Chapter 3

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Chapter 3

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

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