… per share
Expiration date, e.g. 3rd Thu of Sept (ASX)
Option style: American/European: the option can be
exercised before/on the expiration day.
Underlying assets:
stocks, bonds, indices, commodities, FX, etc.

12/02/2023 33

Trading Mechanisms
Dealership
All trades are against bid and ask quotes posted by dealers.
Over-the-counter (OTC) markets: e.g. the London gold market.
Double auction
Buyers/sellers submit orders to buy/sell the asset.
Price and time priority.
Most centralized exchanges for stocks and derivatives.
English auction: buyers bid up the price of the asset,
e.g. real estate, art, antique, etc.
Search: broker finds buyers or sellers, e.g. real estate.
Hybrid of dealership and auction
NYSE designated market makers (DMM), the FX markets

34

17
 12/02/2023

Financial Market Classifications

By product:
Debt, equity, derivatives, currencies, etc.
By trading mechanisms
By function:
Primary: new bonds and stocks are issued.
• Companies raise capital for future investments.
• IPOs and SEOs
Secondary: existing bonds and stocks are traded.
• The issuing company does not receive funds from the
secondary market.
• Is trading in the secondary market important for the listed
company? Why?

12/02/2023 35

Positive Roles of Financial Markets

Raise capital for investments
Diversify/allocate risk
Improve capital allocation
Consumption smoothing
Separate ownership from management
Monitor and evaluate managers
Promote the growth of financial institutions and
services

36

18
 12/02/2023

Negative Effects and Remedies

Short-term performance: “Greed is good”
Conflicts between shareholders and stakeholders
Periodic market crashes and their detrimental
impact
Financial markets need to be understood,
monitored, and proactively regulated: the case of
Australia
Sustainable finance:
Corporate social responsibilities (CSR)
Environmental, social, and governance (ESG) investing

37

Annual Growth of GDP per capita

38

19
 12/02/2023

39

Readings and Exercises

Readings
Ch 2
Recommended exercises
Ch 2: 1 – 3, 7, 10 – 12, 15 – 16; CFA: 1

40

20