Investment Management

Investment management
N. Instefjord
FN3023, 2790023
2011
Undergraduate study in
Economics, Management,
Finance and the Social Sciences
This is an extract from a subject guide for an undergraduate course offered as part of the
University of London International Programmes in Economics, Management, Finance and
the Social Sciences. Materials for these programmes are developed by academics at the
London School of Economics and Political Science (LSE).
For more information, see: www.londoninternational.ac.uk
This guide was prepared for the University of London International Programmes by:
N. Instefjord, PhD, Associate Graduate Director, Essex Business School, University of Essex.
This is one of a series of subject guides published by the University. We regret that due to
pressure of work the author is unable to enter into any correspondence relating to, or arising
from, the guide. If you have any comments on this subject guide, favourable or unfavourable,
please use the form at the back of this guide.
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Reprinted with minor revisions 2011
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Contents
Contents
Chapter 1: Introduction........................................................................................... 1
Subject guide structure and use ..................................................................................... 1
Aims and objectives ....................................................................................................... 1
Learning outcomes ........................................................................................................ 2
Syllabus ......................................................................................................................... 2
Reading advice .............................................................................................................. 3
Online study resources.................................................................................................... 4
Examination structure .................................................................................................... 5
Chapter 2: Financial markets and instruments ....................................................... 7
Learning outcomes ........................................................................................................ 7
Essential reading .......................................................................................................... 7
Further reading .............................................................................................................. 7
Guide to readings .......................................................................................................... 7
Introduction .................................................................................................................. 7
Money and bond markets .............................................................................................. 8
Money market instruments ............................................................................................ 9
Bond market instruments ............................................................................................. 10
Equity markets ............................................................................................................. 11
Equity instruments ....................................................................................................... 12
Derivatives markets ..................................................................................................... 13
Managed funds ........................................................................................................... 13
Exchange traded funds ................................................................................................ 14
Exchange trading and over-the-counter (OTC) trading ................................................... 14
Clearing, settlement, margin trading, short sales and contingent orders ........................ 15
Working out the profitability of margin trades .............................................................. 15
Regulation of financial markets .................................................................................... 17
Summary ..................................................................................................................... 17
Activities ..................................................................................................................... 17
A reminder of your learning outcomes .......................................................................... 18
Sample examination question ...................................................................................... 18
Chapter 3: The history of financial markets ......................................................... 19
Learning outcomes ...................................................................................................... 19
Essential reading ......................................................................................................... 19
Further reading ............................................................................................................ 19
Introduction ................................................................................................................ 19
A history of financial innovation .................................................................................. 19
Recent financial innovations ........................................................................................ 20
Investment returns in equity and bond markets ............................................................ 23
The equity premium puzzle .......................................................................................... 24
Summary ..................................................................................................................... 25
Activities ..................................................................................................................... 25
Sample examination question ..................................................................................... 26
23 Investment management
Chapter 4: Fund management and investment .................................................... 27

Further reading ............................................................................................................ 27
Introduction ................................................................................................................ 27
Historical mutual fund performance ............................................................................. 28
Market effciency and behavioural finance ..................................................................... 29
Return based trading strategies .................................................................................... 31
Hedge funds ................................................................................................................ 32
Performance of hedge funds ........................................................................................ 34
Algorithmic or program trading (statistical arbitrage) ................................................... 34
Summary ..................................................................................................................... 36
Activities ..................................................................................................................... 37
Chapter 5: Market microstructure ........................................................................ 39
Further reading ............................................................................................................ 39
Introduction ................................................................................................................ 39
Limit order markets ...................................................................................................... 40
Bid-ask bounce: the Roll model .................................................................................... 41
Glosten-Milgrom ......................................................................................................... 42
Kyle ............................................................................................................................. 45
Discrete version of the Kyle model ................................................................................ 47
Why market microstructure matters .............................................................................. 48
Summary ..................................................................................................................... 49
Activity ........................................................................................................................ 49
Chapter 6: Diversification ..................................................................................... 51
Further reading ............................................................................................................ 51
Introduction ............................................................................................................... 51
Expected portfolio return and variance.......................................................................... 52
Definition of risk premium ........................................................................................... 53
Numerical example ...................................................................................................... 53
Asset allocation: Two assets ......................................................................................... 54
Meanvariance preferences ......................................................................................... 55
Optimal asset allocation with a risk free asset .............................................................. 56
CARA utility and normal returns ................................................................................... 56
The portfolio frontier ................................................................................................... 57
Expected returns relationships ..................................................................................... 59
Estimation issues ......................................................................................................... 59
Diversification: The single index model ......................................................................... 60
The TreynorBlack model ............................................................................................. 61
Factor models .............................................................................................................. 63
ii
Contents
Asset allocation over longer time horizons.................................................................... 64

Summary ..................................................................................................................... 65
Activities ..................................................................................................................... 65
Chapter 7: Portfolio immunisation ....................................................................... 67
Introduction ................................................................................................................ 67
Bond maths ................................................................................................................. 68
The term structure ....................................................................................................... 70
Duration....................................................................................................................... 70
Numerical example ...................................................................................................... 72
Convexity .................................................................................................................... 73
Immunisation of bond portfolios .................................................................................. 74
Convexity and immunisation ........................................................................................ 75
Immunisation of equity portfolios ................................................................................. 76
Hedge ratios futures trading ..................................................................................... 78
Summary ..................................................................................................................... 79
Activity ........................................................................................................................ 79
A reminder of your learning outcomes........................................................................... 79
Chapter 8: Risk and performance measurement .................................................. 81
Further reading ............................................................................................................ 81
Introduction ................................................................................................................ 81
Types of risk ................................................................................................................ 82
Risk decomposition ..................................................................................................... 83
Value-at-Risk ............................................................................................................... 83
The Sharpe ratio .......................................................................................................... 84
Treynors ratio .............................................................................................................. 85
More portfolio performance measures .......................................................................... 86
Sharpe vs Treynor ......................................................................................................... 87
Changing risk .............................................................................................................. 88
Market timing .............................................................................................................. 89
Summary ..................................................................................................................... 90
Activity ........................................................................................................................ 90
Chapter 9 Risk management ................................................................................ 93
Further reading ............................................................................................................ 93
Introduction ................................................................................................................ 93
Risk management for investors .................................................................................... 94
Risk management for corporations ............................................................................... 94
Risk management for banks ......................................................................................... 95
Put option protection ................................................................................................... 95
Put protection vs VaR ................................................................................................... 96
iii
Portfolio insurance with calls ........................................................................................ 97

Non-linear pay-offs ...................................................................................................... 98
Extreme risk ................................................................................................................ 99
Hedging credit risk .................................................................................................... 100
Hedging volatility ...................................................................................................... 101
Risk capital allocation ................................................................................................ 102
Summary ................................................................................................................... 102
A reminder of your learning outcomes ........................................................................ 103
Sample examination question .................................................................................... 103
Chapter 10: Important concepts.......................................................................... 105
Investment returns ..................................................................................................... 105
Averages: geometric vs arithmetic .............................................................................. 106
Taylor approximation ................................................................................................. 107
Optimisation ............................................................................................................. 107
Regression methods .................................................................................................. 108
Utility theory ............................................................................................................. 109
Risk aversion coefficient ............................................................................................ 109
Expected utility maximisation ..................................................................................... 110
Variance aversion and the portfolio frontier ................................................................ 110
Standard normal distribution ..................................................................................... 112
American vs European options ................................................................................... 113
Chapter 11: Sample examination paper ............................................................. 115
Appendix 1: Technical terms................................................................................ 119
Averages: geometric vs arithmetic............................................................................... 119
Investment returns ..................................................................................................... 119
A review of regressions methods................................................................................. 121
Utility theory ............................................................................................................. 122
Risk aversion coefficient ............................................................................................ 123
Expected utility maximisation ..................................................................................... 123
CARA utility functions ................................................................................................ 123
iv
Chapter 1: Introduction
Finance is essentially about pricing financial assets, but in this subject
guide we will focus more on what we use pricing theory for from an
investment perspective. We will seek to apply pricing theory (among other
things) to tell us something about how to invest our money optimally in
financial assets rather than for pricing itself. We will spend some time
looking at how to protect our investments using techniques from the area
of risk management. For those who want a more thorough overview of
pricing theory, see the subject guide for course 92 Corporate finance.
Subject guide structure and use

