FINS5513 Lecture 1A
Financial Instruments
and Securities Trading
❑ 1.1 Financial Instruments
➢ Overview
➢ Debt Securities
• Money market
• Bonds and bond indices
➢ Equity Securities
• Equity indices (price weighted vs value weighted)
➢ Derivatives
❑ 1.2 Securities Trading
➢ Issuing Securities
➢ Costs of Trading
• Order types
• Spreads and commissions
Lecture Outline
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1.1 Financial Instruments
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Introduction
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Overview of Asset Classes
Financial Assets
A non-physical, liquid asset that
derives its value from a claim
on future cash flows
Debt Securities
Promises a fixed stream of
income or a stream of income
determined by a specified
formula
Equity Securities
Represents an ownership
share in a corporation
Derivatives
Provide payoffs that are
determined by the prices of
other assets
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Overview of Asset Classes
Financial
Assets
Debt Securities
Equity Securities
Derivatives
Money Markets
Bond Markets
Preferred Stock
Common Stock
Futures
Options
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Debt Securities
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Short term debts (maturity of less than 1 year), highly marketable and liquid:
❑ Treasury bills – T-Bills (Government issued)
❑ Certificates of Deposit - CDs (Bank issued)
❑ Commercial Paper - CP (Company issued)
❑ Bankers Acceptances
❑ Eurodollars: dollar-denominated deposits in banks outside the U.S.
❑ Repos and reverse repos: Short-term loan (typically overnight) backed by government
securities
❑ Fed Funds: Overnight loans between banks for Fed deposits
❑ Brokers’ Calls – rate brokers borrow from banks
❑ LIBOR Market – interbank lending. Reference rate for many loans
Money Market Instruments
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❑ LIBOR (London Inter-Bank Offer Rate) has historically been an important reference rate for a
wide variety of transactions, both in the interbank market and the corporate loan market
➢ Based on a survey of rates reported by participating banks rather than actual transactions
➢ Interbank lending has become more sparse recently, resulting in less reference points
➢ As the sample size is decreasing and following a scandal arising from manipulation of the
rate in 2012, the search for a replacement is on
❑ LIBOR proposed to be phased out by 2021 and replaced by averages using actual
transactions
➢ SONIA: Sterling overnight interbank average rate (GBP)
➢ SOFR: Secured overnight funding rate (USD)
➢ TONA/ TONAR: Tokyo overnight average rate (JPY)
➢ ESTER / €STR: Euro short term rate (EUR)
➢ AONIA: RBA interbank overnight cash rate (“cash rate”) (AUD)
Money Market Instruments
Further Reading 1AR1: “Understanding the LIBOR Scandal”
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Medium to long term debts (1 - 30+ years)
❑ US Treasury Notes and Bonds (T-Notes and T-Bonds)
❑ Inflation-Protected Treasury Bonds (TIPS)
❑ Federal Agency Issues eg Federal Home Loan Bank (FHLB), Fannie Mae, Freddie Mac
❑ International Bonds
➢ Eurobonds – bond denominated in a currency different to the country where it’s issued
• E.g. Dollar bond issued in UK = Eurodollar bond
➢ Foreign bonds – same currency as the country of issue but issued by a foreign borrower
• E.g. Yankee bond = dollar bond, sold in US, by non-US issuers
❑ Municipal Bonds – tax advantaged
❑ Corporate Bonds
❑ Mortgage-Backed Securities
Bond Markets
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❑ Major indices: Merrill Lynch, Barclays, Citigroup
❑ Challenges:
➢ Wider universe: While a company may have 1 or 2 types of stocks, a company may have
numerous bonds on issue (10+)
➢ Illiquid: A significant number of bonds are illiquid and infrequently traded
➢ Turnover: Bond indices turn over more than stock indices as the bonds mature (highly
dynamic)
Bond Indices
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Equity Securities
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❑ Common stock
➢ Limited liability
➢ Residual claim
➢ Perpetuity – no fixed term
❑ Preferred stock: Fixed dividends
➢ Dividend is cumulative (and commonly fixed)
➢ Priority over common stock
➢ Often a perpetuity
❑ American Depository Receipts (ADRs)
➢ Certificates traded on US exchanges representing ownership of shares in foreign firms
➢ Created as a simplified way for foreign firms to satisfy US security registration requirements
➢ Most common way for US investors to trade shares in foreign corporations
Equity Securities
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❑ Many stock market indices exist:
➢ Dow Jones Industrial Average (DJIA) – 30 large U.S. blue-chip stocks
➢ S&P500 – 500 largest U.S. stocks by market capitalisation
➢ NASDAQ Composite; NYSE Composite; Wilshire 5000
➢ ASX200 for Australia; FTSE for UK; Shanghai Index for China; Hang Seng for Hong Kong;
Nikkei for Japan
❑ How are stocks weighted?
