Chapter 1: An overview of the investment process
1.1. What is an investment?
1.1.1. Investment defined
Investment: The current commitment of money 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 period, and (3) the uncertainty of the future payments.
Required rate of return: This is the rate of return that compensates them for (1) the time the funds
are committed, (2) the expected rate of inflation during this time period, and (3) the uncertainty of the
future payments.
1.2. Measures of return and risk
1.2.1. Measures of historical rates of return
Holding period: The period during which you own an investment.
Holding period return: The rate of return you earn on the investment during the holding period.
P1
HPR=
P0
If HPR>1 , there has been an increase in your wealth, ie. you received a positive rate of return
during the period. If HPR<1 , there has been a decrease in your wealth, ie. you has a negative
return during the period. If HPR=0 , you have lost all your money invested in the asset.
Holding period yield (HPY): HPY = HPR−1 gives a percentage value of the holding period
return.
1
To find an annual HPY: Annual HPR=HP R n where n is the number of years the investment
is held.
1.2.2.Computing mean historical returns
For a single investment:
Arithmetic mean ( AR ) =∑ ( HPYn )
1
Geometric mean ( GM ) =( ⊓ HPR ) n −1
Where ⊓ is the product of all the annual HPRs: HP R1 × HP R1 ×… × HP Rn
The arithmetic mean is used best as an expected value for an individual year, while the geometric
mean is the best measure of long-term performance since it measures the compound annual rate of
return for the asset being measured.
For a portfolio of investments: The mean HPY is measured as the weighted average of the HPYs for
the individual investments in the portfolio. The weights used are the relative beginning market values
for each investment.
1.2.3.Calculating expected rates of return
Risk: The uncertainty that an investment will earn its expected rate of return.
Expected return=∑ Probability of return× Possible return
1.2.4.Measuring the risk of expected rates of return
2
Variance ( σ 2 ) =∑ Probability × ( Possible return−Expected return )
, Standard deviation ( σ )=√ σ 2
Coefficient of variation (CV) is used as a measure of relative variability to indicate risk per unit of
expected return. This is used to compare investments with widely different rates of return and
standard deviations of returns.
Standard deviation of returns
CV =
Expected rate of return
1.2.5.Risk measures for historical returns
To measure the risk for a series of historical rates of returns:
2
σ =
[∑ [ HP Y −E ( HPY ) ] ]
i
2
n
1.3. Determinants of required rates of return
1.3.1.The real risk-free rate
Real risk-free rate: The basic interest rate, assuming no inflation and no uncertainty about future
cash flows.
This rate of exchange is measured in real terms because we assume that investors want to increase the
consumption of actual goods and services rather than consuming the same amount that had come to
cost more money. Two factors influence this rate: (1) the time preference of individuals for the
consumption of income (subjective factor), and (2) the set of investment opportunities available in the
economy which is then determined by the long-run real growth rate of the economy (objective factor
and there is a positive relationship between (2) and the real risk-free rate).
1.3.2.Factors influencing the nominal risk-free rate (NRFR)
(1) Conditions in the capital market: The cost of funds (the interest rate) at any time is the price
that equates the current supply and demand for capital. The change in the relative ease or
tightness in the capital market is a short-run phenomenon caused by a temporary
disequilibrium in the supply and demand of capital. For example, disequilibrium caused by an
unexpected change in monetary policy or fiscal policy.
(2) Expected rate of inflation: If investors expected the price level to increase (ie. an increase in
the inflation rate) during the investment period, they would require the rate of return to
include compensation for the expected rate of inflation.
NRFR= [ (1+ RRFR)×(1+ Expected rate of inflation)] −1
or
RRFR=
[ (1+ NRFR of Return)
(1+ Rate of inflation)]−1
1.3.3. Risk premium
Risk premium: The increase in the required rate of return over the nominal risk-free rate. There are
five major sources of uncertainty with investments.
(1) Business risk: The uncertainty of income flows caused by the nature of a firm’s business.
(2) Financial risk: The uncertainty introduced by the manner in which the firm finances its
investments. The degree of financial leverage has an effect on this, in which the amount of
debt financing which causes fixed financial obligations has a direct effect on the amount of
financial risk.
, (3) Liquidity risk: The uncertainty introduced by the secondary market for an investment. The
more difficult it is to convert the investment into cash, the higher is the liquidity risk.
(4) Exchange rate risk: The uncertainty of returns to an investor who acquires securities
denominated in a currency different from his own. The more volatile the exchange rate
between two countries, the less certain you would be regarding the exchange rate, the greater
the exchange rate risk, and the larger the exchange rate risk premium you would require.
