FIN6123 Investment Management and Analysis

Lecture 1: Introduction to Financial Assets and Markets

Xiao (Shaun) Ren

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Instructor
• Xiao (Shaun) Ren, Ph.D.
• Assistant professor, SME/SFI, CUHK Shenzhen
• Research area: Empirical corporate finance
• Contact: [email protected]
• Office hours: By appointment
• Teaching assistant: Jingyu Bi
• Contact: [email protected]

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Course Overview
• An introduction to the theory and practice of investment management
and analysis
• In short, how to “make money” in the stock market
• But it is much more complicated than that…
• How should we define “making money”?
• How can we design investment strategies that might “make money”?
• How do we know if an investment strategy actually “makes money”?
• Why do some strategies “make money” while others do not?
• What this course is not about
• Individual stock picking
• Speculation
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Course Overview
• What you are going to learn from the class:
• Basic features of various types of financial assets
• Basic features of stock markets and trading mechanisms
• Methodologies to analyze stock prices and returns
• How to construct and optimize investment portfolios
• How to design trading strategies and evaluate their performance
• Investment in the recent years: COVID, inflation, interest rate changes, AI
boom, tariff…
• Basic valuation and application of fixed-income securities and derivatives

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Course Schedule (Tentative)
Week Content/ topic/ activity
1 Introduction to Financial Assets and Markets
2 Stock Markets and Trading Mechanisms
3 Equity Valuation and Return Prediction
4 Portfolio Theory and Practice
5 Asset Pricing Models
6 Investment Performance Evaluation/Trading Strategy Design
7 Case Studies
8 Midterm Exam
9 Macro Economy, Monetary Policy, and Stock Investment
10 Stock Investment Project Presentations
11 Fixed-income securities
12 Derivatives
13 Course Review
14 Final Exam

• *This is a tentative course schedule and is subject to change

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Grading
Component % weight
Midterm exam 20%
Projects and presentation 30%
Final exam 40%
Lecture attendance and participation 10%
Total 100%

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Today’s Topic
• Financial assets and financial markets
• Investment companies
• The investment process
• Outlook of the semester

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Real Assets and Financial Assets
• Real assets
• Land, buildings, machines, knowledge, etc. that can be used to produce goods
and services
• Determines the productive capacity of an economy
• Financial assets
• Means by which individuals in economies hold their claims on real assets
• Do not contribute directly to the productive capacity of the economy
• Investors buy securities from companies; Companies use the money to
purchase real assets

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Financial Markets and the Economy
• The information role of financial markets
• Security prices reflect investors’ collective assessment of a firm’s current
performance and future prospects
• Financial markets direct capital to the firms with the greatest perceived
potential
• Consumption timing
• In high-earning periods, individuals can invest savings in financial assets
• In low-earnings periods, individuals can sell assets to support consumption
needs

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Financial Markets and the Economy
• Allocation of risk
• Financial markets allow more risk-tolerant individuals to invest in risky assets
and the less risk-tolerant individuals to invest in safer assets
• The allocation of risk also benefits firms that need to raise capital
• Separation of ownership and control
• Owners and managers of the firm are different parties
• Allows firms to be managed by skilled professionals
• Managers’ goal should be maximizing shareholder value

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Main Attributes of Financial Assets
• Return or yield
• Risk
• Liquidity
• Timing of cash flows

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Competitiveness of Financial Markets
• Financial markets are highly competitive as investors actively search for
“good” financial assets to invest in
• The risk-return trade-off
• If an asset has high expected return but low risk, investors will rush in to buy the
asset, drive up its price, and lower the expected return
• Therefore, higher-risk assets should be priced to offer higher expected returns than
lower-risk assets
• Efficient markets
• If the market is efficient, security prices should reflect all the information available to
investors concerning the security values
• There should be neither underpriced nor overpriced securities

