Instructor Manual for Investment Analysis and Portfolio Management, 11th Edition by Ace Test Banks

Instructor Manual for Investment Analysis and Portfolio Management, 11th Edition.

12 - 1

CHAPTER 1

THE INVESTMENT SETTING

What is an Investment ▪ ▪ ▪ ▪ ▪

Income streams and spending needs usually do not coincide If income is greater than spending, then people tend to invest the surplus. If spending is greater than income, then people tend to borrow to cover the deficit. People would be willing to forgo current consumption only if they are confident of achieving greater consumption in the future. The rate of exchange between future consumption (future dollars) and present consumption (current dollars) is the pure rate of interest. Market forces determine this rate.

1.1.1 Investment Defined ▪ Investment is the current commitment of dollars for a period of time to obtain future payments that will compensate the investor for the time the funds are committed, for the expected rate of inflation during this period, and for the uncertainty of the future payments. ▪ In all cases, the investor is trading a known dollar amount today for some expected future steam of payments that will be greater than the current dollar amount today. ▪ The return is the investor’s required rate of return.

1.2 Measures of Return and Risk 1.2.1 Measures of Historical Rates of Return ▪ Holding Period Return (HPR) - the total return from an investment, including all sources of income, for a given period of time. A value of 1.0 indicates no gain or loss. A value greater than 1.0 indicates an increase in wealth, a value less than 1.0 indicates a decline in wealth, and a value of zero indicates that all of the money invested in that asset has been lost.

HPR =

▪

Ending Value of Investment Beginning Value of Investment

Holding Period Yield (HPY) - the total return from an investment for a given period of time stated as a percentage. 12 - 2

HPY = HPR - 1

Annual HPR = HPR1/n where: n is the number of years the investment is held

1.2.2 Computing Mean Historical Returns ▪ Mean rates of return - the average of an investment's returns over time. 1. Single Investment a. Arithmetic Mean (AM) - a measure of mean return equal to the sum of annual HPYs divided by the number of years.

AM =  HPY/n

b. Geometric Mean (GM) - the nth root of the product of the annual holding period returns for n years, minus one (1). GM = [HPR]1/n - 1 where:  = the product of the annual holding period returns, i.e., (HPR 1) x (HPR2) ... (HPRn)

▪

A Portfolio of Investments – The mean historical rate of return for a portfolio of investments is measured as the weighted average of the HPYs for the individual investments in the portfolio or the overall percent change in value of the original portfolio. The weights used in computing the averages are the relative beginning market values for each investment; this is referred to as the dollar-weighted or value-weighted mean rate of return. (Exhibit 1.1)

1.2.3 Calculating Expected Rates of Return (Exhibit 1.2, 1.3, 1.4) ▪ ▪

Risk - the uncertainty that an investment will earn its expected rate of return. Probability - the likelihood of an outcome 12 - 3

▪

To compute the expected rate of return, the investor assigns probability values to all possible returns. These probabilities range from zero (no chance) to one (complete certainty). Expected Return n

Expected Return =  (Prob.of Return) x (Possible Return) i =1 n

E(R i ) =  (Pi )(R i ) i =1

▪

Risk aversion - the assumption that most investors will choose the least risky alternative, all else being equal, and that they will not accept additional risk unless they are compensated for that risk in the form of higher return.

1.2.4 Measuring the Risk of Expected Rates of Return 1. Variance - a measure of risk equal to the sum of the probability of return times the squares of a return's deviation from the mean. n

Variance =  (Prob.)(Possible Return - Expected Return)2 i =1 n

 2 =  (Pi )[R i - E(R i )]2 i =1

2. Standard Deviation () - a measure of risk equal to the square root of variance. 3. Coefficient of variation (CV) - a measure of relative variability that indicates risk per unit of return. It is used to compare alternative investments whose rates of return and standard deviation vary widely.