(5) Country/political risk: The uncertainty of returns caused by the possibility of a major
change in the political or economic environment of a country.
These risk factors can be considered to be a security’s fundamental risk because it deals with the
intrinsic factors that should affect a security’s volatility of returns over time.
1.3.4. Risk premium and portfolio theory
Systematic market risk: The variability of returns that is due to macroeconomic factors that affect all
risky assets. Because it affects all risky assets, it cannot be eliminated by diversification. This risk is
represented by beta β .
1.3.5. Fundamental risk versus systematic risk
Evidence has shown that there is a significant relationship between the market measure of risk (ie.
systematic risk) and the fundamental measures of risk (such as business risk, financial risk, etc).
However, this can either be a direct or an indirect relationship.
1.3.6. Summary of required rate of return
The overall required rate of return is determined by three variables:
(1) The economy’s RRFR
(2) Variables that influence the NRFR
(3) The risk premium on all the investments
Measures of market risk include (1) variance of rates of return, (2) standard deviation of rates of
return, (3) coefficient of variation of rates of return, and (4) covariance of returns with the market
portfolio (beta).
The sources of fundamental risk include business risk, financial risk, liquidity risk, exchange rate risk
and country/political risk.
1.4. Relationship between risk and return
Security market line (SML): The line that reflects the combination of risk and return of alternative
investments. In CAPM, risk is measured by systematic risk (beta). It shows that investors increase
their required rates of return as perceived risk (uncertainty) increases. Investors select investments
that are consistent with their risk preferences.
1.4.1. Movements along the SML
Any change in an asset that affects its fundamental risk or systematic risk will cause the asset to move
along the SML.
1.4.2. Changes in the slope of the SML
The slope of the SML indicates the return per unit of risk required by all investors. It is possible (since
it is a straight line) to select any point on the SML and compute a risk premium for an asset using the
following equation:
, R P i=E ( Ri )−NRFR
The market portfolio risk premium is computed as follows:
R P m=E ( Rm ) −NRFR
A change in the slope of the SML is caused by a change in the market risk premium which is caused
by changes in the yield spreads over time between assets with different levels of risk.
1.4.3. A shift in the SML
This reflects a change in expected real growth in the economy, a change in capital market conditions
(such as ease or tightness of money), or a change in the expected rate of inflation.
,Chapter 2: The Asset Allocation Decision
Asset allocation: The process of deciding how to distribution an investor’s wealth among different
countries and asset classes for investment purposes.
Asset class: Each class is comprised of securities that have similar characteristics, attributes, and
risk/return relationships.
2.1. Individual investor life cycle
2.1.1. The preliminaries
Insurance: It is important to have insurance (life, health, disability, automobile and home) as a lack
of insurance coverage can ruin the best-planned investment programme.
Cash reserve: It is important to have a cash reserve as a safety cushion (for emergencies, job layoffs or
unforeseen expenses), as well as to reduce the likelihood of being forced to sell investments at
inopportune times to cover unexpected expenses.
2.1.2. Investment strategies over an investor’s lifetime
(1) Accumulation phase: Individuals in the early-to-middle years of their working careers. They are
trying to accumulate assets to satisfy fairly immediate needs (such as buying a house or car) or longer-
term goals (children’s college education or retirement). Typically, their net worth is small and their
debt is heavy. They are willing to make relatively high-risk investments in return for high returns.
(2) Consolidation phase: Individuals past the midpoint of their careers, have paid off much or all of
their outstanding debts, and perhaps have paid, or have the assets to pay, their children’s college bills.
Moderately high risk investments are attractive for retirement or estate planning needs.
(3) Spending phase: This begins when individuals retire. Livings expenses are covered by income
from prior investments (including pensions). Although their overall portfolio may be less risky than in
the previous phase, they still need some risky growth investments for inflation (purchasing power)
protection.
(4) Gifting phase: This is similar to, and may be concurrent with, the spending phase. Individuals
believe they have sufficient income and assets to cover their current and future expenses while
maintaining a reserve for uncertainties.
2.1.3. Life cycle investment goals
Near-term, high-priority goals: Shorter-term financial objectives that individuals set to fund
purchases that are personally important to them (such as buying a car or paying college expenses).
Because of the emotional importance of these goals and their short time horizon, high-risk
investments are not usually considered suitable for achieving them.
Longer-term, high-priority goals: These include some form of financial independence (such as the
ability to retire at a certain age). Because of their long-term nature, higher-risk investments can be
used to help meet these objectives.
