Chapter 13

THE INVESTMENT SETTING

Chapter 1 Questions
What is an investment ? What key issues should investors always consider? What types of investments can one make?

What is an investment ?
An investment is the current commitment of resources for a period of time in the expectation of receiving future resources greater than the current outlay.

What is an investment ?
Is hiding money in a mattress or keeping it in a piggy bank an investment ? No! The safekeeping of money does not involve any expected compensation.

WHY DO WE INVEST ? (JONES)

To improve our welfare To manage our wealth effectively

REASONS FOR INVESTING (Reilly and Norton)

Income: investments are made in the hopes of generating income. Capital preservation: investments are made with the goal of preserving capital, or the original value. Capital appreciation: investments are made so that funds will appreciate, or grow in value, to provide for a future need such as retirement or childrens college education.

Issues That Investors Should Always Consider

There is a trade-off between risk and expected return. Developed financial markets are nearly efficient. Focus on after-tax returns, net of expenses. Diversify across asset types, industries, and even countries.

Risk-Return Trade-Off
Because investors tend to be risk averse, it makes sense that they will only take on riskier investments if they expect to earn more than with lower risk investments.

Market Efficiency
An efficient market is one where

Information is quickly and accurately reflected in asset prices, What appears to be news is not useful in predicting future asset prices,

So

With the result that

Investors cannot systematically and consistently beat the market without the aid of either inside information or loads of luck.

Implications of Market Efficiency

Its what is unexpected that moves the market (the genuinely new information in news). We should be skeptical of investment strategies that claim to be able to beat the market on a consistent basis.

The Paradox of Market Efficiency

If markets are perfectly efficient, it makes no sense to seek out superior investments. But if nobody seeks out superior investments, the market would not remain efficient!

Take Taxes and Expenses Into Account

Its what you get to keep that counts! Taxes affect investment decisions

Some allow for lower or no tax burden (Municipal bonds)

Diversify, Diversify, Diversify

Dont put all of your eggs in one basket! Diversification reduces risk without necessarily sacrificing expected return. Its a no-brainer!

Real assets vs. Financial assets

What types of investments can one make?

Tangible assets vs. Claims on assets Individual securities vs. pools of assets Futures, options

Direct vs. Indirect financial investments

Derivatives

TYPES OF INVESTMENTS
Real Assets Investments
Financial Assets

Investor

II

Persh. Investasi

DI

Aset-Aset Finansial

DI

Financial Markets
Traditional Financial Markets
(Short-term) Money Market T-Bills CD CP BA Repos/Reverses Federal funds LIBOR market T-Notes/Bonds Municipal bonds Corporate Bonds ABS/MBS

Financial Markets

(Long-term) Capital Market

Bonds

Stocks

Derivatives Foreign Exchange Market

Forward Futures Option Swap

Whole sales market Retail market

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Performance by market sectors

17

Risk vs. Return by market sectors

18

Stock Indexes

Represent the performance of the stock market as a whole, e.g., DJIA, S&P500, Wilshire 5000, etc.
Useful to track average returns of the stock market Useful as a benchmark for the performance of fund managers Used as base of derivatives

Many kinds of stock indexes exist

Representative? Broad or narrow? How is it weighted? Price-weighted index Dow Jones Industrial Average (30 blue-chip stocks) Market value-weighted index Standard & Poors 500, NASDAQ Composite, Wilshire 5000 Equally weighted index Value Line Index
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Basic Investment Philosophies

In forming an investment portfolio, several questions are paramount: In what types of securities should I invest?

Asset Allocation

Within each security type, how do I select which assets to purchase?

Security Selection

Finally, how active should I manage my portfolio?

Should I be an active or passive investor?

Ethics in Investments
Financial markets are vitally important to a well-functioning economy. Trust in information and faith in fairness are essential. Codes of ethics for financial professionals and strict regulations attempt to create such an environment where financial markets can efficiently fulfill their economic function.

Jobs in Investments
Sales

Registered representative of a brokerage firm Financial planners

Investment Analysis and Portfolio Management

Brokerage firms, banks, money managers, mutual fund managers, insurance companies Chartered Financial Analyst (CFA) Certified Financial Planner (CFP)

Professional Designations

How firms issue securities?