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Active vs. Passive Investment
• Active management: Attempting to improve performance either by
identifying mispriced securities or by timing the performance of broad
asset classes
• Passive management: Holding highly diversified portfolios without
spending effort or other resources attempting to improve investment
performance

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Segments of Financial Markets
• Money markets
• Where commercial banks and other businesses adjust their liquidity position
by borrowing, lending, or investing for short periods of time
• Short-term, marketable, liquid, low-risk debt securities
• Capital markets: Equity markets, bond markets, derivative markets
• Where capital goods are financed with stock, long-term debt instruments, etc.
• Longer term and riskier securities

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Money Markets
• Treasury bills
• Short-term direct obligations issued by the government with maturities less than one
year
• Certificates of deposit (CD)
• Large-denomination time deposits of large commercial banks
• Commercial paper
• Unsecured promissory notes issued by large companies
• Federal funds
• Bank deposits held with the central bank
• Repurchase agreements (repos) and reverse repos
• Repo: A dealer sells securities to an investor on an overnight basis with an agreement
to buy back those securities the next day
• Reverse repo: A dealer buys securities from an investor with an agreement to sell
them back to the investor on a future date
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Bond Markets
• Treasury notes and bonds
• Treasury notes: Government-issued obligations with maturities between 1 and 10
years
• Treasury bonds: Government-issued obligations with maturities between 10 and 30
years
• Inflation-protected Treasury bonds
• Treasury bonds with principal amount adjusted in proportion to increases in the
Consumer Price Index (CPI)
• Municipal bonds
• Long-term debt obligations issued by state or local governments
• Corporate bonds
• Long-term debt obligations issued by corporations
• Mortgages and mortgage-backed securities (MBS)
• Long-term loans of consumers secured by real estate
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Equity Markets
• Common stock
• Represents ownership shares in a corporation
• Holders have the lowest priority claim if the company goes bankrupt
• Holders receive dividend payment after preferred stock owners
• In general, one vote is attached to each share of stock
• Preferred stock
• Holders have higher priority claim than common stock owners in case of bankruptcy
• Usually have fixed amount of dividend payments (non-participating)
• Holders receive dividend payment before common stock owners
• Holders receive cumulative dividend payment
• Usually have no voting rights attached
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Equity Markets
• Convertible securities
• Securities that are convertible into common stock
• Convertible preferred stock: Preferred stock that can be converted into
common stock
• Convertible bonds: Bonds that can be converted into common stock
• Depository receipts
• Certificates traded in a country that represent ownership in shares of a foreign
company