Lower-priority goals: These are objectives which the individual would like to meet but which are not
critical. Examples include purchasing a car every few years, etc.
2.2. The portfolio management process
Step 1: Construct a policy statement. Investors specify the types of risks they are willing to take and
their investment objectives and constraints. Investment objectives are the investment goals expressed
in terms of both risk and returns. Return objectives include the following:
(a) Capital preservation – investors want to minimise their risk of loss (thus maintain the
purchasing power of their investment). Thus the return needs to be no less than the inflation
, rate. This is generally a strategy for risk-averse investors or those who need the funds in the
short term.
(b) Capital appreciation – investors want the portfolio to grow in real terms over time to meet
some future need. Growth mainly occurs through capital gains. This is an aggressive strategy
for longer-term investors.
(c) Current income – investors want the portfolio to concentrate on generating income rather
than capital gains. This is for investors who want to supplement their earnings, such as
retirees.
(d) Total return – the investors want the portfolio to grow over time to meet a future need. This
growth is achieved both by capital gains, as well as the reinvestment of current income.
Investment constraints include:
(a) Liquidity needs – longer-term investors may have liquidity needs in the short term, such as
paying taxes or funding college tuition, which the investment plan must consider.
(b) Time horizon – investors with short time horizons generally favour more liquid and less
risky investments because losses are harder to overcome during a short time frame; whereas
investors with long horizons generally require less liquidity and can tolerate greater portfolio
risk.
(c) Tax concerns – Taxes usually complicate investments. Taxable income from interest,
dividends or rents is taxable at the investor’s marginal tax rate. Capital gains or losses are
taxed differently to taxable income.
(d) Legal and regulatory factors – Both the investment process and the financial markets are
highly regulated and subject to numerous laws which can constrain the investment strategies
of individuals and institutions.
(e) Unique needs and preferences – such as how much time the investor has to be involved with
the investment process, or an unwillingness to invest in companies that produce
environmentally harmful products.
There are two important reasons for constructing a policy statement: (a) it helps the investor decide on
realistic investment goals after learning about the financial markets and the risks of investing, and (b)
is creates a standard by which to judge the performance of the portfolio manager. The policy
statement typically includes a benchmark portfolio which will have the same risk and assets as the
real portfolio. It is important that the portfolio managers consistently follow the client’s policy
guidelines.
Step 2: Determine an investment strategy. The portfolio manager studies current financial and
economic conditions and forecasts future trends in order to assess the future and derive strategies that
offer the best possibility of meeting the policy statement guidelines.
Step 3: Construct the portfolio. With the investor’s policy statement, the investment strategy
outlined and the input of the financial forecasts, the portfolio manager determines how to allocate
available funds across difference countries, asset classes and securities. This involves constructing a
portfolio that will minimise the investor’s risks while meeting the needs specified in the policy
statement.
Step 4: Continual monitoring. This involves continuously updating the investor’s needs and capital
market conditions, and when necessary, updating the policy statement.
,Chapter 3: The Global Market Investment Decision
3.1. The case for global investments
There are three reasons why investors should think of constructing global investment portfolios:
(1) Ignoring foreign markets reduces your investment choices. Thus because more opportunities
broaden your range of risk-return choices, it makes sense to evaluate foreign securities when
selecting investments and building a portfolio.
(2) The rates of return available on foreign securities often exceed those on domestic securities
(especially for developing countries).
(3) Investors should diversify their portfolios and the relevant factor when diversifying a
portfolio is low correlation between asset returns over time. Investing in foreign securities can
provide this diversification.
3.1.1. Relative size of US financial markets
The US security markets now include a substantially smaller proportion of the total world capital
market, and thus US investors should consider investing in foreign securities because of the growing
importance of foreign securities in world capital markets.
3.1.3. Risk of combined country investments
Proper diversification reduces the variability of the portfolio because alternative investments have
different patterns of returns over time. Thus, if a portfolio is properly diversified, it should provide a
more stable rate of return for the total portfolio (that is, it will have a lower standard deviation and
therefore less risk).
The way to measure whether two investments will contribute to diversifying a portfolio is to compute
the correlation coefficient between their rates of return over time. Combining two investments with
large negative correlation in a portfolio would be ideal for diversification because it would stabilise
the rates of return over the portfolio.
Global bond portfolio risk: Why do the correlation coefficients for returns between domestic bonds
and those of foreign countries differ (for example, why does the US-Canada coefficient differ from
the US-Japan coefficient)? This is because of the macroeconomic differences between the countries,
such as the differences in the international trade patterns, economic growth, fiscal policies, and
monetary policies. Furthermore, the correlation of returns between a single pair of countries changes
over time because the factors influencing the correlations, such as international trade, economic
growth, fiscal policy and monetary policy, change over time.
