Summary of book Investments

An investment is the current commitment of money or other resources in the expectation of reaping
future benefits. Basically, you sacrifice something of value now, expecting to reap the benefits later.

1.1 Real Assets vs Financial Assets

Real Assets: land, buildings, etc.

Financial Assets: stocks, bonds, etc.

In well-developed countries, people use financial assets as claims to the income generated by real
assets. National wealth consists only of real assets.

1.2 Financial Assets

Three types of financial assets are fixed income, equity, and derivatives.

Fixed income promise either a fixed payment or based on a specific formula. Ex, corporate bond that
yields fixed interest and floating rate bonds.

Derivative securities such as options and futures contracts provide payoffs that are determined by
the prices of other assets such as bond or stock prices. The Call option gives the right to buy an asset
at a predetermined price within a specified time, it is used when the price of the asset is expected to
rise, basically buy low sell high. The put option gives the buyer the right to sell an asset at a
predetermined price within a specified time, use it when expecting the price of the asset to fall.
Basically, sell high, buy low.

1.3 Financial Markets and the Economy

This section emphasizes the crucial roles financial assets and markets play in developed economies,
despite real assets determining wealth. The informational role of financial markets is highlighted,
with stock prices reflecting investors' assessment of a firm's performance and future prospects. This
assessment influences capital allocation, directing funds to firms with perceived potential.

Financial markets enable the timing of consumption by allowing individuals to invest during high-
earning periods and sell assets during low-earning periods. This facilitates the shifting of
consumption over a lifetime, aligning with satisfaction.

The allocation of risk is discussed, emphasizing how financial markets enable investors to bear risk
according to their preferences. This benefits firms in need of capital, allowing them to attract funds
from risk-tolerant investors.

The separation of ownership and management is crucial in large firms. Financial markets, through
buying and selling financial assets, allow for this separation, providing stability and facilitating easy
transfer of ownership. This also creates agency problems.

Corporate governance and ethics are addressed, acknowledging past scandals that highlighted flaws
in transparency and incentives. The text explores mechanisms like compensation plans, boards of
directors, and the threat of takeovers as means to mitigate agency problems. The Sarbanes-Oxley Act
of 2002 is mentioned as a response to ethics scandals, introducing rules to enhance corporate
governance and disclosure.

1.4 The Investment Process

Investors manage portfolios, collections of investment assets, through processes like rebalancing -
selling, and buying. Asset allocation decisions involve choosing broad asset classes (stocks, bonds,
etc.), while security selection involves choosing specific securities within each class.

Two portfolio construction strategies are highlighted:

Top-down starts with asset allocation decisions (ex, how would an individual decide the proportion
of the portfolio. In this case, the assets chosen have a reason why they are chosen.

Bottom-up focuses on attractive securities without strict asset allocation concerns. Which means
that investors pick the assets based on what they like or prefer.

1.5 Markets Are Competitive

Efficient markets
In fully efficient markets when prices quickly adjust to all relevant information, there should be
neither underpriced nor overpriced securities.

Risk-return trade-off
Higher-risk assets are priced to offer higher expected returns than lower-risk assets.

Three major players in financial markets are identified:

- Firms (net demanders of capital)

- Households (net suppliers of capital)
- Governments

Financial intermediaries, like banks and investment companies, connect suppliers and demanders of
capital. Economies of scale and specialization create profit opportunities for financial intermediaries,
offering advantages such as diversification and risk assessment.
 How securities are traded – Chapter 3
The Marketplace

Primary market- for newly issued securities.

Secondary market – trades in existing securities

A privately held firm is owned by a relatively small number of shareholders. They don’t have to
disclose information, and as they don’t have to give quarterly earnings announcements they can aim
for longer-term goals.

When a private firm goes public to raise capital, it goes to the initial public offering (IPO), then it
issues shares.

Types of markets:

1) Brokered markets – Markets where brokers act as intermediaries.

2) Dealer markets – When trading activity of a particular assets increases, this market rises.
This is where investors can sell and buy assets under the bid-ask prices to create profit.
3) Auction markets – The NYSE is an example of auction market, in which all traders converge
at one place to buy or sell an asset.
4) Direct search – where buyers and sellers seek each other.

In the bid-ask spread (market

order) – in the market order
you buy or sell immediately at
current market prices. In the
following picture, the buyer
would purchase the stock at
the best ask, which Is 1006.80,
and if he whishes to sell it
afterwards he would receive
1006.40 for it.

