Investment Management

Transcription

1 Investment Management Professor Giorgio Valente University of Leicester MSc Financial Economics 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 1

2 Preliminary information Prerequisites: basic mathematics, statistics and economics (i.e. means, variances and linear regression) Readings: Bodie, Kane and Marcus (2008), Investments, 7 th edition, McGraw-Hill Elton, E.J., Gruber, M.J., Brown, S.J. and Goetzmann, W.N. (2003), Modern Portfolio Theory and Investment Analysis, 6 th edition, Wiley Mondays: 3 hours (lectures + classes) Evaluation: Investment project : 30% Final Examination : 70% Preliminary information Study groups: The investment project is the result of a collaborative effort done in study group. Groups of no more than 4 members must be formed. Send me by the composition of each group. I will allocate the students who do not belong to any group. Feedbacks and office hours: Mondays 10:45am 12:45pm or by appointment. Make use of them. Ask questions and clarifications if what I said is not clear to you. 2

3 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 What is Investment Management? Investment Management (IM) involves: constructing a portfolio of assets which best matches the investor s preferences and needs evaluating the performance of this portfolio adjusting the composition of the portfolio, as necessary Hence: IM is broader than Security Analysis, which only focuses on pricing of individual securities 3

4 The investment setting What is an investment? How do individuals invest? How do investors measure the rate of return on an investment? How do investors measure the risk related to alternative investments? How do expected rates of return and attitude toward risk affect investment choices? Asset allocation Asset allocation is the key activity in IM, that is how much of an investor s wealth should be invested in each of the following financial instruments: cash equities bonds properties derivative securities 4

5 Financial instruments Financial security legal contract confers the right to receive future benefits usually traded in organised markets Classification cash products versus derivative securities debt versus equities Sub-classification by issuer (e.g. public versus private) by maturity Financial securities: classification 5

6 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 deposit Commercial Paper Eurodollars London Interbank Offered Rate (LIBOR) Hong Kong Interbank Offered Rate (HIBOR) Capital market securities: fixed income securities Capital market securities Maturities greater than 1 year Debt ( fixed income ) versus equity Fixed income securities Promised 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 default Issued by governments and companies Government bonds can be short-dated (less than 5 years) medium-dated (5 to 15 years) long-dated (more than 15 years) 6

7 Capital market securities: equities 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 his original stake in the company 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 individual securities buying/selling options on a particular stock does not affect that company s cashflows 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 stock from the corporation at a set price for a period of time) and convertibles (that allow the holder to convert an instrument into common stock under specified conditions) if these options are exercised, company attributes (such as the number of outstanding shares) do change 7

8 Indirect investment 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 daily Fund manager may charge a fee when the investor buys ( front-end load ) and sells ( back-end load ) Indirect investment (cont d) closed-end funds (Investment Trusts) Pre-determined number of shares in the Fund issued initially Net proceeds of sale of these shares is invested in equities and/or bonds Shares in the Fund are traded on an Exchange Owning shares in a closed-end fund is similar to owning shares in a company, except the assets of the company are the equities and bonds which the Fund owns Unlike open-end funds, shares in a closed-end fund can sell at a premium or discount to the net asset value 8

9 How do individuals invest? Passive management buy and hold a well-diversified portfolio of assets Active management security selection attempts to identify securities that have been mispriced - e.g. buy low and sell high market timing tilts the portfolio composition in favour of (away from) equities when the investor is bullish (bearish) about the stock market Portfolio insurance use derivative securities to manage risk The major players In general, institutional investors: pension funds insurance companies and foreign investors Pension funds Insurance companies Unit trust Investment trusts % 10.0% 1.3% 11.3% % 19.9% 1.6% 1.8% Banks 1.3% 2.1% Individuals 54.0% 14.3% Overseas 7.0% 32.1% Industrial and comm. 5.1% 0.9% Source: own calculations, various sources Public sector Other 1.5% 2.1% 0.1% 10.5% 9