Global equity portfolio risk: The relatively small positive correlations between US stocks and foreign
stocks have similar implications to those derived for bonds. Investors can reduce the overall risk of
their stock portfolios by including stocks. Domestic diversification refers to the fact that as you
increase the number of randomly selected securities in a portfolio, the standard deviation will decline
due to the benefits of diversification within your own country. After a certain number of securities (40
to 50), the risk will flatten out at a level that reflects the basic market risk for the domestic economy.
International diversification allows the investor to experience lower overall risk because the foreign
securities are not correlated with the domestic economy or stock market, allowing the investor to
eliminate some of the basic market risks of the domestic economy.
,3.2. Global investment choices
3.2.1. Fixed-income investments
Fixed-income investments have a contractually mandated payment schedule. Investors in fixed-
income securities are lending some amount of money (the principal) to the borrower, and in return, the
borrower typically promises to make periodic interest payments and to pay back the principal at the
maturity of the loan. Their investment contracts promise specific payments at predetermined times,
although the legal force behind the promise varies and this affects their risks and required returns: (a)
if the issuing firm does not make its payment at the appointed time, creditors can declare the issuing
firm in default, (b) in the case of income bonds, the issuing firm must only make payments if it earns
profits, and (c) with preferred stock, the issuing firm does not have to make dividend payments unless
its board of directions votes to do so.
Savings accounts: An individual who deposits funds into a savings account at a financial institution
is really lending money to the institution, and as a result, earning a fixed payment. These investments
are considered to be convenient, liquid and low risk, which means that the rates of return are generally
low compared with other alternatives. Different types of savings accounts include:
(a) Passbook savings accounts: These have no minimum balance, and funds may be withdrawn
at any time with little loss of interest. Due to their flexibility, the promised interest on
passbook accounts is relatively low.
(b) Certificates of deposit (CDs): These require a minimum deposit ($500) and have fixed
durations (usually 3 months, 6 months, 1 year or 2 years). The promised rates are higher than
those in (a) and the rate increases with the size and the duration of the deposit. An investor
who wants to cash in a CD prior to its stated expiration date must pay a heavy penalty in the
form of a much lower interest rate.
(c) T-bills: These require a minimum deposit of $10 000 and have a fixed duration (mature in 3-
12 months).
(d) Money market certificates: Banks issue these to compete against T-bills. They require a
minimum investment of $10 000 and have minimum maturities of 6 months. The interest rate
fluctuates at some premium over the weekly rate on the 6-month T-bills. Investors can only
redeem these certificates at the bank of issue, and they incur penalties if they withdraw their
funds before maturity.
Capital market instruments are fixed-income obligations that trade in the secondary market. They
fall into four categories:
(a) US Treasury Securities: These securities consist of bills (mature in 1 year or less), notes (1-10
years), and bonds (more than 10 years). These are essentially free of credit risk because there
is little chance of default and they are highly liquid.
(b) US government agency securities: These are securities sold by government agencies but they
are not direct obligations of Treasury. These government agencies include the Federal
National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation
(Freddie Mac), the Federal Home Loan Bank (FHLB) and the Government National
Mortgage Association (Ginnie Mae). These are considered default-free because the
government would never allow them to default.
(c) Municipal bonds: These are issued by local government entities as either general obligation
bonds (GOs are backed by the full taxing power of the municipality) or revenue bonds (the
interest on the bonds is paid by the revenue generated by specific projects). Municipal bonds
are tax-exempt from the federal government and some states (provided the investor is a
resident of that state) which makes them popular with investors in high tax brackets. These
, bonds offer yields that are generally 20-30 percent lower than yields on comparable taxable
bonds.
(d) Corporate bonds: These are fixed-income securities issued by corporations to raise funds in
plant, equipment or working capital. These can be categorised by issuer, credit quality,
maturity or another characteristic of the indenture.
Bond terminology:
Indenture: The legal agreement that lists the obligations of the issuer to the bondholder, including the
payment schedule and features such as call provisions and sinking funds (this specifies payments the
issue must make to redeem a given percentage of the outstanding issue prior to maturity).
Secured bonds: These include various secured issues that differ based on the assets that are pledged.
These are the most senior bonds in a firm’s capital structure and have the lowest risk of
distress/default.
Mortgage bonds: These are backed by liens on specific assets. In the case of default, the proceeds
from the sale of these assets are used to pay off the mortgage bondholders.
Collateral trust bonds: These are a form of mortgage bond except that the assets backing the bonds
are financial assets.