➢ Price weighted (DJIA)
➢ Market-value weighted (S&P500, NASDAQ)
➢ Equally weighted (Value Line Index)
❑ Indices are not traded – however investors can buy into funds which track an index such as:
➢ Index mutual funds – see 1.4
➢ Exchange traded funds (ETFs) – see 1.4
Stock Market Indices
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Price Weighted Index
❑ Price Weighted Index = average price of all stocks in the index
❑ In its simplest form, add up all the prices of stocks in the index and divide by the number of
stocks in the index:
ℎ = =
ℎ
ℎ
❑ The % change in a price weighted index is equal to the return on a portfolio that invests in
one share in each stock in the index
❑ Example 1A1: Calculate the change in a price weighted index of the following stocks:
➢ Step #1: Calculate PWI in Period 1 = (370 + 55 + 135 + 160) / 4 = 180.0
➢ Step #2: Calculate PWI in Period 2 = (350 + 45 + 140 + 165) / 4 = 175.0
➢ Change / return on a 4-stock portfolio = 175 / 180 - 1= -2.78% or (175 – 180) / 180 = -2.78%
Period GS KO APPL JNJ
Period 1 $370 $55 $135 $160
Period 2 $350 $45 $140 $165
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❑ In the simplest case, the divisor (d) in the PWI is the number of stocks
❑ However, when stocks are replaced in the index or undertake a stock split, the divisor needs
to be amended. We do this as follows:
Revised divisor = =
ℎ ℎ ℎ
ℎ ℎ
❑ Example 1A2: Suppose Coca-Cola (KO) were replaced in the index by Microsoft (MSFT).
Keep all other prices equal. Calculate the PWI divisor:
➢ Step #1: Calculate PWI in Period 1 = (370 + 55 + 135 + 160) / 4 = 180.0
➢ Step #2: Calculate revised divisor (from above) d = (370 + 280 + 135 + 160) / 180.0 = 5.25
➢ Verify revised divisor 5.25 (from 4 previously) gives the same PWI as before the
replacement of KO with MSFT: (370 + 280 + 135 + 160) / 5.25 = 180.0
Price Weighted Index
Period GS KO MSFT APPL JNJ
Pre-change prices $370 $55 N/A $135 $160
Post-change prices $370 N/A $280 $135 $160
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❑ A Value Weighted Index (VWI) is calculated based on market capitalisation of index stocks
❑ Each stock is weighted in the index proportional to its current market capitalisation
❑ Label the current period t and the previous period t-1. To calculate we need − 1 :
= − 1 ×
ℎ ℎ
ℎ ℎ −1
❑ Example 1A3: The index value of the S&P500 in the previous period (t-1) was 4000. Based
on the prices and market capitalisations below, calculate the S&P500 in the current period (t)
Value Weighted Index
Period GS KO APPL JNJ
# of Shares mn 340 4,300 16,700 2,630
Price MV $bn Price MV $bn Price MV $bn Price MV $bn
Period t-1 $370 125.8 $55 236.5 $135 2,254.5 $160 420.8
Period t $350 119.0 $45 193.5 $140 2,338.0 $165 433.95
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➢ Use formula to calculate revised S&P500:
= 4000 ×
119.0 + 193.5 + 2,338 + 433.95 = 3084.45
125.8 + 236.5 + 2,254.5 + 420.8 = 3,037.6
➢ VWIt = 4,061.7 which is an increase of 4061.7 / 4000 -1 = +1.54%
❑ Price movements were the same as for the PWI, but the PWI index moves down -2.78%,
while the VWI moves up +1.54%
➢ This is because Apple moving up has a much greater impact on the VWI due to its market
cap being significantly greater than the other stocks
❑ The example demonstrates that in a VWI, larger companies account for much of the
movement; while for a PWI, smaller companies have more of an impact
❑ VWI do not have to be adjusted for events such as stock splits, dividends etc
❑ As fund managers focus on maximising the risk-adjusted value of their portfolios they are
significantly more likely to benchmark against a VWI (S&P500) than a PWI (DJIA)
PWI vs VWI
Video 1AV1: “Here’s how stocks get booted from the Dow” Excel 1AE1: “1A PWI vs VWI” 18
Derivatives
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❑ Derivatives are securities whose value is dependent on the value of other assets, such as
commodity prices, bond and stock prices, or market index values
❑ Forward – a deferred-delivery sale/purchase of an asset with the sales price agreed on today
❑ Futures – similar to a forward
➢ Carries an obligation to make or take delivery of an underlying asset at a price determined
today but settled at a future date
➢ Stipulates the quantity and specifications of the underlying asset
➢ Differences to a forward include:
• Standardised contract – more liquid and tradeable
• Trades on an exchange – mitigates counterparty risk (the exchange is the counterparty)
• Marked to market, with (daily) margin requirements – see 1.3
Futures and Forwards
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Options
❑ A call (put) option gives the holder the right (but not the obligation) to buy (sell) an underlying
asset:
➢ At the exercise or strike price
➢ On or before the expiration date (depending on the type)
❑ Exercise the call option to buy the asset if market value > strike
❑ Exercise the put option to sell the asset if market value < strike
❑ The purchase price of the option is called the premium (both calls and puts)
➢ Buyer pays the premium / Seller (writer) receives the premium
❑ If the holder exercises the option, the option writer must make (call) or take (put) delivery of