CV =

Standard Deviation of Returns Expected Rate of Return

1.2.5 Risk Measures for Historical Returns ▪

Use the historical holding period yields (HPYs)

Determinants of Required Rates of Return ▪ Rates of Return - vary over time and across investments (Exhibit 1.5) 12 - 4

1.3.1 The Real Risk-Free Rate (RRFR) ▪ ▪

▪ ▪

The basic interest rate assuming no inflation and uncertainty about future flows Factors that influence this rate a. Time preference of individuals for the consumption of income b. Investment opportunities available in the economy This real risk-free rate is determined by the long-run real growth rate of the economy that is impacted by growth rate of labor force, hours worked, and rate of productivity. A positive relationship exists between the real growth rate in the economy and the RRFR.

1.3.2 Factors Influencing the Nominal Risk-Free Rate (NRFR) ▪

Note the substantial variation in government T-bill rates over time (Exhibit 1.6)

Conditions in the Capital Markets - Relative ease or tightness (this is a short-run phenomenon) Expected Rate of Inflation - this is a major influence NRFR = [(1 + RRFR) (1 + Expected Rate of Inflation)] -1

RRFR =

(1 + NRFR of Return) -1 (1 + Rate of Inflation)

The Common Effect – all factors discussed thus far affects all investments equally, irrespective of type or form.

1.3.3 Risk Premium ▪

Varies from asset to asset and is responsible for differences in rates of return between assets at a certain point in time. The major determinants of the risk premium are: a. Business risk – uncertainty of income flows caused by the nature of a firm’s business. Sales volatility and operating leverage determine the level of business risk. b. Financial risk – uncertainty caused by the use of debt financing c. Liquidity risk - the inability to buy or sell an asset quickly with little price change. d. Exchange rate risk - the uncertainty of returns on securities acquired in a foreign currency. e. Country risk – also called political risk. It is the uncertainty due to the possibility of major political or economic change in the country where an investment has been made. 12 - 5

1.3.4 Risk Premium and Portfolio Theory ▪ ▪

The relevant risk measure for an individual asset is its comovement with the market portfolio This comovement, which is measured by the asset’s covariance with the market portfolio, is referred to as an asset’s systematic risk

1.3.5 Fundamental Risk versus Systematic Risk ▪ ▪

Fundamental risk comprises business risk, financial risk, liquidity risk, exchange rate risk, and country risk Systematic risk refers to the portion of an individual asset’s total variance attributable to the variability of the total market portfolio

1.3.6 Summary of Required Rate of Return ▪ ▪

Research studies have generally concluded that a significant relationship exists between the market measure of risk and the fundamental measures of risk Minimum acceptable rate of return from an investment. Determined by the economy’s RRFR, the variables that influence the NRFR, and the risk premium on the investment

Measures and Sources of Risk a. Business risk b. Financial risk c. Liquidity risk d. Exchange rate risk e. Country risk Relationship between Risk and Return ▪ Security Market Line (Exhibit 1.7) 1.4.1 Movements along the SML ▪

A movement along the line indicates a change in the level of risk for a given company or asset. (Exhibit 1.7)

1.4.2 Changes in the Slope of the SML ▪

A change in the slope of the SML indicates a change in the attitudes of investors toward risk--i.e., a change in the required risk premium for a given asset or asset class. (Exhibit 1.8, 1.9, 1.10)

1.4.3 Changes in Capital Market Conditions or Expected Inflation (Exhibit 1.11) 12 - 6

▪

Can be caused by a change in any of the following: a. expected real growth in the economy b. capital market conditions c. expected rate of inflation

1.4.4 Summary of Changes in the Required Rate of Return 1. A movement along the SML demonstrates a change in the risk characteristics of a specific investment, such as a change in its business risk, its financial risk, or its beta. 2. A change in the slope of the SML occurs in response to a change in the attitude of investors toward risk. 3. A shift in the SML reflects a change in the expected real growth, a change in market conditions, or a change in the expected rate of inflation.

