Investments & Portfolio Management - Lecture notes, lectures 1 - 10 - course notes PDF

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INVESTMENTS & PORTFOLIO MANAGEMENT AFF3121 SEMESTER 1, 2012 Heading 1: Introduction to Investments Investment has been defined in RBS, p.4 as: “…the current commitment of dollars for a period of time in order to derive future payments that will compensate the investor for: (1) the time the funds are committed, (2) the expected rate of inflation during this time, and (3) the uncertainty of the future payments…” An investment is a deferment of current consumption (saving = investment) to some future period. i.e. there is some trade-off that exists: The cost of deferring current consumption (investment) for future consumption is called the pure (or real) rate of interest. Investments is the study of the process of committing funds to one or more assets known as: The Investment Process – a Two Stage Process 1. Security Analysis: Detection of undervalued securities (assets). a. Does price = value? Warren Buffet – “Price is what you pay and value is what you get”. 2. Portfolio Management: Combining and managing individuals securities to form a group of assets as a unit (an optimal portfolio). The Tradeoff Between Expected Return and Risk 

Investors are (typically risk averse and rational) manage risk based on expected returns (ER).

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Any level of expected or required (nominal) return and risk can be attained.

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Nominal risk free rate of return is available to all investors for a riskless asset such as Treasury Bills. Page 1

The required rate of return (RRR) = the nominal rate of return or nominal interest rate. This is the minimum expected rate of return necessary to induce an investor to purchase a security and is the sum of 3 components (Fisher hypothesis – see index in Jones at the end): 1. Pure or Real Risk Free Interest Rate (Real Rate = ER) during investment: 

Real risk free rate (the exchange rate between future consumption and present consumption – based on zero inflation and zero uncertainty) i.e. the expected return minus the risk premium minus the expected inflation.

2. Inflation Protection (Expected Inflation = EI) during investment: 

Nominal risk-free rate of interest (RF) adjusts the real risk-free rate to reflect expected inflation over the life of the investment: RR + EI = RF.

3. Risk involves: 

Risk Premium (RP): Investors need sufficient expected additional compensation in order to bear additional risk.

Required Return = IR = RR + EI + RP Individual vs. Institutional Investors Institutional Investors - Maintain relatively constant profile over time - Legal and regulatory constraints - Well-defined and effective policy is critical

Individual Investors - Life stage matters -

Risk defined as “losing money” Characterized by personalities

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Goals important Tax management is important part of decisions

Managing Risk Since risk drives expected return, investing involves managing risk rather than managing return. In other words, portfolio management is nothing other than risk management. Protection for Individual Investor Risk

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Life Insurance: Providing death benefits and, possibly, additional cash values. o Term life and whole life insurance o Universal and variable life insurance

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Non-Life Insurance o Health insurance & disability insurance o Automobile insurance & home/rental insurance

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Cash Reserve o To meet emergency needs o Equal to six months living expenses

Individual Investor Life Cycle The individual investors life cycle can often be described using four separate phases or stages: 1. 2. 3. 4.

Accumulation phase Consolidation phase Spending phase Gifting phase

Life Cycle Approach There are different positions of risk/ return taken by an investor at various life cycle stages: A. Accumulation phase – early career B. Consolidation phase mid-to late career C. Spending phase – spending and gifting Page 3

A. Accumulation Phase     

Early to middle years of careers where attempts are made to satisfy intermediate and long-term goals. Net worth is usually small and debt may be heavy. Long-term investment horizon means usually willing to take moderately high risks in order to make above-average returns. Life insurance is important in this phase and in the next phase. Start investing early in life to benefit from the magic of compounding and being having more time available for compounding.

B. Consolidation Phase    

Past career midpoint Have paid off much of their accumulated debt Earnings now exceed living expenses, so the balance can be invested Time horizon is still long-term, so moderately high risk investments are still attractive

C. Spending Phase    

Usually begins at retirement Saving before, prudent spending now Living expenses covered by Social Security and retirement plans Changing emphasis toward preservation of capital, but still want investment values to keep pace with inflation: investor’s enemy

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Gifting Phase   

Can be concurrent with spending phase If resources allow, individuals can now use excess assets to provide gifts to other individuals or organisations Estate planning becomes important, especially tax considerations

The Portfolio Management Process The portfolio management process has four steps: 1. Construct a policy statement 2. Study current financial conditions and forecast future trends 3. Construct a portfolio 4. Monitor needs and conditions

Formulate Investment Policy Investment policy summarises the objectives, constraints and preferences for the investor (very important: risk tolerance). Investment policy should contain a statement about return requirements and for inflations adjusted returns. The unique needs and circumstances of the investor may restrict certain asset classes. Constrains and preferences may include:   

Time horizon – Objectives may require specific planning horizon Liquidity needs – Investors should know future cash needs Tax considerations – Ordinary income vs capital gains and retirement programs that offer tax sheltering.

Investment Objectives Possible broad goals include:    

Capital preservation - i.e. maintain purchasing power and minimize the risk of loss Capital appreciation – i.e. achieve portfolio growth through capital gains and accept greater risk Current income – Look to generate income rather than capital gains; may be preferred in “spending phase” and may require relatively low risk. Total return – Combining income returns and reinvestment with capital gains, generally with moderate risk.