the underlying asset
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1.2 Securities Trading
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Issuing Securities
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❑ Public companies
➢ Issued stock is publicly listed on an exchange such as the NYSE, ASX
➢ Known as publicly traded, public companies, or listed companies
❑ Private companies
➢ Issued stock do not trade on an exchange – also known as unlisted companies
➢ Lower liquidity and less public disclosures
❑ Primary Market
➢ Market for newly-issued securities
➢ Proceeds raised from the issue flow directly to the company
➢ Firms issue new securities to the public (often through an underwriter)
❑ Secondary Market
➢ Investors trade previously issued securities among themselves
➢ Proceeds flow between investors that purchase/sell securities and not to the company
Security Issues
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Primary vs Secondary Market
❑ The primary market (first time issue of securities) consists of:
➢ Initial Public Offerings (IPOs)
➢ Follow-on offerings (or a “seasoned equity offering”)
❑ Follow-on offerings refer to any issuance of new shares for companies already listed on an
exchange (i.e. any new share offering subsequent to an IPO)
➢ For example: rights issues, private placements of new shares etc
➢ Proceeds raised from the issue flow directly to the company
❑ The secondary market consists of:
➢ Trading amongst investors on exchanges
➢ Secondary market offerings
• Shares sold by existing shareholders (often called “block trades”)
• Non-dilutive to shareholders as the share count stays the same (they sell directly to each
other and the company receives none of the proceeds)
Further Reading 1AR2: “IPOs: Profiles are high: Returns?”
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Costs of Trading
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❑ Market orders:
➢ No price indication – trade at the prevailing market price
➢ An instruction to trade a quantity at the best price currently available in the market
➢ Market order example: Buy 1000 shares in BHP at market
➢ Advantage: timely, executes immediately. Avoids price moving to a disadvantageous level
➢ Disadvantage: must pay the bid-ask spread. Price may move to a more advantageous level
❑ Limit orders:
➢ Price indication – trade at the best price available if it is no worse than the specified limit
price
➢ Limit order example: Buy 1000 shares in BHP at $46.50
➢ Advantage: may get a good price for the trade. Avoids paying the bid-ask spread
➢ Disadvantage: the trade may not execute (execution risk)
Order Types
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❑ Explicit costs – direct costs of trading such as:
➢ Commission - fee paid to the broker for facilitating the transaction
• Calculated based on the total transaction size
• Range from 0% - 0.1% for online trading platforms to 1%+ for full-service brokers
➢ Transaction taxes, stamp duties, exchange fees etc
❑ Implicit costs – indirect costs such as:
➢ Bid-ask spread
• The difference between the bid and ask prices
➢ Market impact costs
• The effect of the trade on market prices
• Large buyers (sellers) must raise (lower) prices to encourage other investors to trade.
Minimal impact from small orders
• Delay costs (slippage) – suboptimal prices paid/received arising from delayed execution
of a trade due to its size or opportunity costs – profits not realised due to unfilled trades
Costs of Trading
Further Reading 1AR3:
“How no-fee stock trading is
changing the stock market”
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❑ Bid-Ask spread – cost of trading with a counterparty directly (or through a broker/dealer):
➢ Bid: price at which the counterparty is willing to buy
➢ Ask: price at which the counterparty is willing to sell
➢ Bid-Ask spread: Ask - Bid
❑ Market orders – buy at the ask price / sell at the bid price
❑ Limit orders – place an order at a preferred bid (ask) price if you wish to buy (sell)
❑ Example 1A4: Using the transaction information below, calculate the trading costs (assume
the full cost of the spread) and net proceeds paid/received from a market offer trade
Spreads and Commissions
Buyer Seller
Bid-Ask $52.00 - $52.50 $32.70 - $33.00
# of Shares 0.5 million 2 million
Commission 0.20% 0.15%
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➢ Market offer - the buyer buys at (“hits”) the ask and the seller sells at (“hits”) the bid
➢ For the buyer, commissions add to the cost of the trade. For the seller, commissions
reduce the proceeds from the trade
➢ Buyer Pays: 0.5m x 52.50 x (1 + 0.2%) = $26,302,500
Cost of trade: Spread = 52.50 – 52.00 = 50c
0.5m x 52.50 x 0.2% + 0.5m x 50c = $52,500 + $250,000 = $302,500
➢ Seller Receives: 2m x 32.70 x (1 – 0.15%) = $65,301,900
Cost of trade: Spread = 33.00 – 32.70 = 30c
2m x 32.70 x 0.15% + 2m x 30c = $98,100 + $600,000 = $698,100
Spreads and Commissions
Ask price
Bid price
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❑ BKM Chapters 3 and 4
❑ 1.3 Trading on Margin: Long and Short
❑ 1.4 Asset Management Industry: Investment Companies, Hedge Funds and ETFs
Next Lecture