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Chapter 3


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  • 1. Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Eighth Edition by Frank K. Reilly & Keith C. Brown Chapter 3
  • 2. Chapter 3 - Selecting Investments in a Global Market
    • Questions to be answered:
    • Why should investors have a global perspective regarding their investments?
  • 3. Chapter 3 - Selecting Investments in a Global Market
    • Questions to be answered:
    • What has happened to the relative size of U.S. and foreign stock and bond markets?
  • 4. Chapter 3 - Selecting Investments in a Global Market
    • Questions to be answered:
    • What are the differences in the rates of return on U.S. and foreign securities markets?
  • 5. Chapter 3 - Selecting Investments in a Global Market
    • Questions to be answered:
    • How can changes in currency exchange rates affect the returns that U.S. investors experience on foreign securities?
  • 6. Chapter 3 - Selecting Investments in a Global Market
    • Questions to be answered:
    • Is there an additional advantage of diversifying in international markets beyond the benefits of domestic diversification?
  • 7. Chapter 3 - Selecting Investments in a Global Market
    • Questions to be answered:
    • What alternative securities are available? What are their cash flow and risk properties?
  • 8. Chapter 3 - Selecting Investments in a Global Market
    • Questions to be answered:
    • What is the historical return and risk characteristics of the major investment instruments?
  • 9. Chapter 3 - Selecting Investments in a Global Market
    • Questions to be answered:
    • What is the relationship among returns for foreign and domestic investment instruments? What is the implication of these relationships for portfolio diversification?
  • 10. Reasons for the expansion of investment opportunities
    • Growth and development of foreign financial markets
    • 2. Advances in telecommunications technology
    • 3.  Mergers of firms and security exchanges
  • 11. The Case for Constructing Global Investment Portfolios
    • Ignoring foreign markets can substantially reduce the investment choices for U.S. investors
    • The rates of return on non-U.S. securities often have substantially exceeded those for U.S.-only securities
    • The low correlation between U.S. stock markets and many foreign markets can help to substantially reduce portfolio risk
  • 12. Relative Size of U.S. Financial Markets
    • The share of the U.S. in world stock and bond markets has dropped from about 65 percent of the total in 1969 to about 51 percent in 2003
    • The growing importance of foreign securities in world capital markets is likely to continue
  • 13. Relative Size of U.S. Financial Markets
    • Overall value of the total investable capital market has increased from $2.3 Trillion in 1969 to $70.9 Trillion in 2003 and the U.S. portion has declined to less than half.
    • This trend is likely to continue
  • 14. The Case for Global Investments
    • Rates of return available on non-U.S. securities often exceed U.S. Securities due to higher growth rates in foreign countries, especially the emerging markets
  • 15. The Case for Global Investments
    • Diversification with foreign securities can
    • help reduce portfolio risk because foreign
    • markets have low correlation with U.S. capital
    • markets
  • 16. Global Bond Portfolio Risk
    • Macroeconomic differences cause the correlation of bond returns between the United States and foreign countries to differ
    • The correlation of returns between a single pair of countries changes over time because the factors influencing the correlation change over time
  • 17. Risk of Combined Country Investments
    • Diversified portfolios reduce variability of returns over time
    • Correlation coefficients measure diversification contribution
    • Compare correlation of return among U.S. bonds and stocks with returns on foreign bonds and stocks
  • 18. Global Bond Portfolio Risk
    • Low positive correlation
    • Opportunities for U.S. investors to reduce risk
    • Correlation changes over time
    • Adding non-correlated foreign bonds to a portfolio of U.S. bonds increases the rate of return and reduces the risk of the portfolio
  • 19. Global Equity Portfolio Risk
    • Low positive correlation
    • Opportunities to reduce risk of stock portfolio by including foreign stocks
  • 20. Summary on Global Investing
    • Relatively high rates of return combined with low correlation coefficients indicate that adding foreign stocks and bonds to a U.S. portfolio will reduce risk and may increase its average return
  • 21. Global Investment Choices
    • Fixed-income investments
      • bonds and preferred stocks
    • Equity investments
    • Special equity instruments
      • warrants and options
    • Futures contracts
    • Investment companies
    • Real assets
  • 22. Fixed-Income Investments
    • Contractual payment schedule
    • Recourse varies by instrument
    • Bonds
      • investors are lenders
