Lecture Presentation Software

to accompany
Investment Analysis and
Portfolio Management
t /ton
by
Frank K. Rey & Ket C. Brown
apter 3
apter 3 - SeIecting
Investments in a GIobaI
Market
Questions to be answered:
sould investors ave a global
perspective regarding teir investments?
apter 3 - SeIecting
Investments in a GIobaI
Market
Questions to be answered:
at as appened to te relative size of
U.S. and foreign stock and bond
markets?
apter 3 - SeIecting
Investments in a GIobaI
Market
Questions to be answered:
at are te differences in te rates of
return on U.S. and foreign securities
markets?
apter 3 - SeIecting
Investments in a GIobaI
Market
Questions to be answered:
ow can canges in currenc excange
rates affect te returns tat U.S.
investors experience on foreign
securities?
apter 3 - SeIecting
Investments in a GIobaI
Market
Questions to be answered:
s tere an additional advantage of
diversifing in international markets
beond te benefits of domestic
diversification?
apter 3 - SeIecting
Investments in a GIobaI
Market
Questions to be answered:
at alternative securities are available?
at are teir cas flow and risk
properties?
apter 3 - SeIecting
Investments in a GIobaI
Market
Questions to be answered:
at is te istorical return and risk
caracteristics of te major investment
instruments?
apter 3 - SeIecting
Investments in a GIobaI
Market
Questions to be answered:
at is te relationsip among returns
for foreign and domestic investment
instruments? at is te implication of
tese relationsips for portfolio
diversification?
#easons for te expansion of
investment opportunities
1. Growth and development oI Ioreign
Iinancial markets
2. Advances in telecommunications
technology
3. Mergers oI Iirms and security exchanges
%e Case for Constructing
Global nvestment Portfolios
1. Ignoring Ioreign markets can substantially
reduce the investment choices Ior U.S.
investors
2. The rates oI return on non-U.S. securities
oIten have substantially exceeded those Ior
U.S.-only securities
3. The low correlation between U.S. stock
markets and many Ioreign markets can
help to substantially reduce portIolio risk
#elative Size of U.S. Financial
Markets
1. The share oI the U.S. in world stock and
bond markets has dropped Irom about 65
percent oI the total in 1969 to about 51
percent in 2003
2. The growing importance oI Ioreign
securities in world capital markets is likely
to continue
#elative Size oI
U.S. Financial Markets
Overall value oI the total investable capital
market has increased Irom $2.3 Trillion in
1969 to $70.9 Trillion in 2003 and the U.S.
portion has declined to less than halI.
This trend is likely to continue
%e Case for Global
nvestments
#ates oI return available on non-U.S.
securities oIten exceed U.S. Securities due
to higher growth rates in Ioreign countries,
especially the emerging markets
%e Case for Global
nvestments
iversiIication with Ioreign securities can
help reduce portIolio risk because Ioreign
markets have low correlation with U.S. capital
markets
Global Bond Portfolio #isk
1. Macroeconomic diIIerences cause the
correlation oI bond returns between the
United States and Ioreign countries to
diIIer
2. The correlation oI returns between a single
pair oI countries changes over time
because the Iactors inIluencing the
correlation change over time
#isk of Combined Countr
nvestments
iversiIied portIolios reduce variability oI
returns over time
Correlation coeIIicients measure
diversiIication contribution
Compare correlation oI return among U.S.
bonds and stocks with returns on Ioreign
bonds and stocks
Global Bond Portfolio #isk
Low positive correlation
Opportunities Ior U.S. investors to reduce
risk
Correlation changes over time
Adding non-correlated Ioreign bonds to a
portIolio oI U.S. bonds increases the rate oI
return and reduces the risk oI the portIolio
Global Equit Portfolio #isk
Low positive correlation
Opportunities to reduce risk oI stock
portIolio by including Ioreign stocks
Summary on Global Investing
#elatively high rates oI return
combined with low correlation
coeIIicients indicate that adding
Ioreign stocks and bonds to a U.S.