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Derivative Markets
• Derivatives: Financial instruments of which the price is “derived”
from the underlying asset
• Futures and forwards
• Contracts involving two parties agreeing today on a price at which the
purchaser will buy a specified amount of an asset from the seller at a specified
date sometime in the future
• Option
• A contract which gives its owner the right to buy (or sell) the underlying asset
at a predetermined price at a specified date
• Swap
• A contract in which two parties agree to exchange payment obligations on two
underlying financial liabilities that are equal in principal amount but differ in
payment patterns
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Other Market Segmentations
• Primary vs. secondary markets
• Primary markets: Where financial assets are initially sold by fundraisers
• Secondary markets: Where initial holders of previously issued financial assets
sell the assets
• Exchange vs. OTC markets
• Exchange markets: Centralized and organized transactions under a specific set
of rules and regulations
• Over-the-counter (OTC) markets: No central trading place
• Public vs. private markets
• Public markets: Organized financial markets where securities registered with
the regulatory agency are bought and sold
• Private markets: Facilitate direct transactions between two parties
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Investment Companies
• Investment companies are financial intermediaries that collect funds from
individual investors and invest those funds in a potentially wide range of
assets
• Main functions of investment companies
• Record keeping and administration
• Diversification
• Professional management
• Lower transaction costs
• The value of each share of an investment company is called the net asset
value (NAV):
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡𝑠 − 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
𝑁𝑒𝑡 𝑎𝑠𝑠𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 =
𝑆ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
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Types of Investment Companies
• Unit investment trusts
• Pools of money invested in a portfolio that is fixed for the life of the fund
• Managed investment companies
• Companies that pool investments from individual investors and hire managers to
manage funds for an annual fee
• Open-end funds (mutual funds): Funds that stand ready to redeem or issue shares at
their net asset value
• Close-end funds: Funds that do not redeem or issue shares
• Hedge funds
• Similar to mutual funds, but are commonly structured as private partnerships and thus
subject to minimal regulation
• Real estate investment trusts (REITs)
• Invest in real estate or loans secured by real estate
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Mutual Fund Investment Policies
• Money market funds
• Invest in money market securities
• Equity funds
• Invest primarily in stock
• Commonly hold ~5% of total assets in money market securities
• Sector funds
• Equity funds that concentrate on a particular industry
• Bond funds
• Invest in fixed-income securities
• International funds
• Invest in international companies
• Balanced funds
• Invest in both equities and fixed-income securities in relatively stable proportions
• Index funds
• Aim to match the performance of a broad market index
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Equity Fund Styles
• Morningstar Equity style box
• Used by investors to determine a fund’s investment objective
• Can be applied to either individual stocks or mutual funds
• First, divide stocks into three groups based on market cap (size)
• Then within each size group, classifies stocks as value, core (blend), or growth stocks
• Average classification of stocks held by a fund fund determines the fund’s overall
classification
• Size groups:
• Large cap: firms in the largest 70% of the universe market capitalization
• Mid-cap: the next 20% of market cap
• Small-cap: the remaining market cap
• Style groups
• Value: Loosely, firms with low market-to-book ratios
• Growth: Loosely, firms with high market-to-book ratios

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Equity Fund Styles

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Equity Fund Styles (Example)

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Costs of Investing in Mutual Funds
• Operating expenses
• Costs incurred by the mutual fund in operating the portfolio
• Include administrative expenses and advisory fees paid to the investment manager, etc.
• Usually expressed as a percentage of total assets under management
• Periodically deducted from the assets of the fund
• Front-end load
• A commission or sales charge paid when investors purchase the shares
• Effectively reduce the amount of money invested
• Back-end load
• A redemption fee incurred when investors sell the shares
• Effectively reduce the amount of money withdrawn
• The rate of return of a mutual fund is calculated as
𝑁𝐴𝑉1 − 𝑁𝐴𝑉0 + 𝐼𝑛𝑐𝑜𝑚𝑒 𝑎𝑛𝑑 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑔𝑎𝑖𝑛 𝑑𝑖𝑠𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛𝑠
𝑅𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 =
𝑁𝐴𝑉0

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Costs of Investing in Mutual Funds (Example)
Operating expenses

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Costs of Investing in Mutual Funds (Example)
Front-end load Back-end load

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Can Mutual Funds Beat the Market?

• On average, U.S. actively managed funds do not beat the market 31

• No conclusive evidence on whether mutual fund performance is driven by skill or luck

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Can Mutual Funds Beat the Market?
• In China, during 2003-2023, equity mutual funds outperform the market in terms
of both returns and Sharpe ratio (return-to-risk ratio)
• In 12 out of the 21 years, more than 60% of the actively managed funds outperform the market
• In 6 out of the 10 years when the stock market went down, more than 70% of the actively
managed funds outperform the market
• In the years when the market went up, fewer funds beat the market (5% in 2007, 3% in 2009,
6% in 2014)
• Differences between the U.S. and China
• Higher market efficiency in the U.S.: Information is quickly reflected in stock prices
• More institutional investors in the U.S.
• 60% of the U.S. market cap is owned by institutional investors
• 17% of the Chinese market cap is owned by institutional investors