Primary Markets
New securities are issued to the public
For stocks
Initial public offerings (IPO) Seasoned equity offerings (SEO)

For bonds
Public offering Private placement

Issuer receives the proceeds from the sale

Secondary Markets
Subsequent trading occurs, where existing owners sell to another party Issuing firm is not directly involved
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How Firms Issue Securities

Investment Banking Shelf Registration Private Placements Initial Public Offerings (IPOs)

Investment Banking (IB)

IBs are specialized in advising and marketing public offerings of stocks or bonds, and are called underwriters
An underwriting syndicate is formed to share the responsibility of large offerings

IBs provide services such as valuation, marketing plan, roadshow, bookbuilding, pricing, allocation, and price support in aftermarkets
IBs tend to offer a bargain price to induce potential investors to submit their interest in the bookbuilding process This tendency commonly causes underpricing of IPOs, which is reflected in price jumps occurring on the first date of trading (New Issue Puzzle)

Besides underwriting fees of about 7%, such underpricing is an implicit cost to the issuing firm
Highly expensive for small firms, and internet IPOs introduced
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Investment Banking Arrangements

Underwritten vs. Best Efforts
Underwritten: firm commitment on proceeds to the issuing firm Best Efforts: no firm commitment

Negotiated vs. Competitive Bid

Negotiated: issuing firm negotiates terms with investment banker Competitive bid: issuer structures the offering and secures bids

Figure 3.1 Relationship Among a Firm Issuing Securities, the Underwriters and the Public

Shelf Registrations
SEC Rule 415 Introduced in 1982 Ready to be issued on the shelf

Private Placements
Private placement: sale to a limited number of sophisticated investors not requiring the protection of registration Dominated by institutions Very active market for debt securities Not active for stock offerings

Initial Public Offerings

Process
Road shows Bookbuilding

Underpricing
Post sale returns Cost to the issuing firm

Secondary Markets
Organized exchanges OTC market Third market Fourth market

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Organized Exchanges
Auction markets with centralized order flow
NYSE, AMEX, and regional exchanges Listing requirements

Dealership function by Specialists at NYSE

Have exclusive right to make the market in a specified stock on the NYSE Must maintain a fair and orderly market Can be competitive or assigned by the exchange

Traded securities:
stock, bonds, futures, options contracts
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OTC Market
An informal exchange of brokers and dealers negotiating trades, without centralized order flow NASDAQ: largest OTC market since 1971

Computer-linked system providing information on dealers quotation of bid and ask prices Nasdaq National Market System Nasdaq SmallCap Market Lower volume securities OTC Bulletin Board Pink Sheets from NASD

Traded securities:

Stocks, bonds and some derivatives Most secondary bonds transactions

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Third Market
Trading of exchange-listed securities away from the exchange Institutional market, facilitating trades of larger blocks of securities Involves services of dealers and brokers

35

Fourth Market
Investors trading directly with other investors
Originally developed for institutional trading Technological developments lead to individual investors trading directly, without the need of market makers

Advent of ECN
Computer networks allowing direct trading Captures about 30% of the trading volume for NASDAQ-listed stocks in 2001 Competing with Nasdaq and NYSE for volume
Implication of future structure of stock exchanges
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How to place an order?

Instruct your broker the following order specification

Online vs. offline

Name and type of the security to trade Indicate a purchase or sale Order size round lots vs. odd lots Order type market vs. limit orders, etc. Length of time of the order

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Types of Orders
Market order
Buy or sell orders are to be executed immediately at the

best price currently available

Limit order
Specify prices at which buy or sell orders are executed

Stop-loss order
Sell stocks when price falls below a stipulated level This is to stop further losses from a long position

Stop-buy order
Buy stocks when price rises above a stipulated level This is to limit potential losses from a short position
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Costs of Trading
Brokerage commission
Fees paid to broker Full-service vs. discount broker Explicit cost of trading