      • expect interest payment and return of principal
    • Preferred stocks
      • dividends require board of directors approval
  • 23. Savings Accounts
    • Fixed earnings
    • Convenient
    • Liquid
    • Low risk
    • Low rates
    • Certificates of Deposit (CDs)
    • - instruments that require minimum deposits for specified terms, and pay higher rates of interest than savings accounts. Penalty imposed for early withdrawal
  • 24. Money Market Certificates
    • Compete against Treasury bills (T-bills)
    • Minimum $10,000
    • Minimum maturity of six months
    • Redeemable only at bank of issue
    • Penalty if withdrawn before maturity
  • 25. Capital Market Instruments
    • Fixed income obligations that trade in secondary market
    • U.S. Treasury securities
    • U.S. Government agency securities
    • Municipal bonds
    • Corporate bonds
  • 26. U.S. Treasury Securities
    • Bills, notes, or bonds - depending on maturity
      • Bills mature in less than 1 year
      • Notes mature in 1 - 10 years
      • Bonds mature in over 10 years
    • Highly liquid
    • Backed by the full faith and credit of the U.S. Government
  • 27. U.S. Government Agency Securities
    • Sold by government agencies
      • Federal National Mortgage Association (FNMA or Fannie Mae)
      • Federal Home Loan Bank (FHLB)
      • Government National Mortgage Association (GNMA or Ginnie Mae)
      • Federal Housing Administration (FHA)
    • Not direct obligations of the Treasury
      • Still considered default-free and fairly liquid
  • 28. Municipal Bonds
    • Issued by state and local governments usually to finance infrastructural projects.
    • Exempt from taxation by the federal government and by the state that issued the bond, provided the investor is a resident of that state
    • Two types:
      • General obligation bonds (GOs)
      • Revenue bonds
  • 29. Corporate Bonds
    • Issued by a corporation
    • Fixed income
    • Credit quality measured by ratings
    • Maturity
    • Features
      • Indenture
      • Call provision
      • Sinking fund
  • 30. Corporate Bonds
    • Senior secured bonds
      • most senior bonds in capital structure and have the lowest risk of default
    • Mortgage bonds
      • secured by liens on specific assets
    • Collateral trust bonds
      • secured by financial assets
    • Equipment trust certificates
      • secured by transportation equipment
  • 31. Corporate Bonds
    • Debentures
      • Unsecured promises to pay interest and principal
      • In case of default, debenture owner can force bankruptcy and claim any unpledged assets to pay off the bonds
    • Subordinated bonds
      • Unsecured like debentures, but holders of these bonds may claim assets after senior secured and debenture holders claims have been satisfied
  • 32. Corporate Bonds
    • Income bonds
      • Interest payment contingent upon earning sufficient income
    • Convertible bonds
      • Offer the upside potential of common stock and the downside protection of a bond
      • Usually have lower interest rates
  • 33. Corporate Bonds
    • Warrants
      • Allows bondholder to purchase the firm’s common stock at a fixed price for a given time period
      • Interest rates usually lower on bonds with warrants attached
    • Zero coupon bond
      • Offered at a deep discount from the face value
      • No interest during the life of the bond, only the principal payment at maturity
  • 34. Preferred Stock
    • Hybrid security
    • Fixed dividends
    • Dividend obligations are not legally binding, but must be voted on by the board of directors to be paid
    • Most preferred stock is cumulative
    • Credit implications of missing dividends
    • Corporations may exclude 80% of dividend income from taxable income
  • 35. International Bond Investing
      • Investors should be aware that there is a very substantial fixed income market outside the United States that offers additional opportunity for diversification
  • 36. International Bond Investing
    • Bond identification characteristics
      • Country of origin
      • Location of primary trading market
      • Home country of the major buyers
      • Currency of the security denomination
    • Eurobond
      • An international bond denominated in a currency not native to the country where it is issued
  • 37. International Bond Investing
    • Yankee bonds
      • Sold in the United States and denominated is U.S. dollars, but issued by foreign corporations or governments
      • Eliminates exchange risk to U.S. investors
    • International domestic bonds
      • Sold by issuer within its own country in that country’s currency
  • 38. Equity Investments
    • Returns are not contractual and may be better or worse than on a bond
  • 39. Equity Investments
    • Common Stock
      • Represents ownership of a firm
      • Investor’s return tied to performance of the company and may result in loss or gain
  • 40. Classification of Common Stock Categorized By General Business Line
    • Industrial: manufacturers of automobiles, machinery, chemicals, beverages
