TUFE Summer 2025
FIN 310 – Investments
Chapter 1
Part 1 - Market Organization and
Structure
1
Learning Outcomes - I
a. Explain the main functions of the financial system
b. Describe classifications of assets and markets
c. Describe the major types of securities, currencies, contracts,
commodities, and real assets that trade in organized markets,
including their distinguishing characteristics and major subtypes
d. Describe types of financial intermediaries and services that they
provide
e. Compare positions an investor can take in an asset
2
Learning Outcomes - II
h. Compare market orders with limit orders
i. Define primary and secondary markets and explain how
secondary markets support primary markets
j. Describe how securities, contracts, and currencies are traded in
quote-driven, order-driven, and brokered markets
k. Describe characteristics of a well-functioning financial system
l. Describe objectives of market regulation
3
Why is the financial system used?
1. to save money for the future
2. to borrow money for current use
3. to raise equity capital
4. to manage risks
5. to exchange assets for immediate and future deliveries
6. to trade on information
4
Main Functions of the Financial System
1. Achieve the purposes for which people use the financial
system
2. Discovery of the rates of return that equate aggregate
savings with aggregate borrowings
3. Allocation of capital to the best uses
5
A well-functioning Financial System
✓ Reduces transaction costs via financial intermediaries.
✓ Improves market liquidity and encourages efficient investing.
✓ Supports economic growth by channeling funds to their best
uses.
✓ Promotes information dissemination for sound decision making.
6
Saving and Investment through the Financial System
• Savers allocate capital to investments expecting future returns.
– Instruments used: notes, bonds, stocks, mutual funds, real estate.
• Investors require a fair return for the use and risk of their
money.
• The financial system enables tradeable instruments with low
transaction costs.
• Liquidity and fair pricing enhance saving incentives.
• Investment supports personal goals like retirement or asset
growth.
• Effective saving contributes to economic development.
7
Borrowing in the Financial System
• Borrowers access funds for consumption, investment, or operations.
– Common channels: loans, bonds, mortgages, credit cards.
• Lenders require compensation via interest or ownership stakes.
• Collateral reduces borrowing cost and risk to lenders.
• Governments borrow to finance expenditures and projects.
• Efficient systems match savers to borrowers at fair rates.
• Credit bureaus and legal frameworks support borrowing activity.
8
Raising Equity Capital
• Firms issue equity to fund projects and operations.
• Equity capital involves selling ownership for future returns.
• Investment banks and analysts facilitate equity issuance.
• Fair disclosures promote investor trust and participation.
• Liquid secondary markets encourage equity financing.
• Equity holders gain voting rights and residual claims.
• Equity funding supports innovation and growth.
9
Managing Risk with Financial Instruments
• Entities hedge financial risks via contracts like futures, options.
• Hedging balances exposure to price, rate, or currency changes.
• Forward contracts set fixed prices for future transactions.
• Risk transfers benefit both hedgers and counterparties.
• Liquidity in derivative markets enhances hedging ability.
• Insurance products also mitigate financial losses.
• Managing risk enables long-term planning and investment.
10
Spot Markets and Immediate Asset Exchange
• Spot markets involve immediate delivery of assets.
– Used for FX trades, commodity purchases, and asset swaps.
– Examples: exchanging USD for EUR, buying carbon credits.
• Liquidity and low costs make spot markets efficient.
• Used for tactical adjustments and operational needs.
• Prices in spot markets guide future expectations.
• Spot markets support global trade and commerce.
11
Information-Motivated Trading
• Traders seek profit from insights on future price movements.
• Active managers analyze undervalued or overvalued assets.
• Conditional returns exceed normal expected returns.
• Requires timely and proprietary information or analysis.
• Can occur over short or long holding periods.
• Encourages research, price discovery, and efficiency.
• High competition means not all info traders succeed.
12
Equilibrium Interest Rates
• Determines the rate balancing saving and borrowing needs.
– High rates encourage saving but reduce borrowing.
– Low rates encourage borrowing but discourage saving.
– Equilibrium rate aligns aggregate demand and supply of
funds.
• Risk, liquidity, and maturity affect required returns.
• Rates signal capital scarcity or abundance.
– Core to investment decision-making and valuation.
