FIN221: Lecture One Notes
Chapters 1, 2, and 3
Objectives
• To understand the investments field as
currently practiced
• To help you make investment decisions
that will enhance your economic welfare
• To create realistic expectations about the
outcome of investment decisions
Why Study Investments?
• Most individuals make investment
decisions sometime
– Need sound framework for managing and
increasing wealth
• Essential part of a career in the field
– Security analyst, portfolio manager, registered
representative, Certified Financial Planner,
Chartered Financial Analyst
Understanding Investments
Chapter 1
Charles P. Jones, Investments: Analysis and Management,
Eighth Edition, John Wiley & Sons
Prepared by
G.D. Koppenhaver, Iowa State University
Investments Defined
• Investments is the study of the process of
committing funds to one or more assets
– Emphasis on holding financial assets and
marketable securities
– Concepts also apply to real assets
– Foreign financial assets should not be ignored
Investment Decisions
• Underlying investment decisions: the
tradeoff between expected return and risk
– Expected return is not usually the same as
realized return
• Risk: the possibility that the realized return
will be different than the expected return
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 The Tradeoff The Investment Decision
Between ER and Risk Process
• Investors manage • Two-step process:
risk at a cost - – Security analysis and valuation
lower expected Stocks • Necessary to understand security characteristics
returns (ER) ER – Portfolio management
Bonds • Selected securities viewed as a single unit
• Any level of
• How and when should it be revised?
expected return
• How should portfolio performance be measured?
and risk can be
Risk-free Rate
attained
Risk

Factors Affecting the Process The Rise of the Internet

• Uncertainty in ex post returns dominates • Revolutionized the flow of investment
decision process information
– Future unknown and must be estimated • Dramatically lowered commission rates for
• Foreign financial assets: opportunity to individual investors
enhance return or reduce risk
• Institutional investors important
• How efficient are financial markets in
processing new information?

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CHAPTER 2
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 ORGANIZATION
• DIRECT INVESTING
• Debt Securities
• Equity Securities
• Other Securities
MONEY MARKET SECURITIES
• INDIRECT • Treasury Bills
INVESTING
• Negotiable Certificates of Deposit
• Commercial Paper
• Investment
Companies • Repurchase Agreements
– Mutual Funds • Bankers’ Acceptances
– Closed-end Funds
• others
– Unit Investment Trusts
• Exchange- Traded
Funds ( ETFs)

DEBT SECURITIES TYPES OF BONDS

• Money Market • Capital Markets • Federal government • Default free
– short maturities – maturities greater than • Government • some part of
– high quality one year Agencies government, some
– large denominations – range of quality as not
measured by bond
– pays current going • generally exempt
ratings • Municipals
rates for short-term
– various characteristics from federal taxes
securities
as to callability, tax • need taxable
status, retirement of equivalent yield
debt, secured or not
• Corporates
• are rated by rating
agencies

ASSET-BACKED SECURITIES EQUITY SECURITIES

• Securitization--the transformation of
illiquid, risky individual loans into more
liquid, less risky securites produces Asset-
Backed Securities
• Many different types of loans have been
transformed--mortgages, credit card
receivables, boat receivables, etc.
• higher risk, higher return
• Equity securities represent ownership,
while debt securities are creditor
instruments
• Two types of equity securities
– common stock--the basic ownership of the
corporation
– preferred stock--technically an equity security;
it has no maturity debt although it may be
retired by call, convertibility, etc.

