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Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Eighth Edition by Frank K. Reilly

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Title: Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Eighth Edition by Frank K. Reilly


1
Lecture Presentation Software to
accompany Investment Analysis and Portfolio
Management Eighth Edition by Frank K. Reilly
Keith C. Brown
Chapter 3
2
Chapter 3 - Selecting Investments in a Global
Market
  • Questions to be answered
  • Why should investors have a global perspective
    regarding their investments?

3
Chapter 3 - Selecting Investments in a Global
Market
  • Questions to be answered
  • What has happened to the relative size of U.S.
    and foreign stock and bond markets?

4
Chapter 3 - Selecting Investments in a Global
Market
  • Questions to be answered
  • What are the differences in the rates of return
    on U.S. and foreign securities markets?

5
Chapter 3 - Selecting Investments in a Global
Market
  • Questions to be answered
  • How can changes in currency exchange rates affect
    the returns that U.S. investors experience on
    foreign securities?

6
Chapter 3 - Selecting Investments in a Global
Market
  • Questions to be answered
  • Is there an additional advantage of diversifying
    in international markets beyond the benefits of
    domestic diversification?

7
Chapter 3 - Selecting Investments in a Global
Market
  • Questions to be answered
  • What alternative securities are available? What
    are their cash flow and risk properties?

8
Chapter 3 - Selecting Investments in a Global
Market
  • Questions to be answered
  • What is the historical return and risk
    characteristics of the major investment
    instruments?

9
Chapter 3 - Selecting Investments in a Global
Market
  • Questions to be answered
  • What is the relationship among returns for
    foreign and domestic investment instruments?
    What is the implication of these relationships
    for portfolio diversification?

10
Reasons for the expansion of investment
opportunities
  • Growth and development of foreign financial
    markets
  • 2. Advances in telecommunications technology
  • 3.  Mergers of firms and security exchanges

11
The Case for Constructing Global Investment
Portfolios
  • Ignoring foreign markets can substantially reduce
    the investment choices for U.S. investors
  • The rates of return on non-U.S. securities often
    have substantially exceeded those for U.S.-only
    securities
  • The low correlation between U.S. stock markets
    and many foreign markets can help to
    substantially reduce portfolio risk

12
Relative Size of U.S. Financial Markets
  1. 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 51 percent in 2003
  2. The growing importance of foreign securities in
    world capital markets is likely to continue

13
Relative Size of U.S. Financial Markets
  • Overall value of the total investable capital
    market has increased from 2.3 Trillion in 1969
    to 70.9 Trillion in 2003 and the U.S. portion
    has declined to less than half.
  • This trend is likely to continue

14
The Case for Global Investments
  • Rates of return available on non-U.S. securities
    often exceed U.S. Securities due to higher
    growth rates in foreign countries, especially the
    emerging markets

15
The Case for Global Investments
  • Diversification with foreign securities can
  • help reduce portfolio risk because foreign
  • markets have low correlation with U.S. capital
  • markets

16
Global Bond Portfolio Risk
  1. Macroeconomic differences cause the correlation
    of bond returns between the United States and
    foreign countries to differ
  2. The correlation of returns between a single pair
    of countries changes over time because the
    factors influencing the correlation change over
    time

17
Risk of Combined Country Investments
  • Diversified portfolios reduce variability of
    returns over time
  • Correlation coefficients measure diversification
    contribution
  • Compare correlation of return among U.S. bonds
    and stocks with returns on foreign bonds and
    stocks

18
Global Bond Portfolio Risk
  • Low positive correlation
  • Opportunities for U.S. investors to reduce risk
  • Correlation changes over time
  • Adding non-correlated foreign bonds to a
    portfolio of U.S. bonds increases the rate of
    return and reduces the risk of the portfolio

19
Global Equity Portfolio Risk
  • Low positive correlation
  • Opportunities to reduce risk of stock portfolio
    by including foreign stocks

20
Summary on Global Investing
  • Relatively high rates of return combined with low
    correlation coefficients indicate that adding
    foreign stocks and bonds to a U.S. portfolio will
    reduce risk and may increase its average return

