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International, Investment Management Mid term summary
Summary for the course ECB3BL International Investment Management, end term and mid term (everything covered)
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Olivier van den Wall Bake - 5510929International Investment Management Summary
Chapter 1 The Investment Environment
An investment
o The current commitment of money or other resources in the expectation of reaping future benefits
Key aspect:
You sacrifice something of value now expecting to benefit from the sacrifice later
Real assets
o Determine the productive capacity and net income of the economy
Ex: land, buildings, machines, knowledge
Financial assets
o Are the claims on real assets, do not contribute directly to the productive capacity of the economy
Ex: stocks, bonds
o 3 types:
Fixed income (Debt)
Common stock (Equity)
Derivative securities
Investors’ return on securities ultimately come from the income produced by the real assets that were financed by the issuance of those
securities
Money market
o Refers to debt securities that are short term, highly marketable and generally of very low risk
Ex: US treasury bills, Bank certificates of deposit (CDs)
Capital market
o Refers to long term securities, range from very safe to risky high yield bonds, junk bonds
Ex: Treasury bonds, Federal, Corporate, Municipal etc.
Unlike debt securities, common stock or equity in a firm represents an ownership share in the corporation
The performance of equity investments is tied directly to the success of the firm and its real assets. For this reason, equity investments
tend to be riskier than investments in debt securities
Derivative securities
o Such options and futures contracts provide payoffs that are determined by the prices of other assets such as bond and stock
prices
o Their value is derived from the prices of other assets
o Primary use is to hedge risk or transfer them to other parties
o Can also be used to take highly speculative positions
The stock market encourages allocation of capital to those firms that appear at the time to have the best prospects
Consumption timing
o Use securities to store wealth and transfer consumption in the future
Allocation of risk
o Investors can select securities consistent with their tastes for risk, which benefits the firm that need to raise capital as
security can be sold for the best possible price.
Agency problem solutions
o Compensation plans tie the income of managers to the success of the firm
o Proxy contest, renew board of directors and prevent hostile take over
Investors’ portfolio
o The collection of investment assets
Stocks bonds, real estate, commodities
Two decisions in constructing a portfolio
o Asset allocation, the choice among the broad asset classes (stocks, bonds etc)
Also the decision of how much to invest in safe assets, such as bank accounts
o Security selection, the choice of which particular securities to hold within each asset class
Top down approach
o Starts with the asset allocation and afterwards the security selection
Bottom up approach
o The portfolio is constructed from the securities that seem attractively priced without as much concern for the resultant
asset allocation
Can lead to unintended bets, too much invested in just one sector, no diversification
Security analysis
o Involves the valuation of particular securities that might be included in the portfolio
Free lunch
o Securities that are underpriced that they represent obvious bargains
Risk return trade off
o Higher risk assets are priced to offer higher expected returns than lower risk assets
In fully efficient markets when prices adjust quickly to all relevant information, there should be neither underpriced nor overpriced
securities
Passive management
o Calls for holding slightly diversified portfolios without spending effort or other resources attempting to improve investment
performance through security analysis
Active management
o The attempt to improve performance by either identifying mispriced assets/securities, or by timing the performance of
broad asset classes.
Ex: increasing one’s commitment to stocks when one is bullish on the stock market
If markets are efficient and prices reflect all relevant information perhaps it is better to follow passive strategies
,Olivier van den Wall Bake - 5510929
We may observe only near-efficiency in financial markets
3 main players in the financial markets
o firms, are the demanders of capital
o households, are typically the net suppliers of capital
o governments, borrowers and lenders
Financial intermediaries
Ex: banks, investment companies, credit unions, insurance companies
o They issue their own securities to raise funds to purchase the securities of other corporations
o They are distinguished from other businesses in that both their assets and liabilities are overwhelmingly financial
o By pooling the resources of many small investors, they are able to lend considerable sums to large borrowers, and high
diversification
Hedge funds
o Like mutual funds, they also pool and invest the money of many clients, but they are open only to institutional investors that
are more likely to pursue complex and higher risk strategies
Venture capital
Private equity
o Investments in firms that no not trade on public stock exchanges
Chapter summary
Real assets create wealth, financial assets represent claims to parts or all of that wealth. Financial assets determine how the ownership
of real assets is distributed among investors
Financial assets can be categorized as fixed income, equity or derivative instruments. Top-down portfolio construction techniques start
with the asset allocation decision, the allocation of funds across broad asset classes, and then progress to more specific security
selection decisions
Competition in financial markets lead to a risk-return trade off, in which securities that offer higher expected rates of return also impose
greater risks on investors. The presence of risk, however, implies that actual returns can differ considerably from expected returns at
the beginning of the investment period. Competition among security analysts also promotes financial markets that are nearly
informationally efficient, meaning that prices reflect all available information concerning the value of the security. Passive investment
strategies may make sense in nearly efficient markets
Financial intermediaries pool investors funds and invest them. Their services are in demand because small investors cannot efficiently
gather information, diversify, and monitor portfolios. The financial intermediary sells its own securities to the small investors. The
intermediary invests the funds thus raised, uses the proceeds to pay back the small investors, and profits from the difference (the
spread)
Investment banking brings efficiency to corporate fund-raising. Investment bankers develop expertise in pricing new issues and in
marketing them to investors. By the end of 2008, all the major stand alone US investment banks had been absorbed into commercial
banks or had reorganized themselves into bank holding companies. In Europe, where universal banking had never been prohibited,
large banks had long maintained both commercial and investment banking divisions.