portIolio will reduce risk and may
increase its average return
Global nvestment Coices
Fixed-income investments
bonds and preIerred stocks
Equity investments
Special equity instruments
warrants and options
Futures contracts
Investment companies
#eal assets
Fixed-ncome nvestments
Contractual payment schedule
#ecourse varies by instrument
Bonds
investors are lenders
expect interest payment and return oI
principal
PreIerred stocks
dividends require board oI directors
approval
Savings Accounts
Fixed earnings
Convenient
Liquid
Low risk
Low rates
CertiIicates oI eposit (Cs)
- instruments that require minimum deposits
Ior speciIied terms, and pay higher rates oI
interest than savings accounts. Penalty
imposed Ior early withdrawal
Mone Market Certificates
Compete against Treasury bills (T-bills)
Minimum $10,000
Minimum maturity oI six months
#edeemable only at bank oI issue
Penalty iI withdrawn beIore maturity
Capital Market nstruments
Fixed income obligations that trade in
secondary market
U.S. Treasury securities
U.S. Government agency securities
Municipal bonds
Corporate bonds
U.S. %reasur Securities
Bills, notes, or bonds - depending on
maturity
Bills mature in less than 1 year
Notes mature in 1 - 10 years
Bonds mature in over 10 years
Highly liquid
Backed by the Iull Iaith and credit oI the
U.S. Government
U.S. Government Agenc
Securities
Sold by government agencies
Federal 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 oI the Treasury
Still considered deIault-Iree and Iairly liquid
Municipal Bonds
Issued by state and local governments
usually to Iinance inIrastructural projects.
Exempt Irom taxation by the Iederal
government and by the state that issued the
bond, provided the investor is a resident oI
that state
Two types:
General obligation bonds (GOs)
#evenue bonds
Corporate Bonds
Issued by a corporation
Fixed income
Credit quality measured by ratings
Maturity
Features
Indenture
Call provision
Sinking Iund
Corporate Bonds
Senior secured bonds
most senior bonds in capital structure and have
the lowest risk oI deIault
Mortgage bonds
secured by liens on speciIic assets
Collateral trust bonds
secured by Iinancial assets
Equipment trust certiIicates
secured by transportation equipment
Corporate Bonds
ebentures
Unsecured promises to pay interest and
principal
In case oI deIault, debenture owner can Iorce
bankruptcy and claim any unpledged assets to
pay oII the bonds
Subordinated bonds
Unsecured like debentures, but holders oI these
bonds may claim assets aIter senior secured and
debenture holders claims have been satisIied
Corporate Bonds
Income bonds
Interest payment contingent upon earning
suIIicient income
Convertible bonds
OIIer the upside potential oI common
stock and the downside protection oI a
bond
Usually have lower interest rates
Corporate Bonds
Warrants
Allows bondholder to purchase the Iirm`s
common stock at a Iixed price Ior a given time
period
Interest rates usually lower on bonds with
warrants attached
Zero coupon bond
OIIered at a deep discount Irom the Iace value
No interest during the liIe oI the bond, only the
principal payment at maturity
Preferred Stock
Hybrid security
Fixed dividends
ividend obligations are not legally
binding, but must be voted on by the board
oI directors to be paid
Most preIerred stock is cumulative
Credit implications oI missing dividends
Corporations may exclude 80 oI dividend
income Irom taxable income
nternational Bond nvesting
Investors should be aware that there is a very
substantial Iixed income market outside the
United States that oIIers additional opportunity
Ior diversiIication
nternational Bond nvesting
Bond identiIication characteristics
Country oI origin
Location oI primary trading market
Home country oI the major buyers
Currency oI the security denomination
Eurobond
An international bond denominated in a
currency not native to the country where it is
issued
nternational Bond nvesting
Yankee bonds
Sold in the United States and denominated is
U.S. dollars, but issued by Ioreign corporations
or governments
Eliminates exchange risk to U.S. investors
International domestic bonds
Sold by issuer within its own country in that
country`s currency
Equit nvestments
#eturns are not contractual and
may be better or worse than on
a bond
Equit nvestments
Common Stock
#epresents ownership oI a Iirm
Investor`s return tied to perIormance oI
the company and may result in loss or
gain
Classification of Common Stock
Categorized B General Business
Line
Industrial: manuIacturers oI automobiles,
machinery, chemicals, beverages
Utilities: electrical power companies, gas
suppliers, water industry
Transportation: airlines, truck lines,
railroads
Financial: banks, savings and loans, credit
unions
Acquiring Foreign Equities
1. Purchase oI American epository #eceipts
(A#s)
2. Purchase oI American shares
3. irect purchase oI Ioreign shares listed on a
U.S. or Ioreign stock exchange
4. Purchase oI international mutual Iunds
American Depositor #eceipts
(AD#s)
Easiest way to directly acquire Ioreign shares
CertiIicates oI ownership issued by a U.S. bank
that represents indirect ownership oI a certain
number oI shares oI a speciIic Ioreign Iirm on
deposit in a U.S. bank in the Iirm`s home country
Buy and sell in U.S. dollars
ividends in U.S. dollars
May represent multiple shares
Listed on U.S. exchanges
Very popular
Purcase or Sale of American
sares
Issued in the United States by transIer
agent on behalI oI a Ioreign Iirm
Higher expenses
Limited availability
Direct Purcase or Sale of
Foreign Sares
irect investment in Ioreign equity markets-
diIIicult and complicated due to
administrative, inIormation, taxation, and
market eIIiciency problems
Purchase Ioreign stocks listed on a U.S.
