Investments - Ivo Welch, Anderson UCLA/NBER: Homepage

190 Pages·2009·2.13 MB·English

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Part II
Investments
ThereisalongversionandshortversionoftheInvestmentspartofthebook. Youarelookingatthe
longversion. Theshortversionwillappearinadedicatedcorporatefinanceversionofthebook,andcan
alreadybedownloadedfromthewebsite.
ThisintroductionappearsintheSurveytextonly.
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149
Transition
You still do not know where the cost of capital, the (r˜), in the present value
E
formula comes from. We just assumed you knew it.
Intherealworld,thecostofcapitalisdeterminedbyyourinvestors—andyour
investors have many choices. You have to understand their mindset. They can
put money in bonds, stocks, projects, etc.—or into your own firm’s projects.
If investors very much like the alternatives, then your firm’s cost of capital
should be high. Think of your corporate cost of capital as your investors’
opportunity cost of capital.
To learn more about where the cost of capital comes from, we have to study
not just our own project, but more generally how investors think—what they
like and dislike.
Of course, it is nice that we are often ourselves investors, so learning how to
best invest money in the financial markets has some nice side benefits.
SIDE NOTE
IntheInvestmentspartofthebook,wewillusetheterms“stock”and“security”veryloosely. Ourconcernis
reallythechoiceamongmanyinvestmentopportunities,whichincludesbonds,options,futures,realestate,etc.
Itisjustmoreconvenienttousethephrasestock,ratherthan“anypossibleinvestmentopportunity.”
150
What You Want to Learn in this Part
Thegoalofthispartofthebookistoteachyouhowpublicinvestorsthink. Thisisimportantnot
onlywhenyouareaninvestorwhowantstodecidehowtoallocatemoneyamongthethousands
ofpossiblefinancialinvestments,butalsoforthecorporatemanagerwhowantstogetyouand
otherinvestorstopartwiththeirmoneyinordertofinancenewcorporateprojects.
(cid:228) Chapter 7 gives a short tour of historical rates of returns to whet your appetite, and
explainssomeofthesetupofequitymarkets.
Typicalquestions: Didstocks,bonds,orcashperformbetteroverthelastthirty
years? Howsafewerestockscomparedtobondsorcash?
(cid:228) Chapter8describeshowyoucantradeequitysecurities(a.k.a. “stocks”),andhowsecurities
canbecombinedintoportfolios.
Typicalquestions: whatwastherateofreturnonaportfoliothatinvestedmoney
intothe30stocksthatformtheDow-JonesIndustrialAverage(DJIA)index?
(cid:228) Chapter9showshowtomeasuretheriskandrewardofsecurities.
Typicalquestions: if you held a portfolio of the 30 stocks that form the DJIA,
whatwouldyourriskbe?
(cid:228) Chapter10showshowtomeasuretheriskandrewardofportfolios.
Typicalquestions: Howwouldtheriskchangeifyourearrangehowmuchmoney
youputintoeachofthe30stocksoftheDowJones?
(cid:228) Chapter11showshowholdingmanystocksinyourportfoliocanreduceyourrisk.
Typicalquestions: Howmuchlowerwouldyourriskbeifyouheldall30stocks
intheDJIAinsteadofjustasinglestockintheDJIA?
(cid:228) Chapter12showshowyoucandeterminethebest portfolio.
Typicalquestions: Canyouinvestbetterthanjustintothe30stocksintheDJIA?
HowmuchriskdoesPepsiCocontributetoyourportfolio? Woulditbebetterif
youshiftedmoremoneyintoPepsiCostock,orshouldyousticktoyourcurrent
portfolio?
(cid:228) Chapter13showswhatexpectedratesofreturnsecuritieshavetoofferif investorsmake
smartinvestmentdecisions. Itgivestheformula(cookbook)versionofthe“CapitalAsset
PricingModel”(CAPM)model,whichanswersthisquestion.
