Chapter 3 Investment Analysis andPortfolio Management.ppt

,Investment Analysis and Portfolio Management by Frank K.Reilly&Keith C.Brown,Chapter 3,Selecting Investments in a Global Market,The Case for Global InvestmentsGlobal Investment ChoicesHistorical Risk-Returns on Alternative Investments,3-2,Growing Investment Opportunities,More investment instruments available in the financial markets as a results of technological advances and new regulationsAbility to invest from a global perspective thanks to the globalization or integration of domestic and foreign financial marketsInvestment vehicles with a variety of maturities,risk-return characteristics,and cash flow patterns being spawned due to competition and deregulations in the financial sector,3-3,The Case for Global Investments,Three reasons U.S.investors should think of constructing global investment portfoliosIgnoring foreign markets can substantially reduce the investment choices for U.S.investorsThe rates of return on non-U.S.securities often have substantially exceeded those for U.S.-only securitiesThe low correlation between U.S.stock markets and many foreign markets can help to substantially reduce portfolio risk,3-4,The Case for Global Investments,Relative Size of U.S.Financial MarketsOverall value of the securities available in world capital market has increased from$2.3 Trillion in 1969 to$103 Trillion in 2006 and the U.S.portion has declined to less than half.The share of the U.S.in world stock and bond markets has dropped from about 65 percent of the total in 1969 to about 46 percent in 2006.The growing importance of foreign securities in world capital markets is likely to continue.Exhibit 3.1 shows the breakdown of securities in the global capital market.,3-5,Exhibit 3.1,3-6,The Case for Global Investments,Rates of Return on U.S.and Foreign SecuritiesGlobal Bond-Market Return:From 19992007,the return performance of the U.S.bond market ranked fifth out of the six countries when the returns are measured in U.S.dollar.The better performance of the non-U.S.markets is partly due to the weakened dollar in this time frameSee Exhibit 3.2Global Equity-Market ReturnFrom 2003 through 2006,the United States average rank in annual return measured in U.S.dollar was 29.5 out of 34 countries.,3-7,Exhibit 3.2,3-8,The Case for Global Investments,Risk of Combined Country InvestmentsDiversification with foreign securities can help reduce portfolio risk because foreign markets have low correlation with U.S.capital markets.The correlation of returns between a single pair of countries changes over time because the factors influencing the correlation change over time.Diversified portfolios reduce variability of returns over time.Correlation coefficients measure diversification contribution.,3-9,The Case for Global Investments,Global Bond Portfolio Risk Low positive correlation(Exhibit 3.4)For a U.S.investor,the average correlation between foreign bond return and U.S.bond return in U.S.dollars is about 0.63 from 1988 to 2006.The U.S.Canada correlation is 0.74,whereas the U.S.Japan correlation is only 0.38.Opportunities for U.S.investors to reduce riskCorrelation changes over timeAdding non-correlated foreign bonds to a portfolio of U.S.bonds increases the rate of return and reduces the risk of the portfolio.(Exhibit 3.5),3-10,Exhibit 3.4,3-11,Exhibit 3.5,3-12,The Case for Global Investments,Global Equity Portfolio RiskLow positive correlation(Exhibit 3.6)The correlation of world equity markets resembles that for bonds;however,the average correlation between U.S.and foreign markets is about 0.56,lower than that for bonds from 1988 to 2006.Again,the U.S.Canada correlation is 0.73,whereas the U.S.Japan correlation is only 0.34.Opportunities to reduce risk of a stock portfolio by including foreign stocks,as illustrated in Exhibit 3.7.,3-13,Exhibit 3.6,3-14,Exhibit 3.7,3-15,Global Investment Choices,Fixed-Income InvestmentsBonds and preferred stocksEquity InvestmentsSpecial Equity InstrumentsWarrants and optionsFutures ContractsInvestment CompaniesReal AssetsLow Liquidity Investments,3-16,Fixed-Income Investments,Basic concepts of fixed-income investmentsContractual payment scheduleRecourse varies by instrumentBondsInvestors are lendersExpect interest payment and return of principalPreferred stocksDividends require board of directors approval,3-17,Fixed-Income Investments,Savings AccountsFixed earningsConvenientLiquid and low riskLow ratesCertificates of Deposit(CDs)Money Market CertificatesCompete against Treasury bills(T-bills)Minimum$10,000Minimum maturity of six monthsRedeemable only at bank of issuePenalty if withdrawn before maturity,3-18,Capital Market Instruments,Fixed income obligations that trade in secondary marketU.S.Treasury securitiesU.S.Government agency securitiesMunicipal bondsCorporate bondsSecured bondsDebenturesSubordinated bondsIncome bondsConvertible bonds,3-19,U.S.Treasury Securities,Issued by the U.S.TreasuryDepending on the maturity,they are:Bills with a maturity