CHAPTER 2 ASSET ALLOCATION AND SECURITY SELECTION 2.1 Individual Investor Life Cycle 2.1.1 The Preliminaries 1. Insurance ▪ Life insurance – provides lump-sum benefit to the heirs upon death of the insured person. Could provide cash value also depending on the type of plan ▪ Health insurance – helps pay medical bills ▪ Disability insurance – provides continuing income should the insured become unable to work ▪ Automobile and home/rental insurance – provides protection against accidents and damage to cars or residences 2. Cash Reserve ▪ Includes cash equivalents such as money market mutual funds ▪ Experts recommend an amount equal to six months’ living expenses. 2.1.2 Investment Strategies over an Investor’s Lifetime (Exhibit 2.1) 1. Accumulation Phase – early to middle years of working career (Exhibit 2.2) 2. Consolidation Phase – past midpoint of careers. Earnings exceed expenses 3. Spending Phase – begins after retirement 4. Gifting Phase – may be concurrent with the spending phase 12 - 7

2.1.3 Life Cycle Investment Goals 1. Near-term, high-priority goals – shorter-term financial objectives that individuals set to fund purchases that are personally important to them 2. Long-term, high-priority goals – include some form of financial independence, such as the ability to retire at a certain age 3. Lower-priority goals – these are not critical 2.2 The Portfolio Management Process (Exhibit 2.3) ▪ Construct a policy statement after determining the investor’s short-term and longterm needs as well as risk tolerance ▪ Examine current financial and economic conditions and forecast future trends ▪ Construct the portfolio ▪ Continual monitoring of investor’s needs and market conditions and update policy statement as needed 2.3 The Need for a Policy Statement ▪ ▪

2.3.1 Understanding and Articulating Realistic Investor Goals Helps investors understand their own needs, objectives, and investment constraints Sets standards for evaluating portfolio performance

▪ ▪

2.3.2 Standards for Evaluating Portfolio Performance Assists in judging the performance of a portfolio manager Typically includes a benchmark portfolio, or comparison standard

▪ ▪

2.3.3 Other Benefits Protects the client against a portfolio manager’s inappropriate investments or unethical behavior Prevents delays in monitoring and rebalancing your portfolio and contributes to a seamless transition between money managers

2.4 Input to the Policy Statement

▪ ▪ ▪

2.4.1 Investment Objectives Objectives are investment goals expressed in terms of both risk and returns. A careful analysis of the client’s risk tolerance should precede any discussion of return objectives. Return objective may be stated in terms of an absolute or relative percentage return. It may be also be stated in terms of general goals such as: - Capital preservation – minimize risk of loss - Capital appreciation – growth of the portfolio in real terms to meet future need 12 - 8

Current income – focus is on generating income rather than capital gains Total return – increase portfolio value by capital gains and by reinvesting current income Examples - Investment Objective: 25-year-old – Given the young age and income growth potential, a total return or capital appreciation objective would be most appropriate. - Investment Objective: 65-year-old – Given the fact that employment will be ceasing soon, a current income and capital preservation or a current income and total return strategy would be most appropriate. -

▪

2.4.2 Investment Constraints 1. Liquidity Needs – vary between investors depending on age, employment, tax obligations, etc. 2. Time Horizon – influences liquidity needs and risk tolerance 3. Tax Concerns ▪ Capital gains or losses – taxed differently from income ▪ Marginal tax rate – tax rate on each additional dollar of income 4. Legal and Regulatory Factors ▪ Both the investment process and the financial markets are highly regulated and subject to numerous laws. ▪ Regulations can also constrain the investment choices available to someone in a fiduciary role. A fiduciary, or trustee, supervises an investment portfolio of a third party, such as a trust account or discretionary account. 5. Unique Needs and Preferences - could influence investment choice 2.5 Constructing the Policy Statement 2.5.1 General Guidelines ▪ Investors and advisors should consider the following questions: - What are the real risks of an adverse financial outcome, especially in the short run? - What probable emotional reactions will I have to an adverse financial outcome? - How knowledgeable am I about investments and financial markets? - What other capital or income sources do I have? How important is this particular portfolio to my overall financial position? - What, if any, legal restrictions may affect my investment needs? - How would any unanticipated fluctuations in my portfolio value affect my investment policy? 2.5.2 Some Common Mistakes ▪ Having too much money invested in the employer’s stock ▪ Trading stocks too often ▪ Selling stocks too soon 12 - 9