21
Global Investment Choices
  • Fixed-income investments
  • bonds and preferred stocks
  • Equity investments
  • Special equity instruments
  • warrants and options
  • Futures contracts
  • Investment companies
  • Real assets

22
Fixed-Income Investments
  • Contractual payment schedule
  • Recourse varies by instrument
  • Bonds
  • investors are lenders
  • expect interest payment and return of principal
  • Preferred stocks
  • dividends require board of directors approval

23
Savings Accounts
  • Fixed earnings
  • Convenient
  • Liquid
  • Low risk
  • Low rates
  • Certificates of Deposit (CDs)
  • - instruments that require minimum deposits for
    specified terms, and pay higher rates of interest
    than savings accounts. Penalty imposed for early
    withdrawal

24
Money Market Certificates
  • Compete against Treasury bills (T-bills)
  • Minimum 10,000
  • Minimum maturity of six months
  • Redeemable only at bank of issue
  • Penalty if withdrawn before maturity

25
Capital Market Instruments
  • Fixed income obligations that trade in secondary
    market
  • U.S. Treasury securities
  • U.S. Government agency securities
  • Municipal bonds
  • Corporate bonds

26
U.S. Treasury 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 full faith and credit of the U.S.
    Government

27
U.S. Government Agency 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 of the Treasury
  • Still considered default-free and fairly liquid

28
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

29
Corporate Bonds
  • Issued by a corporation
  • Fixed income
  • Credit quality measured by ratings
  • Maturity
  • Features
  • Indenture
  • Call provision
  • Sinking fund

30
Corporate Bonds
  • Senior secured bonds
  • most senior bonds in capital structure and have
    the lowest risk of default
  • Mortgage bonds
  • secured by liens on specific assets
  • Collateral trust bonds
  • secured by financial assets
  • Equipment trust certificates
  • secured by transportation equipment

31
Corporate Bonds
  • Debentures
  • Unsecured promises to pay interest and principal
  • In case of default, debenture owner can force
    bankruptcy and claim any unpledged assets to pay
    off the bonds
  • Subordinated bonds
  • Unsecured like debentures, but holders of these
    bonds may claim assets after senior secured and
    debenture holders claims have been satisfied

32
Corporate Bonds
  • Income bonds
  • Interest payment contingent upon earning
    sufficient income
  • Convertible bonds
  • Offer the upside potential of common stock and
    the downside protection of a bond
  • Usually have lower interest rates

33
Corporate Bonds
  • Warrants
  • Allows bondholder to purchase the firms common
    stock at a fixed price for a given time period
  • Interest rates usually lower on bonds with
    warrants attached
  • Zero coupon bond
  • Offered at a deep discount from the face value
  • No interest during the life of the bond, only the
    principal payment at maturity

34
Preferred Stock
  • Hybrid security
  • Fixed dividends
  • Dividend obligations are not legally binding, but
    must be voted on by the board of directors to be
    paid
  • Most preferred stock is cumulative
  • Credit implications of missing dividends
  • Corporations may exclude 80 of dividend income
    from taxable income

35
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

36
International Bond Investing
  • Bond identification characteristics
  • Country of origin
  • Location of primary trading market
  • Home country of the major buyers
  • Currency of the security denomination
  • Eurobond
  • An international bond denominated in a currency
    not native to the country where it is issued

37
International Bond Investing
  • Yankee bonds
  • Sold in the United States and denominated is U.S.
    dollars, but issued by foreign corporations or
    governments
  • Eliminates exchange risk to U.S. investors
  • International domestic bonds
  • Sold by issuer within its own country in that
    countrys currency

38
Equity Investments
  • Returns are not contractual and may be better or
    worse than on a bond

39
Equity Investments
  • Common Stock
  • Represents ownership of a firm
  • Investors return tied to performance of the
    company and may result in loss or gain

40
Classification of Common Stock Categorized By
General Business Line
  • Industrial manufacturers of automobiles,
    machinery, chemicals, beverages
  • Utilities electrical power companies, gas
    suppliers, water industry
  • Transportation airlines, truck lines, railroads
  • Financial banks, savings and loans, credit unions