13
Capital Allocation Efficiency
• Efficient allocation means capital funds productive projects.
• Investors avoid funding low-value or risky projects.
• Good information improves allocation decisions.
• Market prices reflect expected returns and risks.
– Only valuable projects should attract investment.
– Mispricing leads to wasteful or missed investments.
• Well-functioning systems support economic productivity.
14
Classifications of Assets and Markets - I
• Assets - include securities, currencies, contracts, commodities, and
real assets.
– Financial versus physical assets
• Securities - are categorized as debt, equity, or pooled investment
vehicles.
– Also Public vs. Private
• Contracts are classified by underlying asset type and settlement
method.
15
Classifications of Assets and Markets - II
• Markets - can be classified as spot or forward/futures based on
delivery time.
• Markets - are divided into primary (issuance) and secondary
(trading).
• Financial Markets – money markets deal with short-term
instruments; capital markets which deal with long-term.
• Investment markets - are also grouped as traditional (stocks,
bonds) or alternative (e.g., hedge funds).
16
Major Securities: Types and Characteristics
• Fixed income securities - bonds, notes, and bills with scheduled
payments. Also repos.
– Short-term, intermediate-term, long-term
• Equities - represent ownership; common and preferred shares are key
types.
• Pooled investments - mutual funds, ETFs, and REITs offer diversification.
• Convertibles - combine debt with equity conversion options.
• Warrants – allow for the purchase of equity at a specified price.
• Asset-backed securities – values derived from pool of assets.
– Securities may be public (exchange-traded) or private (less liquid).
– Valuation depends on cash flows, risk, and market conditions.
– Securities serve purposes of investment, funding, and ownership.
17
Currencies, Commodities, and Real Assets
• Currencies - are national legal tenders traded in FX markets.
• Commodities - include metals, energy, agriculture—traded for
spot or future delivery.
• Real assets - are tangible e.g., real estate, machinery, and
natural resources.
– They provide inflation hedging and low correlation with financial
assets.
– Real assets often require active management and are illiquid.
– REITs and MLPs offer indirect, more liquid real asset exposure.
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Contracts: Derivatives and Insurance
• Forward contracts - are private agreements for future delivery.
• Futures - are standardized, exchange-traded, with margin
requirements.
• Swaps - exchange periodic cash flows based on asset prices or
rates.
• Options - give the right, but not obligation, to buy/sell an asset.
• CDS and insurance contracts - hedge credit or event risk.
➢ Contracts can be physically, or cash settled
➢ Used for hedging, speculation, and arbitrage
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Financial Intermediaries and Services
✓ Include banks, brokers, dealers, investment funds, and insurance
firms.
✓ Match buyers with sellers to reduce transaction costs.
✓ Provide liquidity, safekeeping, and credit information.
✓ Help raise capital, manage risk, and support price discovery.
– Exchanges and clearinghouses standardize and settle trades.
– Mutual and hedge funds pool assets and offer professional
management.
– Regulated to ensure stability and transparency.
20
Financial Intermediaries contd.
• Brokers match buyers and sellers
• Dealers trade on their own account
• Arbitrageurs trade similar instruments at different prices in different
markets
– Both dealers and arbitrageurs provide liquidity
• Exchanges and Alternative Trading Systems (ATS) or Electronic
Communications Networks (ECNs) provide trading venues
– Many ATNs are know as dark pools
• Investment banks underwrite securities
• Insurance companies manage risk and payout claims
21
Investor Positions in Assets
• Long position benefits from asset price appreciation.
• Short position profits when asset prices fall.
• Margin trading allows leverage but increases risk.
– Leverage ratio = total value / investor equity
• Rate of return considers margin and asset price changes.
• Margin calls occur when equity falls below maintenance level.
• Understanding position mechanics is key to risk management.
22
Market Orders vs. Limit Orders
• Market orders execute immediately at best available price.
– Market orders guarantee execution but not price.
• Limit orders execute only at a specified price or better.
– Limit orders prioritize price but may not fill.
– Limit orders provide liquidity and set bid/ask spreads.
• Traders choose based on urgency, price sensitivity, and strategy.
• Order visibility impacts market dynamics.
