Types/Alternatives of Investments

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Arnold Hamilton
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1 Topic 1: Investment Alternatives Investments in this Course - All investments are seen form the investors perspective o All investors we have in mind are rational Know what to do to maximise their happiness o Will try to Increase Return Reduce Risk - Portfolio Analysis o Will not look at individual securities in isolation Will only look at the individuals contribution to the portfolio Types/Alternatives of Investments Direct investment - Non marketable financial assets o Cant be sold on to another buyer - Money Market o Instruments o E.g. T-Bills and Commercial Bills - Fixed Income Securities o Bonds - Equity Securities o Common stock and preferred stock - Derivatives o Things that the return is derived from another instrument o E.g. Options and futures Indirect Investments - Mutual Funds o Kiwi Saver o Can always be given more money to invest in - Closed in Funds o Fixed size Therefore once it has reached its max size the only way to invest in is to buy ownership of someone who already has them - ETFs o Mimics the NZX15

2 DIRECT INVESTMENTS: Money Market - This is a market for the sale and purchase of short-term debt instruments o Attributes Low Risk Highly Liquid Usually less than 12 months Dominated by financial institutions - Treasury Bills o T-Bills Sold by the US treasury They are used as a proxy for the risk free rate Rf As they are getting compensated for the waiting only time value of money etc. In NZ Govt Debt Issued by the Crown Traded in Parcels of 1M o Therefore the large institutions control them and sell them on retail to individual investors Redeemable at Par Value at the date of maturity by who ever is holding them at that time - T-Bill Yield o Investment Yield o Actual Annualised Yield = (Face Value Market Value/Market Value ) * (365/# of Days) o Discount Yield Quoted Yield The Yield that will be shown when the T-Bills are quoted easier to work out and will be a more rounded number = (Face value Market Value/Face Value) * (360/# of Days) o Effective Annual Interest Rate: EAR This is the interest rate you actually get when you can get interest on interest the compounding effect = (1+(Par Value Market Value/Market value))^(365/#of Days) - 1 o Realised Annual Return This is the amount of return you actually got, after you have bought and sold the asset = ((Psell/Pbuy)-1)*(365/# of Days)*100 The reason why this can be higher or lower than the expected return is due to the fact that if the yield changes from when you bought it to when you sold it, then the price will change inversely

3 o Price Note that the prices move inversely to the Yield = Par Value/(1+r *(#ofdays/365)) Example: - T-Bill - 90 days $1000 Par Value o Issued at 990 o What is the Investment Yield = ( /990) * (365/90) = 4.096% Per Annum. o What is the EAR = (1+( /990))^(365/90) 1 = 4.16% o What is the quoted yield = ( /1000) *(360/90) = 4% - A 6 Day t-bill is quoted at r = 0.04% p.a. o Price = = (Face value Market Value/Face Value) * (360/# of Days) Change into this: Market Value = Face Value*(1 (Discount Yield)*(# of Days/360)) = 1000*( *(6/360)) = Commercial Bill (NZ)/Paper (US) - These are Documents comprising of a promise from the borrower to repay the lender o Sold at a discount to face value due to time value of money and risk etc. o Short term - Example o You wish to borrow money 500,000 for 90 days You sell (issue) at 90 day bill at 500,000 and promise to repay the face value (e.g. 550,000) at the end of the 90 days The bill may be sold on but the original buyer is liable to who they sell it to Who ever holds it at maturity claims back from the issuer If they have gone bankrupt, they claim after buyer 1, and so on In NZ they can be accepted/endorsed by a bank turns them into bank bills which makes them more secure bank charges a fee for their increased risk - Other Money Market Securities o Certificate of Deposit From a bank o Repurchase agreement Firm agrees to sell a asset to another company at a discounted rate, then buys it back at a set ate for a higher price o Banker s Acceptance They are basically borrowing money with large collateral

4 A time draft drawn on a bank by a customer Fixed Income Securities - Debt securities that offer a fixed interest rate known as coupons - Plus repayment of the principal at maturity - E.g. Bonds o Maturities are greater than one year o Sold by companies and governments to raise money - Quoted on a yield to maturity basis o Yield This is the Discount per year Applied to all cash flows Therefore as the maturity date draws nearer, the price and the par value will converge o Yield to Maturity The minimum return expected from holding a bond to maturity and re-investing all cash flows at the same interest rate This is determined by market price, therefore it also measures an investors required rate of return - Bond Pricing o Market value what it is worth now o Par value/face Value What you get back at maturity usually $1,000 o The Market Price depends on three factors The market interest rate The coupon rate The length of time o Relationship If the market rate is Higher than the coupon rate The price will be sub-par - Discount o As people will not be interested in this investment when they can get a higher rate of return elsewhere If the Coupon rate is higher than the Market rate The price will be above par - Premium o As people will be more interested in this investment as it will generate a higher return than the going market rate The length of time will effect the price in the following way The longer the time, the higher the price o As the longer the time to maturity, the higher the risk that the market rate will increase to higher than the coupon rate Pricing Formula Sum i=1 to n(cfn/(1+r)^n) + Par-v/(1+r)^n Total Return