    • Utilities: electrical power companies, gas suppliers, water industry
    • Transportation: airlines, truck lines, railroads
    • Financial: banks, savings and loans, credit unions
  • 41. Acquiring Foreign Equities
    • 1. Purchase of American Depository Receipts (ADRs)
    • 2. Purchase of American shares
    • 3. Direct purchase of foreign shares listed on a U.S. or foreign stock exchange
    • 4. Purchase of international mutual funds
  • 42. American Depository Receipts (ADRs)
    • Easiest way to directly acquire foreign shares
    • Certificates of ownership issued by a U.S. bank that represents indirect ownership of a certain number of shares of a specific foreign firm on deposit in a U.S. bank in the firm’s home country
    • Buy and sell in U.S. dollars
    • Dividends in U.S. dollars
    • May represent multiple shares
    • Listed on U.S. exchanges
    • Very popular
  • 43. Purchase or Sale of American shares
    • Issued in the United States by transfer agent on behalf of a foreign firm
    • Higher expenses
    • Limited availability
  • 44. Direct Purchase or Sale of Foreign Shares
    • Direct investment in foreign equity markets- difficult and complicated due to administrative, information, taxation, and market efficiency problems
    • Purchase foreign stocks listed on a U.S. exchange – limited choice
  • 45. Purchase or Sale of Global Mutual Funds or ETFs
    • Global funds - invest in both U.S. and foreign stocks
    • International funds - invest mostly outside the U.S.
    • Funds can specialize
      • Diversification across many countries
      • Concentrate in a segment of the world
      • Concentrate in a specific country
      • Concentrate in types of markets
    • Exchange-traded funds or ETFs are a recent innovation in the world of index products
  • 46. Special Equity Instruments
    • Equity-derivative securities have a claim on common stock of a firm
    • Options are rights to buy or sell at a stated price for a period of time
    • Warrants are options to buy from the company
    • Puts are options to sell to an investor
    • Calls are options to buy from a stockholder
  • 47. Futures Contracts
    • Exchange of a particular asset at a specified delivery date for a stated price paid at the time of delivery
    • Deposit (10% margin) is made by buyer at contract to protect the seller
    • Commodities trading is largely in futures contracts
    • Current price depends on expectations
  • 48. Financial Futures
    • Recent development of contracts on financial instruments such as T-bills, Treasury bonds, and Eurobonds
    • Traded mostly on Chicago Mercantile Exchange (CME) and Chicago Board of Trade (CBOT)
    • Allow investors and portfolio managers to protect against volatile interest rates
    • Currency futures allow protection against changes in exchange rates
  • 49. Investment Companies
    • Rather than buy individual securities directly from the issuer they can be acquired indirectly through shares in an investment company
    • Investment companies sell shares in itself and uses proceeds to buy securities
    • Investors own part of the portfolio of investments
  • 50. Investment Companies
    • Money market funds
      • Acquire high-quality, short-term investments
      • Yields are higher than normal bank CDs
      • Typical minimum investment is $1,000
      • No sales commission charges
      • Withdrawal is by check with no penalty
      • Investments usually are not insured
  • 51. Investment Companies
    • Bond funds
      • Invest in long-term government, corporate, or municipal bonds
      • Bond funds vary in bond quality selected for investment
      • Expected returns vary with risk of bonds
  • 52. Investment Companies
    • Common stock funds
      • Many different funds with varying stated investment objectives
        • Aggressive growth, income, precious metals, international stocks
      • Offer diversification to smaller investors
      • Sector funds concentrate in an industry
      • International funds invest outside the United States
      • Global funds invest in the U.S. and other countries
  • 53. Investment Companies
    • Balanced funds
      • Invest in a combination of stocks and bonds depending on their stated objectives
  • 54. Investment Companies
    • Index Funds
      • These are mutual funds created to equal the performance of a market index like the S&P 500
  • 55. Investment Companies
    • Exchange-Traded Funds (ETFs)
      • These are depository receipts for a portfolio of securities deposited at a financial institution in a unit trust that issues a certificate of ownership for the portfolio of stocks
      • The stocks in a portfolio are those in an index like the S&P 500 and dozens of country or industry indexes
      • ETFs can be bought and sold continuously on an exchange like common stock
  • 56. Real Estate Investment Trusts (REITs)
    • Investment fund that invests in a variety of real estate properties
    • Construction and development trusts provide builders with construction financing