10 The major players (cont d) How do institutional investors allocate their assets? Short-term asset Insurance companies 10.3% Pension funds 4.0% Domestic govt securities 13.6% 11.7% Domestic companies securities 52.2% 49.8% Source: own calculations, various sources Overseas securities Other assets 14.6% 9.4% 19.8% 14.7% What about Asia? (the case of HK) Source: Tsoi, E. (2004), HKEx 10

11 What about Asia? (HK cont d) Source: Tsoi, E. (2004), HKEx Risk and return: an introduction Investments are evaluated on the basis of their return/risk profiles 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 Pt+ 1 Pt + D 1 t+ 1 HPR, + 1 = = n AHPR HPRii, + 1 tt P n i= 1 t standard deviation (SD), variability of realized HPRs SD n ( HPRii, + 1 AHPR) 2 n n n 1 i = 1 n = 11

12 What prices? Quoted prices for each asset at any point in time in the real world trading are not single numbers We can distinguish between: ask prices, the price at which an agent (i.e. dealer) is willing to sell a security bid prices, the price at which an agent (i.e. dealer) is willing to purchase a security Therefore ask price is always greater then bid price. The difference between ask and bid prices (= bid-ask spread) represents dealer s profit During our course, for simplicity we assume a single price, i.e. mid-price (=[ask + bid]/2) Returns: historical perspective 12

13 Risk: historical perspective Returns in the US 13

14 Wealth in the US (B&H) Expected returns and risk Historical returns are realized returns Investors decide on potential investment opportunities by looking at anticipated or expected rates of return Risk is therefore the uncertainty that an investment will earn its expected rate of return 14

15 Expected returns and risk (cont d) Expected returns are weighted averages of rates of returns in each scenario: E( r) = p( s) r( s) s in our example: E(r) = (.25 x 44%) + (.5 x 14%) + (.25 x -16%) = 14% The uncertainty (or risk) surrounding E(r) can be measured by the standard deviation of returns σ = s ( ) ( ) ( ) 2 p s r s E r in our example σ = 21.21% How much would you invest in the stock market if the bill rate is equal to 5%? It depends on each investor s risk aversion Risk and risk aversion Example: an investor owns an initial endowment of $100,000 and he/she has to decide to invest in one of the following alternative investments. Investment 1: Two possible outcomes are available: 1) with probability 0.6 the investor will receive $150,000, 2) with probability 0.4 the investor will receive $80,000. Investment 2: Invest safely his/her endowment in T-bills and earn 5% (or $5,000). 15

16 Risk and risk aversion (cont d) the expected outcome (wealth) of the risky Investment 1 is: E(W) =.6 x 150, x 80,000 = $122,000 or differently its expected profit is $22,000 The incremental profit of the risky investment over the safe investment is $22,000 - $5,000 = $17,000 $17,000 is defined as risk premium, that is the compensation for the risk of the investment 1. Investors can be classified according to their preferences with respect risk premia Investors can be: Risk and preferences risk averse, those who reject gambles with zero risk premia (= fair games) or worse risk lover, those who will always engage in fair games risk neutral, those who are indifferent to the level of risk and will judge investments prospects on the basis on expected returns only 16

17 Risk aversion and utility scores Risk-averse investors penalize the expected return from a risky portfolio by a certain percentage to take into account the risk involved Scoring system, Mean-Variance utility (commonly used, Association of Investment Management and Research; AIMR) ( ) U = E r 12Aσ 2 that means that investors utility (U) is increased by high expected returns and reduced by high levels of risk. A denotes the coefficient of risk aversion. How risk averse you are There are stylized facts in the investment literature describing risk aversion among individuals Please fill in the questionnaire (no grades associated with it! Just for discussion) clearly indicating your gender and your background (i.e. Engineering, Finance, Humanities etc.) Next week I will present the results and discuss them in class 17

18 Why is risk aversion so important? Readings Bodie, Kane and Marcus Chapters 1,2,3,5 18