Basic Financial Management Lecture Notes - Behavioral Finance

Behavioral Finance LECTURE NOTES Financial Markets and Institutions ● The capital allocation process ○ 1. Direct transfers ■ Business to savers ● Securities (stocks or bonds) ■ Savers to business ● Dollars ○ 2. Indirect transfers through investment bankers ■ Business to investment bankers to savers ● Through securities ■ Savers to investment bankers to business ● Through dollars ○ 3. Indirect transfers through a financial intermediary ■ Business to financial intermediary to savers ● Through business securities )until financial mediary) and then using intermediaries securities ■ Savers to financial intermediary to business ● Through dollars ● Types of financial institutions ○ Investment banks ○ Commercial banks ○ Financial services corporation ○ Pension funds ○ Mutual funds ○ Exchange traded friends ○ Hedge funds ○ Private equity funds ● Summary of major market instruments ○ 1. Instrument ■ 2. Market ● 3. Major participants ○ 4. (Riskiness ■ 5. Original maturity ● 6. Interest rate on 3/26/18^a) ○ 4-6 are security characteristics ○ 1. Instrument: US treasury bills ■ 2. Market: money ■ 3. Major participants: sold by US treasury to finance federal expenditures ■ 4. Riskiness: default-free, close to riskless ■ 5. Original maturity: 91 days to 1 year ■ 6. Interest rate on 3/26/18^a: 1.76% ○ 1. Instrument: commercial paper ■ 2. Market: money ■ 3. Major participants: issued by financially secure firms to large investors ■ 4. Riskiness: low default risk ■ 5. Original maturity: up to 270 days ■ 6. Interest rate on 3/26/18^a: 1.92% ○ 1. Instrument: negotiable certificates of deposits (CDs) ■ 2. Market: money ■ 3. Major participants: issued by major money-centered commercial banks to large investors ■ 4. Riskiness: default risk depends on the strength of the issuing banks ■ 5. Original maturity: up to 1 year ■ 6. Interest rate on 3/26/18^a: 0.88% ○ 1. Instrument: money market mutual funds ■ 2. Market: money ■ 3. Major participants: invest in treasury bills, CDs, and commercial paper; held by individuals and businesses ■ 4. Riskiness: low degree of risk ■ 5. Original maturity: no specific maturity (instant liquidity) ■ 6. Interest rate on 3/26/18^a: 0.35% ○ 1. Instrument: consumers credit, including credit card debt ■ 2. Market: money ■ 3. Major participants: issued by bank, credit unions and finance companies to individuals ■ 4. Riskiness: risk is favorable ■ 5. Original maturity: variable ■ 6. Interest rate on 3/26/18^a: variable but average APR is 13.09% to 23.59% ○ 1. Instrument: US treasury notes and bonds ■ 2. Market: capital ■ 3. Major participants: issued by US government ■ 4. Riskiness: no default risk, but price will decline if interest rates rise; hence, there is some risk ○ ○ ○ ○ ○ ■ 5. Original maturity: 2 to 30 years ■ 6. Interest rate on 3/26/18^a: 2.32% on 2-year to 3.07% on 30-year bonds 1. Instrument: mortgages ■ 2. Market: capital ■ 3. Major participants: loans to individuals and businesses secured by real estate; bought by banks and other institutions ■ 4. Riskiness: risk is variable; risk is high in the case of subprime loans ■ 5. Original maturity: up to 30 years ■ 6. Interest rate on 3/26/18^a: 4.20% adjustable 5-year rate, 4.45% 30-year fixed rate 1. Instrument: state and local government bonds ■ 2. Market: capital ■ 3. Major participants: issued by state and local governments; held by individuals and institutional investors ■ 4. Riskiness: riskier than US government securities but exempt from most taxes ■ 5. Original maturity: up to 30 years ■ 6. Interest rate on 3/26/18^a: 2.90% to 3.45% on 20-year AAA-rated to A-rated bonds 1. Instrument: corporate bonds ■ 2. Market: capital ■ 3. Major participants: issued by corporations; held by individuals and institutional investors ■ 4. Riskiness: riskier than US government securities but less risky than preferred and common stocks; varying degree of risk within bonds