Equipment trust certificates: These are mortgage bonds that are secured by specific pieces of
transportation equipment.
Debentures: These are promises to pay interest and principal, but they pledge no specific assets. This
means that the bondholder depends on the success of the borrower to make the promised payment.
Debenture holders usually have first call on the firm’s earnings and any unpledged assets.
Subordinated bonds are similar to debentures but in the case of default, subordinated bondholders
have claim to the assets of the firm only after the firm has satisfied the claims of all senior secured
and debenture bondholders. These bonds include senior subordinated, subordinated and junior
subordinated bonds.
Income bonds stipulate interest payments schedules, but the interest is due and payable only if the
issuers earn the income to make the payment by stipulated dates. If the company has not made the
income, the interest payment is considered in arrears and if subsequently earned, must be paid off.
These are not considered as safe as a debenture or mortgage bond, so income bonds offer higher
returns to compensate investors for the added risk.
Convertible bonds have the interest and principal characteristics of other bonds, with the added
feature that the bondholder has the option to turn them back to the firm in exchange for its common
stock. Because of their desirable conversion option, they usually pay lower interest rates than
nonconvertible debentures of comparable risk. These are almost always subordinated to the
nonconvertible debt of the firm, so they are considered to have higher credit risk and receive a lower
credit rating.
An alternative to convertible bonds is a debenture with warrants attached. The warrant is an option
that slows the bondholder to purchase the firm’s common stock from the firm at a specified price for a
given time period. The specified price is typically above the price of the stock at the time the firm
issues the bond but below the expected future stock price. The warrant makes the debenture more
desirable, which lowers its required yield.
, A zero coupon bond promises no interest payments during the life of the bond but only the payment of
the principal at maturity. Therefore, the purchase price of the bond is the present value of the principal
payment at the required rate of return.
Preferred stock is classified as a fixed-income security because its yearly payment is stipulated as
either a coupon or a stated dollar amount. Preferred stock differs from bonds because its payment is a
dividend and thus not legally binding. However, the stock is considered to be practically binding
because of the credit implications of a missed dividend. Furthermore, because companies can exclude
80 percent of intercompany dividends from taxable income, preferred stocks have become attractive
investments for financial corporations. Due to this tax benefit to corporations, the yield on high-grade
preferred stock is typically lower than that on high-grade bonds.
3.2.2. International bond investing
A Eurobond is an international bond denominated in a currency not native to the country where is it
issued.
Yankee bonds are sold in the US, denominated in USD, but issued by foreign corporations or
governments. This allows a US citizen to buy the bond of a foreign firm/government but receive all
payments in US dollars, eliminating exchange rate risk. This can happen with other countries as well.
International domestic bonds are sold by an issuer within its own country in that country’s currency.
3.2.3. Equity investments
Common stock represents ownership of a firm. Investing in common stock entails all the advantages
and disadvantages of ownership and it’s a relatively risk investment compared with fixed-income
securities. This is reflected in relative return volatility.
Acquiring foreign equities:
(a) Purchase/sale of American Depository Receipts (ADRs): These are certificates of ownership
issued by a US bank that represent indirect ownership of a certain number of shares of a
specific foreign firm on deposit in a bank in the firm’s home country. ADRs are a convenient
way to own foreign shares because the investor buys and sells them in USD and receives all
dividends in USD. The shareholder absorbs the additional handling costs of an ADR through
higher transfer expenses, which are deducted from dividend payments.
(b) Purchase/sale of American shares: American shares are securities issued in the US by a
transfer agent acting on behalf of a foreign firm. Because of the added effort and expense
incurred by the foreign firm, a limited number of American shares are available.
(c) Direct purchase/sale of foreign shares: There are a number of ways of doing this, including
(1) the investor can buy the shares in the country where the firm is located, however this is
difficult and complicated because it must be carried out in the foreign currency and the shares
must then be transferred to the US; (2) a transaction can be made on a foreign stock exchange
where the shares are listed but outside of the country where the securities originated; and (3)
you could purchase foreign stocks listed on the domestic stock exchange, however there is a
limited number of foreign firms on domestic exchanges because of the high costs of listing.
(d) Purchase/sale of global mutual funds or EFTs: These funds make it possible for investors to
indirectly acquire the stocks of foreign firms. The alternatives range from global funds, which
invest in both domestic and foreign stocks, to international funds, which invest almost wholly
in foreign stocks. International funds can (1) diversify across many countries, (2) concentrate
in a segment of the world, (3) concentrate in a specific country, or (4) concentrate in types of
markets.