This subject guide is not a course text. Wider reading is essential as you
are expected to see the area of study from an holistic point of view, and
not just as a set of limited topics. The structure of the subject guide is as
follows.
Chapter 2 introduces you to financial markets and instruments.
Chapter 3 surveys some of the history behind the innovation of new
financial markets and instruments and the return that investors have
historically achieved from holding various classes of financial assets.
Chapter 4 surveys some of the empirical findings regarding active fund
management and investment strategies. We look at the performance
of mutual funds, the performance of certain popular contrarian and
momentum investment strategies, and finally we look at the investment
strategies of hedge funds.
Chapter 5 surveys some of the literature on market microstructure,
with the emphasis on how the bid-ask spread is formed in financial
markets and on how speculators seek to optimally benefit from their
information advantage.
Chapter 6 discusses optimal investment for investors using optimal
diversification strategies.
Chapter 7 discusses risk immunisation strategies to remove some or all
risk factors from the investors portfolio.
Chapter 8 discusses risk and performance measurement.
Chapter 9 looks at portfolio insurance strategies and value-at-risk based
risk management strategies.
Aims and objectives

This subject guide is designed to introduce you to the investment
environment in the role of a private or professional investor. This course
does not cover pricing theory, which is a major part of 92 Corporate
finance. Instead, it emphasises the use of pricing theory in investment
management. It aims to:
provide an overview of institutional details linked to financial markets
and the trading process
provide an overview of historical trends and innovations in financial
instruments and trading processes
1
provide an overview of various financial instruments

provide insight into the use of finance theory in investment
management
provide a guide to the measurement and analysis of risk of financial
investments
provide a guide to the measurement of performance of fund
management
address key issues in risk management.
Learning outcomes
At the end of this course, and having completed the Essential reading and
activities, you should be able to:
list given types of financial instruments and explain how they work in
detail
contrast key characteristics of given financial instruments
briefly recall important historical trends in the innovation of markets,
trading and financial instruments
name key facts related to the historical return and risk of bond and
equity markets
relate key facts of the managed fund industry
define market microstructure and evaluate its importance to investors
explain the fundamental drivers of diversification as an investment
strategy for investors
aptly define immunisation strategies and highlight their main
applications in detail.
discuss measures of portfolio risk-adjusted performance in detail and
critically analyse the key challenges in employing them
competently indentify established risk management techniques used by
individual investors and corporations.
Syllabus
Exclusions: This course has replaced course 121 International
financial markets and may not be taken if you are taking or have
passed course 121 International financial markets. If you have
failed course 121 and wish to transfer to course 23, your fail on course
121 will count as one of the three chances you have to pass the new
course.
Prerequisites: If you are taking this course as part of a BSc degree, you
must have already taken course 24 Principles of banking and
finance (or course 94 Principles of banking for students registered
before 1 September 2005). Course 92 Corporate finance must also be
taken with or before this course.
The syllabus comprises the following topics:
1. Financial markets and instruments: money and bond markets;
equity markets; derivative markets; managed funds; margin trading;
regulation of markets.
2. History of financial markets: historical and recent financial innovation;
historical equity and bond market returns; equity premium puzzle.
2
3. Fund management and investment: historical mutual fund

performance; market efficiency and behavioural finance; return based
trading strategies; hedge funds.
4. Market microstructure: types of markets; bid-ask bounce: the Roll
model; Glosten-Milgrom model; Kyle model; discrete version of the
Kyle model; limit order markets; statistical arbitrage (algorithmic
trading, program trading); why market microstructure matters.
5. Diversification: expected portfolio return and variance; definition of
risk premium; asset allocation two assets: mean-variance preferences;
optimal asset allocation with a risk free asset; CARA utility and normal
returns; portfolio frontier; expected return relationships; estimation
issues; diversification the single index model; Treynor-Black model;
factor models; statistics of asset allocation.
6. Portfolio immunisation: bond math; term structure; duration;
numerical examples; immunisation of bond portfolios; convexity and
immunisation; immunisation of equity portfolios.
7. Risk and performance management: types of risk; risk decomposition;
hedge ratios; Value-at-Risk; Sharpe ratio; Treynors ratio; more
portfolio performance measures; Sharpe vs Treynor; portfolios with
changing risk; market timing; non-linear pay-offs; extreme risk.
8. Risk management: risk management for investors; risk management
for corporations; risk management for banks; delta hedging; put option
protection; put protefction vs VaR; portfolio insurance with calls;
hedging credit risk; hedging volatility; risk capital allocation.
Reading advice
At the start of each chapter in this subject guide your recommended
reading appears in two categories, Essential reading and Further reading,
to be found in both textbooks and journal articles.
Essential reading
The course uses two essential textbooks as listed below:
Bodie, Z., A. Kane and A.J. Marcus Investments. (Boston, Mass.; London:
McGraw-Hill Irwin, 2008) eighth edition [ISBN 9780071278287].
Elton, E.J., M.J. Gruber, S.J. Brown and W.N. Goetzmann Modern Portfolio
Theory and Investment Analysis. (New York; Chichester: John Wiley & Sons,
2010) eighth edition [ISBN 9780470505847].
Detailed reading references in this subject guide refer to the editions of the
set textbooks listed above. New editions of one or more of these textbooks
may have been published by the time you study this course. You can use
a more recent edition of any of the books; use the detailed chapter and
section headings and the index to identify relevant readings. Also check
the VLE regularly for updated guidance on readings.
Further reading
Please note that as long as you read the Essential reading you are then free
to read around the subject area in any text, paper or online resource. You
will need to support your learning by reading as widely as possible and by
thinking about how these principles apply in the real world. To help you
read extensively, you have free access to the virtual learning environment
(VLE) and University of London Online Library (see below).
Other useful texts for this course include:
Books
Allen, F. and D. Gale Financial Innovation and Risk Sharing. (Cambridge, Mass.;
London: MIT Press, 1994) [ISBN 9780262011419].
Campbell, J.Y. and L.M. Viceira Strategic Asset Allocation. (New York: Oxford
University Press, 2002) [ISBN 9780198296942] Chapter 2.
Duffe, D. and K.J. Singleton Credit Risk: Pricing, Measurement and Management.
(Princeton, NJ: Princeton University Press, 2003) [ISBN 9780691090467]
Chapter 1.
Embrechts, P., C. Kluppelberg, and T. Mikosch Modelling Extremal
Events. (New York; Berlin; Heidelberg: Springer-Verlag, 1997) [ISBN
9783540609315]. Note that this book is very advanced and is not really
drawn on except for some initial observations made in the very beginning
of Chapter 8 of the guide.
Grinblatt, M. and S. Titman Financial Markets and Corporate Strategy. (Boston,
Mass.; London: McGraw-Hill Irwin, 2008) [ISBN 9780077119027]. Please
note that at the time of going to print there is a new edition of this textbook
due to be published.
Hasbrouck, J. Empirical Market Microstructure. (Oxford: Oxford University
Press, 2007) [ISBN 9780195301649]. A relatively current textbook on
market microstructure which forms the basis for the chapter on market
microstructure.
Lo, Andrew W. Hedge Funds. (Princeton, NJ: Princeton University Press, 2008)
[ISBN 9780691132945].
Pole, Andrew Statistical Arbitrage. (Hoboken, NJ: Wiley Finance, 2007)
[ISBN 9780470138441].
MacKenzie, Donald An Address in Mayfair. (London Review of Books) www.lrb.
co.uk/v30/n23/mack01.html
Stultz, R. Risk Management and Derivatives. (Mason, Ohio: Thomson SouthWestern, 2003) [ISBN 9780538861014]. This book specifically deals with
risk management.
Journals
There are a number of important journal articles that deal with investment
management - those listed here are just a few:
Elton, E.J. and M.J Gruber Modern portfolio theory: 1950 to date, Journal of
Banking and Finance 21(1112) 1997, pp.174359.
Elton, E.J., M.J. Gruber and C.R. Blake Survivorship bias and mututal fund
performance, Review of Financial Studies 9(4) 1996, pp.1097120.
Mehra, R. and E.C. Prescott The Equity Premium: A Puzzle, Journal of
Monetary Economics 15(2) 1985, pp.14561.
Sharpe, W.F. Asset Allocation: Management Style and Performance
Measurement, Journal of Portfolio Management 30(10) 1992, pp.716.
Online study resources