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 PREFERRED STOCK
• Hybrid Security
– like common stock, has no maturity date
– like a bond, pays a fixed dividend
• Relatively small supply--therefore,
relatively unimportant
• Dividends on the preferred are not
deductible for the corporation
• Most investors treat it as a substitute for
bonds
COMMON STOCKHOLDERS
• Stockholders can benefit directly from a
common stock in only two ways:
– dividends--the cash payments of the
corporation. A firm has no obligation.
Dividends can be raised, lowered, or
suspended
– price change--the difference between
purchase price and sale price. This can be +,
-, or 0
– therefore, stock returns can be positive,
negative or zero
IMPORTANT TERMS WITH
STOCKS
• Dividend Yield--annual dividend divided by
current stock price
• Payout Ratio--the ratio of dividends to
earnings (the percentage of earnings paid
out as dividends)
• P/E Ratio--the number of times earnings
that investors are willing to pay for a stock,
used in valuation of stocks
COMMON STOCK
• Represents the ownership of the
corporation
• Stockholders are the residual claimant--
they get what is left after the bondholders
and preferred stockholders have been
paid
• Therefore, payoffs can be large or small
• Risk is large because of the uncertain
payoffs
A NOTE ON DIVIDENDS
• Dividend yield (dividend divided by price)
is one of the two components of Total
Return for stockholders
• Dividend yield on the S&P 500 is at an all-
time low (1870-2000) of about 1.4%
• If the dividend yield remains this low, and
stockholders expect to receive the same
Total Returns, how can this happen?
OTHER SECURITIES
• Derivative Securities derive their value
from their connected underlying securities
– Options--typically, puts and calls; the right but
not the obligation to buy or sell an asset
– Futures Contracts--available for financial
assets; carry an obligation to act, but can be
offset by taking the opposite position
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 PUTS AND CALLS
• Call--the right to buy 100 shares of an
asset at a stated price within a stated time
• Put--the right to sell 100 shares of an
asset at a stated price within a stated time
• These options have short maturities of up
to a few months--therefore, they are
wasting assets
• LEAPs have longer maturities, up to three
years
FUTURES CONTRACTS
• Available on commodities and on financial
assets
• They are agreements providing for the
future exchange of a particular asset
between buyer and seller
• Margin must be put up to ensure
performance--a small percentage of the
value of the contract
CHAPTER 3
INVESTMENT COMPANIES
PUTS AND CALLS
• Puts and Calls are bought by investors
who think prices will move in a certain
direction, and are sold by investors with
opposite beliefs
• The premium is paid by the buyer, and
received by the seller. Both pay
brokerage costs
• Options trade on organized exchanges
FUTURES CONTRACTS
• Are standarized and trade on organized
exchanges
• Most are not exercised--they are “offset”
by taking the opposite position
• Most participants are either hedgers or
speculators
– hedging--seek to reduce price uncertainty
– speculate--seek to profit from the uncertainty
HOUSEHOLDS
• Households have opted more and more
for indirect investing
– in pension fund assets
– in investment companies, primarily mutual
funds
• Indirect investing involves turning one’s
funds over to an intermediary to invest
• Investors can invest directly, invest
indirectly, or do a combination
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INVESTMENT COMPANIES
• Definition--a financial services
organization that sells shares in itself and
uses the funds to invest in a portfolio of
securites
• Three types:
– open-end investment companies --mutual
funds
– closed-end investment companies
– unit investment trusts
CLOSED-END INVESTMENT
COMPANIES
• Trade on Exchanges like other stocks
• Are relatively few in number, with relatively
small total assets
• Include various types of equity and bond
funds
• Almost always sell at discounts and
premiums rather than at NAV per share

MAJOR TYPES OF MUTUAL

MUTUAL FUNDS
• Technically, mutual funds are open-end
investment companies because the
number of its own shares outstanding is
constantly changing
• Investors buy from and sell back to the
investment company itself
• As of August, 2001 there were about 8300
mutual funds in the United States
FUNDS
• Money Market Funds--invest in money
market securities such as Treasury bills,
commercial paper, and negotiable CDs
• Equity and Bond & Income Funds--invest
in portfolios of stocks or bonds, or in the
case of balanced funds, both. There are
various types of stock funds as well as
bond funds (short or long-term, taxable or
not)

NET ASSET VALUE SALES CHARGES

• Each investment company has a Net NO-LOAD LOW LOAD LOAD
Asset Value (NAV) per share
• It is calculated as the value of the no sales low sales sales charge
securities in the portfolio, less any charge charge, such currently,
liabilities, divided by the number of shares as 2-3% maximum of 5
of the fund outstanding to 6%
• Therefore, it is the per share value of the
portfolio of securities

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 ADDITIONAL COSTS
• The load fee is the sales charge, primarily
used to compensate the sales force
• The fund may charge a 12b-1 fee, as
much as 1% of assets annually, to cover
distribution costs
• Class B and Class C shares can carry a
redemption fee
OPERATING EXPENSE RATIO
• Unless waived for marketing reasons, all
funds charge an annual operating expense
for managing the fund.
• This cost is calculated as a percentage of
average assets under management
• The average for equity funds is about
1.4%, for bond funds perhaps 1%, and for
money market funds less than 1%
INDEX FUNDS
• Index Funds are designed to replicate
some market index or benchmark, with no
active management
• Costs are very low because no research
or active management is needed
• Vanguard’s Index 500 fund is now the
largest mutual fund in the United States
SHARE CLASSES
• Many funds have at least three classes of
shares, referred to as A, B and C
• A shares are the “norm,” carrying a load fee
• B shares carry no load, but have a redemption
charge that declines over 5 or 6 years for
investors redeeming shares early
• C shares have a redemption charge for one year
but an annual 12b-1 fee of maybe 1%
MEASURING FUND
PERFORMANCE
• Cumulative Total Return measures the
actual cumulative performance over some
period of time, such as 3, 5 or 10 years
• Average Annual Return is the compound
rate that if achieved annually would have
produced the same cumulative total return
(this is a compound annual return, not the
actual returns of the fund each year)
FUND PERFORMANCE
• Fund performance has been often debated
as to consistency and actual results
• Many comparisons indicate that a majority
of mutual funds do not outperform the
proper benchmark such as the S&P 500
• Given an annual average expense ratio of
1.4%, equity funds must earn more than
that plus the benchmark return to add
value
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 INVESTING
FUND SUPERMARKETS
INTERNATIONALLY
• International funds concentrate primarily • Some large brokerage firms like Schwab
on international stocks and Fidelity offer fund “supermarkets.”
• Global funds keep a significant portion of • Investors can buy a variety of funds
assets in U. S. stocks through their brokerage accounts,
• Single-country funds concentrate on the meaning they do it all in one account.
securities of a single country
• Investing internationally exposes investors
to currency risk (exchange-rate risk)