Typicalquestions: WhatisafairrewardforPepsiCo’sstockinvestors,givenhow
muchriskitcontributestotheoverallmarketportfolio?
(cid:228) Chapter14explainsmoreofthetheorybehindtheCAPM.
(cid:228) Chapter16expandsontheefficientmarketsconcept,firstmentionedintheintroduction.
Italsoexplainsthedifferencebetweenarbitrageandgoodbets.
Typicalquestions: whatkindofinformationcanyouusetobeatthemarket?
CHAPTER 8§
Securities and Portfolios
Applications
ThischapterappearsintheSurveytextonly.
Thischapterfirstexplainswherestockscomefromandwheretheyaretraded. Itthenexplains
theprocessofgoinglong(buyinganassettospeculatethatitwillgoup)andgoingshort
(sellinganassettospeculatethatitwillgodown). Finally,itexplainsportfoliosandindexes.
§©IvoWelch,2008. Confidential: AccessbyPermissionOnly!
secpfios-g.tex: Lastfilechange: Mar16,2008(20:24h). Latexedon: (15:38h).
165
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166 Chapter8 SECURITIESANDPORTFOLIOS 166
8 1 A Brief Overview of Equities Market Institutions and Vehicles
·
Let’s look into the institutional arrangements for equity trading. After all, from a corporate
perspective,stocksaremoreinterestingthanmanyotherfinancialinstruments,suchasforeign
governmentbonds,evenifthereismoremoneyinforeigngovernmentbondsthanincorporate
equity. Itistheequityholderswhofinancemostoftherisksofcorporateprojects. Moreover,
althoughthereismoremoneyinnonequityfinancialmarkets,thesubjectareaofinvestments
alsotendstofocusonequities(stocks),becauseretailinvestorsfinditeasytoparticipateandthe
dataonstocksarerelativelyeasytocomeby. Soitmakessensetodescribeafewinstitutional
detailsastohowinvestorsandstocks“connect”—exchangecashforclaims,andviceversa.
8 1.A. Brokers
·
Retailbrokersexecute Mostindividualsplacetheirorderstobuyorsellstockswitharetailbroker,suchasAmeritrade
tradesandkeeptrack (a“deep-discount”broker),CharlesSchwab (adiscountbroker),orMerrillLynch (a“full-service”
ofportfolios. (They
broker). Discount brokers may charge only about $10 commission per trade, but they often
alsoarrangeshorts.)
receive“rebate”paymentsbackfromthemarketmaker[seebelow]towhichtheyrouteyour
order. Thisiscalled“paymentfororderflow.” Themarketmakerinturnrecoupsthispayment
tothebrokerbyexecutingyourtradeatapricethatislessfavorable. Althoughthepurpose
ofsuchanarrangementseemsdeceptive,theevidencesuggeststhatdiscountbrokersarestill
oftencheaperinfacilitatinginvestortrades—especiallysmallinvestortrades—evenaftertaking
thishiddenpaymentintoaccount. Theyjustarenotas(relatively)cheapastheywanttomake
youbelieve. Investorscanplaceeithermarketorders,whichaskforexecutionatthecurrent
price, or limit orders, which ask for execution if the price is above or below a limit that the
investorcanspecify. (Therearealsomanyothertypesoforders,e.g.,stop-loss orders[which
instructabrokertosellasecurityifithaslostacertainamountofmoney],good-til-canceled
orders,andfill-or-kill orders.) Thefirstfunctionofretailbrokersthenistohandletheexecution
oftrades. Theyusuallydosobyroutinginvestors’orderstoacentralizedtradinglocation(e.g.,
aparticularstockexchange),thechoiceofwhichistypicallyattheretailbroker’sdiscretion,as
istheparticularagent(e.g.,floorbroker)engagedtoexecutethetrade. Thesecondfunctionof
retailbrokersistokeeptrackofinvestors’holdings,tofacilitatepurchasingonmargin(whereby
investorscanborrowmoneytopurchasestock,allowingthemtopurchasemoresecuritiesthan
theycouldaffordonapurecashbasis),andtofacilitatesellingsecurities“short,”whichallows
investorstospeculatethatastockwillgodown.