Price-contingent order – here, investors also may place

orders specifying prices at which they are willing to buy or
sell a security. The stop-loss is to sell when a limit is met
and stop-buy is to buy when a certain price is reached.
Buying and selling on the marketplace margin.

Normal trading occurs with a cash account or margin account.

To buy on margin the investor borrows a percentage of the stock price from the broker. When
purchasing securities, investors have easy access to a source of debt financing called “Broker’s call
loans”. Taking advantage of these loans is called buying on margin. Purchasing stocks on margin
means the investor borrows part of the purchase price from the broker. The broker then borrows the
money from banks at the current rate, then they charge their clients that rate plus a service charge.
The limit of the margin requirement is 50%, meaning that at least 50% of the purchase price must be
paid for in cash, with the rest borrowed.

Example:

In here we have a
60% margin at the
beginning.
Declining price of
stock after time, it
will reduce the %
of the margin. If it
increases, it will
increase the % of
the margin. When
it decreases, the
broker (who took
the loan) will want
to be sure that he
will get paid, and
that he will not
incur a loss. He will
then establish a
maintenance
margin, which is
reached when the
price of the stock
decreases and the
equity % is low
enough to be close
to create a loss.
Thus, he will ask the investor to pump more cash (margin call), or if the investor refuses, he would
sell the securities to pay the loan and get his cut. Let’s say that the maintenance margin is 30%. How
far down should the price of the stock be to do the margin call?

Where: P is the price (unknown), 4000 = loan, 100 = previous price.

P = $57.14, thus, if the price falls below that number, the investor will
receive a margin call.
 Buying and selling on the market place – short sales
Short sales – you sell and then you buy shares. You will always begin and end with no shares.

A Short sale allows investors to profit form a decline in security’s price. Here, investor borrows a
share of stock from a broker and sells it. Later, the short-seller must purchase a share of the same
stock in order to replace the one that was borrowed. This is called covering the short position.

Normal purchase of stock, is that at

time = 0 you get the share and at
t=1 you receive its dividend and sell
it.

Profit there

In the case of short sale you borrow

share and sell it at t=0, then at t=1,
you buy the share back. The profit
of it is initial price – (ending price +
dividend). Remember dividend.

Risk, return, and the historical record

Expected return when performing scenario analysis, which is when we organize our beliefs about
possible outcomes by positing various economic scenarios as well as their probabilities.

here we are looking at the future:

p(s) = probability of a state

r(s) = return if a state occurs

s = state
 Holding Period Returns

*Always use total return (price + dividend)*

The geometric (Time-weighted) Average Return

Actual return on time series is called geometric rate or return = g (or compound rate of return).

Lets say year 1 = +25% and year 2 = - 25%. What is the average return here?

Saying that the price in y1 is = 100, we have 100*(1+0.25) = 125 after year 1. Then, after year two we
have: 125*(1 – 0.25) = 93.75.

we have the Terminal Value (TVn) and “g” the geometric average :

average realized returns for multiple investment in one period: suppose we have two investments in
one year where one would earn 25% and the other -25%. What is the average return?

Time-weighted average returns vs dollar-weighted returns

Dollar weighted return:
 Risk variance (or dispersion) of returns.
Variance =

Risk often denoted by standard deviation 𝜎 which equals (Variance)^1/2

Risk and return integrated – Sharpe ratio (S)

S = Risk premium / Risk of excess return

p = portfolio

f = risk free asset

The sharpe ratio divides average portfolio excess return over the sample period by standard
deviation of returns over that period. It measures the reward to total volatility trade-off.

Important:

When having in hundreds use 100P. when having

thousands use 1000P, etc.
 Weekly exercises

a) A fixed salary is independent from firm’s success. Thus, the compensation for the
performance of the company is not rewarded. This can make the manager not compelled to
work hard and maximize firm value. The good part would be that it is a stable salary and the
manager can value it more.
b) As the manager becomes a stock holder, his probable aim would be to increase the value of
the stock as much as possible. Aligning his aim with the one of the owners’. The problem
arises when the stock compensation is overdone as the manager might view it as overly risky
since the manager’s career is already linked to the firm and this is undiversified exposure.
c) A profit-linked salary creates great incentives for managers to contribute to the firm’s
success. However, a manager whose salary is tied to short-term profits will be risk seeking,
especially if these short-term profits determine salary or if the compensation structure does
not bear the full cost of the project’s risks (e.g., docked pay for failed projects). Shareholders,
in contrast, bear the losses as well as the gains on the project and might be less willing to
assume that risk.