41
Acquiring Foreign Equities
  • 1. Purchase of American Depository Receipts
    (ADRs)
  • 2. Purchase of American shares
  • 3. Direct purchase of foreign shares listed on a
    U.S. or foreign stock exchange
  • 4. Purchase of international mutual funds

42
American Depository Receipts (ADRs)
  • Easiest way to directly acquire foreign shares
  • Certificates 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 country
  • Buy and sell in U.S. dollars
  • Dividends in U.S. dollars
  • May represent multiple shares
  • Listed on U.S. exchanges
  • Very popular

43
Purchase or Sale of American shares
  • Issued in the United States by transfer agent on
    behalf of a foreign firm
  • Higher expenses
  • Limited availability

44
Direct Purchase or Sale of Foreign Shares
  • Direct investment in foreign equity markets-
    difficult and complicated due to administrative,
    information, taxation, and market efficiency
    problems
  • Purchase foreign stocks listed on a U.S. exchange
    limited choice

45
Purchase or Sale of Global Mutual Funds or ETFs
  • Global funds - invest in both U.S. and foreign
    stocks
  • International funds - invest mostly outside the
    U.S.
  • Funds can specialize
  • Diversification across many countries
  • Concentrate in a segment of the world
  • Concentrate in a specific country
  • Concentrate in types of markets
  • Exchange-traded funds or ETFs are a recent
    innovation in the world of index products

46
Special Equity Instruments
  • Equity-derivative securities have a claim on
    common stock of a firm
  • Options are rights to buy or sell at a stated
    price for a period of time
  • Warrants are options to buy from the company
  • Puts are options to sell to an investor
  • Calls are options to buy from a stockholder

47
Futures Contracts
  • Exchange of a particular asset at a specified
    delivery date for a stated price paid at the time
    of delivery
  • Deposit (10 margin) is made by buyer at contract
    to protect the seller
  • Commodities trading is largely in futures
    contracts
  • Current price depends on expectations

48
Financial Futures
  • Recent development of contracts on financial
    instruments such as T-bills, Treasury bonds, and
    Eurobonds
  • Traded mostly on Chicago Mercantile Exchange
    (CME) and Chicago Board of Trade (CBOT)
  • Allow investors and portfolio managers to protect
    against volatile interest rates
  • Currency futures allow protection against changes
    in exchange rates

49
Investment Companies
  • Rather than buy individual securities directly
    from the issuer they can be acquired indirectly
    through shares in an investment company
  • Investment companies sell shares in itself and
    uses proceeds to buy securities
  • Investors own part of the portfolio of investments

50
Investment Companies
  • Money market funds
  • Acquire high-quality, short-term investments
  • Yields are higher than normal bank CDs
  • Typical minimum investment is 1,000
  • No sales commission charges
  • Withdrawal is by check with no penalty
  • Investments usually are not insured

51
Investment Companies
  • Bond funds
  • Invest in long-term government, corporate, or
    municipal bonds
  • Bond funds vary in bond quality selected for
    investment
  • Expected returns vary with risk of bonds

52
Investment Companies
  • Common stock funds
  • Many different funds with varying stated
    investment objectives
  • Aggressive growth, income, precious metals,
    international stocks
  • Offer diversification to smaller investors
  • Sector funds concentrate in an industry
  • International funds invest outside the United
    States
  • Global funds invest in the U.S. and other
    countries

53
Investment Companies
  • Balanced funds
  • Invest in a combination of stocks and bonds
    depending on their stated objectives

54
Investment Companies
  • Index Funds
  • These are mutual funds created to equal the
    performance of a market index like the SP 500

55
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 stocks
  • The stocks in a portfolio are those in an index
    like the SP 500 and dozens of country or
    industry indexes
  • ETFs can be bought and sold continuously on an
    exchange like common stock

56
Real Estate Investment Trusts (REITs)
  • Investment fund that invests in a variety of real
    estate properties
  • Construction and development trusts provide
    builders with construction financing
  • Mortgage trusts provide long-term financing for
    properties
  • Equity trusts own various income-producing
    properties