• Source: 曹泉伟、陈卓、舒涛：《2024年中国公募基金研究报告》
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The Investment Process
• A portfolio is a collection of investment assets
• The asset allocation decision is the choice among broad asset classes
• The security selection decision is the choice of which particular
securities to hold within each asset class
• Security analysis involves the valuation of particular securities that
might be included in the portfolio

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Tentative Outlook of the Semester
• Our class focuses on
• The asset allocation decision and the security selection decision in the
investment process
• Common stocks traded in the secondary/exchange/public markets
• We will cover some basics of fixed-income securities and derivatives at the
end of the semester

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Tentative Outlook of the Semester
• Week 2: Stock Markets and Trading Mechanisms
• How are the stock markets organized?
• How do funds and ownership flow in the stock markets?
• How do transactions take place in the stock markets?
• What is margin trading and how does it affect returns?
• What to do when we expect the price of a stock to fall?
• Week 3: Equity Valuation and Return Prediction
• How do investors usually estimate the value of stocks and predict stock returns?
• Can we predict stock returns?
• What is the relationship between stock return predictability and market efficiency?
• Why are markets not efficient?
• Applications of generative AI in the investment process
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Tentative Outlook of the Semester
• Week 4: Portfolio Theory and Practice
• What factors should investors consider when making investment decisions?
• Why should investors hold well-diversified portfolios instead of single stocks?
• How does diversification help reduce the risk of investment?
• What is an optimized portfolio for an investor and how should investors
construct it?
• Week 5: Asset Pricing Models
• Overview of commonly used asset pricing models
• What are the applications and implications of asset pricing models?
• How can we use the asset pricing models to help us make investment
decisions?

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Tentative Outlook of the Semester
• Week 6: Investment Performance Evaluation/Trading Strategy Design
• Is a high-return investment strategy necessarily a “good” one?
• How should investors adjust for risk when evaluating investment performance?
• What are some trading strategies that are proven to be “good”?
• How to design your own trading strategies and evaluate whether they are “good”?
• Week 7: Case Study
• Week 8: Midterm Exam
• Week 9: Macro Economy, Monetary Policy, and Stock Investment
• Recent turmoil caused by COVID and monetary policy changes have affected the
stock market significantly. Why is that?
• What is the relation between macro economy and stock investments in general?
• Week 10: Stock Investment Project Presentations

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Stock Investment Project Overview
• This is going to be a group project (the number of students allowed in
each group is TBD)
• Each group will
• Design an investment strategy based on knowledge learned in class and real-
life experience
• Conduct research on the strategy and analyze why the strategy might generate
abnormal returns
• Collect data to evaluate the performance and feasibility of the strategy
• Analyze the return and risk pattern of the strategy

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Tentative Outlook of the Semester
• Weeks 11: Fixed-income Securities
• What are the basic features of corporate bonds?
• How are bond prices calculated?
• What are the risks of bond investments and how should we estimate the risk?
• Can we predict bond returns?
• Week 12: Derivatives
• What are the basic features of forwards/futures/options/swaps?
• What are some commonly used option trading strategies?
• How should we use derivatives in the investment process?
• Week 13: Course Summary and Review
• Week 14: Final Exam
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Summary
• Financial assets and financial markets
• Real assets vs. financial assets
• Financial markets and the economy
• Main attributes of financial assets
• Competitiveness of financial markets
• Types of financial markets and assets
• Money markets
• Bond markets
• Equity markets
• Derivative markets
• Investment companies
• Types of investment companies
• Mutual fund investment policies
• Cost of investing in mutual funds
• Can mutual funds beat the market?
• The investment process
• Outlook of the semester
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Suggested Reading
• Chapters 1, 2, and 4 of Bodie, Kane, and Marcus

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References
• 曹泉伟、陈卓、舒涛：《2024年中国公募基金研究报告》
• Malkiel, B.G., 1995. Returns from investing in equity mutual funds
1971 to 1991. The Journal of Finance, 50(2), pp.549-572.

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