Primebrokersleave Manylargerandinstitutionalinvestors,suchasfunds(describedinSection8 3.B),breakthe
executiontotheclient twofunctionsapart: Theinvestorcanemployitsowntraders,whilethebroker·takescareonly
investor.
(cid:44) ofthebookkeepingoftheinvestor’sportfolio,marginprovisions,andshortingprovisions. Such
Unknown8 3.Bon
Pa·ge177 limitedbrokersarecalledprimebrokers.
How Shorting Stocks Works
Shortingislike Ifyouwanttospeculatethatastockgoesdown,youwouldwanttoshortit. Thisshortingwould
borrowingandthen bearrangedbyyourbroker. Itisimportantenoughtodeserveanexplanation:
issuingsecurities.
Proceedinterestmay (cid:228) You find an investor in the market who is willing to lend you the shares. In a perfect
beearnedbythe
market, this does not cost a penny. In the real world, the broker has to find a willing
brokerorbytheclient
(orbeshared). lender. Boththebrokerandlenderusuallyearnafewbasispointsperyearfordoingyou
(cid:44)
BondShorting, thefavoroffacilitatingyourshortsale.
Subsectionbon
(cid:228) Afteryouhaveborrowedtheshares,yousellthemintothemarkettosomeoneelsewho
Page105
wanted to buy the shares. In a perfect market, you would keep the proceeds and earn
interestonthem. Intherealworld,yourbrokermayforceyoutoputtheseproceedsinto
low-yieldsafebonds. Ifyouareasmallretailinvestor,yourbrokeragefirmmayevenkeep
theinterestproceedsaltogethertohimself.
(cid:228) When you want to “unwind” your short, you repurchase the shares and return them to
yourlender.
167 8 1 ABRIEFOVERVIEWOFEQUITIESMARKETINSTITUTIONSANDVEHICLES 167
·
Forexample,ifyouborrowedtheshareswhentheyweretradingfor$50,andthesharesnow
sell for $30 each, you can repurchase them for $20 less than what you sold them into the
market for. This $20 is your profit. In an ideal world, you can think of your role effectively
asthesameasthatofthecompany—youcanissuesharesandusetheproceedstofundyour
investments. Intherealworld,youhavetotaketransactioncostsintoaccount. (Shortinghas
becomesocommonthattherearenowexchange-tradedfuturesonstocksthatmakethiseven
(cid:44)
easier. FuturesareexplainedinSection??.) Futuresand
Forwards,Section??on
Page??
Q8.1 Whatarethetwomainfunctionsofbrokeragefirms? SolveNow!
Q8.2 Howdoesaprimebrokerdifferfromaretailbroker?
Q8.3 Isyourrateofreturnhigherifyoushortastockintheperfectworldorintherealworld?
Why?
8 1.B. Exchanges and Non-Exchanges
·
A retail broker would route your transaction to a centralized trading location. The most Thetwobigstock
prominent are exchanges. An exchanges is a centralized trading locations where financial exchangesarethe
NYSEandNASDAQ.
securities are traded. The two most important stock exchanges in the United States are the
TheNYSEisahybrid
NewYorkStockExchange(NYSE,alsonicknamedtheBigBoard)andNASDAQ(originallyan market. TheNASDAQ
acronymfor“NationalAssociationofSecuritiesDealersAutomatedQuotation”System). The isonlyelectronic.