57
Direct Real Estate Investment
  • Purchase of a home
  • Average cost of a single-family house exceeds
    100,000
  • Financing by mortgage requires down payment
  • Homeowner hopes to sell the house for cost plus a
    gain

58
Direct Real Estate Investment
  • Purchase of raw land
  • Intention of selling in future for a profit
  • Ownership provides a negative cash flow due to
    mortgage payments, taxes, and property
    maintenance
  • Risk from selling for an uncertain price and low
    liquidity

59
Direct Real Estate Investment
  • Land Development
  • Buy raw land
  • Divide into individual lots
  • Build houses or a shopping mall on it
  • Requires capital, time, and expertise
  • Returns from successful development can be
    significant

60
Direct Real Estate Investment
  • Rental Property
  • Acquire apartment buildings or houses with low
    down payments
  • Derive enough income from the rents to pay the
    expenses of the structure, including the mortgage
    payments, and generate a good return
  • Rental property provides a cash flow and an
    opportunity to profit from the sale of the
    property

61
Low-Liquidity Investments
  • Some investments dont trade on securities
    markets
  • Lack of liquidity keeps many investors away
  • Auction sales create wide fluctuations in prices
  • Without markets, dealers incur high transaction
    costs

62
Antiques
  • Dealers buy at estate sales, refurbish, and sell
    at a profit
  • Serious collectors may enjoy good returns
  • Individuals buying a few pieces to decorate a
    home may have difficulty overcoming transaction
    costs to ever enjoy a profit

63
Art
  • Investment requires substantial knowledge of art
    and the art world
  • Acquisition of work from a well-known artist
    requires large capital commitments and patience
  • High transaction costs
  • Uncertainty and illiquidity

64
Coins and Stamps
  • Enjoyed by many as hobby and as an investment
  • Market is more fragmented than stock market, but
    more liquid than art and antiques markets
  • Price lists are published weekly and monthly
  • Grading specifications aid sales
  • Wide spread between bid and ask prices

65
Diamonds
  • Can be illiquid
  • Grading determines value, but is subjective
  • Investment-grade gems require substantial
    investments
  • No positive cash flow until sold
  • Costs of insurance, storage, and appraisal

66
Historical Risk-Returns on Alternative Investments
  • World Portfolio Performance
  • Reilly and Wright (2004) examined the performance
    of various investment alternatives from the
    United States, Canada, Europe, Japan, and the
    emerging markets for the period 1980-2001

67
Reilly and Wrights 2004 Study
  • Asset Returns and Total Risk
  • The expected relationship between annual rates of
    return and total risk (standard deviation) of
    these securities was confirmed

68
Reilly and Wrights 2004 Study
  • Return and Systematic Risk
  • The systematic risk measure (beta) did a better
    job of 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 SP 500 Index

69
Reilly and Wrights 2004 Study
  • Correlations between Asset Returns
  • 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

70
Art and Antiques
  • Market data is limited
  • Results vary widely, and change over time, making
    generalization impossible, but showing a
    reasonably consistent relationship between risk
    and return
  • Correlation coefficients vary widely, allowing
    for great diversification potential
  • Liquidity is still a concern

71
Real Estate
  • Returns are difficult to derive due to lack of
    consistent data
  • Residential shows lower risk and return than
    commercial real estate
  • During some short time periods REITs have shown
    higher returns than stock with lower risk
    measures
  • Long term returns for real estate are lower than
    stocks, and have lower risk

72
Real Estate
  • Negative correlation between residential and farm
    real estate and stocks
  • Low positive correlation between commercial real
    estate and stocks
  • Potential for diversification

73
The Internet Investments Online
  • http//www.site-by-site.com
  • http//www.moneycafe.com
  • http//www.emgmkts.com
  • http//www.law.duke.edu/globalmark
  • http//www.lebenthal.com
  • http//www.sothebys.com

74
  • Appendix Chapter 3
  • Covariance and Correlation

75
Covariance
  • absolute measure of the extent to which two sets
    of numbers move together over time

76
Covariance
77
Correlation
  • relative measure of a given relationship

78
Correlation
79
Future topics Chapter 4
  • Organization of markets
  • Functioning of security markets
  • Trading systems
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