depends on strength of issuer ■ 5. Original maturity: up to 40 years ■ 6. Interest rate on 3/26/18^a: 3.89% on 20-year AAA bonds, 4.15% on 20-year A bonds 1. Instrument: leases ■ 2. Market: capital ■ 3. Major participants: similar to debt in that firms can lease assets rather than borrow and then buy the assets ■ 4. Riskiness: risk similar to corporate bonds ■ 5. Original maturity: generally 3 to 20 years ■ 6. Interest rate on 3/26/18^a: similar to bond yields 1. Instrument: preferred stocks ■ 2. Market: capital ■ 3. Major participants: issued by corporations to individuals and sinsational investors ■ 4. Riskiness: generally riskier than corporations but less risky than common stock ■ 5. Original maturity: unlimited ■ 6. Interest rate on 3/26/18^a: 5.75% to 9.5% ○ 1. Instrument: common stocks ■ 2. Market: capital ■ 3. Major participants: issued by corporations to individuals and institutional investors ■ 4. Riskiness:riskier than bonds and preferred stock; risk varies from company to company ■ 5. Original maturity: unlimited ■ 6. Interest rate on 3/26/18^a: NA ○ Preferred stock ■ Ownership ■ Paid out to shareholders before other shareholders ○ Common stock ■ No guarantee dividend or interest ■ Pure ownership of company ■ Must riskier than preferred stock and bonds ■ Provide highest potential return to investors ● 10 largest ETFs (January 2020) ○ ETF or exchange traded funds are types of financial instruments ■ Many people like trading them ■ Similar to mutual funds ■ People can pool assets and buy into commonly managed product ■ Advantages: ● Trade like stock on market ● These trade regularly not just end of day ● The way they are created ○ Process of buy and sell ○ People in market can buy or exchange ■ Helps keep ETF closer to value ● Tax efficiencies ○ SPDR S7P 500 ETF ■ SPY ■ AUM: $312,850,220 ■ Avg Volume: $59,223,578 ○ iShares Core S&P 500 ETF ■ IVV ○ Vanguard total stock market ■ VTI ○ Vanguard S&P 500 ETF ■ VOO ○ Invesco QQQ ■ QQQ ○ Vanguard FTSE developed ■ VEA ○ iShares Core MSCI EAFE ETF ■ IEFA ○ iShared Core US Aggregate ■ AGG ○ Vanguard FTSE Emerging ■ VWO ○ iShares MSCI EAFE ETF ■ EFA ■ AUM: $63,348,880 ■ Avg Volume: $21,256,664 ○ Several of largest are based on S&P 500 ■ Largest companies ■ Very core component to portfolio ○ Vanguard is broad index and similar to S&P 500 ○ International products are EFA, VWO, IEFA, VEA ■ Emerging, developed, or international ● 10 largest hedge funds (2017) ○ A hedge fund is not necessarily risky, but can be ○ Original hedge fund idea was going to try to move investment whether market was up or down ○ Limited to who can invest: accredited investor ○ Nomura Asset Management Co. LTD ■ Assets under management (billions): $416.0 ○ Bridgewater Associate, LP ○ Millennium Management LLC ○ Samsung Asset Management Company, LTD ○ Citadel Advisors LLC ○ Nikko Asset management Co. LTD ○ Apollo capital management, LP ○ Pictet asset management SA ○ Vanguard asset management LTP ○ The carlyle Group ■ 101.9 ● 10 Largest Banks and Underwriters (2018) ○ (first three) ○ Panel A: US bank holding companies ■ JPMorgan Chase & Co ■ Bank of America Corp. ■ Wells Fargo & Co. ○ Panel B: world banking companies ■ Industrial & commercial bank of china Ltd. (China) ■ China construction bank corporation (China) ■ Agricultural bank of china Ltd (China) ○ Panel C: leading global IPO underwriters ■ Morgan Stanley ■ JPMorgan ■ Citi ● What is a market? ○ Anywhere where individuals come together and exchange goods services ○ Physical ○ Common interest ○ Could be remote ■ Ebay or amazon ■ Use tech to bring together buyers and sellers ● Types of financial markets ○ Physical assets vs. financial assets ○ Spot vs. futures ○ Money vs. capital ○ Primary vs. secondary ○ Public vs. private ● Physical assets vs. financial assets ○ Physical assets ■ Tangible or “real” assets ■ Wheat, autos, real estate, computers ○ Financial assets ■ Stocks, bonds, notes, motragtes, derivatives ■ NYSE ● Trading assets ● Trading financial instruments ● Spot markets vs. futures markets ○ Spot ■ Sold “on the spot” ■ Delivery within a few days ● ● ● ● ○ Futures ■ Agree to buy or sell an asset at some future date ■ Ex: farmer wants to sell crop not today but 6 months from now, enter into a futures contract Money markets vs. capital markets ○ Money market ■ Short-term (<1 year), highly liquid debt ■ Largest money markets in new york, london, and tokyo ○ Capital market ■ Intermediate (1-10 years) and long-term (10+ years) debt ■ Corporate stock ■ New York Stock Exchange (NYSE) Primary markets vs. secondary markets ○ Primary markets ■ Raise new capital or new funds ■ Through issuing debt, stock, bonds ■ If new funds are flowing to company that is primary market transaction ○ Secondary markets ■ Trade existing securities ■ Majority of trading existing security ■ If I sell my ford stock to someone else ford gets nothing, I do though Stock market transactions ○ Apple decides to issue additional stock with the assistance of its investment banker. An investor purchases some of the only issued shares. Is this a primary market transaction or a secondary ■ Since new shares of stock are being issued, this is a primary market transaction ○ What if instead an investor buys existing shares of apple stock in the open market. Is this a primary or secondary market transaction? ■ Since no new shares are created, this is a secondary market transaction Private markets vs. public markets ○ Private ■ Transactions negotiated directly between two parties ■ EX: im selling you ford stock negotiating directly between two people ■ EX: Garage sale, no third party ○ Public ■ Standardized contracts on organized exchanges ■ One benefit trading stocks on public market is finding people to sell to ■ Facilitate trade ■ EX: Ebay, using ebay as third party with rules to engage in transaction ● The importance of financial markets ○ Well-functioning financial markets facilitate the flow of capital from investors to the users of capital ○ Well-functioning markets promote economic growth ○ Economies with well-developed markets perform better than economies with poorly-functioning markets ● What are derivatives? ○ A derivative security’s value is “derived” from the price of another security (e.g., options and futures) ○ Can be used to “hedge” or reduce risk ○ Also, speculators can use derivatives to bet on the direction of future stock prices, interest rates, etc. ○ EX: Use if worried about market decline ● Stock quote for Twitter, Inc., March 29, 2018 ○ Shows example of stock quote ○ Market open and open price ○ Show increase or decrease in cost ○ After hours ○ Days range is price fluctuation throughout day ○ See larger range ○ Volume is volume of shares traded in one day ○ Average value is average traded on day ○ Market capitalization or cap ■ # shares outstanding x price ■ Shows how much they are worth ○ Beta is measure of risk or volatile in market ○ 1 year target estimate shows target set in past has been met or succeeded ● S&P 500 Index, Total Return: dividend yield + capital gain or loss (1968-2017) ○ Looking at how much more positive returns there are then negative returns ● What is meant by stock market efficiency? ○ Securities are normally in equilibrium and are “fairly priced” ○ Investors cannot “beat the market” except through good luck or better information ○ Efficiency conitum ○ Highly inefficient ■ Small companies not followed by many analysts. Not much contact with investors ● EX: warren buffet looked for small companies and invested when he saw value opportunity and profited ○ What he did relied on not having efficient markets ○ Highly efficient ● ● ● ● ● ■ Large companies followed by many analysts. Good communications with investors ● EX: NYSE ■ Capital markets You hear in the news that a medical research company received FDA approval for one of its products. If the market is highly efficient, can you expect