Bid-ask spread: implicit cost of trading

Bid: price that a dealer is willing to buy from you Ask: price that a dealer is willing to sell to you Typically, Ask > Bid

and the difference ask bid is called as bid-ask spread, which is dealers gain for the marketmaking service
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Margin Trading
Only a portion of the investment proceed comes from your

own money
Remaining portion is borrowed from a broker

Bet on a rise in the price of the security Higher leverage, magnifying upside and downside risks Stocks purchased on margin must be maintained with the broker as collateral for the loan

Initial margin
Currently 50%, set by the Fed You can borrow up to 50% of the stock value

Maintenance margin:
Minimum amount of equity maintained in the account Margin call: call from a broker to put up more equity funds

Margin arrangements differ for stocks and futures

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Margin Trading Initial Margin

X Corp.

1,000 50% 40%

Initial Position

$70 current price Shares Purchased Initial Margin Maintenance Margin

Stock $70,000 Borrowed $35,000 Equity 35,000

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Margin Trading Maintenance Margin

If stock price falls to $60 per share,

New Position Stock $60,000

Borrowed $35,000 Equity 25,000

Margin (%) = Equity in account / Value of stock

= $25,000 / $60,000 = 41.67%

Rate of return = (25,000 35,000)/35,000 = -28.57%

Rate of return if own money of $35,000 is used to buy 500 shares

= (30,000 35,000) / 35,000 = 14.28%

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Margin Trading Margin Call

How far can the stock price fall before getting a

margin call?
Margin (%) = Equity in account / Value of stock = (1,000P - $35,000) / 1,000P = 40%

P = $58.33
If stock price falls below $58.33, one gets a margin call

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Short Sales
Opposite case of the margin purchase, i.e., only a portion of

the securities are supplied by the seller

Remaining portion of the securities are borrowed from a broker

Bet on a decline in the price of the security Higher leverage, magnifying upside and downside risks The proceeds from the short sale must be maintained with the broker as collateral

Mechanics
Borrow stocks from a broker Sell it, and deposit the proceeds and margin money in an account Close out the position by buying the stock and returning it to the lender

Short-seller must pay any dividends paid during the short sale to the

lender of the stock

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Struktur Pasar Modal Indonesia

Bapepam ( Badan Pengawas Pasar Modal ) Melakukan pembinaan, pengaturan dan pengawasan harian kegiatan pasar modal, dgn tujuan mewujudkan terciptanya kegiatan pasar modal yang teratur, wajar dan efisien

Bursa Efek Jakarta (BEJ) Pertama kali berdiri, Bapepam sbg pengelola Setelah itu diserahkan kepada lembaga swasta PT. BEJ Sekarang menggunakan Jakarta Automated Trading System (JATS), sistem perdagangan efek berbasis komputer. Tiga bentuk pasar dalam BEJ: 1. Pasar reguler: sistem tawar menawar, jumlah minimal 500 lembar ( 1 lot )

2. Pasar Non Reguler Sistem negoisasi dibedakan dlm 4 jenis: a. Perdagangan block sale: minimal 200 ribu saham/ 400 lot b. Perdagangan odd lot: kurang dari 500 lembar c. Perdagangan tutup sendiri: transaksi jual beli yg dilakukan oleh satu pialang dalam jumlah dan harga yang sama d. Perdagangan porsi asing untuk saham yang porsi asingnya telah mencapai 49% 3. Pasar Tunai Negoisasi langsung dgn tunai. Diperuntukkan bagi pialang yang gagal menyelesaikan transaksi pada pasar reguler atau non reguler

PT. Kliring Deposit Efek Indonesia

Berfungsi untuk merancang,

mengembangkan dan mengoperasikan mekanisme kliring dan penyelesaian transaksi efek (settlement, penyerahan barang/uang) sehingga aktifitas dapat efisien.

Lembaga Penunjang Pasar Modal

1.
2. 3.

Bank Kustodian Wali Amanat Biro Administrasi Efek

Profesi Penunjang Pasar Modal

1.
2. 3.

4.

Akuntan Publik Notaris Konsultan Hukum Perusahaan penilai (appraiser)