    • Mortgage trusts provide long-term financing for properties
    • Equity trusts own various income-producing properties
  • 57. Direct Real Estate Investment
    • Purchase of a home
      • Average cost of a single-family house exceeds $100,000
      • Financing by mortgage requires down payment
      • Homeowner hopes to sell the house for cost plus a gain
  • 58. Direct Real Estate Investment
    • Purchase of raw land
      • Intention of selling in future for a profit
      • Ownership provides a negative cash flow due to mortgage payments, taxes, and property maintenance
      • Risk from selling for an uncertain price and low liquidity
  • 59. Direct Real Estate Investment
    • Land Development
      • Buy raw land
      • Divide into individual lots
      • Build houses or a shopping mall on it
      • Requires capital, time, and expertise
      • Returns from successful development can be significant
  • 60. Direct Real Estate Investment
    • Rental Property
      • Acquire apartment buildings or houses with low down payments
      • Derive enough income from the rents to pay the expenses of the structure, including the mortgage payments, and generate a good return
      • Rental property provides a cash flow and an opportunity to profit from the sale of the property
  • 61. Low-Liquidity Investments
    • Some investments don’t trade on securities markets
    • Lack of liquidity keeps many investors away
    • Auction sales create wide fluctuations in prices
    • Without markets, dealers incur high transaction costs
  • 62. Antiques
    • Dealers buy at estate sales, refurbish, and sell at a profit
    • Serious collectors may enjoy good returns
    • Individuals buying a few pieces to decorate a home may have difficulty overcoming transaction costs to ever enjoy a profit
  • 63. Art
    • Investment requires substantial knowledge of art and the art world
    • Acquisition of work from a well-known artist requires large capital commitments and patience
    • High transaction costs
    • Uncertainty and illiquidity
  • 64. Coins and Stamps
    • Enjoyed by many as hobby and as an investment
    • Market is more fragmented than stock market, but more liquid than art and antiques markets
    • Price lists are published weekly and monthly
    • Grading specifications aid sales
    • Wide spread between bid and ask prices
  • 65. Diamonds
    • Can be illiquid
    • Grading determines value, but is subjective
    • Investment-grade gems require substantial investments
    • No positive cash flow until sold
    • Costs of insurance, storage, and appraisal
  • 66. Historical Risk-Returns on Alternative Investments
      • World Portfolio Performance
      • Reilly and Wright (2004) examined the performance of various investment alternatives from the United States, Canada, Europe, Japan, and the emerging markets for the period 1980-2001
  • 67. Reilly and Wright’s 2004 Study
    • Asset Returns and Total Risk
      • The expected relationship between annual rates of return and total risk (standard deviation) of these securities was confirmed
  • 68. Reilly and Wright’s 2004 Study
    • Return and Systematic Risk
      • The systematic risk measure (beta) did a better job of explaining the returns during the period than did the total risk measure
      • The beta risk measure that used the Brinson index as a market proxy was somewhat better than the beta that used the S&P 500 Index
  • 69. Reilly and Wright’s 2004 Study
    • Correlations between Asset Returns
      • U.S. equities have a reasonably high correlation with Canadian and U.K. stocks but low correlation with emerging market stocks and Japanese stocks
      • U.S. equities show almost zero correlation with world government bonds, except U.S. bonds
  • 70. Art and Antiques
    • Market data is limited
    • Results vary widely, and change over time, making generalization impossible, but showing a reasonably consistent relationship between risk and return
    • Correlation coefficients vary widely, allowing for great diversification potential
    • Liquidity is still a concern
  • 71. Real Estate
    • Returns are difficult to derive due to lack of consistent data
    • Residential shows lower risk and return than commercial real estate
    • During some short time periods REITs have shown higher returns than stock with lower risk measures
    • Long term returns for real estate are lower than stocks, and have lower risk
  • 72. Real Estate
    • Negative correlation between residential and farm real estate and stocks
    • Low positive correlation between commercial real estate and stocks
    • Potential for diversification
  • 73. The Internet Investments Online
  • 74.
    • Appendix Chapter 3
      • Covariance and Correlation
  • 75. Covariance
    • absolute measure of the extent to which two sets of numbers move together over time
  • 76. Covariance
  • 77. Correlation
    • relative measure of a given relationship
  • 78. Correlation
  • 79. Future topics Chapter 4
    • Organization of markets
    • Functioning of security markets
    • Trading systems