to take advantage of this information by purchasing the stock? ○ No trading advantage ○ Everyone thinking the same thing Smaller investor has been reading about a “hot” IPO that is scheduled to go public later this week. She wants to buy as many shares as she can get her hands on, and is planning on buying a lot of shares the first day once the stock begins trading. Would you think that this would be a good thing for her to do? ○ No, too popular. No substantial return ■ Should try diversifying ○ IPO = initial public offering Behavioral finance: possible implications for market efficiency ○ It is costly and/or risky for traders to take advantage of mispriced assets ○ Cognitive biases cause investors to make systematic that lead to inefficiencies ■ Examples: ● Evaluating risks differently in up and down markets ● Investors become “anchored” to certain view points, and fail to optimally respond to new information that conflicts with their existing views ○ Too much mental focus on something that isn't relevant ○ Buying stock for themselves Erik, a trader, wants to buy 1,000 shares of XYZ stock, while a second trader, Alison, is willing to sell 1,500 shares of the same stock. Unfortunately, Erik and Alison don’t know one another and must complete their transactions using the stock exchange’s market-making dealer. XYZ’s market maker is willing to sell her shares for $27.00 per share and purchase additional shares for $26.00 per share. Select the most appropriate values in the following table: ○ Bid price: $26.00 ○ Ask price: $27.00 ○ Bid-ask spread: $1.00 ■ Difference between two prices If the market maker is willing to purchase the entire block of 1,500 shares from Alison and, from that block, resell 1,000 shares to Erik, then the market maker’s net profit from Erik’s transaction—excluding any inventory effects—will be $1,000. ○ Net profit = (bid-ask spread x amount of shares to buy) ● Indigo Inc. is going public and issuing 150,000 shares of common stock. The capital raised in the IPO will fund the company’s proposed expansion. A Dutch auction is used to allocate shares in the Indigo IPO. The following table shows the number of shares requested by potential investors in each row. ● The market-clearing price in a Dutch auction is the highest price at which all the shares will be sold. The maximum offer price that Indigo can set is $55 if it wants to sell all 150,000 shares through the Dutch auction. Remember that investors who are willing to pay more than $55 for a share of Indigo stock would be happy if they had to pay only $55 for it. ● ● ● What is Smith’s earnings per share (EPS) for the trailing 12 months? ○ Last trade price/ (P/E ttm) ○ 51.63/28.21 How much did the price increase today over yesterday’s closing price? ○ Difference in end price today versus yesterdays ○ How heavy was the trading of Smith’s stock today relative to the normal level of trading? What is Behavioral Finance? Discussion: please provide (a) a general description of the bias, (b) an example of how that bias could be applied in personal finance context ● 3 investing mistakes and need to avoid ○ 1. Overconfidence bias ■ Think too highly of yourself ■ Taking too must risk and being sure of themselves and conclusion ■ Less cocky are women which improves returns ○ 2. Narrow frame of reference ■ Investing for long haul ■ Get perspective ○ 3. Anchoring bias ■ Too influence by price of stock we buy, or house ■ Mental achor can drag us down ■ Whatever number in head it is meaningless ■ Hurts by anchoring statements of destruction, goes back up that's when it sells ■ Ride it down to zero ■ Value is number market sayas not the market in your head ● Behavioral finance is the application of cognitive psychology to finance ○ How we think and solve problems ● Intuition, judgment, cognitive prais, take too much risk,too sure of decision, better on average by at least one percentage, men trading more often, a little self doubt