If you own a small part of a company (10k), saying Ford, and you want ot increase value by 5%, your
benefit would only be $500, which is too low. In contrast, if a large entity saying a bank, lends money
to Ford (100m), they would invest money to make sure that Ford is doing the right thing to be able to
payback the loan and the interests.

T bills are risk-free investments and are high in liquidity. The higher return on the stocks is due to the
risk you infer when purchasing it.
Traders will increase willingness to make risky decisions because it pays off more. This is moral
hazard – where the owners suffer gains and losses, and traders suffer losses way less, as they can
lose their job only.

A limit buy order is an order that purchases stock if the price falls below a determined value.

Limit sell order is to sell the stock when the prices reaches a determined value.

Market order is to either buy or sell order that is executed immediately at current price.

The use of leverage necessarily magnifies returns to investors. Leveraging borrowed money allows
for greater return on investment if the stock price increases. However, if the stock price declines, the
investor must repay the loan, regardless of how far the stock price drops and incur a negative rate of
return. For example, if an investor buys an asset at $100 and the price rises to $110, the investor
earns 10%.

If an investor takes out a $40 loan (thus $60 margin) at 5% and buys the same stock, the return will
be 13.3%:

Of course, if the stock price falls below $100, the negative return will be greater for the leveraged
account. For example, if the price falls 10% to $90:

Conclusion, the impact of leveraged investments is higher, regardless if they are positive or negative.
 a. The stock is purchased for: 300  $40 = $12,000. The amount borrowed is $4,000. Therefore,
the investor put up equity, or margin, of $8,000.
The margin = 8,000/12,000 = 66.66%

b. As the price fell to $30, the total value of the stock is now $9,000 = 12,000 * 𝛥𝑃. The loan
has interest and by the end of the year the loan amount is $4,000  1.08(int rate) = $4,320.
Therefore, the remaining margin in the investor’s account is: $9,000 − $4,320 = $4,680
Margin = 9,000-4,320/9,000 = 52%

c. Margin call (maintenance margin) = (Pt=0 *Pt=1 – Loan)/(Pt=0 * Pt=1) and clear Pt=1.
The percentage margin is now: $4,680/$9,000 = 0.52, or 52% > 30%. Therefore, the investor
will not receive a margin call.

d. The rate of return on the investment is: (Ending equity – initial equity):
4,680 – 8,000 = -41.5%. Alternatively, sum the loss and interest generated over the initial
equity: ($3,000 loss + $320 interest) /$8,000 = −0.415.

7.

1,000 shares at $40 = $40,000. 1,000 shares at $50 = $50,000. 1,000 shares paying $2 dividend each
= $2,000.

a) The initial margin was: 0.50 * 1,000 (shares) * $40 (Price) = $20,000.

a. The initial margin was $20,000 As a result of the increase in the stock price, Old Economy Traders
loses: $10  1,000 = $10,000 Margin decreases by $10,000. Old Economy Traders must pay the
dividend of $2 per share to the lender of the shares; the margin in the account decreases by an
additional $2,000. Therefore, the remaining margin is: $20,000 − $10,000 − $2,000 = $8,000
b. To receive the margin call the margin % must be under 30%. The percentage margin is:
$8,000/$50,000 = 0.16 or 16% < 30% There will be a margin call.

The $50,000 are from the actual value of the stocks. Thus, $50 * 1000. Not from $40 as we must take
into account the time and price change.

c. The equity in the account decreased from $20,000 to $8,000 in 1 year, for a rate of return of:

(old value of equity – new value of equity – dividend * shares)/equity (initial investment)

Data:

- $50 a share
- 100 shares
a) You must put: (50 – x)/50 = 0.50 → clear x = 25 * number of shares = $2,500
b) With a 30% maintenance margin, the price would have to increase up to:

Maintenance margin, which is reached when the price of the stock decreases and the equity % is
low enough to be close to create a loss. This margin’s formula is:

The value of the shares = $50 * 100 = $5,000. You give the broker $2,500 as need in the initial
margin requirement of 50%. So, total assets are: $7,500. To find how high the price should go
you must put it in a formula as variable and 2 numbers that are equal (on denominator and
nominator) to find that point. You also must equal that function to 30% and solve for “P”. Thus,
we have:

Then P = $57.69, which is how high the stock price can go before you get a margin call.
Data:

- $20 per share

- You buy 1,000 shares using $15,000 of your money. Borrowing $5,000 from your broker.
- Rate on loan is 8%.

