l Investment Analysis and Portfolio Management
l Lecture 1
l Gareth Myles
l Website
l The module website is
people.ex.ac.uk/gdmyles/GDM.html
l The website provides
l A complete set of notes
l Powerpoint slides
l Exercises
l Solutions
l Assessments/Assignments
l Past examsl The slides are added before each lecture
l Financial Data
l Many of the exercises use real financial data
l This is obtained from Yahoo Finance
l Share prices are obtained by typing company name into the “Get Quotes” box
l “Historical Prices” provides data at a chosen frequency (daily, weekly, monthly)
l The data can be downloaded to a spreadsheet
l Gains and Losses
l Some investments can be very successful.
l £10,000 invested in September 2001 in Lastminute.com would have been worth £134,143 in August 2003
l $10,000 invested in August 1998 in Cephalon would have been worth $107,096 in September 2003 (and $180,000 in 2007)
l Gains and Losses
l But past performance is a very poor guide to future performance
l And this is despite recent headlines
l October 2009 Scientific American Magazine
l Turbocharging the Brain--Pills to Make You Smarter? ( Preview ) Will a pill at breakfast improve concentration and memory—and will it do so without long-term detriment to your health?
l And Losses
l Losses in value can be even more spectacular
l $10,000 invested in September 2000 in Palm Inc. would have been reduced to $91 by April 2003
l A holding in July 2000 of £15 million in Exeter Equity Growth Fund would have been worth £72,463 in August 2003 (the share price fell from 103.50 to 0.50)
l Gains and Losses
l Variability
l The essentially feature of stock prices is unpredictable variability
l Even when averaged into an index this variability is apparent
l Portfolio management is about coping with the variability
l Investment analysis is about underlying longer-term trends
l The same principles apply to both
l Variability
l Variability
l Variability
l Variability
l Overview
l This semester is about investment in financial portfolios
l Investment is defined as a sacrifice made now to obtain a return later
l It is current consumption that is sacrificed
l Two forms of investment can be defined
l Real investment is the purchase of land, machinery, etc
l Financial investment is the purchase of a "paper" contract
l Overview
l Real investments and financial investments are linked
l The share issue of a firm finances the purchase of capital
l The commitment to a mortgage finances the purchase of property
l Financial investment can provide finance for real investment decisions
l Financial investment can guide real investment decisions
l Financial Investment
l There are numerous components to financial investment
l Markets: where assets are bought and sold, and the forms of trade
l Securities: the kinds of securities available, their returns and risks
l Investment process: the decision about which securities, and how much of each
l Financial theory: the factors that determine the rewards from investment (and the risks)
l Markets
l A market is any organized system for connecting buyers and sellers
l There are many security markets
l Markets may have a physical location
l The New York Stock Exchange
l Or exist only as computer networks
l The London Stock Exchange
l Markets vary in the securities that are traded and in the way securities are traded
l Characteristics of Markets
l There are a number of ways to classify markets
l Primary/Secondary
l Primary markets are security markets where new issues of securities are traded
l A secondary market is a market where securities are resold
l The London Stock Exchange is a secondary market
l Most activity on stock exchanges is in the secondary market
l Characteristics of Markets
l Trades on the primary market raise capital for firms
l Trades on the secondary market do not raise additional capital for firms
l The secondary market is still important
l It gives liquidity to primary issues. New securities would have a lower value if they could not be subsequently traded
l It signifies value. Trading in assets reveals information and provides a valuation of the assets. This helps to guide investment decisions
l Characteristics of Markets
l A second way to classify markets is the times of trading
l Call/continuous
l In a call market trading takes place at a specified time intervals
l Some call markets have a provision that limits movement from the prior price. This is to prevent a temporary order imbalance from dramatically moving the price
l In a continuous market there is trading at all times the market is open
l Characteristics of Markets
l Markets can also be characterized by the lifespan of the assets traded
l Money/Capital
l Money market: the market for assets with a life of less than 1 year
l Capital market: the market for assets with a life greater than 1 year
l Some assets, such as most bonds, have a fixed lifespan
l Common stock have an indefinite lifespan
l Brokers
l A broker is a representative appointed by an individual investor
l Brokers have two conflicting roles
l An advisor: a broker can offer investment advice and information
l A sales person: brokers are rewarded through commission and have an incentive to encourage trade
l A full-service broker is a brokerage house that can offer a full range of services including investment advice and portfolio management
l Brokers
l A discount broker offers a restricted range of services at a lower price
l To complete a trade additional brokers are needed
l A floor broker is located on the floor of the exchange and does the actual buying and selling
l A specialist ensures trade happens by holding an inventory of stock and posting prices
l Securities
l The standard definition of a security is:
"A legal contract representing the right to receive future benefits under a stated set of conditions"
l The piece of paper defining the property rights held by the owner is the security
l Securities
l Money market securities
l Short-term debt instruments sold by governments, financial institutions and corporations
l They have maturities when issued of one year or less
l The minimum size of transactions is typically large, usually exceeding $100,000
l 1. Treasury Bills
l US Treasury Bills are the least risky and the most marketable of all money markets instruments
l They represent a short-term IOU of the US federal government
l Similar bills are issued by many other governments
l Securities
l New 91- and 182- day T-bills are issued weekly, by auction whereas 52-week T-bills are issued monthly.
