Financial vs.

Real Assets
MGMT 436: Investments
Real Assets
Assets used to produce goods and services
e.g. land, buildings, intellectual property

Part I (Topic 1)
Introduction
(Chapter 1)

Financial Assets
Claims on real assets
e.g. title, bonds, loans

Asset Classes & Financial Instruments

(Chapter 2)
G. S. Pandher
Faculty of Management, UBC
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Created/destroyed by financial transactions & contracts Which side of balance sheet?

Which are financial assets?

mortgage secured by a house stock factory college education

Table 1.1. Balance Sheet U.S. Households, 2008

Table 1.2 Domestic Net Worth, 2008

Class Exercise: 9, 10
Lanni Products startup computer software development firm.
Currently owns computer equipment worth $30,000 and cash on hand of $20,000 contributed by Lannis owners. Identify the real/financial assets that trade hands in each of the following transactions. Prepare Lannis balance sheet after each transaction. a) Lanni takes out a bank loan. Receives $50,000 in cash and signs a note promising to pay it back in 3 yrs. b) Lanni uses the cash from the bank plus $20,000 of its own funds to develop a new financial planning software.
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Class Exercise: 9, 10
c) Lanni sells the software to Miscrosoft which will market the software under its name. Lanni accepts payment in the form of 1,500 shares in Microsoft (the market price is $80 per share). d) Lanni sells the shares of stock for $80 per share and uses part of the proceeds to pay off the bank. What is the ratio of real assets to total assets in a)-d)?

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Solution Lanni Products

a) Lanni takes out a bank loan. Receives $50,000 in cash and signs a note promising to pay it back in 3 yrs.
Assets Cash $70,000 Computers 30,000 Total $100,000 Liabilities & Shareholders Equity Bank loan $50,000 Shareholders Equity 50,000 $100,000

Solution Lanni Products

b) Lanni uses the cash from the bank plus $20,000 of its own funds to develop a new financial planning software.
Assets Software $70,000 Computers 30,000 Total $100,000 Liabilities & Shareholders Equity Bank loan $50,000 Shareholders Equity 50,000 $100,000

Ratio (real to total) = 30/100 = 0.3 Financial assets: create bank loan, transfer cash
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Ratio (real to total) = 100/100 = 1 No financial asset created; real asset produced (software)
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Solution Lanni Products

c) Lanni sells the software to Miscrosoft which will market the software under its name. Lanni accepts payment in the form of 1,500 shares in Microsoft (the market price is $80 per share).
Assets Microsoft $120,000 Shares Computers 30,000 Total $150,000 Liabilities & Shareholders Equity Bank loan $50,000 Shareholders Equity 100,000 $150,000

Solution Lanni Products

d) Lanni sells the shares of stock for $80 per share and uses part of the proceeds to pay off the bank.
Assets Cash $70,000 Computers 30,000 Total $100,000 Liabilities & Shareholders Equity Bank loan $0 Shareholders Equity 100,000 $150,000

Ratio (real to total) = 30/150 = 0.2 Financial asset: new issue of Microsoft shares
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Ratio (real to total) = 30/150 = 0.2 Financial asset: bank loan destroyed Increase in equity!
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The Players: Economy & Financial Markets

Households

Big Picture players

Insur Comp

Households net savers Business Firms net borrowers Governments can be both Financial Intermediaries
Commerical Banks
Make loans funded by deposits

Invest Comp

Banks

Investment companies
Market/sell securities issued by corporations/governments Mutual/Hedge Funds

Financial Markets (Eq, Debt, Derivs)

Public Companies

Insurance companies Investment Banks Pension Funds

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Invest Banks Central Bank

Municipal Govts

Federal Govt
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The Case-Shiller Index of U.S. Housing Prices

This Course Focus

Financial markets
Characteristics & performance of important broad asset classes Asset pricing models that can explain returns for equity securities

Mutual funds & investment companies

Methods for evaluating performance How much value is added by fund manager (vs. passive strategy)? Attribution analysis: Asset allocation (across broad asset classes) vs. security selection

Equity Valuation Models

Fundamental analysis approach valuation based on cashflows Multi-stage discount, multiplier, and EVA models

Market Efficiency & Behavioral Finance

To what extent are markets efficient (world where market outcome determined only by rational behavior)? What can happen to asset returns when markets are not efficient?