less than 1 yearNotes with a maturity in 1-10 yearsBonds with a maturity over 10 yearsHighly liquidEssentially free of credit risk:They are backed by the full faith and credit of the U.S.Government,3-20,U.S.Government Agency Securities,Sold by government agenciesFederal National Mortgage Association(FNMA or Fannie Mae)Federal Home Loan Bank(FHLB)Government National Mortgage Association(GNMA or Ginnie Mae)Federal Housing Administration(FHA)Not direct obligations of the TreasuryStill considered almost default-free and fairly liquid,3-21,Municipal Bonds,Issued by state and local governments usually to finance infrastructural projects.Exempt from taxation by the federal government and by the state that issued the bond,provided the investor is a resident of that state.Two types:General obligation bonds(GOs)Revenue bonds,3-22,Corporate Bonds,Basic ConceptsIssued by a corporationFixed incomeCredit quality measured by ratingsMaturityFeaturesIndentureCall provisionSinking fundSeniority categories,3-23,Corporate Bonds,Secured bondsSenior secured bondsMost senior bonds in capital structure and have the lowest risk of defaultMortgage bondsSecured by liens on specific assetsCollateral trust bondsSecured by financial assetsEquipment trust certificatesSecured by transportation equipment,3-24,Corporate Bonds,DebenturesUnsecured promises to pay interest and principalIn case of default,debenture owner can force bankruptcy and claim any unpledged assets to pay off the bondsSubordinated bondsUnsecured like debentures,but holders of these bonds may claim assets after senior secured and debenture holders claims have been satisfied,3-25,Corporate Bonds,Income bondsInterest payment contingent upon earning sufficient income If subsequently earned,it must be paid offRiskier than debenture bondsConvertible bondsOffer the upside potential of common stock and the downside protection of a bondUsually have lower interest rates,3-26,Corporate Bonds,WarrantsAllows bondholder to purchase the firms common stock at a fixed price for a given time periodInterest rates usually lower on bonds with warrants attachedZero coupon bondOffered at a deep discount from the face valueNo interest during the life of the bond,only the principal payment at maturity,3-27,Preferred Stock,Hybrid securityFixed dividendsDividend obligations are not legally binding,but must be voted on by the board of directors to be paidMost preferred stock is cumulativeCredit implications of missing dividendsCorporations may exclude 80%of dividend income from taxable income,3-28,International Bond Investing,Investors should be aware that there is a very substantial fixed income market outside the United States that offers additional opportunity for diversification and returns.Bond identification characteristicsCountry of originLocation of primary trading marketHome country of the major buyersCurrency of the security denomination,3-29,International Bond Investing,EurobondAn international bond denominated in a currency other than the country where it is issuedYankee bondsSold in the United States and denominated is U.S.dollars,but issued by foreign corporations or governmentsEliminates exchange risk to U.S.investorsInternational domestic bondsSold by issuer within its own country in that countrys currency,3-30,Equity Investments,Common StockRepresents ownership of a firmInvestors return tied to the performance of the company and may result in loss or gainCommon Stock Classifications Industrial:manufacturers of automobiles,machinery,chemicals,beveragesUtilities:electrical power companies,gas suppliers,water industryTransportation:airlines,truck lines,railroadsFinancial:banks,savings and loans,credit unions,3-31,Acquiring Foreign Equities,American Depository Receipts(ADRs)Easiest way to directly acquire foreign sharesCertificates of ownership issued by a U.S.bank that represents indirect ownership of a certain number of shares of a specific foreign firm on deposit in a U.S.bank in the firms home countryBuy and sell in U.S.dollarsDividends in U.S.dollarsMay represent multiple sharesListed on U.S.exchangesVery popular,356 out of 462 on NYSE in 2006,3-32,Acquiring Foreign Equities,Purchase of American SharesIssued in the United States by transfer agent on behalf of a foreign firmHigher expensesLimited availabilityDirect Purchase of Foreign Shares In the foreign firms own countryListed on a foreign stock exchange outside the home country(e.g.,French firms on LSE)Listed on a U.S.stock exchange,3-33,Acquiring Foreign Equities,Global Mutual Funds or ETFsGlobal funds:Invest in both U.S.and foreign stocksInternational funds:Invest mostly outside the U.S.Funds can specializeDiversification across many countriesConcentrate in a segment of the worldConcentrate in a specific countryConcentrate in types of marketsExchange-traded funds or ETFs are a recent innovation in the world of index products,3-34,Special Equity Instruments:Options,These are equity-derivative securities which have a claim on the common stock of a