EC7092: Investment Management

Transcription

1 October 10,

2 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 2

3 Preliminary Information Prerequisites: basic mathematics, statistics (means, variances and 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, 6th edition, Wiley. Evaluation will be based entirely on the final examination. 3

4 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 4

5 What is Investment Management? Investment Management (IM) involves the construction of a portfolio of assets which best matches the investor s preferences and needs, evaluating the performance of this portfolio and adjusting the composition of the portfolio, as necessary. IM is broader than Security Analysis, which only focuses on pricing of individual securities. 5

6 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? 6

7 Asset Allocation How much of an investor s wealth should be invested in each of the following financial instruments? cash equities bonds properties derivative securities Asset allocation is the choice among these broad asset classes while Security allocation is the choice of which particular security to hold within each asset class. 7

8 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 8

9 Classification of Financial Securities Indirect Investments (for example, mutual funds). Direct Investments Money market instruments Derivative instruments Capital market instruments Fixed income instruments Equity instruments 9

10 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 European Money Market: LIBOR, EURIBOR Hong Kong Money Market: HIBOR 10

11 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 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) 11

12 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 his original stake in the company Residual Claim refers to the fact that shareholders are at the bottom of the list of claimants to assets of a corporation in the event of failure or bankruptcy 12

13 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 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 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. 13

14 Indirect Investment Most investors do not invest directly but through an intermediary. The firms specializing in this activity are known as investment companies. Investment companies provide, among others, the following services to an investor. Record keeping and administration, Diversification and divisibility, Professional management, Lower transaction costs. 14

15 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 daily Fund manager may charge a fee when the investor buys ( front-end load ) and sells ( back-end load ) 15

16 Indirect Investment (continued) 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 16

17 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 17

18 The major players Investors 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% 18

19 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% 19

20 What about Hong Kong? Source: Tsoi, E. (2004) HKEx 20

21 What about Hong Kong? (continued) Source: Tsoi, E. (2004) HKEx 21

22 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 standard deviation (SD), variability of realized HPRs HPR t,t+1 = P t+1 P t +D t+1, AHPR = 1 n n P t SD = 1 n 1 i=1 n (HPR i,i+1 AHPR) 2 i=1 HPR i,i+1 22

23 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 (the bid-ask spread) represents dealers profits During our course, for simplicity we assume a single price, i.e. mid-price ([ask + bid]/2) 23

24 Returns: Historical Perspective 24

25 Risk: Historical Perspective 25

26 Returns in the USA 26

27 Wealth in the USA 27

28 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 28

29 Expected Returns and Risk (continued) 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 44%)+(.5 14%)+(.25 ( )16%) = 14% The uncertainty (or risk) surrounding E(r) can be measured by the standard deviation of returns σ = p(s)(r(s) E(r)) 2 s In our example σ = 21.21%. How much would you invest in the stock market if the bill rate is equal to 5%? Answer: It depends on each investor s risk aversion. 29

30 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: 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 and earn 5% (or $5,000). 30

31 Risk and Risk Aversion (continued) The expected outcome (wealth) of the risky Investment 1 is E(W) =.6 150, ,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 the risk premium, that is, the compensation for the risk of the investment 1. Investors can be classified according to their preferences with respect to risk premia. 31

32 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) (1/2)Aσ 2 This 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. 32

33 Utility scores and Certainty Equivalent rate The utility score can be interpreted as a certainty equivalent rate of return. CE rate is that risk-free investments would need to offer to provide the same utility score as the risky portfolio. Example A Utility Score of Portfolio M Utility Score of Portfolio N E(r) = 0.07,σ = 0.05 E(r) = 0.09,σ = = = = =

34 Risk and Preference Investors can be risk averse (A > 0), those who reject gambles with zero risk premia (= 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 of risk and will judge investments prospects on the basis on expected returns only 34

35 Risk and Preferences Less risky lover has a shallower indifference curve. An increase in risk requires less increase in expected return to restore utility to the original level 35

36 Why is risk aversion so important? 36

37 Readings Bodie, Kane and Marcus, Chapters 1, 2, 4, 5 and 6. 37