23
Order Instructions
• Market orders guarantee execution, not price
• Limit orders control price but may not fill
• Stop orders trigger at specified levels
• Good-till-cancelled vs day orders
• Clearing instructions affect trade settlement
• Execution instructions ensure trade efficiency
24
Primary and Secondary Markets
• Primary market - issuance of new securities to raise capital.
• Secondary market - trading existing securities among investors.
– Secondary markets provide liquidity and price discovery.
– Strong secondary markets support efficient primary markets.
– Issuers benefit from investor confidence in exit options.
• Examples: IPOs (primary), NYSE trades (secondary).
• Essential for capital formation and investor participation.
25
Market Structures: Quote-, Order-, Brokered
• Quote-driven markets: dealers quote prices (e.g., NASDAQ).
• Order-driven: prices determined by matching buyer/seller orders.
• Brokered markets: use intermediaries to arrange trades.
➢ Each structure differs in transparency and execution speed.
➢ Hybrid markets combine features of multiple types.
➢ Liquidity and costs vary by structure.
➢ Market design influences trading behavior and fairness.
26
Characteristics of a Well-Functioning Financial System
• High liquidity and low transaction costs.
• Information is widely available and reliable.
• Fair and transparent trading practices.
• Protection of investor rights and property.
• Efficient capital allocation to productive uses.
• Regulation ensures integrity and reduces systemic risk.
– Trust in markets promotes participation and growth.
27
Objectives of Market Regulation
1. control fraud
2. control agency problems
3. promote fairness
4. set mutually beneficial standards
5. prevent undercapitalized financial firms from exploiting their
investors by making excessively risky investments
6. ensure that long-term liabilities are funded.
28
Questions?
Quiz 1: Functions of Financial Systems
• Which of the following is NOT a function of the financial
system?
A. Determining equilibrium interest rates
B. Allocating capital to its most productive uses
C. Ensuring minimum profitability for firms
D. Facilitating risk management
Quiz 1: Functions of Financial Systems
• Which of the following is NOT a function of the financial
system?
A. Determining equilibrium interest rates
B. Allocating capital to its most productive uses
C. Ensuring minimum profitability for firms
D. Facilitating risk management
Quiz 2: Investor Position
• An investor who sells borrowed shares in anticipation of a
price decline is taking a:
A. Long position
B. Short position
C. Covered position
D. Leveraged position
Quiz 2: Investor Position
• An investor who sells borrowed shares in anticipation of a
price decline is taking a:
A. Long position
B. Short position
C. Covered position
D. Leveraged position
Quiz 3: Order Types
• Which of the following orders is most likely to execute
immediately at the best available price?
A. Market order
B. Limit order
C. Stop order
D. Stop-limit order
Quiz 3: Order Types
• Which of the following orders is most likely to execute
immediately at the best available price?
A. Market order
B. Limit order
C. Stop order
D. Stop-limit order
Quiz 4: Market Structures
• In which market structure do dealers maintain inventories and
provide bid–ask quotes?
A. Order-driven market
B. Brokered market
C. Quote-driven market
D. Hybrid market
Quiz 4: Market Structures
• In which market structure do dealers maintain inventories and
provide bid–ask quotes?
A. Order-driven market
B. Brokered market
C. Quote-driven market
D. Hybrid market
Quiz 5: Market Regulation
• One objective of market regulation is to:
A. Increase investor risk
B. Eliminate all financial losses
C. Prevent all trading in alternative investments
D. Ensure accurate and timely information disclosure
Quiz 5: Market Regulation
• One objective of market regulation is to:
A. Increase investor risk
B. Eliminate all financial losses
C. Prevent all trading in alternative investments
D. Ensure accurate and timely information disclosure
Quiz 6: Leverage Ratio
• An investor buys $10,000 of securities using $4,000 of their
own funds. What is the leverage ratio?
A. 2.5
B. 1.5
C. 2.0
D. 1.25
Quiz 6: Leverage Ratio
• An investor buys $10,000 of securities using $4,000 of their
own funds. What is the leverage ratio?
A. 2.5
B. 1.5
C. 2.0
D. 1.25
Quiz 7: Return on Leveraged Position
• An investor buys 100 shares at $40 per share using 50%
margin. If the stock rises to $44, what is the % return on
equity?
