FINA 6112 Investment and Portfolio Analysis

Course Overview

LUO Dan
Sep 4 & 5, 2024
Instructor: LUO Dan 罗丹
• Used to be a student in econ & finance for long
– Bachelor and Master in Economics from Tsinghua University
– Ph.D. in Finance from Stanford University

• A junior teacher
– Joined CUHK last summer
– Any suggestion on teaching would be very helpful!

• How to find me
– Email: danluo@cuhk.edu.hk
– Office: CYT 1236

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Course Information
• Tutor: YU Min
– Min will give tutorial sessions.
– Find her at minyu@cuhk.edu.hk or CYT 1239

• Textbook
– BD: J. Berk and P. DeMarzo 2023, Corporate Finance (6th
edition).
– BKM: Z. Bodie, A. Kane, and A.J. Marcus 2024, Investments (13th
Edition), McGraw-Hill Education International Edition.

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Assessment and Grading
• Mid-term Exam: 25%
– Written exam, covering the content of the first five lectures
– In Week 8: Oct 22 Tuesday afternoon

• Final Exam: 40%

– Written exam, covering the content of all the ten lectures, more on
the last five ones.
– In Week 13: Nov 26 Tuesday afternoon

• The program has checked that the time has no conflict with
other MSc courses.
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Assessment and Grading
• Assignments: 35%
– Excel problems, which are probably challenging but helpful to you.
– Three group assignments, one to two students per group

• Participation: only upgrades, no downgrade!

• The grade you earn depends on your performance relative

to other students taking the course.
– The final distribution of grades will be set in accordance with
departmental and school policy.
– The strictness of grading may vary with problems but must be the
same for everyone.
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Course Schedule
Week 1 Course Overview & Basics of Investments
Week 2 Time Value of Money & Risk Preference
Week 3 No Class
Week 4 Risk-return tradeoff & Diversification
Week 5 The Capital Asset Pricing Model (CAPM)
Week 6 Investor Behavior & Capital Market Efficiency
Week 7 Fixed-Income Securities
Week 8 Mid-term Exam
Week 9 Equity
Week 10 Options
Week 11 Other Derivatives
Week 12 Alternative Assets
Week 13 Final Exam

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• Congratulations on being here!
• Our program is small and selective.
• We think that you all did very well in college.

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You should know soon

• Basic statistical concepts

– Expected value, standard deviation, covariance, regression, etc.

• Basic financial concepts

– Return, risk, discount rate, cash flow, net present value, stock,
bond, etc.

• Basic economic concepts

– Preference, opportunity cost, demand, supply, GDP, inflation, etc.

• Familiarity with Microsoft Excel

– strongly recommend some self-guided Excel tutorials.

• Min will help you out during tutorials.

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FINA 6112 Investment and Portfolio Analysis

Lecture 1: Basics of Investments

LUO Dan
Sep 4 & 5, 2024
What is an investment?

• Commit current resources, and expect to reap future

benefits
– No free lunch: always one good thing for another good thing

• Examples
– Save money in banks
– Buy and hold stocks
– Do a degree at CUHK
– Have kids and nurture them

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Why do we need investments?

• Humans prefer to smooth consumption

– E.g., we need to have meals everyday!

• The endowment of resources are not naturally smooth

– E.g., humans produce more when young than when old
– E.g., you need to pay hospital bills when you get ill

• Intertemporal reallocation of resources

– Sacrifice now and get something back later
– E.g., saving

• Interstate reallocation of resources

– Sacrifice in one state and get something back in another state
– E.g., insurance
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Why are investments complicated?

• Fundamental: the future is uncertain

– E.g., how much oil underneath is unknown when an oil company
buys land.
– Information is valuable but far from fully resolving uncertainty

• Investments are risky but humans are risk-averse

– Investments involve multiple objectives: higher returns, lower risks

• There are many assets, and their natures are not simple
– What’s worse, assets are correlated!

• What others think of an investment also matters

– Need to guess others’ thoughts, even wrong ones.

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This Course: FINA 6112

• How to invest wisely in an uncertain world

– How to predict the future is also important, but not covered

• Fundamental aspects of investments

– Asset classes and financial markets
– Money allocation and portfolio construction
– Determination of the fair price of assets
– Evaluate standard assets
– Understand the functions of securities

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As an investor, we need to know

• What things we can trade

– Money Market Securities
– Bonds
– Equity Securities
– Stock and Bond Market Indexes
– Derivatives

• How to trade them

– Venues and procedures available for trading securities
– Trading mechanisms

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• Will see a lot of things probably new to you today.
• Do not worry if you could not memorize or understand
them.
• Just want to give you some initial impressions
• Hope that you can gradually understand them by
yourselves when interacting with the world.