NYSEusedtobeexclusivelyanauctionmarket,inwhichonedesignatedspecialist(assignedfor
eachstock)managedtheauctionprocessbytradingwithindividualbrokersonthefloorofthe
exchange. Thisspecialistwasoftenamonopolist. However,eventheNYSEnowconductsmuch
tradingelectronically. IncontrasttotheNYSE’shybridhuman-electronicprocessprimarilyinone
physicallocationonWallStreet,NASDAQhasalwaysbeenapurelyelectronicexchangewithout
specialists. (Forsecurityreasons,itslocation—well,thelocationofitscomputersystems—is
secret.) ForeachNASDAQstock,thereisatleastonemarketmaker,abroker-dealerwhohas
agreedtocontinuouslystandbytooffertobuyorsellshares,electronicallyofcourse,thereby
creatingaliquidandimmediatemarketforthegeneralpublic. Moreover,marketmakersare
paidforprovidingliquidity: theyreceiveadditionalrebatesfromtheexchangewhentheypost
a bid or an ask that is executed. Most NASDAQ stocks have multiple market makers, drawn
fromapoolofabout500tradingfirms(suchasJ.P.MorganorETrade),whichcompetetooffer
thebestprice. Marketmakershaveoneadvantageoverthegeneralpublic: Theycanseethe
limitorderbook,whichcontainsas-yet-unexecutedordersfrominvestorstopurchaseorsell
if the stock price changes—giving them a good idea at which price a lot of buying or selling
activitywillhappen. TheNYSEistheolderexchange,andforhistoricalreasons,isthebiggest
exchangefortradingmost“bluechip”stocks. (“Bluechip”nowmeans“wellestablishedand
serious”; ironically, the term itself came from poker, where the highest-denomination chips
wereblue.) In2006,theNYSElistedjustunder3,000companiesworthabout$25trillion. (This
isabouttwicetheannualU.S.GDP.)NASDAQtendstotradesmallerandhigh-technologyfirms,
listsaboutasmanyfirms,andhasmoretradingactivitythantheNYSE.Somestocksaretraded
onbothexchanges.
Continuoustrading—tradingatanymomentaninvestorwantstoexecute—reliesonthepresence Auctionmarkets,
ofthestandbyintermediaries(specialistsormarketmakers),whoarewillingtoabsorbshares popularinother
countries,havelower
whennooneelseisavailable. Thisisriskybusiness,andthusanyintermediarymustearna
executioncosts,but
goodrateofreturntobewillingtodoso. Toavoidthiscost,somecountrieshaveorganized alsolowerexecution
theirexchangesintononcontinuousauctionsystems,whichmatchbuyandsellordersacouple speed.
oftimeseachday. Thedisadvantageisthatyoucannotexecuteordersimmediatelybuthave
todelayuntilawholerangeofbuyordersandsellordershaveaccumulated. Theadvantage
isthatthiseliminatestheriskthatan(expensive)intermediarywouldotherwisehavetobear.
Thus,auctionsgenerallyofferlowertradingcostsbutslowerexecution.
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168 Chapter8 SECURITIESANDPORTFOLIOS 168
Newalternativetrading Even in the United States, innovation and change are everywhere. For example, electronic
institutions: electronic communications networks(ECNs)haverecentlymadebiginroadsintothetradingbusiness,
communication
replacingexchanges,especiallyforlargeinstitutionaltrades. (Theycantradethesamestocks
networks(ECNs).
thatexchangesaretrading,andcompetewithexchangesintermsofcostandspeedofexecution.)
AnECNcutsoutthespecialist,allowinginvestorstopostprice-contingentordersthemselves.
ECNsmayspecializeinlowerexecutioncosts,higherbrokerkickbacks,orfasterexecution. The
biggest ECNs are Archipelago and Instinet. In 2005, the NYSE merged with Archipelago, and
NASDAQpurchasedInstinet. (Itishardtokeeptrackofthemostrecenttradingarrangements.
Forexample,in2006,theNYSEalsomergedwithArcaEx,yetanotherelectronictradingsystem,
andmergedwithEuronext,apan-EuropeanstockexchangebasedinParis. Asofthiswriting,it
isnowofficiallycalledNYSEEuronext. Inaddition,theNYSEconvertedfromamutualcompany
ownedbyitstradersintoapubliclytradedfor-profitcompanyitself.)