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Legal and Regulatory Requirements The Prudent Man Rule:   

Followed in fiduciary responsibility Interpretation can change with time and circumstances Standard applied to individual investments rather than the portfolio as a whole.

Investment laws prohibit insider trade. Further, Employee Retirement Income Security Act 1974 (ERISA) – USA: requires diversification and standards applied to an entire portfolio. Capital Market Expectations Macro factors include expectations about the capital markets. Micro factors include estimates that influence the selection of a particular asset for a particular portfolio. Rate of return assumptions must be realistic and historical returns should be studied carefully. Rate of Return Assumptions How much influence should recent stock market returns have?  

Reversion to the mean arguments Stock returns involve considerable risk, probability of 10% return is 50% regardless of the holding period. Probability of >10% return decreases over longer investment horizons but expected returns are not guaranteed.

Constructing the Portfolio Use investment policy and capital market expectations to choose a portfolio of assets. Define the securities that are eligible for inclusion in a particular portfolio, use an optimization procedure to select securities and determine the proper portfolio weights (Markowitz provides a formal model). Asset Allocation This step involves deciding on weights for cash, bonds, and stocks. It is the most important decision:   

Differences in allocation cause differences in portfolio performance. Because securities within asset classes tend to move together, asset allocation is an important investment decision. Should consider international securities, real estate, and domestic Treasury (government) securities.

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There are a number of factors to consider. They include; return requirements, risk tolerance, time horizon and the age of the investor Investment Strategy Four decisions in an investment strategy: 1. 2. 3. 4.

What asset classes should be considered? What should be the normal weight for each asset class? What are the allowable ranges for the weights? What specific securities should be purchased?

Monitoring Conditions and Circumstances Investor circumstances can change for several reasons:      

Wealth changes affect risk tolerance Investment horizon changes Liquidity requirement changes Tax circumstance changes Regulatory considerations Unique needs and circumstances

Portfolio Adjustments    

Portfolios are not intended to stay fixed The key is to know when to rebalance them Rebalancing also involves costs, i.e. brokerage commissions, the possible impact of trade on market price and the time involved in deciding to trade. There is also the cost of not rebalancing which involves holding in unfavourable positions.

Performance Measurement Performance measurement allows for analysis of the success of portfolio management. Key part of monitoring strategy and evaluating risks. It is important for those who employ a manager and those who invest personal funds. Performance measurement also allows for discovery of reasons for success or failure. “The Financial System and its Workings” Notes (Ch 1, Viney) Equity Equity can take a number of forms. For example, if you buy a new car by paying a deposit from your own funds and borrowing the remainder, your equity in the car is the amount of the deposit paid. Paying off the loan will increase your level of equity.

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Equity in a business corporation is represented through the ownership of shares. The principal form of equity issued by a corporation is an ordinary share or common stock. Another form of equity is known as a hybrid security. A hybrid security is a financial instrument that incorporates the characteristics of both debt and equity (preference shares). Preference shares, while being a form of equity finance, have many characteristics in common with debt, i.e. holders are entitled to received specified fixed dividend for a defined period and the dividend must be paid before any dividend is paid to ordinary share holders. Also rank ahead of ordinary holders in the case of liquidation. Debt Instruments Entitle the holder to a claim (ahead of equity holders) to the income stream produced by the borrower and to the assets of the borrower if the borrower defaults on payments. There is secured (specifying assets) and unsecured debt. Derivatives Used to manage an exposure to an identified risk. i.e. a borrower might be concerned that interest rates on existing debt funding may rise and thus will seek to reduce that risk by locking in an interest rate today using derivatives. Four types: 

Futures – contract to buy a specified amount of a commodity or financial instrument at a price determined today for future settlement

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Forwards – like a futures contract but typically more flexible. Establishes currency exchange or interest rate in the future for the future.

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Options – gives the buyer the right to buy the designated asset at a specified date or within a specified period during the life of the option at a predetermined price.

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Swap –arrangement to exchange specified future cash flows, i.e. an interest rate swap or cross currency swap.

Primary and Secondary Markets Primary market transaction involves the issue of a new financial instrument whereas a secondary market transaction involves the buying and selling of existing financial securities which involves a transfer of ownership.

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The Benefits of Financial Intermediation

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Asset transformation – intermediaries offer customer a wide range of financial products on both sides of the balance sheet.

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Maturity transformation – savers prefer liquidity and borrowers prefer longer-term commitment/ Banks can pool funds and offer a range of maturity termed products.

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Credit risk diversification – saver’s credit risk exposure is limited to the intermediary; the intermediary is exposed to the credit risk of the ultimate borrower.

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Liquidity transformation – measured by the ability of a saver to convert a financial instrument into cash.

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Economies of scale – size and volume of business transactions allows for development of cost-efficient distribution systems and technology based systems such as ATMs, online and telephone banking.

Wholesale and Retail Markets Wholesale markets provide for direct financial transactions between institutional investors and borrowers. Retail markets comprise of transactions primarily of individuals and small to medium-sized businesses.