If the price changes to:

i) $22 – you gain 22 – 20 = $2 per share. 2 * 1,000 = $2,000 increase in equity. The percentage
increase is taken from having two equal numbers (one denominator, one nominator) in this
case those are $15,000 (equity investment), and on nominator $17,000 which is new value of
equity.
17 – 15 / 15 = 0.13333 v 13.33%.

ii) if it goes to $20, nothing changes.

iii) to $18, it would be 18 – 20 = -$2 per share. -2 * 1,000 = -2,000. repeating same process:
13 – 15 / 15 = -13.33%

B) The maintenance margin being 25% the down-limit of the stock price would be:

Where x = $5,000 (loan), y = 0.25

$6.67 because there is more equity than usual.

C) If equity would have been $10,000 then the Price for the margin call would be higher:
The rate of return is determined by summing/subtracting the amount of shares (in dollars) that you
bought, minus the loan taking into account the interests generated, minus equity and all of that over
equity. This means:

Investment – loan+interest – equity / equity

E) Right before getting a margin call at 25% - LOW - the price of the stock would be:

(1000P – 5400)/1000P = 0.25

P = $7.20 or lower

Note that the change is because we add the interests to the loan amount.

a) $55.50, the highest price because you are buying.

b) $55.25, the lowest price because you are selling.
c) Limit sell order is to sell the stock when the price reaches a determined value.
Therefore, at $55.62 nothing will happen because 55.50 is not enough, the bid price is lower
than the price specified I the limit-sell order.
d) A limit buy order is an order that purchases stock if the price falls below a determined value.
Thus, the trade will not happen cause the asked price is greater than the price specified in
the limit-buy order.
 HPR

First, get the expected return of the three scenarios (mean rate return) →

Then compute the variance →

𝜎^2 = 651.175 → 𝜎 = 25.52 = 25.52%

Chapter 24 exercises

The IRR (dollar-weighted return) cannot be ranked relative to either the geometric average
return (time-weighted return) or the arithmetic average return. Under some conditions, the IRR
is greater than each of the other two averages or the IRR can also be less than each of the other
averages. Several scenarios illustrate this conclusion. Consider a scenario where the rate of
return each period consistently increases over several time periods. If the amount invested also
increases each period, then all the proceeds are withdrawn at the end of several periods; the IRR
is greater than either the geometric or arithmetic average since more money is invested at the
higher rates than at the lower rates. If withdrawals gradually reduce the amount invested as the
rate of return increases, then the IRR is less than the other averages. Numerical examples in the
text illustrate scenarios where the geometric average exceeds the IRR, and, in Concept Check 1,
where the IRR exceeds the geometric average (although the solutions to this concept check
focused on arithmetic average rather than the geometric average.).

a) The arithmetic average return on the stocks is when you sum them all and divide all by the
number of stocks.

r(ABC) = (20+12+14+3+1)/5 = 10%

r(XYZ) = (30+12+18+0+(-10) = 10%

b) Dispersion is measured as standard deviation. You can get the standard deviation by getting
the variance 𝜎2, and then rooting it.
ABC = [(20-10)^2 + (12-10)^2 + (14-10)^2 + (3-10)^2 + (1-10)^2]/5 = 50 → √50 = 7.07%
Same for XYZ = 15.56%
7<15% Thus, stock XYZ has a higher level of dispersion around the mean return.
c)

If you need to get the geometric average:

1) Get TVn
2) Get g

1)
 d) 10%
e) Even though the dispersion is greater, your expected rate of return would
still be the arithmetic average or 10%.
f) In terms of “forward-looking” statistics, the arithmetic average is the better estimate of
expected rate of return. Therefore, if the data reflect the probabilities of future returns, 10%
is the expected rate of return for both stocks.

Then compute the arithmetic mean & the geometric mean:

b)

Check this in class

a) Summarize the HPR (holding period return) to be able to get the geometric average:
HPR on year 1 = 11.11%
HPR on year 2 = 0%
HPR on year 3 = 0%

b)

c)