In addition to the subject guide and the Essential reading, it is crucial that
you take advantage of the study resources that are available online for this
course, including the virtual learning environment (VLE) and the Online
Library.
You can access the VLE, the Online Library and your University of London
email account via the Student Portal at:
http://my.londoninternational.ac.uk
You should receive your login details in your study pack. If you have not,
or you have forgotten your login details, please email uolia.support@
london.ac.uk quoting your student number.
4
The VLE
The VLE, which complements this subject guide, has been designed to
enhance your learning experience, providing additional support and a
sense of community. It forms an important part of your study experience
with the University of London and you should access it regularly.
The VLE provides a range of resources for EMFSS courses:
Self-testing activities: Doing these allows you to test your own
understanding of subject material.
Electronic study materials: The printed materials that you receive from
the University of London are available to download, including updated
reading lists and references.
Past examination papers and Examiners commentaries: These provide
advice on how each examination question might best be answered.
A student discussion forum: This is an open space for you to discuss
interests and experiences, seek support from your peers, work
collaboratively to solve problems and discuss subject material.
Videos: There are recorded academic introductions to the subject,
interviews and debates and, for some courses, audio-visual tutorials
and conclusions.
Recorded lectures: For some courses, where appropriate, the sessions
from previous years Study Weekends have been recorded and made
available.
Study skills: Expert advice on preparing for examinations and
developing your digital literacy skills.
Feedback forms.
Some of these resources are available for certain courses only, but we
are expanding our provision all the time and you should check the VLE
regularly for updates.
Making use of the Online Library

The Online Library contains a huge array of journal articles and other
resources to help you read widely and extensively.
To access the majority of resources via the Online Library you will either
need to use your University of London Student Portal login details, or you
will be required to register and use an Athens login: http://tinyurl.com/
ollathens
The easiest way to locate relevant content and journal articles in the
Online Library is to use the Summon search engine.
If you are having trouble finding an article listed in a reading list, try
removing any punctuation from the title, such as single quotation marks,
question marks and colons.
For further advice, please see the online help pages: www.external.shl.lon.
ac.uk/summon/about.php
Examination structure
Important: the information and advice given here are based on the
examination structure used at the time this guide was written. Please
note that subject guides may be used for several years. Because of this
we strongly advise you to always check both the current Regulations for
relevant information about the examination, and the virtual learning
5
environment (VLE) where you should be advised of any forthcoming

changes. You should also carefully check the rubric/instructions on the
paper you actually sit and follow those instructions.
Remember, it is important to check the VLE for:
up-to-date information on examination and assessment arrangements
for this course
where available, past examination papers and Examiners commentaries
for the course which give advice on how each question might best be
answered.
The Investment management examination paper is three hours in
duration and you are expected to answer four questions, from a choice
of eight. You should ensure that you answer four questions, allow yourself
an approximately equal amount of time to answer each question and
attempt all parts or aspects of a question. Remember to devote some time
to planning your answer.
A full sample examination paper appears at the end of this guide. You are
required to answer any four of these eight questions, each of which carries
25 marks. A typical question contains three sub-questions which may not
be drawn from the same area, the first of which is relatively less diffcult
than the other and carries a weight of five marks against 10 marks for the
other two.
Chapter 2: Financial markets and instruments
Chapter 2: Financial markets and

instruments
Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
accurately distinguish key characteristics between equity and debt
claims
clearly express the main differences between IPOs (initial public
offerings) and SPOs (seasoned public offerings)
contrast exchange traded securities and OTC (over-the-counter)
securities in detail
adequately describe given money market and bond market instruments
differentiate clean and dirty bond prices and aptly explain how
accrued interest is calculated
cogently discuss the importance of financial markets regulations
Essential reading
McGraw-Hill Irwin, 2008) Chapters 1, 2, 3, 4, 14, 20, 22 and 23.
Elton, E.J., M.J. Gruber, S.J. Brown and W.N. Goetzmann Modern Portfolio
Theory and Investment Analysis. (New York; Chichester: John Wiley & Sons,
2010) Chapters 2 and 3.
Further reading
Grinblatt, M. and S. Titman Financial Markets and Corporate Strategy. (Boston,
Mass.; London: McGraw-Hill Irwin, 2008) Chapters 1, 2 and 3.
Guide to readings
This chapter is an introductory chapter and contains a great deal of
background readings from both the Essential and the Further readings.
The Essential reading for the general material in this chapter is contained
in Bodie, Kane and Marcus Chapters 1 through to 4. Here you can read the
material relatively quickly as there are few technical details to remember.
Some of the more technical material in this chapter is covered in Bodie,
Kane and Marcus Chapters 14, 20, 22 and 23. Here you can be more
selective in your reading, but you may also have to read the material more
carefully so that you are sure you understand it properly.
Introduction
Financial assets are distinct from real assets in that they do not generate
a productive cash flow that is what real assets do. Examples of real
assets are: a block of flats that can be let to provide the owner with future
rental income; the rights to manufacture and sell a particular product
generating future sales revenue; or a particular piece of computer software
that generates future sales and registration income. Examples of financial
assets are: a loan that is used to fund the acquisition of the block of
7
flats and whose payments are financed by the rental income; or equity
capital used to fund the research and development costs for the consumer
software products mentioned above. The equity holders benefit in terms of
future dividends or capital gains that are generated from the future sales
income of the products. From the point of view of cash flow generation,
therefore, financial assets do not have much of a role to play. Financial
assets are not neutral in the sense that they transform the cash flow of real
assets for the holder. For instance, the loan generates a relatively stable
income even though the underlying cash flow is risky. Also, the loan might
have enabled the investor to raise suffcient funds for investment in the
first place. We trade financial assets, therefore, to repackage or transform
the cash flow of real assets, either through time or across states of nature.
Financial assets also do another important job they enable us to separate
the functions of ownership and control of real assets. As a rule, real assets
do not just passively generate a cash flow they need to be managed.
A company owns a collection of real assets. The job of managing these
is highly specialised and it is necessary that it is done by a professional.
This individual may or may not be the owner of the real assets, so it
makes sense for the company to keep the ownership and control functions
separate. This can be done by issuing equity with claims on the real assets
of the company the owners of the companys equity then become the
owners of the company so that the company can hire a professional
manager to manage its pool of real assets.
Who uses financial markets? There are three key sectors:
The household sector you and me who need to invest for retirement
income or mortgages for house acquisitions and various insurance
products, for instance.
The business sector consisting of firms that need to issue financial
claims on their future cash flow to finance current investments which
need to manage the risk of their business through derivatives trading
and insurance products.
The government sector that has a need to finance public expenditure.
This sector is special as it sometimes also intervenes in financial
markets to provide a public policy objective for instance, influence
the interest rate to manage inflation and additionally by acting as a
regulator of the activity in financial markets.
On the other hand, financial markets are not the only way these sectors
are served by financial instruments. Financial intermediaries also provide
services. These are companies such as banks and investment houses which
can lend money to, and help companies issue securities, and collect
deposits or lend to households, or manage households and companies
funds. In this chapter, we shall discuss a relatively broad range of financial
assets (also known as financial instruments), and their key defining
characteristics.
Money and bond markets

The simplest form of claim is a bond. A bond is a fixed claim meaning
that it promises a particular cash flow normally a coupon payment that
is an annual or semi-annual payment measured as a percentage of the
principal amount, and then ultimately at maturity the principal repayment
is made. For instance, a 10-year 5% bond with principal 100, will pay
a coupon payment of 5% of 100 each year until maturity, or five, and
additionally at maturity, in year 10, it pays the principal of 100.
8
The cash flow promised to bond holders comes from the cash flow
generated by real assets. Since the cash flow of real assets is often risky, it
may be that there is not enough to pay the promised amount at all times.
If this happens, the bond may default. In the example above, for instance,
the coupon promises a cash flow of 100 to be paid to the bond holders, but
if the corporate cash flow available in year 10, after coupon repayments
are made, is only 70 the bond holders stand little chance of receiving their
promised repayment of 100. The bond defaults, therefore, and the bond
holders can expect to receive at most only 70. Some bonds are, however,
practically default-free for instance, bonds issued by the government
(government bonds they are often called treasury bonds in the USA
and gilts in the UK). Bond instruments are traded in the money market
or the bond market. The distinction between these markets is essentially
that of the original maturity of the instrument. If a bond was issued with
very short maturity normally less than six months it will be traded in
the money market. If a bond has longer maturity it is traded in the bond
market. Another distinction is the denomination of the claim.
Normally, money market instruments are traded in large denominations
so as to be out of reach of normal households. They are used by banks and
corporations to lend and borrow in the short term. Bonds, on the other
hand, can be held by households.
Money market instruments