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Table 1.3 Balance Sheet of Commercial Banks - 2008

Table 1.4 Balance Sheet of Nonfinancial U.S. Business

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Major Classes of Financial Assets

Fixed-Income Market
Money market, Bond market

Money Market Instruments & Rates

Treasury Bills Certificates of Deposit Commercial Paper Bankers Acceptances Eurodollars Repos and Reverses Brokers Calls Federal Funds LIBOR (London Interbank Offer Rate)
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Equity markets
Common stock, Preferred Stock Indexes

Derivative markets
Future contracts, Options

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Treasury Bills
Treasury bills
Issued by Denomination Maturity Liquidity Default risk Interest type Taxation Federal Government Various e.g. 5K, 25K, 100K, $1m 4, 13, 26, or 52 weeks Highly liquid None Discount Federal taxes owed, exempt from state and local taxes

Figure 2.2: Treasury Bills

Wall Street Journal: September 25, 2008 (http://www.treasurydirect.gov/RI/OFBills)

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Certificates of Deposit (CD)

Certificates of Deposit
Issued by Denomination Maturity Liquidity Default risk Interest type Taxation Depository Institutions Any, $100,000 or more are marketable Varies, typically 14 day minimum
3 months or less are liquid if marketable First $100,000 ($250,000) is insured Add on Interest income is fully taxable

Bankers Acceptances & Eurodollars

Bankers Acceptances
An order to a bank by a banks customer to pay a sum of money on a future date When the customers bank stamps (accepts) the draft it becomes a contingent liability of the bank and becomes a marketable security.

Eurodollars
Dollar denominated (time) deposits held outside the U.S. Pay a higher interest rate than U.S. deposits.

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Repos & Federal Funds

Repos and Reverses
Short-term loan backed by government securities e.g. Borrower receives cash for treasuries; agrees to buy them back at future date (e.g. next day, week)

Table 2.1 Major Components of the Money Market

Federal Funds Rate

Very short-term loans between banks Depository institutions must maintain deposits with the Federal Reserve Bank. Banks at deficit can borrow from those banks with a surplus at the fed funds rate Key interest rate for the economy
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Figure 2.1 Money Rates

Figure 2.3: Spreads on CDs and Treasury Bills

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Treasury Notes and Bonds (Figure 2.4)

Municipal Bonds
Issued by state and local governments Interest income on municipal bonds is not subject to federal tax
capital gains still taxed

Types
General obligation bonds Revenue bonds
Industrial revenue bonds

Maturities range up to 30 years

Wall Street Journal: September 25, 2008
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Figure: Tax-exempt Debt Outstanding

Question: Municipal Bond

If you are in the 25% tax bracket, would you prefer a taxable bond that pays 10% or a municipal bond that pays 8%? What is the breakeven rate for the taxable bond at which an investor in the 25% tax bracket would be indifferent?

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Municipal Bond Yields

To compare yields on taxable securities a Taxable Equivalent Yield (r) is constructed r = rm / (1-t)
where rm is the yield on the municipal bond; t is the tax rate of the investor

Table 2.2 Tax-Exempt Yield Table

The equivalent taxable yield is simply the tax-free rate, rm , divided by (1-t).
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Corporate Bonds
Issued by private firms
Semi-annual interest payments Subject to larger default risk than government securities

Figure 2.7 Investment Grade Bond Listings

Options in corporate bonds

Callable Convertible
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Mortgage-Backed Securities (MBS)

Securities based on pooling mortgages
Issuers: Government National Mortgage Association (Ginnie Mae) Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) FNM - Stock Chart Create sub-assets that are attractive to institutional investors (e.g. pension funds) Pass-through of interest and principal repayments Default and pre-payment risk

Securitization
MBS are one particular example of securitization Pooling income-producing assets into standardized securities
traded in financial markets