5 This is a combination of coupon and capital gains o This will be Yield to maturity Unless they do not hold onto it until maturity Rt = P1 P0 + Interest/P0 - Price Example o Band has coupon rate of 10% per year o Nominal par of 1,000 o Interest paid annually o RR = 6% o Expires on the 04/03/2015 o Todays date is the 05/03/ Therefore: o 3 years o PV = 100/(1.06) + 100/(1.06)^ /(1.06)^ /(1.06)^3 o =$1, Types of Bonds: - Zero Coupon Bond o Only get the Par value back o Therefore it will always sell at a discount (Sub-par) - Treasuries o Treasury inflation-protected securities - Federal Agency Securities o Mortgage backed securities Therefore they supply liquidity to local banks so that they can give mortgages to everyone - Municipal Bonds o Political entities other than the federal government E.g. city councils Exempt from federal taxes - Corporate Bonds o Businesses issuing bonds o Default Risk is higher o Credit ratings Taxable equivalent yield = Yield,(1-marginal tax rate) Equity Securities Common Stock - Ownership Interest (residual claim) - Limited liability - Voting rights - Dividends Preferred Stock

6 - Fixed or variable rate - Seniority of dividends Derivative Securities - Options: - When you buy a call or a put option you rights that do not have to be exercised: o Call Right to buy at a pre-determined price at/up to specified date Would only exercise right if the market price is higher than the option price Buying it for less than its worth o Put Right to sell at a pre-determined price at/up to specified date Would only exercise right if the market price was lower than the option price Selling it for more than its worth - Futures o The holder has an obligation to buy/sell an asset in the future at a price specified now E.g. like a spot sale at a future date, but terms are specified now - Contract for Difference (CFD) o Bet on the difference between future price and now o Not allowed in the US INDIRECT INVESTMENTS: - Buying and selling the shares of intermediaries that hold securities in portfolio (Buying shares of companies that own many different stocks) o Shares are ownership interest in portfolio entitled to portfolio income o Shareholders also pay expenses - Types o Open end Funds o Closed end funds o Exchange traded funds Open End Funds - Shares continue to be sold to the public at Net Asset Value (NAV) after initial sale that capitalises the company o Shares may be sold back to the company at NAV o Company size constantly changes o Also called mutual funds

7 Close End Funds - No additional Shares sold after initial public offering o Only way in after the IPO is to buy off someone who is already an owner o Cant make more by buying in - Share price o Determined and traded in a secondary market Price may not equal Net Asset value of the shares o E.g. Listed Property Funds Exchange Traded Funds - Portfolio of assets that offer diversification over a sector, region, or market o Kind of a closed end fund - Management owns actual assets stocks o Then they trade at the same price as the weighted average of their NAV o This is because the stocks in the ETF can be traded in for the actual assets that they own making them mimic the actual assets in the stock exchange - The are traded like any other stock - Why are they so popular? o They have low management fees and other beneficial tax implications - Example: o S&P Depositary Receipts (SPIDER) Cost Considerations of Indirect Investments Usually 1% per year management fee - Would be very hard to find a manager that will consistently deliver 1% over the market - Liquidation value different to price of the stocks for closed end funds o As share price will not be equal to NAV of the stocks they own - Can be fees in selling stocks o And a back-end fee on redemption or a distribution fee Measures of Performance issues - Returns are reported on a regular basis in the popular press o However, as they don t have to show the returns of these You will only usually see the winners Active managers on average underperform the market o Also the net performance will be different As then expenses are deducted - These returns are measured over a set time - Include reinvested dividends and capital gains

8 Topic 1: Investment Alternatives Investments in this Course - All investments are seen form the investors perspective o All investors we have in mind are rational Know what to do to maximise their happiness o Will try to Increase Return Reduce Risk - Portfolio Analysis o Will not look at individual securities in isolation Will only look at the individuals contribution to the portfolio Types/Alternatives of Investments Direct investment - Non marketable financial assets o Cant be sold on to another buyer - Money Market o Instruments o E.g. T-Bills and Commercial Bills - Fixed Income Securities o Bonds - Equity Securities o Common stock and preferred stock - Derivatives o Things that the return is derived from another instrument o E.g. Options and futures Indirect Investments - Mutual Funds o Kiwi Saver o Can always be given more money to invest in - Closed in Funds o Fixed size Therefore once it has reached its max size the only way to invest in is to buy ownership of someone who already has them - ETFs o Mimics the NZX15

