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2022Investments
KUL
JUTTA BELLIU
,Master in Business Economics KUL
Table of contents
Capital Markets and Products ............................................................................................................................ 2
Investment Concepts .......................................................................................................................................... 7
Allocation to risky assets .................................................................................................................................. 10
Optimal risky portfolios .................................................................................................................................... 14
Index models .................................................................................................................................................... 21
Market Efficiency.............................................................................................................................................. 25
Behavioural finance and limits to arbitrage ..................................................................................................... 29
Fixed income instruments ................................................................................................................................ 35
Managing fixed income portfolios ................................................................................................................... 42
Applied portfolio management ........................................................................................................................ 50
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,Master in Business Economics KUL
Capital Markets and Products
F Financial markets
o Financial markets allow to share or transfer risk –> willingness to take on risk.
§ As investor you take on risk, BUT: ALWAYS want to be compensated for it.
o Financial markets allow to separate the timing of income and consumption à store
wealth to transfer it to the future.
§ Savings accounts are made possible through the storage of wealth.
o Financial markets allow to separate ownership and management in support of large-
scale businesses, BUT: be careful with associated agency problems.
§ When you are connected to a specific founder à there is less opportunity to
grow –> will use external funding.
o Financial markets allow to allocate resources efficiently –> to most productive real
investment.
§ This is the informational role of financial markets à market efficiency >>>
money flows to productive opportunities.
o The traditional asset classes:
§ Money market instruments à these are short term, low risk debt securities
–> “cash”.
• They allow us to save.
• Are relatively risk-free assets.
§ Capital market instruments à these are long term, riskier and more diverse
assets –> “stocks and bonds”.
• These usually have a longer maturity –> are also riskier assets.
• They have a wide range of instruments.
§ Each instrument is unique in terms of uncertainty of payments and timing of
payments and has a distinct contribution to investment portfolio –> each has
unique risk return profile + different role to play in portfolio.
o Money market instruments:
§ Treasury bill = Government debt obligation with a maturity of less than a
year.
§ Certificate of deposit (CD) = Time deposit at a bank.
§ Commercial paper (CP) = Short term unsecured debt issued by a large
corporation.
§ Bankers’ acceptance = A bank promise to pay a prespecified amount.
§ Repurchase agreement (repo or RP) = A short term loan (usually overnight)
using other securities (usually government securities) as collateral.
§ Interbank loans = These are short term loans among banks (from which
reference rates are being calculated à ESTR, EURIBOR).
• ESTR = cost of borrowing from a bank overnight
§ Central bank deposits and loans = Short term deposit/ loan of a bank by its
central bank à federal funds, MRO, deposit facilities, lending facilities, MRR.
• Central bank acts as a bank to other banks à where the other banks
become the consumers.
§ Call loans = Loans that need to be repaid, on demand at any time à is often
made by banks to brokerage firms to fund individuals that buy on margin.
• Buy on margin = You borrow money & with that money you make
risky investment –> fundamentally. Banks sponsor the risky
investment.
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, Master in Business Economics KUL
ð Most money market instruments are low risk, BUT: they are NOT risk free.
• T-bills have the lowest risk, BOTH in terms of credit risk, as well as in
liquidity risk
• When the economy is stable à ALL rates are relatively similar, BUT:
in unstable economy à they can vary a lot.
§ Rates spiked during the credit crisis >>> banks were in trouble
and a credit risk.
• Central Banks use the base rates in the economy as a policy tool.
o Capital market instruments
§ Bonds = These are debt issues by government or corporations.
• Longer term debt instrument with wide range of maturities >>> can
be bond from 1 year and onwards.
• Have various credit qualities à from high credit-quality instruments
to (very) low credit-quality (junk) instruments.
o High risk = high compensation.
• Liquidity can vary from very high to almost 0.
o If bond does NOT trade on regular basis à price might be
reduced >>> is NOT accurate anymore –> depends on
liquidity.
• Often in smaller denominations such that they can be held by retail
investors.
• Often NOT traded on the exchange, BUT: rather traded over the
counter (OTC) via dealers.
• Expressed as a % of the par value.
• Typically pay coupon interest.
• Performance measurement à hpr or yield which includes a risk.
Premium for credit risk.
è Currently we’re in an uncertain period with inverse relationship of bonds
and interest rates –> right now it is better to have short run bonds >>>
interest rates are increasing.
§ Types of bonds
• Treasury notes = Government debt with a maturity that is more than
1 year and less than 10.
• Treasury bonds = Government debt with a maturity larger than 10
years.
• Treasury inflation-protected securities (TIPS) = These are
government debt with principal and interest adjusted for inflation.
• Federal agency/ municipal bonds = Debt issued or guaranteed by,
respectively, a federal agency, state, or local government/
• Corporate bonds = Debt issued by a large corporation; typically,
larger default risk as compared to government debt; options
included (callable, convertible).
• Asset backed debt = Proportional ownership claims in an asset pool
à securitisation.
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