ec7092: investment management · 1 ec7092: investment management suresh mutuswami october 10, 2011...
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EC7092: Investment Management
Suresh Mutuswami
October 10, 2011
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Outline
Introduction
Market instruments, risk and return
Portfolio analysis and diversification
Implementation of Portfolio theory (CAPM, APT)
Equities
Performance measurement
Interest rate theory and pricing of bonds
Managing equities and bond portfolios
Derivatives
International portfolio management (FX)
Introduction to behavioural finance
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Preliminary Information
Prerequisites: basic mathematics, statistics (means, variancesand linear regression) and economics
Readings
Bodie, Kane and Marcus (2011), Investments and Portfolio
Management, McGraw-Hill.Elton, E.J., Gruber, M.J., Brown, S.J. and Goetzmann, W.N.(2003), Modern Portfolio Theory and Investment Analysis, 6thedition, Wiley.
Evaluation will be based entirely on the final examination.
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Road Map
Investment Management
Financial instruments
Financial markets and financial agents
Risk and return (historical perspective)
Risk and expected returns
Risk aversion and investors preferences
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What is Investment Management?
Investment Management (IM) involves
the construction of a portfolio of assets which best matchesthe investor’s preferences and needs,evaluating the performance of this portfolio andadjusting the composition of the portfolio, as necessary.
IM is broader than Security Analysis, which only focuses onpricing of individual securities.
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The Investment Setting
What is an investment?
How do individuals invest?
How do investors measure the rate of return on aninvestment?
How do investors measure the risk related to alternativeinvestments?
How do expected rates of return and attitude toward riskaffect investment choices?
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Asset Allocation
How much of an investor’s wealth should be invested in eachof the following financial instruments?
cashequitiesbondspropertiesderivative securities
Asset allocation is the choice among these broad asset classeswhile Security allocation is the choice of which particularsecurity to hold within each asset class.
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Financial Instruments
Financial security
legal contractconfers the right to receive future benefitsusually traded in organised markets
Classification
cash products versus derivative securitiesdebt versus equities
Sub-classification
by issuer (e.g. public versus private)by maturity
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Classification of Financial Securities
Indirect Investments (for example, mutual funds).
Direct Investments
Money market instrumentsDerivative instrumentsCapital market instruments
Fixed income instrumentsEquity instruments
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Money market securities
Short term (less than 1 year) debt
Issued by governments or companies
Examples
Treasury Bills (or T-bills)Repurchase agreements (or REPOs)Certificates of depositCommercial PaperEurodollarsEuropean Money Market: LIBOR, EURIBORHong Kong Money Market: HIBOR
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Capital market securities: Fixed income securities
Capital market securities have Maturities greater than 1 year.They are classified as either debt (“fixed income”) or equity.
Fixed income securitiespromised stream of future cash flows.
fixed interest payments (“coupons”)fixed dates for coupon payments and repayment of principal
Failure to meet a coupon payment = immediate defaultIssued by governments and companiesGovernment bonds can be
short-dated (less than 5 years)medium-dated (5 to 15 years)long-dated (more than 15 years)
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Capital Market Securities: Equity
Ownership claim on the assets and earnings of a company
Unique feature is Limited Liability
If company goes bankrupt, investor’s loss is limited to hisoriginal stake in the company
Residual Claim
refers to the fact that shareholders are at the bottom of thelist of claimants to assets of a corporation in the event offailure or bankruptcy
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Derivative Securities
Value derived from the value of some underlying asset (i.e.equity, bonds, currencies)
Futures, options
Options are side-bets on the performance of individualsecurities.
buying/selling options on a particular stock does not affectthat company’s cashflow.no change in the number or type of outstanding securities.
Companies can issue their own contingent claims.
warrants (that allow the holder to purchase common stockfrom the corporation at a set price for a period of time) andconvertibles (that allow the holder to convert an instrumentinto common stock under specified conditions).if these options are exercised, company attributes (such as thenumber of outstanding shares) do change.
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Indirect Investment
Most investors do not invest directly but through anintermediary. The firms specializing in this activity are knownas investment companies.
Investment companies provide, among others, the followingservices to an investor.
Record keeping and administration,Diversification and divisibility,Professional management,Lower transaction costs.
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Indirect Investment (continued)
Mutual Funds“open-end” funds (Unit Trusts)
“Units” are bought from (sold to) the Mutual Fund directly“Units” are bought (sold) at the net asset value of the Fund,which is determined dailyFund manager may charge a fee when the investor buys(“front-end load”) and sells (“back-end load”)
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Indirect Investment (continued)
closed-end funds (Investment Trusts)
Pre-determined number of shares in the Fund issued initiallyNet proceeds of sale of these shares is invested in equitiesand/or bondsShares in the Fund are traded on an ExchangeOwning shares in a “closed-end” fund is similar to owningshares in a company, except the assets of the “company” arethe equities and bonds which the Fund ownsUnlike “open-end” funds, shares in a “closed-end” fund cansell at a premium or discount to the net asset value
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How do individuals invest?