2.6 The Importance of Asset Allocation (Exhibits 2.4, 2.5, 2.6) 2.6.1 Investment Returns after Taxes and Costs ▪ Taxes and inflation can significantly lower returns. 2.6.2 Returns and Risks of Different Asset Classes ▪ Small company stocks have generated the highest returns historically, but the volatility of the returns have been the greatest as well. 2.6.3 Asset Allocation Summary ▪ A major portion of a portfolio’s returns is explained by asset allocation. 2.6.4 Asset Allocation and Cultural Differences ▪ Asset allocations differ across countries. 2.7 The Case for Global Investments 2.7.1 Relative Size of U.S. Financial Markets (Exhibit 2.7) ▪ Overall value of all securities increased dramatically, and the composition has also changed. 2.7.2 Rates of Return on U.S. and Foreign Securities 1. Global Bond-Market Returns (Exhibit 2.8) 2. Global Bond-Market Returns (Exhibit 2.9) 2.7.3 Risk of Diversified Country Investments 1. Global Bond Portfolio Risk (Exhibits 2.10, 2.11) 2. Global Equity Portfolio Risk (Exhibits 2.12, 2.13) 3. Summary on Global Investing ▪ Market for non-U.S. bonds and stocks, and found that this market has grown in size and importance. ▪ Rates of return for foreign bond and stock investments were often superior to those in the U.S. market. ▪ Diversification is important in reducing the variability of portfolio returns over time, which reduces the risk of the portfolio. ▪ Adding foreign stocks and bonds to a U.S. portfolio will reduce the risk of the portfolio and can possibly increase its average return ▪ Investors should develop a global investment perspective because it is clearly justified, and this trend toward global investing will continue. 2.8 Historical Risk-Returns on Alternative Investments

12 - 10

2.8.1 World Portfolio Performance (Exhibit 2.14) 1. Asset Return and Total Risk ▪ Riskier assets with higher standard deviations experienced higher returns. 2. Return and Systematic Risk (Exhibit 2.15) ▪ The systematic risk measure (beta) did a better job of explaining the returns during the period than the total risk measure (standard deviation). 3. Correlations between Asset Returns (Exhibit 2.16) 2.8.2 Art and Antiques ▪ Study by Reilly (1992): - Correlations among alternative antique and art categories vary substantially. - Correlations between art/antiques and bonds were generally negative. - Correlations of art/antiques with stocks were typically small, positive values. - Correlation of art and antiques with the rate of inflation indicates that several of the categories were fairly good inflation hedges since they were positively correlated with inflation. ▪ Most art and antiques are quite illiquid, and the transaction costs are very high compared to those of financial assets. 2.8.3 Real Estate (Exhibits 2.17, 2.18) ▪ Studies by Eichholtz (1996), Mull and Socnen (1997), and Quan and Titman (1997): - Returns on real estate are equal to or slightly lower than returns on common stocks, but real estate possesses favorable risk and diversification results. - Individual real estate assets had much lower standard deviations and either low positive or negative correlations with other asset classes in a portfolio context. - All the real estate series had significant positive correlation with inflation, which implies strong potential as an inflation hedge.