A. 5%
B. 10%
C. 20%
D. 25%
Quiz 7: Return on Leveraged Position
• An investor buys 100 shares at $40 per share using 50%
margin. If the stock rises to $44, what is the % return on
equity?
A. 5%
B. 10%
C. 20%
D. 25%
Quiz 8: Return on Leveraged Position
• Sophia Carter purchased 400 shares of a company at $40 per share. The
stock was bought on 60 percent margin. One month later, she had to pay
interest on the borrowed amount at a rate of 1.5 percent per month. At
that time, Carter received a dividend of $0.40 per share. Immediately
after that, she sold all the shares at $35 per share. She paid commissions
of $15 on the purchase and $15 on the sale of the stock. What was the
rate of return on this investment for the one-month period?
A. -17.2%
B. -20.5%
C. -22.3%
D. -25.0%
Quiz 8: Return on Leveraged Position
• Sophia Carter purchased 400 shares of a company at $40 per share. The
stock was bought on 60 percent margin. One month later, she had to pay
interest on the borrowed amount at a rate of 1.5 percent per month. At
that time, Carter received a dividend of $0.40 per share. Immediately
after that, she sold all the shares at $35 per share. She paid commissions
of $15 on the purchase and $15 on the sale of the stock. What was the
rate of return on this investment for the one-month period?
A. -17.2%
B. -20.5%
C. -22.3%
D. -25.0%
Quiz 9: Short Selling Return
• An investor sells short 100 shares at $50 using 25% margin. If
the stock falls to $45, what is the percentage return on
equity?
A. 25%
B. 30%
C. 40%
D. 50%
Quiz 9: Short Selling Return
• An investor sells short 100 shares at $50 using 25% margin. If
the stock falls to $45, what is the percentage return on
equity?
A. 25%
B. 30%
C. 40%
D. 50%
TUFE Summer 2025
FIN 310 – Investments
FIN 310: Investments
Professor Hibbert
1
TUFE Summer 2025
FIN 310 – Investments
Chapter 1
Part 2 – Security Market Indices
2
Learning Outcomes - I
a. Describe a security market index
b. Calculate and interpret the value, price return, and total return of
an index
c. Describe the choices and issues in index construction and
management
d. Compare the different weighting methods used in index
construction
e. Calculate and analyze the value and return of an index given its
weighting method
3
Learning Outcomes - II
f. Describe rebalancing and reconstitution of an index
g. Describe uses of security market indexes
h. Describe types of equity indexes
i. Describe types of fixed-income indexes
j. Describe indexes representing alternative investments
k. Compare types of security market indexes
4
What is a Security Market Index?
• A security market index tracks the performance of a group of
securities – market, market segment or asset class
• Used as benchmarks for investment returns.
• Helps track market trends and investor sentiment.
– Examples include the S&P 500, Dow Jones, and FTSE 100.
• Composed of stocks, bonds, or alternative assets.
• Can be broad-based or sector-specific.
5
Calculating Index Value and Returns
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒕𝒐𝒕𝒂𝒍 𝒎𝒂𝒓𝒌𝒆𝒕 𝒗𝒂𝒍𝒖𝒆
𝑰𝒏𝒅𝒆𝒙 𝒗𝒂𝒍𝒖𝒆 = × 𝑩𝒂𝒔𝒆 𝒊𝒏𝒅𝒆𝒙 𝒍𝒆𝒗𝒆𝒍
𝑩𝒂𝒔𝒆 𝑽𝒂𝒍𝒖𝒆
• Price return: measures percentage change in prices only
• Total return: includes price changes and income (e.g., dividends)
𝐸𝑛𝑑𝑖𝑛𝑔 𝑣𝑎𝑙𝑢𝑒 + 𝐼𝑛𝑐𝑜𝑚𝑒 – 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑣𝑎𝑙𝑢𝑒
𝑇𝑜𝑡𝑎𝑙 𝑟𝑒𝑡𝑢𝑟𝑛 =
𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑣𝑎𝑙𝑢𝑒
✓ Adjusted for corporate actions like stock splits.
✓ Critical for passive investment product returns.
6
Issues in Index Construction
• Selection of constituent securities is a key issue.