firm.Options are rights to buy or sell common stock or other underlying assets at a stated price for a period of time.Puts are options to sell Calls are options to buyWarrants An options issued by a company giving the holders the right to buy its common stockNormally issued with bonds,3-35,Futures Contracts,Exchange of a particular asset at a specified delivery date for a stated price paid at the time of deliveryDeposit(10%margin)is made by buyer at contract to protect the sellerCommodities trading is largely in futures contractsCurrent price depends on expectations,3-36,Futures Contracts,Financial Futures Recent development of contracts on financial instruments such as T-bills,Treasury bonds,and EurobondsTraded mostly on Chicago Mercantile Exchange(CME)and Chicago Board of Trade(CBOT)Allow investors and portfolio managers to protect against volatile interest ratesCurrency futures allow protection against changes in exchange ratesVarious stock futures on market indexes such as the S&P 500 and Value Line Index,3-37,Investment Companies,Rather than buy individual securities directly from the issuer they can be acquired indirectly through shares in an investment companyInvestment companies sell shares in itself and uses proceeds to buy securitiesInvestors own part of the portfolio of investments,3-38,Investment Companies,Money Market FundsAcquire high-quality,short-term investmentsYields are higher than normal bank CDsTypical minimum investment is$1,000No sales commission chargesWithdrawal is by check with no penaltyInvestments usually are not insuredThe total value of these funds reached more than$2.5 trillion in 2007,3-39,Investment Companies,Bond FundsInvest in long-term government,corporate,or municipal bondsBond funds vary in bond quality from the risk-free government bonds to the high-yield or junk bondsExpected returns also differ reflecting the risk level of bonds in the fund,3-40,Investment Companies,Common Stock FundsMany different funds with varying stated investment objectivesAggressive growth,income,precious metals,international stocksOffer diversification to smaller investorsSector funds concentrate in an industryInternational funds invest outside the United StatesGlobal funds invest in the U.S.and other countries,3-41,Investment Companies,Balanced FundsInvest in a combination of stocks and bonds depending on their stated objectivesIndex FundsThese are mutual funds created to track the performance of a market index like the S&P 500Appeal to passive investors who want to simply experience returns equal to some market indexNumerous non-stock indexes including various bond indexes have been created,3-42,Investment Companies,Exchange-Traded Funds(ETFs)These are depository receipts for a portfolio of securities deposited at a financial institution in a unit trust that issues a certificate of ownership for the portfolio of stocksThe stocks in a portfolio are those in an index like the S&P 500 and dozens of country or industry indexesETFs can be bought and sold continuously on an exchange like common stock,3-43,Real Estate,Real Estate Investment Trusts(REITs)Investment fund that invests in a variety of real estate properties,similar to a stock or bond mutual fundConstruction and development trusts provide builders with construction financingMortgage trusts provide long-term financing for propertiesEquity trusts own various income-producing properties,3-44,Real Estate,Direct Real Estate Investment Purchase of a homePurchase of raw landIntention of selling in future for a profitOwnership provides a negative cash flow due to mortgage payments,taxes,and property maintenanceLand DevelopmentDivide the land into individual lotsBuild houses or a shopping mall on itRequires capital,time,and expertise,3-45,Real Estate,Rental PropertyAcquire apartment buildings or houses with low down paymentsDerive enough income from the rents to pay the expenses of the structure,including the mortgage payments,and generate a good returnRental property provides a cash flow and an opportunity to profit from the sale of the property,3-46,Low-Liquidity Investments,Basic ConceptsSome investments dont trade on securities marketsLack of liquidity keeps many investors awayAuction sales create wide fluctuations in pricesWithout notional markets,dealers incur high transaction costsSome may consider them more as hobbies than investments,3-47,Low-Liquidity Investments,AntiquesDealers buy at estate sales,refurbish,and sell at a profitSerious collectors may enjoy good returnsIndividuals buying a few pieces to decorate a home may have difficulty overcoming transaction costs to ever enjoy a profit them more as hobbies than investments,3-48,Low-Liquidity Investments,ArtInvestment requires substantial knowledge of art and the art worldAcquisition of work from a well-known artist requires large capital commitments and patienceHigh transaction costsUncertainty and illiquidity,3-49,Low-Liquidity Investments,Coins and Stamps Enjoyed by many as hobby and as an investment