Andcrossingnetworks Anevenmoreinterestingmethodtobuyandtradestocksisthatof crossingsystems,suchas
andmore... ITG’sPOSIT.ITGfocusesprimarilyonmatchinglargeinstitutionaltradeswithoneanotherin
anauction-likemanner. Ifnomatchontheothersideisfound,theordermaysimplynotbe
executed. Butifamatchismade,bycuttingoutthespecialistormarketmaker,theexecution
is a lot cheaper than it would have been on an exchange. Recently, even more novel trading
placeshavesprungup. Forexample,Liquidnetusespeer-to-peernetworking—liketheoriginal
Napster—to match buyers and sellers in real time. ECNs or electronic limit order books are
nowthedominanttradingsystemsforequitiesworldwide,withonlytheU.S.exchangefloorsas
holdouts. Similarexchangesandcomputerprogramsarealsousedtotradefutures,derivatives,
currencies,andevensomebonds.
Therearealsoinformal There are many other financial markets, too. There are financial exchanges handling stock
financialmarkets, options,commodities,insurancecontracts,andsoon. Ahugesegmentistheover-the-counter
especiallyOTC
(OTC)markets. Over-the-countermeans“callaround,usuallytoasetoftraderswellknownto
(over-the-counter).
tradeintheasset,untilyoufindsomeonewillingtobuyorsellatapriceyoulike.” Thoughun-
dergoingrapidinstitutionalchange,mostbondtransactionsarestillover-the-counter. Although
OTCmarketshandlesignificantlymorebondtradingintermsoftransactiondollaramounts
thanexchanges,theirtransactioncostsareprohibitivelyhighforretailinvestors—ifyoucall
withoutknowingthemarketingreatdetail,thepersonontheotherendofthelinewillbehappy
to quote you a shamelessly high price, hoping that you do not know any better. The NASD
(NationalAssociationofSecuritiesDealers)alsooperatesasemi-OTCmarketforthestocksof
smallerfirms,whicharelistedontheso-calledpinksheets. Foreignsecuritiestradeontheir
localnationalexchanges,butthecostsforU.S.retailinvestorsareagainoftentoohightomake
directparticipationworthwhile.
SolveNow!
Q8.4 Howdoesacrossingsystemdifferfromanelectronicexchange?
Q8.5 Whatisaspecialist? Whatisamarketmaker? Whentrading,whatadvantagedothetwo
haveoveryou?
Q8.6 Describesomealternativestotradingonthemainstockexchanges.
169 8 1 ABRIEFOVERVIEWOFEQUITIESMARKETINSTITUTIONSANDVEHICLES 169
·
8 1.C. Investment Companies and Vehicles
·
TheSECregulatesmanyinvestmentvehiclesthatareactiveintheU.S.financialmarkets. Under
theInvestmentCompanyActof1940,therearethreetypesofinvestmentcompanies: open-end
funds,closed-endfunds,andunitinvestmenttrusts(UITs).
IntheUnitedStates,open-endfundisasynonymformutualfund. (Elsewhere,mutualfundscan The“openend”feature
includeotherclasses.) Beingopenendmeansthatthefundcancreatesharesatwill. Investors allowsinvestorsto
redeemtheirshares. It
canalsoredeemtheirfundsharesattheendofeachtradingdayinexchangeforthenetasset
forcesthefund’s
value(NAV),whichmustbeposteddaily. Thisgivesinvestorslittlereasontoselltheirfund sharestotradefor
sharestootherinvestors—thus,mutualfundsdonottradeonanyexchanges. Theredemption closetothevalueofits
holdings.
rightgivesthelawofonepricealotofbite—fundsharesarealmostalwaysworthnearlyexactly
whattheirunderlyingholdingsareworth. Ifanopen-endfund’ssharepriceweretofallmuch
belowthevalueofitsholdings,anarbitrageurcouldbuyupthefundshares,redeemthem,and
therebyearnfreemoney. (Onediscrepancyisduetosomeoddtaxcomplications: thefund’s
capitalgainsandlossesarepassedthroughtothefundinvestorsattheendofeveryyear,but
theymaynotbewhateveryinvestorexperienced.) Interestingly,intheUnitedStates,thereare
nowmoremutualfundsthantherearestocksinthefinancialmarket.