The money market consists of fixed-income instruments of relatively short
maturity. This market also tends to be highly liquid, and instruments can
be in very high denominations, making it impractical for ordinary people
to trade. The players who operated in this market are normally private
banks, the central bank and corporations. There are a number of risk
free instruments traded, which are issued by the government, such as US
treasury bills, certificates of deposits and commercial papers.
Treasury bills (T-bills) initially have a maturity of 28, 91 or 182 days
(approximately one, three and six months). Treasury bills have two
atypical characteristics that set them apart from many of the other money
market instruments. They normally sell in low denominations of US$
10,000, making them tradeable by individuals.
A certificate of deposit (CD) is a deposit with a bank that has a clearly
defined time limit, so cannot be withdrawn on demand. These are,
therefore, very similar to T-bills except they are issued by a private bank
instead of the government. CDs are in denominations of US$100,000 or
greater, and in maturities of three months or shorter. Although there is a
theoretical default risk on CDs, they are treated as normal bank deposits,
so will be subject to governmental deposit insurance schemes.
A commercial paper is another short term fixed income security that is
similar to the ones we have looked at above but is issued by corporations.
There is a default risk associated with these instruments, but often they
are backed up by a bank line of credit so the borrower can access funds to
pay off the commercial paper at maturity. These instruments are also often
rolled over at maturity, such that the old commercial paper is paid off by
issuing a new one. The denominations are in multiples of US$100,000 so
commercial papers are rarely traded by individuals.
An important source of very short term financing used to trade
government bonds is the repo market (and the mirror reverse market).
A repo (RP) is a repurchase agreement where a dealer sells government
9
securities overnight to an investor and promises to buy the security back

the next day at a given (and slightly higher) price. The transaction is,
therefore, equivalent to a one-day loan agreement, since the agreement
provides a cash inflow today to the seller (as will be the case with a loan)
against a specified cash outflow tomorrow (as will be the case when
repaying a loan). These agreements are also very secure to the buyer in
the agreement (in this case he plays the role of a lender), who holds the
government bond overnight which serves as collateral in case the borrower
cannot raise suffcient funds to buy back the bond as promised. A reverse
repo is the mirror image, a buy transaction held overnight under the
promise of selling the securities the next day. Longer agreements are called
term repos, and are used for loans up to 30 days or more.
Another important short term financing market is the market (the London
Interbank Offered Rate) which is the rate at which large banks in London
are willing to borrow and lend money. Access to this LIBOR market is
of course restricted, but the LIBOR rate has become very important as
a reference rate, and many short-term fixed income instruments with
a floating rate tie their rates to the LIBOR (i.e. the rate is LIBOR plus a
margin).
Bond market instruments

The bond market also offers fixed income securities, only at longer
maturities than the money market instruments. A very large part of this
market consists of government bonds which are debt instruments with
payments guaranteed by the government. These bonds are important
because they offer investors claims that are in effect risk free, and they are
important to the government because they provide an important source
of borrowing. Common bonds are Treasury bonds and bills (issued by
the US government) and gilts (issued by the UK government). The UK
government bond market also trades two very unique types of bonds:
consol bonds (bonds with no redemption date, they are in effect a
perpetual loan that pays a coupon rate forever); and index linked bonds
(bonds where the repayments coupons and capital repayments are
index linked to the inflation rate). The yield of index linked bonds is the
closest we get to a direct estimate of the real interest rate.
Zero-coupon bonds are bonds that have no coupon payments. These bonds
always trade below par value (the nominal value of the loan) because of
the time value of money. If the interest rate is 5%, the value of a five-year
zero coupon bond equals the discounted capital repayment. If the par
value is 100, the current price of the bond is 78.35:
Price = 78:35 =
100
1.055
The convention in quoting bond prices is to adjust for accrued interest

the clean price. This means that the bond price you actually pay is in
general not equal to the bond price that is quoted in the financial pages.
The price you pay is the quoted price plus the accrued interest the
dirty price. The adjustment for accrued interest involves stripping the
bond price of the first coupon payment. Consider two bonds: one bond
has maturity 11 years less one day and the other maturity 10 years plus
one day. Both bonds have an annual coupon with rate of 5% prices the
holders of the first bond has just received a coupon payment one day ago,
and the holders of the second bond is due a coupon payment shortly in
one days time. Suppose the discount rate is also 5%. The actual prices of
the two bonds are:
10
Price first bond = 100.013 =
100 + 5
1.05364/365
Price second bond = 104.986 =
100 + 5
1.051/365
At the time of the next coupon payment, the bonds trade at exactly par
value since the coupon rate equals the discount rate. But because of the
difference in the timing of the coupon the actual prices are different. The
accrued interest for the two bonds is given by the formula:
Accrued interest = coupon payment
days since last coupon payment

days separating coupon payments
We find, therefore, the following quoted prices for the two bonds:
Quoted price first bond = 100.013 5
1
= 100.00
365
Quoted price second bond = 104.986 5
364
= 100.00
365
The adjustment for accrued interest makes the prices comparable. Bonds
are fixed securities but they often feature call provisions. Gilts often have
call provisions determining the redemption date so that the UK
government may retain flexibility to redeem the bond within given time
intervals. It is common in these circumstances to treat the redemption date
as the first date in the redemption interval if the coupon rate is greater
than the current market rate (so that the loan is relatively expensive
compared to the current rate for the UK government) and conversely as
the last date in the redemption interval if the coupon rate is less than the
current market rate.
Equity markets
Equity is, as opposed to a fixed claim like a bond, a residual claim. This
means that it has a cash flow that is in the form of the residual cash flow
of the real asset after all fixed claims with promised payments are paid
off. For instance, if a business is financed by a 10-year bond in addition
to its equity, the equity holders have a claim on the business net of the
cash flow that is promised to the bond holders. The equity claim is the
means by which ownership and control for corporations are separated.
When we refer to the owners of a corporation we mean the owners of the
corporate equity and not the owners of the corporate debt, although both
have claims on the cash flow of the firm. The owners of the equity are,
however, normally not directly involved in the running of the corporation
this is the job of the executive manager who is hired to do precisely
this job. Therefore, the ownership is separated from the control function
in corporations. The manager is hired on a long-term basis (although he
may be fired at short notice) whereas the owners of the equity can decide
for themselves whether they wish to invest long-term or short-term in
the corporation. The separation of ownership and control is, therefore, a
simple way to achieve a long-term stable management structure even if
the owners of equity are all short-term investors. In partnerships (such
as many accounting and legal practices) it would create a great deal of
operational upheaval to have ongoing ownership changes taking place.
11
We can say, however, that the equity holders have more influence on the
running of the company than the debt holders. The direct influence of an
individual equity holder is nonetheless limited. An equity holder normally
gets the right to vote in general meetings. This means in practice that
he gets the chance to influence a few very important decisions such as
large investment projects or decisions related to corporate mergers and
takeover through his vote, and also to influence the choice of who sits
on the non-executive board of directors (NED). The NED has a direct
oversight on the executive management team of the corporation, and it
is essentially through representation on the NED that shareholders have
their main influence in the running of the firm. A lot of measures aimed at
strengthening corporate governance are aimed at making the NED more
effective in overseeing the executive management team.
Initially, companies issue equity that is owned privately (i.e. it is not
listed on a stock exchange) by an entrepreneur, a family, or by venture
capitalists. The process of making private equity public normally involves
the corporation seeking listing of its equity on a stock exchange. The
equity can thereafter be traded freely by all investors. The first time
a company seeks a listing is called an Initial Public Offering (IPO).
Subsequent equity issues are called seasoned issues, and these are much
less involved than the IPO since the equity has been traded for a while
before the issue. If the company sells existing equity (for instance, if the
government sells equity that is already issued but fully state owned) in the
IPO or during a seasoned issue, we call it a secondary issue. If new equity
is issued, we call it a primary issue. Sometimes the company needs to raise
additional capital when it goes public, and in this case it is necessary to
make some of the issued equity a primary issue. Otherwise, the issue is
primarily a process of transferring equity from the initial owners to the
new investors.
Equity instruments
Equity instruments consist of stocks common stocks or preferred stocks
in publicly traded companies. The two most distinctive features are that
they are residual claims and that an owner can exercise the right to limited
liability (i.e. the owner can decide to relinquish his claim on the real
underlying assets and instead hand these over to the other claim holders).
A residual claim is a claim that is unspecified, it will be determined as the
residual of the total corporate cash flow net of all fixed claims. Therefore,
if the corporate cash flow is 100m, on which the debt holders have a
fixed claim of 75m, the residual cash flow due to the equity holders is
the residual 100m 75m = 25m. The implication of the fact that equity
is a residual claim is that its value can never exceed the value of the total
real assets of the firm. The implication of the fact that the equity holders
can exercise the right to limited liability is that the value of the equity
can never become negative. Common stock and preferred stock differ in
two respects. First, common stock holders normally have voting power in
general meetings whereas preferred stock holders have not. Second, the
claim of preferred stock holders has seniority over that of common stock
holders. Thus, if the company wishes to pay dividends to its common stock
holders it must first pay a dividend to its preferred stock holders.
Common stock is often split into two classes (dual-class shares), usually
called A and B shares. These classes differ in their voting power, where
one class (normally A shares) have superior voting power relative to
the other class. The reason dual-class share structures are introduced is
12
that a controlling family may wish to retain the majority of the voting
power whilst at the same time may diversify by selling B shares to outside
investors. Dual-class share structures are relatively rare in the USA and the
UK but can frequently be found in Europe and Japan.
Derivatives markets
Bonds and equity claims are claims that perform a dual role. For the issuer
(businesses, banks or governments), these claims are a means of raising
capital used for investment or expenditure. For the investors, these claims
are means of smoothing real cash flows across time and states. Derivatives
are instruments that do not really play a direct role as a means of raising
capital that is, these instruments are in zero net supply. If no buyer exists
for a particular derivative instrument, then also no seller exists. Derivatives
are, therefore, almost exclusively used for risk management purposes.
Derivatives are also sometimes called contingent claims. The cash flow of
derivatives is almost always linked to the price of a primary asset such as a
bond or an equity claim the underlying asset. In this sense, therefore, the
cash flow is a function of, or contingent on, what happens to the price of
the underlying asset. However, recently we also observed derivatives that
had a cash flow contingent on other events, such as the event that a bond
defaults (credit derivatives), or the event that the weather is bad (weather
derivatives).
There are three broad types of derivative claims: futures (forwards),
options and swaps.
If you enter into a futures or forward agreement, you effectively
undertake the obligation to buy or sell an asset at a specified price in
the future.
An option is like a futures agreement, except that you have the right
to buy or sell rather than an obligation. This implies that you have
the right to opt out of the transaction if you own an option, but must
always carry out the transaction if you own a futures contract.
A swap is an undertaking to swap one cash flow for another cash flow.
Managed funds
Managed funds represent, in essence, a delegation of the investment
decision from the individual investor to a professional fund manager. We
distinguish between active and passive funds, fixed income and equity
funds, and open-end and closed-end funds.
An active fund is one where the fund manager typically makes investment
decisions that are in the form of bets the manager might think that
certain sectors or certain stocks are better bets than others and influences
the investments of funds to these sectors or stocks. A passive fund is
one where the fund manager typically attempts to mimic a broad stock
market index (like the FTSE 100 in London and the Standard & Poor 500
in New York). This normally amounts to physically holding the index or
a large number of stocks in the index. Open-end funds are funds where
the investors clear their holding directly with the fund. Therefore, if a
new investor comes in to buy units of the fund the fund simply issues
new units. The price the investor pays is the Net Asset Value (NAV) less
charges. The NAV is calculated as the total net value of the fund divided by
the number of units issued to investors. Closed-end funds are funds which
have a fixed number of units issued. If an investor wishes to buy units in
13
the fund he needs to trade with existing investors. Units in closed-end