Examples:
mortgage-backed securities (MBS); collateralized mortgage obligations (CMOs) car loans Student loans credit card loans

Collateralized Mortgage Obligation (CMO)

multiple tranches (e.g. classes A, B, C)

Interest Only (IO) & Principal Only (PO)

Both risky: PO becomes more valuable as the prepayment rate increases; IO cashflows decrease with prepayment
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Moral hazard!
Role of rating agencies (S&P, Fitch, Moodys)
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Figure. Mortgage-backed securities outstanding

Collateralized Mortgage Obligations (CMO)

A pool of mortgages (debt) issues are put into a special purpose trust Trust issues claims against the debt in a number of tranches
First tranche covers x% of notional and absorbs first x% of default losses Second tranche covers y% of notional and absorbs next y% of default losses etc

A tranche earn a promised yield on remaining principal in the tranche

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CMO Structure
Mortgage 1 Mortgage 2 Mortgage 3 Trust Tranche 1 1st 5% of loss Yield = 35% Tranche 2 2nd 10% of loss Yield = 15% Tranche 3 3rd 10% of loss Yield = 7.5% Tranche 4 Residual loss Yield = 6%
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Equity Markets
Common stock
(http://www.marketwatch.com/investing/stock/ibm) Residual claim Limited liability

Preferred stock
Fixed dividends - limited Priority over common Tax treatment

Mortgage n Average Yield 8.5%

American Depository Receipts

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Stock Market Listings

Stock Market Indexes

Equity Market Indexes. Examples:
US: Dow Jones Industrial Average (DJIA*), S&P500 Japan: Nikkei 225*, Nikkei 330 Canada: TSX composite (227)

Uses
Barometer of markets Base of derivatives Offers a benchmark for comparing performance of funds & managers Used in estimating market-risk models (e.g CAPM)
(* represents price-weighted index; otherwise, value-weighted)
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Table 2.6 Companies in the Dow Then & Now

Types of Stock Indexes

Representative?
Broad or narrow?

How is it weighted?
Price weighted (DJIA)
simple average of stock prices

Market weighted (S&P 500, NASDAQ)

weighted average of prices in proportion to their outstanding market value

Equal weighted (Value Line Index)

equal dollar values in each stock
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Table 2.4 Data to Construct Stock Price Indexes

DJIA Price-Weighted Average

Using data from Table 2.4; example 2.2
Initial value Final value = = $25 + $100 = $125 $30 + $ 90 = $120

Percentage change in portfolio value

Initial index value = (25 + 100)/2 = 62.5 Final index value = (30 + 90)/2 = 60 Percentage change = -2.5/62.5 = -0.04 = -4% in index
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Impact of Stock Split Price-Weighted Average

Suppose that XYZ company has a 2-1 stock split during the period
Doubling of outstanding shares from 1m to 2m Corresponding end price in $45 (half of $90)

Impact of Stock Split Price-Weighted Average

Suppose that XYZ company has a 2-1 stock split during the period
Doubling of outstanding shares from 1m to 2m Corresponding end price in $45 (half of $90)

Percentage change in portfolio value

Initial index value = (25 + 100)/2 = 125/2 = 62.5 Final index value = (30 + 45)/2 = 75/2 = 37.50 Percentage change = -25/62.5 = -0.4 = -40%! in index
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Percentage change in portfolio value

Initial index value = (25 + 100)/2 = 125/2 = 62.5 Final index value = (30 + 45)/2 = 75/2 = 37.50 Percentage change = -25/62.5 = -0.4 = -40%! in index
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Stock Split Adjustment Price-Weighted Average

XYZ company has a 2-1 stock split during the period
Corresponding end price in $45 (half of $90)

S&Ps Composite 500 Market Value-Weighted Index

Using data from Table 2.4:
Construct index with market weighted prices
ABC would have five times the weight given to XYZ Return = 690/600 1 = 15%
higher than price-weighted

Adjust divisor d (initial divisor is 2)

Find divisor that gives initial index value (after split)

(25 + 50)/d = 62.5 (initial index value) d = 75/62.5 = 1.2 Percentage change in portfolio value
Final index value = (30 + 45)/1.2 = 62.5 Percentage change = 0/62.5 = 0% in index

New index value = Old index value x 1.15%

What is the effect of the stock split?