12 - 11

APPENDIX Objectives and Constraints of Institutional Investors

Mutual Funds – pool investors funds and invest them in financial assets as per their investment objectives

II. Pension Funds – receive contributions from the firms, their employees, or both and invest those funds A. Defined Benefit – promise to pay retirees a specific income stream after retirement B. Defined Contribution – do not promise a set of benefits. Employees’ retirement income is not an obligation of the firm

III. Endowment Funds – represent contributions made to charitable or educational institutions

IV. Insurance Companies 1. Life Insurance Companies 2. Nonlife Insurance Companies

V. Banks – a bank’s success is primarily based on its ability to generate returns in excess of its cost of funds

VI. Institutional Investor Summary

CHAPTER 3 12 - 12

ORGANIZATION AND FUNCTIONING OF SECURITIES MARKETS 3.1 What is a Market? ▪ A market is a means through which buyers and sellers are brought together to aid in the transfer of goods and/or services. 3.1.1 Characteristics of a Good Market ▪ Timely and accurate information on volume and prices of past transactions and all currently outstanding bids and offers ▪ Liquidity (ability to buy or sell quickly at a price close to prior price) - Price continuity – prices do not change much from one transaction to another unless significant new information becomes available. - Depth – several potential buyers and sellers must be willing to trade at prices above and below the current market price. ▪ Low transaction costs (internal efficiency) ▪ Rapid adjustment of price to new information (informational efficiency) 3.1.2 Decimal Pricing ▪ Now U.S. equities are quoted in decimals (cents) rather than in fractions. ▪ Reasons for the change: - Facilitate the understanding and comparison of prices - Reduction in transaction costs - To make U.S. financial markets more competitive on a global basis 3.1.3 Organization of the Securities Market ▪ Primary markets are those in which new securities are sold and funds go to an issuing unit. ▪ Secondary markets are those in which outstanding securities are bought and sold by investors. The issuing unit does not receive any funds in a secondary market transaction. 3.2 Primary Capital Markets 3.2.1 Government Bond Issues -

Treasury Bills – negotiable, non-interest bearing securities with original maturities of one year or less Treasury Notes – original maturities of 2 to 10 years Treasury Bonds – original maturities of more than 10 years

3.2.2 Municipal Bond Issues ▪ Method of sale 12 - 13

Competitive bid – usually involves sealed bids Negotiated sales – involves contractual arrangements between underwriters and issuers - Private placement – involves sale of securities directly to a small group of investors or institutional investors Underwriting function (Exhibit 3.1) - The investment banker purchases the entire issue from the issuer and resells the security to the investing public. The firm charges a commission for providing this service. For municipal bonds, the underwriting function is performed by both investment banking firms and commercial banks This function can involve three services: origination, risk-bearing, and distribution a. Origination – involves the design of the bond issue and initial planning b. Risk-bearing – refers to the underwriter’s risk of reselling the securities to the investing public c. Distribution – selling to investors with the help of selling syndicate consisting of other investment banking firms and/or commercial banks if the issue is very large -

▪

3.2.3 Corporate Bond Issues ▪ Almost always sold through a negotiated arrangement with an investment banking firm that maintains a relationship with the issuing firm 3.2.4 Corporate Stock Issues ▪

Types of new issues - Seasoned equity issues – new shares offered by firms that already have stock outstanding - Initial public offerings (IPOs) – a firm selling its common stock to the public for the first time - New issues (seasoned or IPOs) are typically underwritten by investment bankers 1. Introduction of Rule 415 - allows large firms to register security issues and sell them piecemeal during the following two years

3.2.5 Private Placements and Rule 144A - Allows both U.S. and non-U.S corporations to place securities privately with large, sophisticated institutional investors without extensive registration documents 3.3 Secondary Financial Markets 3.3.1 Why Secondary Markets Are Important ▪ Enhances liquidity of the securities and enables price discovery