• Number of securities and market coverage matter.
• Weighting method affects representativeness.
• Rebalancing and reconstitution required over time.
➢ Transparency and objectivity enhance credibility.
➢ Bias can arise from inclusion/exclusion criteria.
• Objective: accurate and investable representation.
7
Index Weighting Methods
• Price-weighted: higher price stocks get more weight (e.g., DJIA).
• Market-cap weighted: based on company size (e.g., S&P 500).
• Equal-weighted: all constituents have same weight.
• Fundamentally weighted: based on financial metrics like
earnings.
• Float-adjusted: only public shares are considered.
➢ Weighting affects volatility and risk exposure.
➢ Each method has pros and cons for tracking and investing.
8
Rebalancing and Reconstitution
• Rebalancing adjusts weights to maintain index methodology.
• Reconstitution updates index membership based on criteria.
– Typically occurs quarterly, semi-annually, or annually.
– Ensures index reflects current market conditions.
– Reduces tracking error for passive funds.
– Can lead to trading volume surges in impacted securities.
– Important for maintaining investment relevance and
accuracy.
9
Uses of Security Market Indexes
• Benchmark for performance measurement of portfolios.
• Base for index mutual funds and ETFs.
• Used in asset allocation and economic analysis.
• Support for active and passive management decisions.
• Track investment style (e.g., growth vs. value).
• Risk/return comparison across asset classes.
• Provide market sentiment and trend insights.
10
Types of Equity Indexes
• Broad market indexes: cover entire markets (e.g., Russell
3000).
• Sector indexes: focus on specific industries (e.g., technology).
• Style indexes: reflect value, growth, or blend investing.
• Size-based indexes: large-, mid-, or small-cap focus.
• Geographic indexes: domestic, regional, global.
– Serve different investor goals and exposure needs.
– Support thematic and targeted investing.
11
Types of Fixed-Income Indexes
• Track bond performance across sectors and maturities.
• May cover government, corporate, or municipal debt.
• Vary by credit rating, duration, currency, and region.
• Examples: Bloomberg Barclays Aggregate Bond Index.
– Harder to replicate due to bond illiquidity and variety.
– Used in passive and active bond fund strategies.
– Key tool for assessing interest rate sensitivity.
12
Indexes for Alternative Investments
• Include real estate, commodities, hedge funds, and private equity.
– Real estate indexes track REITs or property values.
– Commodity indexes measure prices of physical goods.
– Hedge fund indexes based on self-reported data.
– Private equity indexes have limited transparency.
• Help monitor asset class performance and risk.
• Useful for diversification and alternative exposure.
13
Comparing Index Types
• Indexes differ by asset class, construction method, and purpose.
• Equity indexes vary by size, style, and region.
• Fixed-income indexes differ by duration, credit quality, issuer.
• Alternative indexes often face liquidity and valuation challenges.
• Index selection depends on investment objective.
• No single index fits all benchmarking needs.
• Diverse index types support broad portfolio design.
14
Questions ??
15
Quiz 1: Purpose of Indexes
• Which of the following is most accurate about security market
indexes?
A. They always include all securities in a given market.
B. They are constructed solely for tracking individual securities.
C. They serve as benchmarks and reflect market performance.
D. They do not require regular reconstitution or rebalancing.
16
Quiz 1: Purpose of Indexes
• Which of the following is most accurate about security market
indexes?
A. They always include all securities in a given market.
B. They are constructed solely for tracking individual securities.
C. They serve as benchmarks and reflect market performance.
D. They do not require regular reconstitution or rebalancing.
17
Quiz 2: Return Types
• The difference between a price return index and a total return
index is that the:
A. Price return index includes dividend reinvestment.
B. Total return index reflects both price changes and income.
C. Total return index excludes bond coupons.
D. Price return index adjusts for stock splits.
18
Quiz 2: Return Types
• The difference between a price return index and a total return
index is that the:
A. Price return index includes dividend reinvestment.
B. Total return index reflects both price changes and income.
C. Total return index excludes bond coupons.
D. Price return index adjusts for stock splits.
19
Quiz 3: Weighting Method
• An index that gives equal importance to each constituent
regardless of market size uses which method?