9 DIRECT INVESTMENTS: Money Market - This is a market for the sale and purchase of short-term debt instruments o Attributes Low Risk Highly Liquid Usually less than 12 months Dominated by financial institutions - Treasury Bills o T-Bills Sold by the US treasury They are used as a proxy for the risk free rate Rf As they are getting compensated for the waiting only time value of money etc. In NZ Govt Debt Issued by the Crown Traded in Parcels of 1M o Therefore the large institutions control them and sell them on retail to individual investors Redeemable at Par Value at the date of maturity by who ever is holding them at that time - T-Bill Yield o Investment Yield o Actual Annualised Yield = (Face Value Market Value/Market Value ) * (365/# of Days) o Discount Yield Quoted Yield The Yield that will be shown when the T-Bills are quoted easier to work out and will be a more rounded number = (Face value Market Value/Face Value) * (360/# of Days) o Effective Annual Interest Rate: EAR This is the interest rate you actually get when you can get interest on interest the compounding effect = (1+(Par Value Market Value/Market value))^(365/#of Days) - 1 o Realised Annual Return This is the amount of return you actually got, after you have bought and sold the asset = ((Psell/Pbuy)-1)*(365/# of Days)*100 The reason why this can be higher or lower than the expected return is due to the fact that if the yield changes from when you bought it to when you sold it, then the price will change inversely

10 o Price Note that the prices move inversely to the Yield = Par Value/(1+r *(#ofdays/365)) Example: - T-Bill - 90 days $1000 Par Value o Issued at 990 o What is the Investment Yield = ( /990) * (365/90) = 4.096% Per Annum. o What is the EAR = (1+( /990))^(365/90) 1 = 4.16% o What is the quoted yield = ( /1000) *(360/90) = 4% - A 6 Day t-bill is quoted at r = 0.04% p.a. o Price = = (Face value Market Value/Face Value) * (360/# of Days) Change into this: Market Value = Face Value*(1 (Discount Yield)*(# of Days/360)) = 1000*( *(6/360)) = Commercial Bill (NZ)/Paper (US) - These are Documents comprising of a promise from the borrower to repay the lender o Sold at a discount to face value due to time value of money and risk etc. o Short term - Example o You wish to borrow money 500,000 for 90 days You sell (issue) at 90 day bill at 500,000 and promise to repay the face value (e.g. 550,000) at the end of the 90 days The bill may be sold on but the original buyer is liable to who they sell it to Who ever holds it at maturity claims back from the issuer If they have gone bankrupt, they claim after buyer 1, and so on In NZ they can be accepted/endorsed by a bank turns them into bank bills which makes them more secure bank charges a fee for their increased risk - Other Money Market Securities o Certificate of Deposit From a bank o Repurchase agreement Firm agrees to sell a asset to another company at a discounted rate, then buys it back at a set ate for a higher price o Banker s Acceptance They are basically borrowing money with large collateral

11 A time draft drawn on a bank by a customer Fixed Income Securities - Debt securities that offer a fixed interest rate known as coupons - Plus repayment of the principal at maturity - E.g. Bonds o Maturities are greater than one year o Sold by companies and governments to raise money - Quoted on a yield to maturity basis o Yield This is the Discount per year Applied to all cash flows Therefore as the maturity date draws nearer, the price and the par value will converge o Yield to Maturity The minimum return expected from holding a bond to maturity and re-investing all cash flows at the same interest rate This is determined by market price, therefore it also measures an investors required rate of return - Bond Pricing o Market value what it is worth now o Par value/face Value What you get back at maturity usually $1,000 o The Market Price depends on three factors The market interest rate The coupon rate The length of time o Relationship If the market rate is Higher than the coupon rate The price will be sub-par - Discount o As people will not be interested in this investment when they can get a higher rate of return elsewhere If the Coupon rate is higher than the Market rate The price will be above par - Premium o As people will be more interested in this investment as it will generate a higher return than the going market rate The length of time will effect the price in the following way The longer the time, the higher the price o As the longer the time to maturity, the higher the risk that the market rate will increase to higher than the coupon rate Pricing Formula Sum i=1 to n(cfn/(1+r)^n) + Par-v/(1+r)^n Total Return

12 This is a combination of coupon and capital gains o This will be Yield to maturity Unless they do not hold onto it until maturity Rt = P1 P0 + Interest/P0 - Price Example o Band has coupon rate of 10% per year o Nominal par of 1,000 o Interest paid annually o RR = 6% o Expires on the 04/03/2015 o Todays date is the 05/03/ Therefore: o 3 years o PV = 100/(1.06) + 100/(1.06)^ /(1.06)^ /(1.06)^3 o =$1, Types of Bonds: - Zero Coupon Bond o Only get the Par value back o Therefore it will always sell at a discount (Sub-par) - Treasuries o Treasury inflation-protected securities - Federal Agency Securities o Mortgage backed securities Therefore they supply liquidity to local banks so that they can give mortgages to everyone - Municipal Bonds o Political entities other than the federal government E.g. city councils Exempt from federal taxes - Corporate Bonds o Businesses issuing bonds o Default Risk is higher o Credit ratings Taxable equivalent yield = Yield,(1-marginal tax rate) Equity Securities Common Stock - Ownership Interest (residual claim) - Limited liability - Voting rights - Dividends Preferred Stock

FINANCIAL INSTRUMENTS (All asset classes)

YOUR INVESTMENT KNOWLEDGE AND EXPERIENCE KNOWLEDGE SHEETS FINANCIAL INSTRUMENTS (All asset classes) What are bonds? What are shares (also referred to as equities)? What are funds without capital protection?