In a closed-end fund, there is one big initial primary offering of fund shares, and investors Closed-endfundsdo
cannotredeemtheirfundsharesfortheunderlyingvalue. Theadvantageofaclosed-endfund notallowsharestobe
redeemed. Thisis
isthatitcanitselfinvestinassetsthatarelessliquid. Afterall,itmaynotbeforcedtosellits
usefulforfundswhich
holdingsonthewhimsofitsowninvestors. Manyclosed-endfundsareexchangetraded,so areinvestinginilliquid
thatifaclosed-endfundinvestorneedscash,shecanresellhershares. Thedisadvantageof assets.
theclosed-endschemeisthatthelawofonepricehasmuchlessbite. Onaverage,closed-end
fundstradepersistentlybelowthevalueoftheirunderlyingholdings,roughlyinlinewiththe
(oftenhigh)feesthatthemanagersofmanyoftheseclosed-endfundsarecharging.
Bothmutualfundsandclosed-endfundmanagersareallowedtotradetheirfundholdingsquite Mutualfundsare
actively—andmanydoso. Althoughsomefundsspecializeinimitatingcommonstockmarket open-ended,actively
tradedinvestment
indexes, many more try to guess the markets or try to be more “boutique.” Most funds are
vehicles.
classifiedintoacategorybasedontheirgeneraltradingmotivation(suchas“markettiming,”or
“growth”or“value,”or“income”or“capitalappreciation”).
A unit investment trust (UIT) is sort of closed end in its creation (usually through one big UITsarepassive
primaryoffering)andsortofopenendinitsredemptionpolicies(usuallyacceptinginvestor “basket”investment
vehicles.
redemptionrequestsondemand). Moreover,SECrulesforbidUITstotradeactively(although
thisisabouttochange),andUITsmusthaveafixedterminationdate(evenifitis50yearsin
thefuture). UITscanbelistedonastockexchange,whichmakesiteasyforretailinvestorsto
buyandsellthem. Someearlyexchange-tradedfunds(ETFs)werestructuredasUITs,although
this required some additional legal contortions that allowed them to create more shares on
demand. ThisiswhyETFsarenowadaysusuallystructuredasopen-endfunds.
Some other investment vehicles are regulated by the SEC under different rules. The most ADRsareinvestment
prominentmaybecertainkindsof AmericanDepositaryReceipt(ADR).AnADRisapassive vehicles,too. Many
ADRs(thoughnotall)
investmentvehiclethatusuallyownsthestockofonlyoneforeignsecurity,heldinescrowata
areregulatedbythe
U.S.bank(usuallytheBankofNewYork). TheadvantageofanADRisthatitmakesiteasierfor SECunderdifferent
U.S.retailinvestorstotradeintheforeignsecuritywithoutincurringlargetransactioncosts. rules.
ADRsareredeemable,whichgivesthelawofonepricegreatbite.
TherearealsofundsthatarestructuredsothattheydonotneedtoregisterwiththeSEC.This Otherfundsare
meansthattheycannotopenlyadvertisefornewinvestorsandarelimitedtofewerthan100 entirelyunregulated.
investors. This includes most hedge funds, venture capital funds, and other private equity
funds. ManyoffshorefundsaresetuptoallowforeigninvestorstoholdU.S.stocksnotonly
withoutSECregulation,butalsowithouteverhavingtotreadintothedomainoftheU.S.IRS.
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170 Chapter8 SECURITIESANDPORTFOLIOS 170
SolveNow!
Q8.7 Whatshouldhappeniftheholdingsofanopen-endfundareworthmuchmorethanwhat
thesharesofthefundaretradingfor? Whatshouldhappeninaclosed-endfund?