A. Market-cap weighting
B. Float-adjusted weighting
C. Price weighting
D. Equal weighting
20
Quiz 3: Weighting Method
• An index that gives equal importance to each constituent
regardless of market size uses which method?
A. Market-cap weighting
B. Float-adjusted weighting
C. Price weighting
D. Equal weighting
21
Quiz 4: Rebalancing Concept
• Rebalancing is best described as:
A. Changing the securities in the index based on inclusion rules.
B. Adjusting the weightings of existing index constituents.
C. Replacing the base index level.
D. Switching from price return to total return calculation.
22
Quiz 4: Rebalancing Concept
• Rebalancing is best described as:
A. Changing the securities in the index based on inclusion rules.
B. Adjusting the weightings of existing index constituents.
C. Replacing the base index level.
D. Switching from price return to total return calculation.
23
Quiz 5: Replication Difficulty
• Which type of index is most likely to be difficult to replicate
due to the nature of its underlying assets?
A. Equity index
B. Government bond index
C. Private equity index
D. Market-cap weighted index
24
Quiz 5: Replication Difficulty
• Which type of index is most likely to be difficult to replicate
due to the nature of its underlying assets?
A. Equity index
B. Government bond index
C. Private equity index
D. Market-cap weighted index
25
Quiz 6: Price-Weighted Index
• A price-weighted index consists of three stocks with the
following prices:
Stock A = $20, Stock B = $50, Stock C = $30.
What is the initial value of the index if the divisor is set to the
number of stocks?
A. 33.33
B. 34.00
C. 35.00
D. 100.00
Quiz 6: Price-Weighted Index
• A price-weighted index consists of three stocks with the
following prices:
Stock A = $20, Stock B = $50, Stock C = $30.
What is the initial value of the index if the divisor is set to the
number of stocks?
A. 33.33
B. 34.00
C. 35.00
D. 100.00
Quiz 7: Equal-Weighted Return
• An equal-weighted index has three stocks. Their price returns over a
period are:
Stock X = 5%
Stock Y = –2%
Stock Z = 3%
What is the index return over the period?
A. 1.33%
B. 2.00%
C. 2.50%
D. 3.00%
Quiz 7: Equal-Weighted Return
• An equal-weighted index has three stocks. Their price returns over a
period are:
Stock X = 5%
Stock Y = –2%
Stock Z = 3%
What is the index return over the period?
A. 1.33%
B. 2.00%
C. 2.50%
D. 3.00%
Quiz 8: Market-Cap Weighted Return
• A market-cap-weighted index contains the following stocks:
Stock A: $100M cap, Return = 10%
Stock B: $300M cap, Return = –5%
What is the index return?
A. –1.25%
B. –0.25%
C. 1.25%
D. 5.00%
Quiz 8: Market-Cap Weighted Return
• A market-cap-weighted index contains the following stocks:
Stock A: $100M cap, Return = 10%
Stock B: $300M cap, Return = –5%
What is the index return?
A. –1.25%
B. –0.25%
C. 1.25%
D. 5.00%
Quiz 9: Float-Adjusted Weighting
• A company has 1,000,000 shares outstanding at $50 per
share. 40% of the shares are held by insiders and not
available to the public. What is the float-adjusted market
capitalization?
A. $20,000,000
B. $30,000,000
C. $40,000,000
D. $50,000,000
Quiz 9: Float-Adjusted Weighting
• A company has 1,000,000 shares outstanding at $50 per
share. 40% of the shares are held by insiders and not
available to the public. What is the float-adjusted market
capitalization?
A. $20,000,000
B. $30,000,000
C. $40,000,000
D. $50,000,000
Quiz 10: Total Return Index
• An index has a beginning value of 1,000. Over the period:
Price return = 4%
Income return (dividends) = 1.5%
What is the total return index value at the end of the period?
A. 1,040.0
B. 1,045.0
C. 1,050.0
D. 1,055.0
Quiz 10: Total Return Index
• An index has a beginning value of 1,000. Over the period:
Price return = 4%
Income return (dividends) = 1.5%
What is the total return index value at the end of the period?
A. 1,040.0
B. 1,045.0
C. 1,050.0
D. 1,055.0