exchange limited choice
Purcase or Sale of Global Mutual
Funds or E%Fs
Global Iunds - invest in both U.S. and
Ioreign stocks
International Iunds - invest mostly outside
the U.S.
Funds can specialize
iversiIication across many countries
Concentrate in a segment oI the world
Concentrate in a speciIic country
Concentrate in types oI markets
Exchange-traded Iunds or ETFs are a recent
innovation in the world oI index products
Special Equit nstruments
Equity-derivative securities have a claim on
common stock oI a Iirm
Options are rights to buy or sell at a stated
price Ior a period oI time
Warrants are options to buy Irom the
company
Puts are options to sell to an investor
Calls are options to buy Irom a stockholder
Futures Contracts
Exchange oI a particular asset at a speciIied
delivery date Ior a stated price paid at the
time oI delivery
eposit (10 margin) is made by buyer at
contract to protect the seller
Commodities trading is largely in Iutures
contracts
Current price depends on expectations
Financial Futures
#ecent development oI contracts on Iinancial
instruments such as T-bills, Treasury bonds,
and Eurobonds
Traded mostly on Chicago Mercantile
Exchange (CME) and Chicago Board oI Trade
(CBOT)
Allow investors and portIolio managers to
protect against volatile interest rates
Currency Iutures allow protection against
changes in exchange rates
nvestment Companies
#ather than buy individual securities
directly Irom the issuer they can be acquired
indirectly through shares in an investment
company
Investment companies sell shares in itselI
and uses proceeds to buy securities
Investors own part oI the portIolio oI
investments
nvestment Companies
Money market Iunds
Acquire high-quality, short-term investments
Yields are higher than normal bank Cs
Typical minimum investment is $1,000
No sales commission charges
Withdrawal is by check with no penalty
Investments usually are not insured
nvestment Companies
Bond Iunds
Invest in long-term government,
corporate, or municipal bonds
Bond Iunds vary in bond quality selected
Ior investment
Expected returns vary with risk oI bonds
nvestment Companies
Common stock Iunds
Many diIIerent Iunds with varying stated
investment objectives
Aggressive growth, income, precious metals,
international stocks
OIIer diversiIication to smaller investors
Sector Iunds concentrate in an industry
International Iunds invest outside the United
States
Global Iunds invest in the U.S. and other
countries
nvestment Companies
Balanced Iunds
Invest in a combination oI stocks and
bonds depending on their stated
objectives
nvestment Companies
Index Funds
These are mutual Iunds created to equal
the perIormance oI a market index like
the S&P 500
nvestment Companies
Exchange-Traded Funds (ETFs)
These are depository receipts Ior a portIolio oI
securities deposited at a Iinancial institution in
a unit trust that issues a certiIicate oI ownership
Ior the portIolio oI stocks
The stocks in a portIolio are those in an index
like the S&P 500 and dozens oI country or
industry indexes
ETFs can be bought and sold continuously on
an exchange like common stock
#eal Estate nvestment %rusts
(#E%s)
Investment Iund that invests in a variety oI
real estate properties
Construction and development trusts
provide builders with construction
Iinancing
Mortgage trusts provide long-term
Iinancing Ior properties
Equity trusts own various income-
producing properties
Direct #eal Estate nvestment
Purchase oI a home
Average cost oI a single-Iamily house exceeds
$100,000
Financing by mortgage requires down payment
Homeowner hopes to sell the house Ior cost
plus a gain
Direct #eal Estate nvestment
Purchase oI raw land
Intention oI selling in Iuture Ior a proIit
Ownership provides a negative cash Ilow due to
mortgage payments, taxes, and property
maintenance
#isk Irom selling Ior an uncertain price and low
liquidity
Direct #eal Estate nvestment
Land evelopment
Buy raw land
ivide into individual lots
Build houses or a shopping mall on it