12 - 14

3.3.2 Secondary Bond Markets (Exhibit 3.2) 1. Secondary Markets for U.S. Government and Municipal Bonds - U.S. government bonds are traded by bond dealers that specialize in either Treasury bonds or agency bonds. - Major market makers in the secondary municipal bond market are banks and investment firms. 2. Secondary Corporate Bond Markets - Traditionally investment banks - Movement toward a widespread transaction-reporting service 3.3.3 Financial Futures ▪ Allow the holder to buy or sell a specified amount of a given bond issue at a stipulated price 3.3.4 Secondary Equity Markets 1. Basic Trading Systems - Pure auction market (order-driven market) - Dealer market (quote-driven market) 2. Call versus Continuous Markets - Call Market - trading for individual stocks takes place at specified times, while, in a continuous market, trades occur at any time the market is open - Continuous market - trades occur at any time the market is open wherein stocks are priced either by auction or by dealers 3.4 Classification of U.S. Secondary Equity Markets 3.4.1 Primary Listing Markets 1. New York Stock Exchange (NYSE) - Largest organized securities market in the U.S. that was established in 1817 as the New York Stock and Exchange Board. Changed its name to the New York Stock Exchange in 1863 2. American Stock Exchange (AMEX) - Was acquired by the NYSE in 2007 and is now known as the NYSE AMEX 3. Global Stock Exchanges - Each country typically has one relatively large exchange that dominates the market. - Emerging economies have stock exchanges because of the liquidity. 4. The Global 24-Hour Market - Made possible by advances in technology 5. The NASDAQ Market - Dealer market in which trading takes place electronically - About 3,000 issues are actively traded on the NASDAQ. 6. Listing Requirements for NASDAQ 12 - 15

Alternative standards National Market System (NMS) list and a regular NASDAQ list

3.4.2 The Significant Transition of the U.S. Equity Markets (Exhibit 3.2) 1. The Initial Setting 2. The Transition Begins 3. The Move to Decimal Pricing (exhibit 3.3) 4. Stock Exchanges 5. Electronic Communication Networks (ECNs) 6. Dark Pools 7. Broker/Dealer Internalizations 8. Algorithmic Trading (AT) 9. High-Frequency Trading (HFT) 10. AT/HFT and the Flash Crash 11. The Current Status 3.5 Alternative Types of Orders Available 3.5.1 Market Orders ▪

An order to buy or sell a stock at the best current price

3.5.2 Limit Orders ▪ Specifies the buy or sell price 3.5.3 Special Orders ▪ Stop loss order ▪ Stop buy order 3.5.4 Margin Transactions ▪ Initial margin ▪ Maintenance margin 3.5.5 Short Sales ▪

Sale of stock that you do not own with the intent of purchasing it back later at a lower price

3.5.6 Exchange Merger Mania 1. Why Merger Mania? - Trend toward portfolios that are diversified both between countries (globally) and among asset classes - Economics of high technology trading 2. Some Past Mergers - In early 2006, NYSE acquired Archipelago Holdings Co., and renamed itself as NYSE Group, Inc. - NYSE Group, Inc. merged with Euronext NV in 2007 - Acquisition of Instinet Group by NASDAQ - CME and CBOT merged in late 2007. They then merged with New York Mercantile Exchange in 2008. 12 - 16

- London Stock Exchange acquired Borsa Italiana in 2007. 3. The Present and Future - The trend toward mergers of exchanges is likely to continue globally. CHAPTER 4 SECURITY MARKET INDEXES AND INDEX FUNDS

4.1 Uses of Security Market Indexes ▪ As benchmarks to evaluate the performance of professional money managers ▪ To create and monitor an index fund ▪ To measure market rates of return in economic studies ▪ For predicting future market movements by technicians ▪ As a substitute for the market portfolio of risky assets when calculating the systematic risk of an asset 4.2 Differentiating Factors in Constructing Market Indexes 4.2.1 The Sample – should be representative of the total population ▪ Size ▪ Breadth ▪ Source 4.2.2 Weighting of Sample Members ▪ Price-weighted index ▪ Value-weighted index ▪ Unweighted index ▪ Fundamental weighted index 4.2.3 Computational Procedures