l An active secondary market with very low transactions costs exists for trading T-bills
l T-bills are sold at a discount from face value and pay no explicit interest payments.
l T-bills are considered to have no risk of default, have very short-term maturities, and have a known return
l T-bills are the closest approximations that exist to a risk-free investment
l Securities
l Capital market securities
l Instruments having maturities greater than one year and those having no designated maturity at all
l 1. Fixed income securities
l Fixed income securities have a specified payment schedule
l Bonds promise to pay specific amounts at specific times
l Failure to meet any specific payment puts the bond into default with all remaining payments. The creditor can put the defaulter into bankruptcy
l Securities
l Fixed income securities differ from each other in promised return for several reasons
lThe maturity of the bonds
lThe creditworthiness of the issuer
lThe taxable status of the bond
l Income and capital gains are taxed differently in many countries
l Bonds are designed to exploit these differences
l Securities
l 1.1 Treasury notes and bonds
l The government issues fixed income securities over a broad range of the maturity spectrum
l Both notes and bonds pay interest twice a year and repay principal on the maturity date
l 1.2 Corporate bonds
l These promise to pay interest at periodic intervals and to return principal at a fixed date
l These bonds are issued by business entities and thus have a risk of default
l Securities
l 2. Common stock (shares, equity)
l Common stock represents an ownership claim on the earnings and assets of a corporation
l After holders of debt claims are paid, the management of the company can either pay out the remaining earnings to stockholdings in the form of dividends or reinvest part or all of the earnings
l The holder of a common stock has limited liability – the most they can lose is the value of the shares
l Securities
l 3. Derivative instruments
l Derivative instruments are securities whose value derives from the value of an underlying security or basket of securities
l The instruments are also known as contingent claims, since their values are contingent on the performance of underlying assets
l The most common contingent claims are optionsand futures
l 3.1 An option on a security gives the holder the right to either buy (a call option) or sell (a put option) a particular asset at a future date or during a particular period of time for a specified price
l Securities
l 3.2 A future is the obligation to buy or sell a particular security or bundle of securities at a particular time for a stated price
l A future is simply a delayed purchase or sale of a security
l 3.3 The corporation can issue contingent claims.
l Corporate-issued contingent claims include rights and warrants, which allow the holder to purchase common stocks from the corporation at a set price for a particular period of time
l Securities
l 5. Indirect investing
l The purchase of a shares of an investment portfolio
l A mutual fund holds a portfolio of securities, usually in line with a stated policy objective.
l Unit trusts invest depositors' funds in bonds or equities. Size is determined by inflow of funds.
l Investment trusts Issue a certain fixed sum of stock to raise capital. This fixed capital is then managed by the trust. The initial investors purchase shares, which are then traded on the stock market
l Hedge funds actively manage deposits in excess of £100,000. Trade in all financial markets, including derivatives.