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Money Market Securities
• Refers to very short-term debt instruments.
• Close to money, because of
– a high degree of safety
– relatively low rates of return.

• Treasury Bills (T-bills).

– Short-term debt issued by government

• Certificates of Deposit
– a time deposit with a bank that cannot be withdrawn on demand.

• Commercial paper
– Short-term debt notes, often issued by large, well-known
companies and backed by a bank line of credit

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Bond Market

• Bond market is composed of longer-term borrowing or debt

instruments than those that trade in the money market.
• Treasury notes and Treasury bonds.
– Issued by a country’s government
– Notes—maturities range up to 10 years.
– Bonds—maturities range from 10 to 30 years.

• Municipal Bonds.
– Issued by local governments
– Vary widely in maturity.

• We think that governments are usually able to repay. Why?

– Governments have the privilege to levy taxes!
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Bond Market

• Corporate bonds
– Firms borrow money directly from the public (no banks in the
middle).
– Usually pay semiannual coupons and return face value to
bondholders at maturity
– Complicated due to default risk: secured/unsecured, senior/junior.
– Can be further complicated with
§ Callable: Issuer has option to repurchase at pre-specified price.
§ Convertible: Bondholder has option to convert bond to a
prespecified number of shares of stock.

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Bond Market
• Mortgage-backed securities (MBS)
– Mortgage: a loan backed by real estate
– MBS: Ownership claim in a pool of mortgages or an obligation
that is secured by such a pool.
– Subprime mortgages: Riskier loans made to financially weaker
borrowers.
– Mortgage is probably the cheapest money ordinary people can
borrow. Do not miss it if you need to borrow.

• Asset-backed securities (ABS)

– Like MBS but the underlying asset is other than real estate.
– Student loans, credit card, equipment, automobile, etc.

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MBS Is a Huge Asset Class
• Mortgage-backed securities (MBS) outstanding

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Equity Securities: Common Stock
• Represent ownership shares in a corporation.
• Cash flow rights
– Residual claim: last in line of all who have a claim on the assets
and income of the corporation. (after most stakeholders including
creditors, employees, suppliers)
– Limited liability: shareholders can lose a maximum of their original
investment in the event of corporate failure.

• Control rights
– Each share entitles owner to one vote.
§ The power of one vote may be different for different share
classes.
– Corporation controlled by board of directors elected by
shareholders.

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Equity Securities: Preferred Stock
• A hybrid of CS and bond
– Promises to pay a fixed amount of income each year
– No contractual obligation to pay, but dividends owed accumulate.
– PS holders get repaid after bond holders and before CS holders
– PS holders have few control rights

• Some famous investors loves preferred stocks!

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Equity Securities vs. Debt

• No maturity

• No promise for any payment

• No push for bankruptcy

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Market Indexes
• The Dow Jones Industrial Average (DJIA)
– An index of 30 prominent companies listed on stock exchanges in the
United States.

• Standard & Poor’s 500 (S&P 500).

– An index of 500 largest US firms.

• Hang Seng Index (HSI)

– 66 constituent companies represent about 58% of the capitalization of the
Hong Kong Stock Exchange.

• Shanghai Stock Exchange Composite Index

– An index of all stocks that are traded at the Shanghai Stock Exchange.

• The Barclays U.S. Aggregate Bond Index

– A broad measure of the U.S. investment-grade fixed-income securities
market.

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Market Indexes
• Value-Weighted Indexes
– Average return of index stocks, weighted by value
– The most popular way: S&P 500, Hang Seng Index

• Investing in value-weighted indexes means a buy & hold

strategy weighted by market cap
– Compares today’s market cap to the initial level

å (Q
i =1
it ´ Pit ) Qit is the # of stock i outstanding at time t.
I tV = N
Pit is the price of stock i at time t.
å (Q
i =1
i0 ´ Pi 0 )

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Stock Market Indexes
• Functions of indexes
– Track how securities are doing on average
– Use as a benchmark to compare performance of managers
– Use as base of derivatives

• Nowadays, indexes become much more important

– Indexes are used to construct diversified portfolios.
– Index funds, exchange traded funds (ETF)
– Inclusion in a famous index means a lot to a stock’s liquidity and
pricing.

• Compiling indexes could be a profitable business.

– MSCI: a global provider of equity, fixed income, real estate
indexes, S&P 500 component

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Derivatives
• Derivative asset:
– A claim whose value is directly dependent on the value of an
underlying asset or assets.

• Options
– Call option: Gives holder the right to purchase an asset for a
specified price, called the exercise or strike price, on or before a
specified expiration date.
– Put option: Gives holder the right to sell an asset for a specified
exercise price on or before a specified expiration date.