funds have, therefore, a value which is independent of the value of the
assets held by the fund. There have historically been price discrepancies
between the total value of outstanding units, and the total net value of
assets held by the fund, where units have traded at a considerable discount
relative to their theoretical value.
Exchange traded funds

A fairly new innovation for private investors is the so-called exchange
traded funds (ETFs). These are typically index tracker style funds, but they
are exchange traded like a stock. This makes it possible for small investors
to hold an index cheaply and effciently without having to physically
diversify by trading a large number of stocks in small quantities. Examples
of exchange traded funds are the DIAMONDS fund on the NYSE, which
delivers the Dow Jones Industrial Average Stock Index, and the iFTSE100
fund on the London Stock Exchange, which delivers the FTSE 100 Index.
Exchange trading and over-the-counter (OTC) trading

The process by which financial assets are traded can be divided, broadly
speaking, into exchange trading and over-the-counter (OTC) trading.
Exchange trading involves investors submitting buy-and-sell orders that
are aggregated into some system that allows buyers and sellers to be
matched directly. OTC trading involves investors submitting buy-and-sell
orders to a dealer who acts as an intermediary in the trade. The dealer
will normally take proprietary positions in the stock and thereby expose
himself to inventory risk, but over time these inventories cancel out as
investors execute trades at both the buy and sell side of the dealers
inventory. Large stock markets such as the NYSE (New York Stock
Exchange) and the LSE (London Stock Exchange) are executing exchange
trading of securities, whereas the NASDAQ stock market is an OTC market
with a panel of dealers offering bid and ask prices for the listed stocks. In
a perfect world in which each trader is able to trade at the competitive
prices at all times the difference in market structure does not translate
into any real differences in the execution of the trade. However, the OTC
market structure has been criticised for allowing trading at the bid and
ask prices when there exist limit orders inside the spread that could trade
at a better price (so-called trading through), and large markets such as
the NASDAQ market are working to improve their system. In 1997, the
LSE carried out a conversion from OTC trading (much like the NASDAQ
market structure) to exchange trading using a fully computerised limit
order system (the SETS system). There is no intermediary at all in this
market. The NYSE operates a system in which a limit order book executes
most trades but that also a significant portion of the trading volume is
executed by an intermediary (the so called specialist) who might improve
on the quotes implied by waiting limit orders. The benefit of having such
an intermediary is that relatively competitive quotes are also offered
in stocks that are thinly traded. Chapter 3 of Bodie, Kane and Marcus
describes the securities trading process in more detail.
14
Clearing, settlement, margin trading, short sales and

contingent orders
The trading process of stocks has become increasingly sophisticated.
All transactions taking place on a stock exchange are cleared once a
day, where the net positions are to be settled. If, for instance, you both
buy and sell the same security over the course of a single day, it is only
the net trading that needs to be settled. Settlement takes place within
three working days on the NYSE, so that if you have bought net stock on
Monday, you will receive your share certificates and pay the outstanding
amount on Thursday. You can also trade stock on margin, which means
that you only pay for a part of the purchase price and you borrow the rest
from your broker. The broker normally has a working relationship with a
bank or a financing house to finance loans made through margin trading.
A margin needs to be maintained over time. For instance, if you purchase
shares initially worth 10,000 on a 60% percentage margin, you need to
pay only 6,000 and you borrow the remaining 4,000 from your broker.
Suppose your account stipulates a 50% maintenance margin. If the shares
decline in value, suppose they drop to 7,000, your margin would have
decreased below 60% also. The margin is now (7,000 4,000)/7,000 =
43%, so you need to inject more money into your account to maintain a
margin of 50%. After the repayment, your margin is worth 3,500 and the
loan is 3,500.
You can sell a stock you do not own to take advantage of price drops.
Technically, it is illegal to sell a stock you do not own but you can
circumvent these rules by borrowing share certificates from somebody
who already owns the stock, which are then short sold. The owner of the
share certificates will normally demand a fee. Fund managers who manage
large funds (such as pension funds) are often lending their certificates
to investors who wish to go short in the stock, since these funds do not
normally plan to sell the stock anyway. Short selling is used particularly by
hedge funds as an integral part of the investment strategy.
You can also instruct your broker to execute contingent buy-and-sell
orders. The most common of these are called limit orders, where you
instruct your broker to buy a certain amount of stock as long as the
purchasing price is below a certain limit, or to sell a certain amount of
stock as long as the selling price is above a certain limit. You can also use
so-called stop loss and stop buy orders. A stop loss order is an instruction
to sell a quantity of a stock as long as the price remains below a certain
limit, and a stop buy order is an instruction to buy a quantity of a stock as
long as the price remains above a certain limit. These are used to limit the
loss potential of long and short positions. For instance, if you own a large
quantity of a stock that has already appreciated in value, you may wish to
protect your profit by giving a stop loss order. The sell order comes into
effect if the stock price goes below a certain limit. Similarly, if you have a
large short position and you wish to protect the existing profit you may be
giving a stop buy order.
Working out the profitability of margin trades

When you are trading on margin you are in effect taking a leveraged
position, where the total return is shared between the broker (who
borrows or lends money from you on his margin account) and yourself.
It can become complicated sometimes to work out the return on these
trades, so we will go through a couple of examples here of a long trade
15
(and we need to work out the return on our initial equity position) and a
short trade (which is a loan, and we are interested in the implied loan rate
on our net loan, taking into account the deposit on our margin account).
First consider a long position. You buy 1000 shares of a stock at an initial
price of 100p per share, and one year later the price is 60p per share.
During the year, you receive dividends worth 10p per share. You hold the
position for another year, where you receive dividends of 8p per share, and
then finally at the end of year two you sell the position at a price of 110p
per share. The initial margin is 60%, and the maintenance margin is 40%.
There are three steps to the calculations here. First, you need to work out
the gross cash flows. In year 0, the investment cost is 1000 (1000 units
times the price of 100p). Then in year one, the cash flow is the dividend
payment of 100 (1000 shares times 10p) which we assume arrive at
the end of the year (this may not be the case of course but it is the most
conservative estimate). Finally, in year two, the cash flow is 1100 from
the proceeds of the sale, plus 80 from the dividend payment, a total of
1180. So the gross cash flow is (1000; +100; +1180). Next, we need
to work out the net cash flow. The initial margin is 60%, which means we
can borrow 40% on a margin loan. This gives us a cash inflow in year 0 of
400. Following the initial position there is a maintenance margin of 40%,
which means we have to keep 60% at the minimum as equity. We do not
need to check the end of year two as the margin loan is unwound in any
case, so lets look at year one. Here, the value of the position is 600, and
the margin loan is 400, i.e. an equity position of 200, which is 33.3%.
We need to maintain a 40% equity, so the maximum margin loan is 360.
Therefore, we need to pay off 40 of our margin loan. At the end of year
two the loan is repaid, and if we assume zero interest the cash flow is
360. The margin cash flow is, therefore, (+400; 40; 360). Therefore,
the net cash flow is (1000; +100; +1180) + (+400; 40; 360) =
(600; +60, 820). The final step is to work out the rate of return on our
net investment. Here we use the familiar internal rate of return (IRR)
formula from course 92 Corporate finance:
600 +
60
820
+
=0
1+ IRR (1+ IRR)2
which yields a rate of return of approximately 22%.