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Equally Weighted Index (Value Line)

Places equal weight on each return Using data from Table 2.4
Start with equal dollars in each investment
ABC increases in value by 20% XYZ decreases by 10%

Equally Weighted Index (Value Line)

Places equal weight on each return Using data from Table 2.4
Start with equal dollars in each investment
ABC increases in value by 20% XYZ decreases by 10%

Total return = 5% Need to rebalance to keep equal weights

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Total return = 5% Need to rebalance to keep equal weights

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Re-Indexing
Suppose you have calculated index values over 4 years. You wish to start the index at 100 for 2008. What is new index series?
Year Index ($ millions) $1,687 $1,789 $1,800 $1,700 Calculation Re-Index (base=2006) 100 106.05 106.70 100.77
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Derivatives Markets
Derivatives
financial instruments whose value depends on an underlying asset
underlying can be a stock, index, currency, bond, interest rate.

2008 2009 2010 2011

(1,687/1,687)x100 (1,789/1,687)x100 (1,800/1,687)x100 (1,700/1,687)x100

allow an asset to be bought/sold at a fixed price in the future.

Examples: options, futures

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Options & Futures

Options
Calls: right to buy a stock at a fixed price (exercise price, strike) in the future Puts: right to sell a stock at a fixed price in the future
http://www.marketwatch.com/ Options

Investing in Stocks versus Options

Stocks:
Suppose you have $10,000 for investment. Macron Technology is selling at $50 per share. Number of shares bought = $10,000 / $50 = 200 shares If Macron is selling for $55 per share 3 months later, Profit = ($55 200) - $10,000 = $1,000 If Macron is selling for $45 per share 3 months later, Profit = ($45 200) - $10,000 = -$1,000
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Futures Contracts
Agreement to buy/sell an asset in the future at a fixed price (futures price) e.g. futures on
crude oil, gold, silver, copper, coffee, lumber, cotton, milk S&P500 index, DJIA T-bonds, libor rates

exchanges: CBT, CME, NYME

Investing in Stocks versus Options

Options:
A call option with a $50 strike price and 3 months to maturity is also available at a premium of $4. A call contract costs $4 100 = $400
# of contracts bought = $10,000 / $400 = 25 (for 25 100 = 2500 shares)

Practice Questions Chapter 1: 7, 8 Chapter 2: 8, 13, 18, 19, 22

If Macron is selling for $55 per share 3 months later Profit = {($55 $50) 2500} - $10,000 = $2,500 If Macron is selling for $45 per share 3 months later Profit = ($0 2500) $10,000 = -$10,000
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Project #1: FreedomLife Pricing

(To be handed-in)
Mark is an investment analyst at a private pension fund FreedomLife that develops retirement products for its clients. Mark is given the task of designing a retirement product for your clients at retirement (age 65 years). The retirement product will provide a guaranteed yearly income of $24,000. Answer the following questions. You should use Excel to answer the questions below. Assumptions:
Average life expectancy following retirement is 20 years. Clients receive the guaranteed income at the start of each year. Assume that the company uses an interest rate of 8% to discount the cashflows of this retirement product.
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. . . Mini-Project #1
What is the expected cost of offering this retirement product to FreedomLife when their client retires? b) The company markets its retirement product to people in their 30s and 40s. What is the minimum amount per year the company needs to charge a client aged 35 so that FreedomLife breaks even? Assume that the company will reinvest these proceeds in a lowrisk investment portfolio (mostly fixed-income) that is expected to offer a 5% return per year. Also, for pricing purposes, the payment is assumed to be made at the beginning of each year although clients can pay on a monthly basis. c) How would your answer in b) change if the $24,000 per year payout grew each year at an expected inflation rate of 3%. [Hint: you will need to review relevant time-value-of-money concepts from MGMT 310]
a)
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