Investments: Background and Issues

1
Investments Background and Issues

• Real vs Financial Assets
• Real assets are used to produce goods and
  services
• Financial assets are claims on real assets
• All financial assets are derivative assets (i.e.,
  prices derived from their underlying assets)
• Why financial assets exist?

2

• Financial Market
• Channel funds from the surplus units (typically
  from the consumer sector) to the deficit units
  (from the business sectors or government)
• Financial intermediaries are institutions help
  the fund flows in the financial market for
  efficient fund allocation
• Means to overcome market impediments, e.g., taxes

3
Financial Intermediaries

• Brokerage Function Financial intermediaries that
  bring together buyers and sellers to complete the
  transaction and charges a fee, e.g., investment
  banks
• Asset TransformationFinancial intermediaries
  that pool short-term funds and transform them
  into longer-term assets, e.g., commercial banks

4
Market Structures

• Direct Marketbuyers and sellers find each other
  directly, e.g., resale of real assets
• Brokered MarketBroker brings buyer and sellers
  together, e.g., direct placement of debt
• Dealer MarketDealer purchases the asset and
  later sells it to the investor, e.g., OTC market
• Auction marketAll transactions converge in one
  place to buy or sell, e.g., NYSEcontinuous vs
  discrete auction market

5
Recent Developments in Financial MKT

• Globalization
• Integration of financial markets across nations,
  e.g., mutual fund flows1993, mutual funds
  invested in LDC grew substantially, but
  correction later.
• SecuritizationPackage assets and sell off to
  market, e.g., A/R loans
• Credit Enhancementallows insurance company to
  back credit of a corporation
• Financial Engineeringunbundling and bundling of
  existing assets to create new instruments (dual
  funds)

6
Financial Instruments

• Money Market (short-term)Tbill when issued
  with maturities if 13-w, 26-w or 52-w and are
  sold at a discount basisDY (10,000-price)/10,0
  00(360/n)where DY discount yield n
  days to maturityBEY (10,000-P)/P(365/n)
• BEY is the bond equivalent yieldEffective Yield
  is the yield to maturity that equates the present
  value of the Tbill face value to its current
  price

7

• Certificate of Deposit (CD)time
  depositinstrument with banks. Denominations
  equal to or less 100,000 due to FDIC insurance
  limit.
• Commercial paper Corporate IOUs, less than
  270-day maturity due to SEC ruleIncreasing
  importance instruments that shapesthe banking
  industry
• Bankers Acceptance trade discount instrument
  backed by banks.
• Eurodollar CD deposits with Eurobonds
• Federal Funds bank deposits at FRB as reserve.
  Excess amount than required can beloaned out on
  a overnight basis to satisfy theFRB requirement

8
Capital Market Instruments

• Treasury notes/bonds medium to long-term federal
  government debt instruments at a fixed rate.
• Corporate Bonds private firms debt issues
• Mortgages and Mortgage-backed Securities a
  portfolio of mortgage loans or claims in a pool
  of mortgage loans.
• Preferred stocks dividend typically cumulative
  institutions may have 70 exclusion tax
  consideration
• Common Stocks

9
Stock Index

• Price-Weighted Indice Dow Jones Industrial Index
  (DJIA), 30 stocks.Suppose two stocks, their
  prices are 25 and 100 Index
  (25100)/divisorSince there is 2 stocks,
  divisor2Index (25100)/2 62.5If
  (1) the new price of first one is 30 and the
  second stock undertakes 2/1 split and its new
  price is 45, thenNew Divisor (2550)/62.5
  1.25New Index (3045)/1.25 62.5 (same!)
• Value-Weighted Index e.g., SP 500

10

• Bond Indexes there are many bond indexes, such
  as Lehman Brothers, andIbbotson that indicate
  overall bond marketconditions.
• Other InstrumentsOptions a right to buy/sell a
  security in the futureFutures
  an obligation to buy or sell in
  the future

11
Hong Kong Money Market

• Interbank Market
• most important component of the money market in
  HK
• a short-term unsecured loans between
  deposit-taking institutions (licensed banks,
  restricted licensed banks and deposit-taking
  companies)
• maturity overnight to 12-months
• quote bid-ask spread using HIBOR (Hong Kong
  Interbank Offered Rate) as a reference rate
• its liquidity is influenced by Hong Kong Monetary
  Authority (HKMA)

12

• when HK is under pressure to depreciate from the
  7.8/US, HKMA will raise the interbank rate to
  induce more dollars to interbank market.
• Repo Market
• HKMA provides a discount window called the
  Liquidity Adjustment Facility (LAF) for banks
  between 400-500 pm, i.e., after the close of
  the interbank market
• banks sell securities at discount to HKMA and
  repurchasing back next day.
• Two types of securities are acceptable in
• in the repo market (1) securities issued by the
  statutory bodies, such as Mass Transit Railway
  Corporation and Provisional Airport Authority,
  (2) Securities that arenot lower than A- (SPs)
  or A3 (Moodys) if issued by banks, and not lower
  than A (SPs) or A2 (Moodys) issued by non-banks

13

• Exchange Fund Market
• exchange fund bill (short-term) started in 1990
  and later managed by HKMA
• its maturity 91-day, 182-day, and 364-day
• size HK1.5b, 1b and 0.5 b
• Exchange Fund Notes are longer-maturity with 2-y,
  3-y, 5-y, and 7-yr
• Commercial Paper (CP)
• short-term, 30-days to 1-yr
• unsecured and mainly primary market
• Firms only issued CP if highly rated by rating
  agencies (SP, Moody)
• minimum size, HK500,000, institutional
  participants in the market
• Negotiable CD
• large denominations in HKD (70) andforeign
  currencies
• most in 3-year maturity, primary market

14

• Bankers Acceptance
• largely denominated in foreign currencywith 10
  in HK
• 3-6 months maturity, which is the timefor
  shipment and settlement of goods
• lenders are largely banks and deposit-taking
  companies
• the rate is typically below HIBOR