The financial crisis of 2008 showed the importance of systemic risk. Systemic risk can be limited by:
o Transparency that allows traders and investors to assess the risk of their counterparties
o Capital requirements to prevent trading participants from being brought down by potential losses
o Frequent settlement of gains or losses to prevent losses from accumulating beyond an institution’s ability to bear them
o Incentives to discourage excessive risk taking
o Accurate and unbiased analysis by those charged with evaluating security risk.
, Olivier van den Wall Bake - 5510929
Chapter 2, Asset classes and financial instruments
US treasury bills are the most marketable of all money market instruments
o They represent the simplest form of borrowing. The government raises money by selling bills to the public. Investors buy the
bills at a discount from the stated maturity value
o The difference between the purchase price and ultimate maturity value constitutes the investor’s earnings.
o Maturities of 4, 13, 26 or 52 weeks (all less than a year)
o Investors buy the bills at a discount of the face value
o They are highly liquid, they can easily be converted into cash, and sold at low transaction cost with not much price risk.
o Can be bought via auctions
Noncompetitive bid, a bidder agrees to accept the discount rate determined at the auction (similar to last
week’s market order). The bidder is then guaranteed to receive the full amount of the security bid.
Competitive bid, a bidder specifies the minimum discount rate they are willing to accept (similar to last week’s
limit order). This bid may be accepted in the full amount if the rate specified is less than the discount rate set at
the auction.
The ask price
o The price you would have to pay to buy a security from a securities dealer
The bid price
o Is the slightly lower price you would receive if you wanted to sell a bill to a dealer
The bid-ask spread
o The difference between the two, which is the dealer’s source of profit.
Prices and yields are inversely related
Bank discount method
o The T-bill’s discount from its maturity or face value is annualized based on a 360-day year, and then reported as a
percentage of face value
o Drawbacks of method
It assumes the year only has 360 days
It computes the yield as a fraction of par value rather than of the price the investor paid to acquire the bill
Certificate of deposit (CD)
o Is a time deposit with a bank
o May not be withdrawn on demand
Commercial paper
o Large, well known companies often issue their own short term unsecured debt notes rather than borrow directly from
banks.
o Considered to be a fairly safe asset, because a firm’s condition presumably can be monitored and predicted over a term as
short as a month.
Bankers’ acceptances
o Starts as an order to a bank by a bank’s customer to pay a sum of money at a future date, typically within 6 months. At that
point it is similar to a postdated check.
Eurodollars
o Dollar-denominated deposits at foreign banks or foreign branches of American banks. By locating outside the US, these
banks escape regulation by the Federal Reserve.
o Despite the tag ‘Euro’, these accounts need not be in European banks.
o Eurodollars are considered less liquid and riskier than domestic CDs, and thus offer higher yields.
Repos and reverses
o Dealers in government securities use repurchase agreements, also called repos, or RPs, as a form of short term, usually
overnight, borrowing. The dealer sells government securities to an investor on an overnight basis, with an agreement to buy
back those securities the next day on a slightly higher price. The increase is the overnight interest.
o Reverse repo
The mirror image of a repo. Here the dealer finds an investor holding government securities and buys them,
agreeing to sell them back at a specified higher price on a future date
Federal funds
o Funds in the bank’s reserve account, bla bla
LIBOR market
o The London interbank offered rate. The rate at which large banks in London are willing to lend money among themselves.
TED spread
o LIBOR rate minus the T-Bill rate
o Indicator of credit risk in banking industry.
Yields on money market instruments
o Although most money market securities are of very low risk, they are not risk free.
Money market funds
o Are mutual funds that invest in money market instruments and have become major sources of funding to that sector.
Treasury notes and treasury bonds
o T-notes are issued with maturities ranging up to 10 years, while bonds are issued with maturities from 10-30 years
YTM
o Is calculated by determining the semi-annual yield and then doubling it, rather than compounding it for two half-year
periods. APR
Eurobond
o Is a bond denominated in a currency other than that of the country in which it is issued
o International bonds
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