Heading 2: Fixed Interest Securities Fixed interest (income) securities (FISs) are debt instruments such as bonds, notes and debentures showing fixed contractual obligations of issuers such as governments and large corporations. FISs indicate the interest rate, principal (or par value) and maturity period and the buyer knows future stream of cash flows (to be received until maturity). Important Concepts      

Coupon: Periodic (in general half yearly) interest payments that the issuer pays to the holder. Zero coupon bond: has no coupons attached and sold at a discounted value to be redeemed at face value on maturity date. Junk bonds: have (low) credit ratings of BB or lower (high risk) with high yields. Face value (par value) of most bonds = $1,000 and the price of debt instrument and yield are inversely related. Discount: market price ($900) < face value ($1,000), interest rate declined after issue. Premium: market price ($1100) > face value ($1000), interest rate inclined after issue.

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Constant price (neither discount nor premium): market price = face value = $1000 and the interest rate is unchanged after issue.

Note: In the Australian Financial Review there is a ‘Money & Bond Markets’ section that has a Royal Bank of Scotland (RBS) bond index that will be used in the assignment. There is also an ‘Interest Rate Securities’ section with an index for these securities. Risks of Fixed Interest Securities:       

Interest rate – fluctuation in the interest rate (if it increases, the bond value goes down, Reinvestment rate, Default, Inflation – when issued loan, IR was 3%, inflation now up to 10%, to maintain purchasing power, IR on the loan must go up in line with inflation, Maturity, Call (issuer has the right to call back the bond, high risk for the lender), and Liquidity.

FIS in the Australian Context Types of FISs: three-year and ten-year Commonwealth Government Treasury bonds, corporate debentures and notes. Australian Corporations Law is applicable for companies raising funds through the issue of bonds in Australia. Explaining Bond Prices and Yields    

Bond prices are determined by supply and demand of loanable funds in the economy. A crucial determinant of supply and demand of loanable funds is the interest rate (yield). Fundamental determinants of interest rates are also known as the Fisher Hypothesis. Nominal Interest Rate: i (nominal IR) = RFR (real risk free rate) + I (expected inflation rate) + RP (risk premium)/

RFR + I is the economic (systemic) forces – macro – rate of economic growth (reflecting investment opportunities), capital (loanable funds) market conditions and expected rate of inflation. RP = four components involves issue characteristics: (1) Credit quality (2) Term to maturity (3) Indenture provisions

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(4) Foreign bonds (foreign exchange and country risks) Term Structure of Interest Rates (TSIR) The TSIR (yield curve): relationship between time to maturity and yields for a particular category of bonds at a given point in time. Yield Curve – a graphical representation of the term structure of interest rates – yield to maturity (vertical axis) and time to maturity (horizontal axis). Types of Yield Curves – Upward sloping (normal) yield curve, lower yields for short dated securities and higher yields for long dated securities. Downward sloping (inverse) yield curve: higher yields for shortdated securities and lower yields for long-dated securities. Flat yield curve: approximately equal yields on short-dated and long-dated securities.

Hump-backed yield curve: a mix of the two features above.

Term Structure Theories 1. Expectations Hypothesis – The current interest rate (spot rate) reflects the expectations about future interest (or forward) rates. The long term interest rate is equivalent to the average of short term rates prevailing over the long term. Criticism: Reality is that expectations are NOT the sole basis for the term structure. Central banks intervene in management of short term interest rates.

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2. Liquidity Preference Theory – Interest rates are determined by adding a liquidity premium to the short term rates. Future uncertainty causes an upward or downward bias (liquidity premium is incorporated) in the yield curve. FIND THE LIQUIDITY PREFERENCE DIAGRAM AND INCLUDE 3. Segmented Market Hypothesis – Suggests that the market can be subdivided into two segments: short term (money market) and long term (capital market). 4. Preferred Habitat Theory – Emanates from ‘preferred habitats’ of major (especially institutional) investors, over maturity range of securities. a. Life insurance companies prefer long term (capital market) instruments while money market dealers prefer short term instruments. Yield depends on supply and demand within the maturity segment. b. But are segments and preferred habitats completely separated? No. Most evidence supports the expectations and liquidity preference theory and no the latter two theories. Slope of the Yield Curve The slope of the yield curve reflects expectations on short-term and long-term rates. If an investor expects the slope of the yield curve to move downwards, then invest for a long period and lock in the current high long-term rate. If it is a borrower with the same expectation, then would not lock in the current high long-term rate and rather borrow for a short-period (or even postpone borrowing). Risks inherent in yield curve movements can be managed and reduced by the use of instruments such as financial futures. Interest rate differences can be explained by risk structure of interest rate which is called the yield spreads showing the relationships between bond yields and the particular features on various bonds.  Differences in quality or risk of default – a AAA-rate bond offer lower yield compared to a BAA-rated bon offering a higher yield (look at risk structure diagram, Rates of return (vertical) & risk (horizontal) with different types of instruments or investments along the curve).  Differences in time to maturity – longer the time period, the greater the uncertainty.

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 Differences in call features – callable bonds have higher yields compared to identical noncallable bonds.  Di...