▪ ▪ ▪

Arithmetic average Compute an index and have all changes, whether in price or value, reported in terms of the basic index Geometric average

4.3 Stock-Market Indexes (Exhibit 4.7, 4A.1) 4.3.1. Price-Weighted Index 1. Dow Jones Industrial Average (Exhibit 4.1, 4.2) ▪ Oldest and best-known of the stock market indexes ▪ Computation of DJIA – sum of the prices of 30 blue-chips stocks divided by adjusted divisor 12 - 17

▪

Criticisms of DJIA - Limited to 30 non-randomly selected blue-chip stocks - Includes mostly large, mature, blue-chip companies - The divisor needs to be adjusted every time one of the companies in the index has a stock split - Biased in favor of high-priced stocks Dow Jones also publishes a 20-stock transportation average and a 15-stock utility average.

2. Nikkei-Dow Jones Average (Nikkei Stock Average Index) ▪ 225 stocks on the First Section of the TSE ▪ Criticisms of Nikkei-Dow - Is a price-weighted series. Hence, it suffers from the same shortcomings of the DJIA. - Stocks included in the index comprise only about 15 percent of all stocks on the First Section of the Tokyo Stock Exchange 4.3.2 Value-Weighted Index ▪ Generated by deriving the initial total market value of all stocks used in the index ▪ Example of a Computation of a Value-Weighted Index (Exhibit 4.3, 4.4) ▪ Automatic adjustment for stock splits 4.3.3 Unweighted Index ▪ General computational procedure – all stocks in an unweighted index carry equal weight regardless of their price or market value ▪ Examples of unweighted series ▪ Value Line Averages ▪ Financial Times Ordinary Share Index ▪ Computation of an equally weighted index (Exhibit 4.5) ▪ Arithmetic and Geometric Means (Exhibit 4.6) 4.3.4 Fundamental Weighted Index ▪ Some observers have suggested other measures of a company’s economic footprint. ▪ Firms and authors can and have created indexes with single variables or a different set of fundamental variables to determine the weights. ▪ For example, Research Affiliates, Inc. proposed: ▪ Sales ▪ Profits (cash flow) ▪ Net assets (book value) ▪ Distributions to shareholders (dividends) ▪ Research Associates Fundamental Index [RAFI]) is representative and ensures high liquidity, high quality, and low turnover. 4.3.5 Style Indexes

12 - 18

▪ ▪ ▪ ▪ ▪ ▪

Small-cap growth Mid-cap growth Large-cap growth Small-cap value Mid-cap value Large-cap value

4.3.6. Global Equity Indexes (Exhibit 4.8, 4A.2) 1. FT/S&P-Actuaries World Indexes 2. Morgan Stanley Capital International (MSCI) Indexes 3. Dow Jones World Stock Index (Exhibit 4.9) 4. Comparison of World Stock Indexes – strong, positive correlation between the three series mentioned above (Exhibit 4.10) 4.4 Bond Market Indexes 1. U.S. Investment-Grade Bond Indexes (Exhibit 4.11) 2. High-Yield Bond Indexes 3. Global Government Bond Market Indexes (Exhibit 4.12) 4.5 Composite Stock-Bond Indexes ▪ Merrill Lynch-Wilshire U.S. Capital Markets Index (ML-WCMI) ▪ Brinson Partners Global Security Market Index (GSMI) 4.6 Comparison of Indexes over Time 4.6.1 Correlations between Monthly Equity Price Changes (Exhibit 4.13)

▪ ▪ ▪

High, positive correlation between the S&P 500 and several comprehensive U.S. equity indexes Lower correlations between comprehensive indexes and various style indexes Correlations between the S&P 500 and indexes from Canada, the United Kingdom, Germany, and Japan support the case for global investing.