l Return
l Return
l Example 1
l An initial investment of $10,000 is made. One year later, the value of the investment has risen to $12,500. The return on the investment is
l Example 2
l An investment initially costs $5,000. Three months later, the investment is sold for $6,000. The return on the investment per three months is
l Return and Risk
l The risk inherent in holding a security is the variability, or the uncertainty, of its return
l Factors that affect risk are
l 1. Maturity
lUnderlying factors have more chance to change over a longer horizon
lMaturity value of the security may be eroded by inflation or currency fluctuations
lIncreased chance of the issuer defaulting the longer is the time horizon
l Return and Risk
l 2. Creditworthiness
lThe governments of the US, UK and other developed countries are all judged as safe since they have no history of default in the payment of their liabilities
lSome other countries have defaulted in the recent past
lCorporations vary even more in their creditworthiness. Some are so lacking in creditworthiness that an active ''junk bond'' market exists for high return, high risk corporate bonds that are judged very likely to default
l Return and Risk
l 3. Priority
lBond holders have the first claim on the assets of a liquidated firm
lBond holders are also able to put the corporation into bankruptcy if it defaults on payment
l 4. Liquidity
lLiquidity relates to how easy it is to sell an asset
lThe existence of a highly developed and active secondary market raises liquidity
lA security's risk is raised if it is lacking liquidity
l Risk and Return
l 5. Underlying Activities
lThe economic activities of the issuer of the security can affect how risky it is
lStock in small firms and in firms operating in high-technology sectors are on average more risky than those of large firms in traditional sectors
l Return and Risk
l The greater the risk of a security, the higher is expected return
l Return is the compensation that has to be paid to induce investors to accept risk
l Success in investing is about balancing risk and return to achieve an optimal combination
l The risk always remains because of unpredictable variability in the returns on assets
l The Investment Process
l A description of the process is:
l 1. Set investment policy
l Objectives
l Amount
l Choice of assets
l 2. Conduct security analysis
l Examine securities (identify those which are mispriced?)
Use
l a. Technical analysis – the examination of past prices for trends
l b. Fundamental analysis – true value based on future expected returns
l The Investment Process
l 3. Portfolio Construction
lIdentify assets
lChoose extent of diversification
l 4. Portfolio Evaluation
lAssess the performance of portfolio
l 5. Portfolio Revision
lRepeat previous three steps
l Buying Common Stocks
l Open an account with a brokerage and specify
1. Name of firm
2. Buy or sell
3. Size of order
4. How long until order is cancelled
5. Type of order
l Buying Common Stocks
l Time Limit
l This is the time within which the broker should attempt to fill the order
l Day order – fill during the day it is entered or else cancel
l Open order (or Good Till Cancelled) – remains in effect until filled or cancelled
l Fill-or-kill – cancelled if not executed immediately
l Discriminatory order – left to broker
l Buying Common Stocks
l Type of Order
l Market Order – buy or sell, with broker making best effort
lprice uncertain
l execution certain
l Limit Order – A limit price is specified
la maximum if buying
la minimum if selling
lexecution uncertain
lprice certain
l Buying Common Stocks
l Type of Order
l Stop Order – a stop price is specified
l Sell if price falls below the stop price
l (A stop-loss is used to lock-in profits)
l Buy if price rises above the stop price
l Execution is certain if stop price passed
l Price is uncertain
l Stop Limit Order
l A minimum price is placed below the stop-price for a sell
or
l A maximum price is placed above the stop-price for a buy
l Price is certain within a range
l Execution is uncertain
l Margin Account
l A margin account with a broker allows for limited borrowing to purchase assets
l A margin account needs a hypothecation agreement
l a. broker can pledge securities as collateral
l b. broker can lend the securities to others
l For a. and b., shares are held in street name
l Owned legally by brokerage
l Dividends, voting rights, reports go to investor
l Margin Account
l Margin Purchase
l Borrow money from broker to invest
l The cost of borrowing is interest plus a service charge
l Initial margin requirement
l The minimum % of investment from investor’s own funds
l Actual margin
l Margin Account
l A margin account is marked to market at the end of each trading day
l A daily calculation of actual margin
l A margin account is subject to a maintenance margin requirement
l The minimum acceptable value of the actual margin
l If actual margin < maintenance margin then a margin call is issued
l The investor is obliged to add cash or securities to the margin account
l Margin and Return
l Buying on the margin raises return
l Example
l Let purchase price of a security be £50
l Let price of security now be £65
l Assume 100 units were purchased and no dividends were paid
l Return on cash purchase
l Margin and Return
l Return on margin purchase
l Total cost = £50 x 100 = £5000
l Interest rate = 11%
l Initial margin = 60% so loan = £2000
l Return is increased
l Margin and Return
l But if price falls
l Assume price now is £40 rather than £65
l Hence buying on the margin also magnifies losses
l Conclusion: use margin when belief is that prices will rise
l Short Sales
l A short sale is the sale of a security you do not own
l This is achieved by borrowing share certificates from someone else
l The borrowing process is arranged by a broker
l To allow shares to be borrowed the broker either
l a. Uses shares held in street name
l b. Borrows from another broker
l Short Sales
l Short Sales
l Margin
l There is a risk involved so short seller (A) must make an initial margin advance to the broker
l The broker then calculates the margin each day
l Short sales should be used when prices are expected to fall
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