Now consider a short position. You short 1000 shares of a stock at an
initial price of 100p, and one year later the price is 160p per share.
During the year there is a dividend payment of 10p per share. You hold
the position for another year, where there is a second dividend payment
of 8p per share, and then finally at the end of year two you buy back the
1000 shares at a price of 60p per share. The initial margin is 60%, and the
maintenance margin is 40% (in practice, it is diffcult to short on a margin
less than 50% but it can be useful to have a margin percentage different
from 50% to illustrate which direction the margin requirement pushes).
As above, the first step is to work out the gross cash flows. In year 0, the
proceeds from the short sale raises 1000. In year one, you have to make
good a dividend payment of 100 (this is now a cash outflow since you
are short in the stock). In year one, you buy back the 1000 shares at a cost
of 600, and you have to make good another dividend payment of 80.
The total gross cash flow is, therefore, (+1000;100;680). Now let us
look at the margin cash flows. The initial margin is 60%, which means that
you have to deposit at least 60% of the short liability on a margin deposit
account. This means that you have to put 600 in the margin account with
the broker. You have to maintain a 40% maintenance margin throughout,
16
and as above it suffces to check year one only as you are unwinding the
position in year two. In year one the liability is 1600, and 40% of this
is 640. Since you have only 600 deposited, you need to put another
40 in the margin account. Ignoring interest rates on the margin account,
therefore, the margin cash flows are (600, 40, +640). The net cash
flow is (+1000, 100, 680) + (600, 40, +640) = (+400, 140;
40). The internal rate of return formula gives us here:
400
140
40
=0
1+ IRR
(1+ IRR)2
which is a loan with an interest rate of approximately 46.4%. You can

learn more about margin trading by reading Chapter 3 of Elton, Gruber,
Brown and Goetzmann.
Regulation of financial markets

Financial markets are heavily regulated laying down rules to the way
trade can be conducted. Because we often speak of the free market it
is easy to forget how strict the rules are that govern financial trading.
Regulation is both in the form of self-regulation (where the organisers of
the market set the rules) and government regulation (where a regulator
appointed by the government sets the rules). The reason for regulation is
primarily to provide protection to market participants, particularly those
who are relatively vulnerable to abuse or fraud by other investors, brokers
or exchanges. What are the main objectives of regulation? The first is to
stop companies releasing information to investors that is inaccurate or
misleading, or released in a way that gives some investors an advantage
over others. The second is to make sure unsophisticated investors are not
taken advantage of by more professional or sophisticated investors or by
advisers or institutions involved in the trading process.
Summary
This chapter has outlined some basic facts on financial claims and
markets.
There was an overview of bond and money markets in which we trade
fixed claims, and an overview of equity markets in which we trade
equity claims which are residual claims (the exact opposite of fixed
claims).
There was an overview of derivatives markets, managed funds and
exchange traded funds.
The chapter also dealt with margin trading and how margin accounts
work.
Finally, there was a short discussion of regulation of financial markets.
Activities
1. Discuss why we need regulation of markets. Try to look for arguments
to support your discussion by looking up, for instance, issues related
to regulation on the websites of the London and New York stock
exchanges: www.londonstockexchange.com or www.nyse.com.
17
2. If you buy an asset on a 50% margin, how much would you have to pay
initially if the price is 126p per share and you buy 1000 shares? How
much more do you need to pay if the price went down to 115p per
share?
3. Consider a short sales transaction on a 70% initial margin requirement
and 60% maintenance margin. You keep the transaction over five
months, and you trade 1000 shares of a stock. The initial price is 100p
per share. The price at the end of the first, second, third and fourth
month is 95p per share, 120p per share, 140p per share and 110p
per share, respectively. The price at the end of the fifth month is 98p
per share. Calculate the gross monthly profit, and the net monthly
profit taking into account the margin deposit. You can assume the
margin deposit account is interest free. What is the net monthly profit
if the deposit account pays 0.1% monthly interest rate? What is the
net monthly profit if the commission on the sale and the repurchase
transaction is 0.5% of the transaction amount?
A reminder of your learning outcomes

Having completed this chapter, and the Essential reading and activities,
you should be able to:
accurately distinguish key characteristics between equity and debt
claims
clearly express the main differences between IPOs (initial public
offerings) and SPOs (seasoned public offerings)
contrast exchange traded securities and OTC (over-the-counter)
securities in detail
adequately describe given money market and bond market instruments
differentiate clean and dirty bond prices and aptly explain how
accrued interest is calculated
cogently discuss the importance of financial markets regulations
Sample examination question

1. a. Explain the difference between exchange trading and over-thecounter (OTC) trading of an asset. Explain the typical characteristics
of, and the differences between, debt claims, equity claims and
derivative securities.
b. Explain the reasons why financial markets are regulated.
c. You short 1000 shares of a stock at a price of 100 on a 70% initial
margin. The maintenance margin is 50%. At the end of the first year
the price of the stock increases to 140, and at the same time there is
a dividend payment of 10. At the end of year two the price has gone
down to 80 and you buy back the stock. What is the return on your
short transaction?
18
Chapter 3: The history of financial markets
Chapter 3: The history of financial

markets
Learning outcomes
By the end of this chapter, and having completed the Essential readings
and activities, you should be able to:
broadly identify established examples of financial innovations and their
fundamental characteristics
discuss the main benefits financial innovations provide to investors
confidently explain the notion of equity premium puzzle in the context
of financial markets
clearly define risk aversion and the risk aversion coefficient
aptly characterize constant absolute risk aversion utility functions
(CARA).
Essential reading
McGraw-Hill Irwin, 2008) Chapters 4 and 5.
Further reading
Allen, F. and D. Gale Financial Innovation and Risk Sharing. (Cambridge, Mass.;
London: MIT Press, 1994) Chapter 2.
Introduction
In this chapter we look at the historical and empirical evidence
surrounding financial markets and assets. The first part surveys the
innovations regarding financial instruments and the trading process in
financial markets. The second part surveys the history of investment
returns on financial assets. Three questions are addressed in particular:
What return can investors expect to earn when investing in various
types of financial assets?
What are the risk characteristics of these returns?
Are returns and risk characteristics linked?
An interesting issue is the historic relationship between the risk and return
on various instruments. If investors are risk averse we expect to find they
demand compensation for holding risky portfolios. This will be discussed
in relation to the so-called equity premium puzzle.
A history of financial innovation

Many early civilisations made use of loan agreements between individuals,
and in the old Babylonia and Assyria, several thousand years bc, there
were at least two banking firms in existence. Equities and bonds were
developed during the sixteenth century. Convertible securities also have a
long history. In continental Europe in the sixteenth century there existed
equity issues that could be converted into debt if certain regulations
19
were broken. Similarly, preferred stock has been in use for a long time.
Exchange trading of financial securities also has a surprisingly long history.
Equity was traded in Antwerp and Amsterdam in the 1600s. Moreover,
options and futures (called time bargains at the time) were traded on the
Amsterdam Bourse after it was opened in 1611.
Many of the European stock markets experienced major stock market
bubbles in the eighteenth century. A famous example is the South Sea
Bubble (1720) where the price of the South Sea Company rose from
131% of par in February to 950% by June 23, then fell back to 200%
by December. This bubble led to the so called Bubble Act which made
it illegal to form a company without a charter or to pursue any line of
business other than the one specified in the charter.
We also know of early examples of speculative bubbles.
Recent financial innovations