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Derivatives
Expiration Strike Call Put
6-Aug-2021 280 7.74 5.18
6-Aug-2021 285 5.06 7.48
6-Aug-2021 290 3.31 10.35
17-Sep-2021 280 10.97 8.59
17-Sep-2021 285 8.45 10.79
17-Sep-2021 290 6.22 13.98

• Why are the prices in the bottom three rows always higher than the
corresponding ones in the top three rows?

• Microsoft stock price on this day was $282.51. Why do investors want to hold
– a put option with a strike price of 280
– a call option with a strike price of 290

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How Firms Issue Securities
• Firms requiring new capital can raise funds by borrowing
money or selling shares in the firm.
• Issue securities to investors
– Primary market: The market where new issues of securities are
first offered to the public.

• Trade securities after issuance

– Secondary market: The market where existing securities are
bought and sold.

• Does the secondary market matter for firms?

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How Firms Issue Securities
• Privately Held Firms
– Owned by a relatively small number of shareholders.
– Raise funds through private placement.
– Fewer obligations to release information to the public.

• Publicly Traded Companies

– Initial public offering (IPO): A private firm’s first issue of shares to
the public.
– Seasoned equity offering (SEO): The sale of additional shares by
publicly traded firms.

• Underwriters
– Advise the firm regarding the terms on which it should attempt to
sell the securities.
– Help find investors and create the market for securities
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Types of Markets
• Direct search market
– Least organized.
– Buyers and sellers seek each other out directly.

• Brokered markets
– Brokers offer search services to buyers and sellers.

• Dealer markets
– Traders specializing in particular assets buy and sell assets for
their own accounts.

• Auction markets
– All traders in an asset meet (physically or electronically) at one
place to buy and sell.

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Stock Trading
• Stocks are predominantly traded in exchanges.
• Biggest Stock Markets in the World

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Bond Trading
• Vast majority of bond trading takes place in the OTC
market among bond dealers.
– Over-the-counter (OTC) or off-exchange trading is done directly
between two parties, without the supervision of an exchange.

• Market for many bond issues is “thin” and is subject to

liquidity risk.
– One impediment to heavy electronic trading is lack of
standardization in the bond market.
– A single company may have dozens of outstanding bond issues,
differing by coupon, maturity, and seniority.

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Bid and Ask Prices
Bid Price Ask Price

• Bids are offers to buy. • Asks are offers to sell.

• In dealer markets, the bid • In dealer markets, the ask

price is the price at which the price is the price at which
dealer is willing to buy. the dealer is willing to sell.

• To sell the security, investors • Investors must pay the ask

must accept the bid price price to buy the security.

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Bid–asked spread

• Bid–ask spread is the difference between a dealer’s bid

and ask price.
– Typically, the fair price is between the bid and the ask prices.
– The bid price is always lower than the ask price.
– Why?

• Bid–ask spread is
– the margin that a dealer earns by intermediating transactions.
– Also the cost that an investor pays for doing transaction
– An indicator of market depth

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Types of Orders
• Market order
– simply buys (or sells) shares at the prevailing market prices until
the order is filled.

• Limit order
– specifies a certain price at which the order must be filled, although
there is no guarantee that some or all of the order will trade if the
limit is set too high or low.

• Stop order
– a type of market order, are triggered when a stock moves above or
below a certain level; they are often used as a way to insure
against larger losses or to lock in profits.

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New Trading Strategies
• Algorithmic trading:
– Use of computer programs to make trading decisions.
– High-frequency trading: a subset of algorithmic trading that relies
on programs to make extremely rapid decisions.

• Dark pools:
– Private trading systems where participants can buy or sell large
blocks of securities anonymously.
– Why do some investors care about anonymity that much?

• Order internalization:
– practice by brokers of matching buy and sell orders internally
rather than on exchanges.
– Brokerage captures bid–ask spread and avoids paying exchange
access fees.
– E.g., commission-free Robinhood 36
Trading Costs
• Explicit cost—brokerage commissions
– Full-service versus discount brokers.
– Execute orders, hold securities for safe-keeping, extend margin
loans, facilitate short sales, and provide information and advice
about investment alternatives.

• Implicit costs
– Dealer’s bid–ask spread.
– Price concession an investor may be forced to make for trading in
quantities greater than those associated with the posted bid or ask
price. Why?

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Short Sales
• Short sales allow investors to profit from a decline in a
security’s price.
• Mechanics

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Short Selling Example
$100 Initial Stock Price
1000 Number of Shares Shorted
Initial Position
Cash $100,000 Short $100,000

$70 Final Stock Price

1000 Number of Shares Shorted
Ending Position
Cash $100,000 Short $70,000
Close short position by buying 1000 shares @ $70, a profit of
$30,000
Who are Short Sellers?
• If you want to make money from short sales, you need to
have negative information about the company
– It is hard because the company tries to hide negative information.

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