Passive management: “buy and hold” a well-diversifiedportfolio of assets
Active management
security selection attempts to identify securities that have beenmispriced - e.g. “buy low and sell high”market timing tilts the portfolio composition in favour of (awayfrom) equities when the investor is bullish (bearish) about thestock marketPortfolio insurance
use derivative securities to “manage” risk
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The major players
Investors 1963 2003
Pension Funds 6.4% 15.6%
Insurance Companies 10.0% 19.9%
Unit Trusts 1.3% 1.6%
Investment Trusts 11.3% 1.8%
Banks 1.3% 2.1%
Individuals 54.0% 14.3%
Overseas 7.0% 32.1%
Industrial & Commercial 5.1% 0.9%
Public Sector 1.5% 0.1%
Others 2.1% 10.5%
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The major players (continued)
Type of Asset Insurance Companies Pension Funds
Short term assets 10.3% 4.0%
Domestic govt. securities 13.6% 11.7%
Domestic comp. securities 52.2% 49.8%
Overseas securities 14.6% 19.8%
Other assets 9.4% 14.7%
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What about Hong Kong?
Source: Tsoi, E. (2004) HKEx
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What about Hong Kong? (continued)
Source: Tsoi, E. (2004) HKEx
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Risk and Return: An introduction
Investments are evaluated on the basis of their return/riskprofiles
Historical versus expected measures of returns
Historical measures of return and risk:
holding-period return (HPR), that is, capital gain income(plus dividend income) per dollar invested
standard deviation (SD), variability of realized HPRs
HPRt,t+1 =Pt+1 − Pt + Dt+1
Pt
, AHPR =1
n
n∑
i=1
HPRi ,i+1
SD =
√
√
√
√
1
n − 1
n∑
i=1
(HPRi ,i+1 − AHPR)2
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What Prices?
Quoted prices for each asset at any point in time in the realworld trading are not single numbers
We can distinguish between
ask prices, the price at which an agent (i.e. dealer) is willing tosell a security.bid prices, the price at which an agent (i.e. dealer) is willing topurchase a security.
Therefore, ask price is always greater then bid price.
The difference between ask and bid prices (the bid-ask spread)represents dealers profits
During our course, for simplicity we assume a single price, i.e.mid-price ([ask + bid ]/2)
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Returns: Historical Perspective
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Risk: Historical Perspective
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Returns in the USA
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Wealth in the USA
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Expected Returns and Risk
Historical returns are realized returns
Investors decide on potential investment opportunities bylooking at anticipated or expected rates of return
Risk is therefore the uncertainty that an investment will earnits expected rate of return
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Expected Returns and Risk (continued)
Expected returns are weighted averages of rates of returns ineach scenario:
E (r) =∑
s
p(s)r(s)
In our example:
E (r) = (.25× 44%) + (.5× 14%) + (.25× (−)16%) = 14%
The uncertainty (or risk) surrounding E (r) can be measuredby the standard deviation of returns
σ =
√
∑
s
p(s) (r(s)− E (r))2
In our example σ = 21.21%.
How much would you invest in the stock market if the bill rateis equal to 5%?
Answer: It depends on each investor’s risk aversion.
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Risk and Risk Aversion
Example: an investor owns an initial endowment of $100,000and he/she has to decide to invest in one of the followingalternative investments.
Investment 1: With probability 0.6 the investor will receive$150,000, and with probability 0.4 the investor will receive$80,000.
Investment 2: Invest safely his/her endowment in T-bills andearn 5% (or $5,000).
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Risk and Risk Aversion (continued)
The expected outcome (wealth) of the risky Investment 1 is
E (W ) = .6× 150, 000 + .4× 80, 000 = $122, 000
Or, differently, its expected profit is $22,000.
The incremental profit of the risky investment over the safeinvestment is $22,000 - $5,000 = $17,000.
$17,000 is defined as the risk premium, that is, thecompensation for the risk of the investment 1.
Investors can be classified according to their preferences withrespect to risk premia.
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Risk Aversion and Utility Scores
Risk-averse investors penalize the expected return from a riskyportfolio by a certain percentage to take into account the riskinvolved
Scoring system, Mean-Variance utility (commonly used,Association of Investment Management and Research; AIMR)
U = E (r)− (1/2)Aσ2
This means that investors utility (U) is increased by highexpected returns and reduced by high levels of risk.
A denotes the coefficient of risk aversion.
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Utility scores and Certainty Equivalent rate
The utility score can be interpreted as a certainty equivalentrate of return. CE rate is that risk-free investments wouldneed to offer to provide the same utility score as the riskyportfolio.
Example
A Utility Score of Portfolio M Utility Score of Portfolio NE (r) = 0.07, σ = 0.05 E (r) = 0.09, σ = 0.10
2.0 0.07− 12× 2× .052 = 0.0675 0.09− 1
2× 2× 0.102 = 0.0800
5.0 0.07− 12× 5× .052 = 0.0638 0.09− 1
2× 5× 0.102 = 0.0650
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Risk and Preference
Investors can be
risk averse (A > 0), those who reject gambles with zero riskpremia (= fair games) or worse
risk lover (A < 0), those who will always engage in fair games
risk neutral (A = 0), those who are indifferent to the level ofrisk and will judge investments prospects on the basis onexpected returns only
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Risk and Preferences
Less risky lover has a shallower indifference curve. An increasein risk requires less increase in expected return to restoreutility to the original level
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Why is risk aversion so important?
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Readings
Bodie, Kane and Marcus, Chapters 1, 2, 4, 5 and 6.
Suresh Mutuswami EC7092: Investment Management