#equires capital, time, and expertise
#eturns Irom successIul development can be
signiIicant
Direct #eal Estate nvestment
#ental Property
Acquire apartment buildings or houses with
low down payments
erive enough income Irom the rents to pay the
expenses oI the structure, including the
mortgage payments, and generate a good return
#ental property provides a cash Ilow and an
opportunity to proIit Irom the sale oI the
property
Low-Liquidit nvestments
Some investments don`t trade on securities
markets
Lack oI liquidity keeps many investors
away
Auction sales create wide Iluctuations in
prices
Without markets, dealers incur high
transaction costs
Antiques
ealers buy at estate sales, reIurbish, and
sell at a proIit
Serious collectors may enjoy good returns
Individuals buying a Iew pieces to decorate
a home may have diIIiculty overcoming
transaction costs to ever enjoy a proIit
Art
Investment requires substantial knowledge
oI art and the art world
Acquisition oI work Irom a well-known
artist requires large capital commitments
and patience
High transaction costs
Uncertainty and illiquidity
Coins and Stamps
Enjoyed by many as hobby and as an
investment
Market is more Iragmented than stock
market, but more liquid than art and
antiques markets
Price lists are published weekly and
monthly
Grading speciIications aid sales
Wide spread between bid and ask prices
Diamonds
Can be illiquid
Grading determines value, but is subjective
Investment-grade gems require substantial
investments
No positive cash Ilow until sold
Costs oI insurance, storage, and appraisal
istorical #isk-#eturns on
Alternative nvestments
orld Portfolio Performance
#eilly and Wright (2004) examined the
perIormance oI various investment alternatives
Irom the United States, Canada, Europe, Japan,
and the emerging markets Ior the period 1980-
2001
#eill and rigt`s 2004 Stud
Asset #eturns and Total #isk
The expected relationship between annual rates
oI return and total risk (standard deviation) oI
these securities was conIirmed
#eill and rigt`s 2004 Stud
#eturn and Systematic #isk
The systematic risk measure (beta) did a better
job oI explaining the returns during the period
than did the total risk measure
The beta risk measure that used the Brinson
index as a market proxy was somewhat better
than the beta that used the S&P 500 Index
#eill and rigt`s 2004 Stud
Correlations between Asset #eturns
U.S. equities have a reasonably high correlation
with Canadian and U.K. stocks but low
correlation with emerging market stocks and
Japanese stocks
U.S. equities show almost zero correlation with
world government bonds, except U.S. bonds
Art and Antiques
Market data is limited
#esults vary widely, and change over time,
making generalization impossible, but
showing a reasonably consistent
relationship between risk and return
Correlation coeIIicients vary widely,
allowing Ior great diversiIication potential
Liquidity is still a concern
#eal Estate
#eturns are diIIicult to derive due to lack oI
consistent data
#esidential shows lower risk and return
than commercial real estate
uring some short time periods #EITs have
shown higher returns than stock with lower
risk measures
Long term returns Ior real estate are lower
than stocks, and have lower risk
#eal Estate
Negative correlation between residential
and Iarm real estate and stocks
Low positive correlation between
commercial real estate and stocks
Potential Ior diversiIication
%e nternet
Investments Online
http://www.site-by-site.com
http://www.moneycaIe.com
http://www.emgmkts.com
http://www.law.duke.edu/globalmark
http://www.lebenthal.com
http://www.sothebys.com
Appendix Capter 3
Covariance and Correlation
Covariance
absolute measure oI the
extent to which two sets
oI numbers move together
over time
Covariance

COV
then , j as ) j - (j and i as ) i - (i deIine we II
@ @

@ @

COV
Correlation
relative measure oI a
given relationship
Correlation

7
9 9
COV

9
uture topics
apter 4
Organization oI markets
Functioning oI security markets
Trading systems