The 1960s witnessed a number of innovations driven by regulatory
constraints. The Eurobond market emerged where non-US companies
could borrow in US$. At the time foreign borrowers were excluded from
the US markets. Similarly, currency swaps were developed during this
period to circumvent UK exchange controls. The 1970s witnessed the
introduction of floating-rate instruments (bonds with coupons tied to
a floating rate such as the LIBOR rate in London), and the trading of
financial futures, such as futures on foreign currency, futures on interest
rates and futures on stock market indicies.
Often, the innovation of new securities is initially driven to circumvent
regulatory constraints or to exploit market demand for new types of
claims. Once they become established, however, the investors find they
have other, broader, advantages that make them a useful addition to
the financial system. Below you can find a few case studies of new
innovations.
Case study 1: Floating-rate debt

Floating-rate notes were first issued in 1970, and it was an instrument that
was linked to a floating reference rate the London Interbank Offered Rate
(LIBOR). These instruments came in during a period when inflation risk
became a serious threat, so the nominal rate would fluctuate dramatically.
Allowing loan rates to vary in accordance with these fluctuations was
a natural response. In the mid-1970s the market for floating-rate debt
started growing significantly, and these instruments were fairly widely
used in the early 1980s. Most floating-rate debt is issued in the European
market, and these instruments have never been particularly popular in the
USA. A spin-off innovation is floating-rate preferred stock, a preferred stock
in which the dividend yield is linked to variations in the reference rate.
Case study 2: Zero-coupon bonds

Zero-coupon bonds were first issued in the 1960s, but they did not become
popular until the 1980s. The use of these instruments was aided by an
anomaly in the US tax system, which allowed for deduction of the discount
on bonds relative to their par value. This rule ignored the compounding of
interest, and lead to significant tax-savings when the interest rates were
high or the security had long maturity. Although the tax-loophole was
closed fairly quickly, the bonds were desirable to investors because they
were very simple investment tools. For a bond that has interim coupon
payments the investor would have to reinvest these coupon payments
20
and there may be considerable risk tied to these reinvestment strategies. A

zero-coupon bond has no reinvestment risk.
Case study 3: Poison pill securities

The popularity of corporate acquisitions and mergers has promoted the
emergence of a number of anti-takeover techniques. Some of these have
taken the form of financial innovations. One of the earliest was the socalled preferred stock plans. With these, the target company (the one that
the bidding company seeks to acquire) issues a dividend of convertible
preferred stock to its shareholders, which grants certain rights if the
bidding company buys a large position in the target firm. These rights
might be in the form that the stockholders can require the acquiring firm
to redeem the preferred stock at the highest price paid for common stock
in the past year. If the takeover actually goes through, the highest price
will almost certainly be the takeover price, and the acquiring company
must, therefore, issue a number of new stock at the takeover price in
exchange for the old preferred stock already issued. This will, obviously,
dilute the gains of the takeover to the acquiring party and reduce the
likelihood of a takeover.
Another poison pill security is the so-called flip-over plan. This consists of
the issue of a common stock dividend consisting of a special right. This
right enables the holder to purchase common stock at an exercise price
well above the current market price. Normally, nobody would exercise
these rights as the exercise price is high compared to the current market
price. However, in the event of a merger, they flip-over and give the right
to purchase common stock at an exercise price well below the current
market price. Again, this makes takeovers costly as the bidders profits
from the takeover are heavily diluted by the exercise of the flip-over plans.
Case study 4: Swaps

The first swaps that emerged in the 1960s were currency swaps, and
they emerged like many other innovations on the back of regulation.
In this case, a UK-based multinational company might have a surplus
of funds in the UK that it wished to invest in a US subsidiary but was
prevented due to UK exchange controls. A counterparty in the USA with
the opposite problem, a surplus of US funds but a need to invest in a UK
subsidiary, could often be identified. Since regulation prevented a straight
transfer within each company, the companies could circumvent the rules
by simply using parallel loans the US firm promised to lend dollars to
the UK subsidiary against the UK firm promising to lend pounds to the
US subsidiary. A major problem with these arrangements soon emerged,
however, which was that there was a considerable amount of counterparty
risk involved. A company might have entered into the agreement fully
solvent but might experience problems in the interim period before expiry.
If one party defaulted, would the other party still be obliged to fulfil their
part of the arrangement? This deficiency could be overcome by the swap
agreement, where, in principle, the companies deposited money with each
other and paid the interim interest payments to each other according to
the prevailing interest rates in the two currencies, and finally the principal
amount is cleared at the end of the agreement. The interim payments are
normally netted out using the prevailing exchange rate, so there is only
one payment made.
The swap agreement has also been modified to agreements involving
swapping cash flows of adjustable (floating) rate loans and cash flows
of fixed rate loans. In this case, principal payments are not made in the
21
same way as currency swaps these are also netted out so that the swap
agreement effectively consists of a series of single payments.
Case study 5: Futures trading

The standardised financial futures contracts are a relatively recent
innovation, in contrast to the older, forward style agreements that have
existed since the emergence of a financial system. An important feature
of this contract is the way it is traded, which makes it easy for investors
to enter and exit existing futures agreements in between the start of the
contract and the maturity date of the contract. More importantly, however,
is that futures trading allows investors to shift large amounts of risk
with very little investment. Futures trades are, therefore, highly levered.
For example, margin trading of equity typically involves a margin of
50%, so even if the investor can borrow he still needs to finance half the
investment cost (and further margin calls if the stock price goes down).
With futures positions, investors normally maintain margins less than 10%
of the face value of the futures contract. The futures contract is marked
to market each day, so the investor can unwind his position (sell if the
original transaction was a buy and vice versa) and his account is settled
with no further cash flows taking place.
Case study 6: Credit default swaps

The credit default swap is a derivative security that does not use a
financial asset as the underlying security, but rather the credit event
associated with a bond or money market instrument. The buyer of the
credit default swap undertakes to pay a given amount to the seller until a
credit event occurs. The credit event could be a default of the underlying
bond instrument, but it could also be a ratings downgrade. If a credit event
occurs, the seller must pay the buyer an amount according to the credit
default swap agreement. What is special about these instruments is that
they provide insurance against default. If you are an institution lending
money to a company, for instance, you can safeguard your investment
(since you are lending money the loan is an asset) by simultaneously
buying a credit default swap on the same bond or loan. If the company is
unable to repay you the money they owe, therefore, you can claim money
from the seller (or writer) of the credit default swap.
Case study 7: Collateralised debt/loan obligations

Traditionally, an institution providing a loan to a company would hold
the asset to maturity. This is of course a good idea, since it forces the
institution that makes the decision to lend to stick to it till the end. If the
institution is bad at assessing the risk of the loan it is likely to suffer the
loss as well. However, it can also be a bad idea, as it can be constraining
for financial institutions that historical lending decisions dictate what
they are currently doing. For instance, a financial institution which is
good at marketing loans to companies in a particular industry should
continue using their expertise in future lending decisions. However, if the
industry is facing a downturn with increasing default rates it may be that
losses on loans that are made earlier will prevent future lending. In this
case, lending to the industry is likely to be serviced by other institutions
with less expertise. The idea of selling off loans or bonds is, therefore, a
natural one to consider. Collateralised debt or loan obligations is a way
of doing just that. The institutions typically packages loans or bonds into
large portfolios, then sell off the loans portfolio bit by bit. The way this
is done is by issuing tranches of securities written against the cash flow
of the loans or tranches bond portfolio. The senior tranches (typically top
22
rated instruments) have priority claim to this cash flow. The mezzanine
tranches (with intermediate rating) have seniority after the senior tranches
are serviced, and finally the equity tranche carries the residual claim.
It is commonplace that the financial institution selling off loans or debt
portfolios in this way retains the equity tranche.
It should be mentioned here that collateralised loan or debt obligations
have been cited as one of the factors causing the so-called credit crunch
which started in late 2007 and has continued to the time of writing. A
problem with collateralised loan or debt obligations is that if the financial
institution knows it will be able to sell the loan in the secondary market to
outside parties, there is little incentive to make sure its lending decisions
are sound. The liquidity in the market for collateralised loan or debt
obligations did dry up considerably in late 2007.
Investment returns in equity and bond markets

What returns have investors historically made in the bond and equity
markets around the world? We have about a hundred years of data on
stock market returns, and the brief answer globally is that the countries
most devastated by the Second World War had the lowest long-run
cumulative returns Italy, Belgium, Germany and Japan. The countries
that experienced the least damage, in contrast, have the highest long
run cumulative returns: Australia, Canada and the USA. However, the
real returns (corrected for inflation) are pretty much similar across all
countries.
A major theoretical prediction from pricing models is that the expected
or average return on assets is linked to the risk of holding these assets.
Again, the overall empirical evidence supports this prediction. Looking, for
instance, to the US experience from 1926 to 2002, we find the following:
Asset type
Geometric average
return
Arithmetic average
return
Small-company stocks
11.64%
17.74%
Large-company stocks
10.01%
12.04%
Long-term treasure bonds
5.38%
5.68%
US T-bills
3.78%
3.82%
Inflation
3.05%
3.14%
Table 2.1
For a review of geometric and arithmetic averages, see Appendix 1. If we

compare the numbers in Table 2.1 against the variance of returns, we find
the following:
Asset type
Arithmetic average
return
Standard average
return
Small-company stocks
17.74%
39.30%
Large-company stocks
12.04%
20.55%
Long-term treasure bonds
5.68%
8.24%
US T-bills
3.82%
3.18%
Inflation
3.14%
4.37%
Table 2.2
Among asset classes, therefore, there is a clear relationship between risk

and return (inflation is not an asset). The more risk the investor takes on,
23
the greater is the compensation in terms of expected or average return.