4.6.2 Correlations between Monthly Bond Index Returns ▪ Strong, positive correlations between longer-term, U.S. investment-grade bond indexes. ▪ Low correlations between investment-grade bonds and high-yield bonds. ▪ Low and diverse relationships between U.S. investment-grade bonds and world government bonds without the United States. 4.7 Investing in Security Market Indexes 1. Index Funds 12 - 19

▪

▪ ▪ ▪ ▪

For an indexed portfolio, the fund manager will typically attempt to replicate the composition of the particular index and buy the exact securities comprising the index in their exact weights and then alter those positions anytime the index composition is changes. Index funds have low trading and management expense ratios. Vanguard’s 500 Index Fund (VFINX), which is designed to mimic the S&P 500 Index (Exhibit 4.14) Advantage of index mutual funds is they provide an inexpensive way for investors to acquire a diversified portfolio that emphasizes the desired market or industry within the context of a traditional money management product. Disadvantages of mutual funds are that investors can only liquidate their positions at the end of the trading day (i.e., no intraday trading), usually cannot short sell, and may have unwanted tax repercussions if the fund sells a portion of its holdings, thereby realizing capital gains.

2. Exchange-Traded Funds (Exhibit 4.15) ▪ ETFs are depository receipts that give investors a pro rata claim on the capital gains and cash flows of the securities that are held in deposit by the financial institution that issued the certificates. ▪ Examples include - Standard & Poor’s 500 Depository Receipts (SPDRs), which are based on all the securities held in that index - iShares, which recreate indexed positions in several global developed and emerging equity markets, including countries such as Australia, Mexico, Malaysia, the United Kingdom, France, Germany, Japan, and China - Sector ETFs, which invest in baskets of stocks from specific industry sectors, including consumer services, industrial, technology, financial services, energy, utilities, and cyclicals/transportation ▪ Advantages of ETFs over index mutual funds: - Can be bought and sold (and short sold) like common stock through an organized exchange or in an over-the-counter market - Backed by a sponsoring organization (e.g., for SPDRs, the sponsor is PDR Services LLC, a limited liability company wholly owned by NYSE Euronext exchange where SPDR shares trade) that can alter the composition of the underlying portfolio to reflect changes in the composition of the index - Smaller management fee - Continuous trading while markets are open - Ability to time capital gain tax realizations ▪ ETF disadvantages: - Brokerage commissions - Inability to reinvest dividends, except on a quarterly basis CHAPTER 5

EFFICIENT CAPITAL MARKETS, BEHAVIORAL FINANCE, AND TECHNICAL ANALYSIS

12 - 20

5.1 Efficient Capital Markets ▪ An efficient capital market is one in which security prices adjust rapidly to the arrival of new information, which implies that the current prices of securities reflect all information about the security.

5.1.1 Why Should Capital Markets Be Efficient? ▪

▪ ▪ ▪

Assumptions: - A large number of independent profit maximizing participants who analyze and value securities - New information comes in random fashion. - The buy and sell decisions of profit-maximizing investors cause security prices to adjust rapidly to reflect the effect of new information. Security prices at any point in time are an unbiased reflection of all available information, including the risk involved in owning the security. In an efficient market, the expected returns implicit in the current price of the security should reflect its risk. Investors who buy at informationally efficient prices should receive a rate of return that is consistent with the perceived risk of the security. 5.1.2 Alternative Efficient Market Hypotheses

▪ ▪ ▪

Random walk hypothesis - changes in security prices occur randomly Fair Game Model – current market price reflects all available information about a security and the expected return based upon if this price is consistent with its risk Efficient Market Hypothesis (EMH) - divided into three sub-hypotheses depending on the information set involved ▪ Weak-Form EMH - prices reflect all security-market information ▪ Semistrong-Form EMH - prices reflect all public information ▪ Strong-Form EMH - prices reflect all public and private information 5.1.3 Tests and Results of Efficient Market Hypotheses

▪

Results of some studies have revealed some anomalies related to these hypotheses, indicating results that do not support the hypotheses. 1. Weak-Form Hypothesis: Tests and Results Statistical Tests of Independence - Autocorrelation tests - