This document contains all the notes from the lectures throughout the year and is split up lecture by lecture. This document on its own, is sufficient to get a top mark in your end of year exam for the third year WBS investment management module.
Week 1 – Introduction to Investment Management
Neoclassic theories (CAPM & APT) say that expected return of any asset is proportional to its
systematic risk.
- These markets are efficient as prices in corporate all fundamental information.
- The theories depend on many assumptions and may not hold if the assumptions don’t.
If the market is efficient, use passive investment management.
- Buy and hold. A well-diversified portfolio according to your risk preference
- Only rebalance when the risk profiles change (annually or quarterly) or your own risk profile
changes
- Impossible to beat market and earn abnormal returns.
If the market is inefficient, use active investment management.
- Security selection helps identify mispriced assets: buy low sell high.
- Tilt portfolio for specific asset classes (market timing)
- Delegate investments such as mutual and hedge funds for a fee
Behavioural finance: school of thought that suggests markets can be inefficient and investors can
exhibit behavioural bias and over or under-price some assets.
Financial Assets – legal contracts that give their owners claims to the money generated by the real
assets (land, buildings, factories)
- Main ones are: money market instruments (like cash), equities, fixed income securities, and
derivatives (options, forwards and futures)
Bond holders are paid first, and the residual is shared amongst shareholders.
Shareholders have limited liability: max they could use is stake they paid initially.
Money market instruments
- Assets traded are short term (<1 year) obligations.
- Liquid and low risk
- Issued by governments or private companies.
- Usually known as risk free bonds
- E.g. Treasury Bills, Repurchase agreements, cash, certificates of deposit etc.
Bonds
- Promised stream of future cashflows
1. Fixed ‘coupon payments’ at fixed dates.
2. Fixed payment of face value of bond at maturity
- Failure to pay a coupon payment means default so it carries some risk.
- Issued by governments an companies.
- Risks of long-term bonds are much higher than T Bills
Derivatives
- Value derived from some value of underlying asset.
- Options give holder the right to buy or sell in future.
- Forwards give holder obligation to buy or sell at pre agreed price in the future.
- Used for hedging (portfolio insurance), speculation (i.e. profit from unexpected movements in
an asset you don’t own)
Financial Intermediaries
1. Active: Mutual and Hedge Funds
2. Passive: traders and ETF
Market order – buy/sell at current price (ask/bid)
Limit order – buy/sell if and when the price reaches a specific level.
Trading in capital markets:
- To trade, open account with broker on a platform, on here almost any asset can be traded.
- Platforms collect fees based on trading activities and other factors such as inactivity.
- Institutional investors make much larger trades.
, Mutual Funds
- Publicly available to everyone
- Fund initially collects money from investors and buys securities.
- Shares are therefore bought from or sold to the mutual fund directly at the end of each day
(open ended)
- Shares are bought and sold at Net Asset Value of fund.
- Fund manager may charge a fee when investor buys (front end load) or sells (back-end load)
plus a management fee
- Style of fund specified and tracked against relevant index, using track error indicating how fund
varies compared to index.
Exchange Traded Fund (ETF)
- Similar to mutual fund: open ended, daily creation & cancellation of units as funds flow in/out
- Usually designed to track an index/style/sector so no management or research fees.
- Traded on exchange at any time, no front or back-end load.
- VERY liquid
- Much lower admin fees.
Hedge Fund
- Usually private partnerships, only available to accredited investors.
- Much less regulated
- Fee structure often “2+20”, i.e., 2% of assets plus 20% of gains
- Target mispricings with long short strategies, using leverage.
- Lock up period makes investment illiquid and makes it possible for fund to hold illiquid
investments.
- Usually has min investment requirement.
Buying on the margin
equity
margin=
value of stock∈account
final equity−initial equity
equity= ( value of assets )−( value of liabilities )rate of return=
initial equity
- Maintenance margin: minimum allowed margin, set by
the broker.
- Margin loan rate: charged by broker for loan.
- Margin call: margin < maintenance margin
o If this is the case, you must add cash or close out.
Leverage
- Amplifies returns, creates more upside but also more
downside.
- If investment yields 20% and you invest £1000, next year you have £1200 = 20%
o But if you also borrowed an extra £1000 at rate 1.5%
1.2 ( 2000 )−1.015 ( 1000 )−1000
R= =38.5 %
1000
o But if investment yielded -5%, return after leverage would be -11.5%
If asset OVERvalued, short it.
- Borrow shares from owner, sell them off and buy them back when the price comes back down
and return to owner.
- Also involves additional trading costs such as lender fees and risk that lender could recall at any
time.
Liquidity – tells how easy it is to buy/sell an asset without moving its price too much.
- Liquid assets have lower transaction costs.
- Transaction costs relate to bid/ask spread, which is a form of fee collected by market make for
facilitating trade.
- If market maker has big chance of being picked off by informal trades, bid ask spread increases.
, - Bid ask spreads vary overtime for different stocks depending on market conditions and stock
characteristics.
o Illiquid stocks have higher bid ask spreads
o As do stocks with more subjective valuations
Market Efficiency
- In efficient markets, can use CAPM: E ( r t )−r f = β ( E Rm , t ) −r f
- Active portfolio managers use information at t=0 to obtain abnormal returns
- As they buy/sell under/overvalued assets, they make the market more efficient.
o This is known as arbitrage.
- As a result of higher volumes of trade market becoming more efficient:
o More information about previous trades available to investors so more accurate valuations
o More noise traders coming in to act on gambles, so more sophisticated investors will come
in and exploit which means that the market will still correct and become more efficient
Week 2 – Diversification & Portfolio Theory
( pric e i ,t + dividends )
Asset Return: r i , t= −1
pric e i ,t−1
Risk Premium (excess return): Ri , t=r i, t −r f
T
1
2
Variance of returns: σ i = ∑ ( r −μ )2
T −1 t =1 i ,t i
√
T
1
Standard deviation of returns: σ i= ∑
T −1 t =1
( r i ,t −μi )
2
√
T
1
Covariance: σ ij= ∑ ( r −μ ) ( r −μ j )
N−1 t =1 i ,t i j ,t
σ ij
Correlation: ρ ij =
( σ i) ( σ j )
If you have 2 assets with weights, α1 + α2 = 1
- Mean return is µP = α1µ1 + α2µ2
- Variance can be written as sum of covariances:
2 2 2 2 2
σ P=α 1 σ 11 +2 α 1 α 2 σ 12+α 2 σ 22=α 1 σ 11 +2 α 1 α 2 ρ 12 σ 1 σ 2 +α 2 σ 22
Diversification is beneficial if assets have less than perfect comovement
- It eliminates firm specific shocks
- Poor performances are cancelled out by those doing well
Where does risk come from
1. Systematic: market wide shocks like changes in interest rate, common to all firms
2. Idiosyncratic: firm specific like changing CEO, not correlated across all
firms
Diversification great, but how to decide weights?
- Portfolio giving same returns for less risk is preferred by all
- Investors choose weights to create an efficient portfolio
Risk-free asset: govt. short term bond where E(rt)=rt for sure
Risky asset can be a stock or something with positive risk
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