This can be explained by risk aversion - that investors are unwilling to take
(actuarially) fair risk.
The equity premium puzzle

The return on equity is greater than the return on bonds because the
risk is smaller. What has been found, however, is that the difference (the
so-called equity premium) appears to be bigger than should be expected.
The following example from US stock and bond markets is compelling. A
person who invested $1000 in Treasury bills on 31 December 1925 and
kept it in safe US Treasury bills until 31 December 1995 would have an
investment in 1995 worth $12,720. If the money were invested in the
stock market the corresponding number is $842,000 (66 times the amount
for T-bills). Considering that the equity investment would have survived
two large stock market crashes (in 1929 and in 1987), the difference is
strikingly large.
How should we compare a risky investment with a risk-free one? One
way to do this is by assuming a risk averse investor holds both risk-free
T-bills and risky equities in his portfolio (for a review of utility theory
and risk aversion, see Appendix 1). The premium on the equity is then
compensation for his risk aversion. The greater the premium, the greater
the risk aversion of the investor must be. Using historical data, we can
therefore make inferences about the risk aversion of investors. Risk
aversion is measured by the risk aversion coeffcient, formally derived from
the utility function by the relationship:
Risk aversion coefficient =
u (x)
u (x)
If the investor has CARA (constant absolute risk aversion) utility the utility
function takes the form u(x) = exp(x). The risk aversion coefficient is in
this case (as the CARA name suggests), the constant .
If asset returns are, moreover, normally distributed, we can write the
expected utility function as:
Var(x)
Expected utility = E(x)
2
Suppose a CARA investor is indifferent between holding large-company
stocks and long-term US Treasury bills over a long period of time. Then
the following expression must hold:
0.03182
0.20552 = 0.0382
0.1204
2
2
which is solved for a risk aversion coefficient of 4. This is a fairly
reasonable number, but asset returns are not normal so we cannot use
this simple model to estimate the implied risk aversion coeffcient. This
is the motivation for Mehra and Prescotts study. They fit a rigorous
theoretical model to data on the return on stock market investments and
government bonds. The model generates the risk aversion coefficient of a
representative investor (see Appendix 1 for a review of risk aversion and
the risk aversion coeffcient). They found that a reasonable estimate for the
risk aversion coefficient is between 30 and 40. This is way too high, as a
risk aversion coefficient of 30 implies, for instance, that if the investor is
facing a gamble where he has a 50% chance of doubling his wealth and a
50% chance of halving his wealth, he would be willing to pay up to 49%
of his current wealth to avoid the gamble, i.e. if his current wealth is 100,
24
he would be indifferent between paying 49 and keeping 51 for sure, and

a gamble where there is a half chance of receiving 50 and a half chance
of receiving 200. In practice, it would be diffcult to find anybody not
preferring the gamble in this case.
Can the equity premium puzzle be resolved? Mehra and Prescott might
have sampled data that were special in two senses. First, it might have
been too short so there is a possibility that the period was in some sense
too special to make safe inferences about the implied risk aversion
coeffcient. Their work has been extended to include data all the way back
to 1802. The main finding of this exercise is that the real returns of shortterm fixed income have fallen dramatically over time. The real excess
return on equity would, therefore, on average be about one percentage
point lower than that reported by Mehra and Prescott. This will of course
reduce the magnitude of the risk aversion coefficient but it is doubtful that
the puzzle would be completely resolved.
The second way the data might have been special is that the time series
are too long. This might lead to survivorship bias in the data. When
collecting masses of data we inevitably sample those data-series that have
survived for a long time. The long-surviving data series would also tend to
be healthier and show average returns that are higher than the perceived
expected returns at historical points in time. Investors might reasonably
worry about the risk of a crisis or catastrophe that can wipe out the entire
market overnight. And indeed, of the 36 stock exchanges that operated at
the early 1900s, more than one-half experienced significant interruptions
or were abolished outright up to the current time. Hence, the equity
premium might include some bias if estimated by long time series of data.
Again, survivorship bias might be a source of some errors in the estimation
of the risk aversion coefficient but it is unclear how much it contributes.
Summary
This chapter surveyed the historical perspective on the financial system
and, in particular, financial innovations of various types. There was a
survey of examples of major financial innovations such as swaps and
collateralised debt obligations.
The second part of the chapter dealt with the long term return on
various classes of assets, where a strong relationship between risk and
return was uncovered.
This part also covered some controversial issues related to the
difference between equity returns and government bond returns
issues related to the so-called equity premium puzzle.
Activities
1. Explain the role of poison pill securities and discuss whether this is a
helpful innovation of financial securities.
2. The historical evidence points to the fact that riskier securities have a
greater average return. Explain why. We also know that the expected
prize in lotteries is smaller than the cost of participating (an example is
UKs Lotto: A $1 lottery ticket has an expected prize payment of around
$0.45). Can you think of a reason why people are reluctant to accept
risk in financial markets but happy to pay for risk in lotteries?
25
A reminder of your learning outcomes

Having completed this chapter, and the Essential reading and activities,
you should be able to:
broadly identify established examples of financial innovations and their
fundamental characteristics
discuss the main benefits financial innovations provide to investors
confidently explain the notion of equity premium puzzle in the context
of financial markets
clearly define risk aversion and the risk aversion coefficient
aptly characterise constant absolute risk aversion utility functions
(CARA).
Sample examination question

1. a. What is a zero-coupon bond? What makes a zero-coupon bond often a
more attractive investment vehicle for investors than a coupon bond?
26
b. Explain, in words, the equity premium puzzle. Can bias in the data
explain this puzzle? Explain.
c. Give four examples of recent financial innovations. Explain how

they work, and what reasons there are for investors making use of
the innovations.

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Investment management

University of London International Programmes

Chapter 4: Fund management and investment .................................................... 27

Asset allocation over longer time horizons.................................................................... 64

Portfolio insurance with calls ........................................................................................ 97

Subject guide structure and use

Aims and objectives

provide an overview of various financial instruments

3. Fund management and investment: historical mutual fund

Other useful texts for this course include:

Online study resources

Making use of the Online Library

environment (VLE) where you should be advised of any forthcoming

Chapter 2: Financial markets and instruments

Chapter 2: Financial markets and

Money and bond markets

Chapter 2: Financial markets and instruments

Money market instruments

securities overnight to an investor and promises to buy the security back

Bond market instruments

The convention in quoting bond prices is to adjust for accrued interest

Chapter 2: Financial markets and instruments

Price first bond = 100.013 =

Price second bond = 104.986 =

days since last coupon payment

Quoted price first bond = 100.013 5

Quoted price second bond = 104.986 5

Chapter 2: Financial markets and instruments

the fund he needs to trade with existing investors. Units in closed-end

Exchange traded funds

Exchange trading and over-the-counter (OTC) trading

Chapter 2: Financial markets and instruments

Clearing, settlement, margin trading, short sales and

Working out the profitability of margin trades

which yields a rate of return of approximately 22%.

Chapter 2: Financial markets and instruments

which is a loan with an interest rate of approximately 46.4%. You can

Regulation of financial markets

A reminder of your learning outcomes

Sample examination question

Chapter 3: The history of financial markets

Chapter 3: The history of financial

A history of financial innovation

Recent financial innovations

Case study 1: Floating-rate debt

Case study 2: Zero-coupon bonds

Chapter 3: The history of financial markets

and there may be considerable risk tied to these reinvestment strategies. A

Case study 3: Poison pill securities

Case study 4: Swaps

Case study 5: Futures trading

Case study 6: Credit default swaps

Case study 7: Collateralised debt/loan obligations

Chapter 3: The history of financial markets

Investment returns in equity and bond markets

Long-term treasure bonds

For a review of geometric and arithmetic averages, see Appendix 1. If we

Long-term treasure bonds

Among asset classes, therefore, there is a clear relationship between risk

the greater is the compensation in terms of expected or average return.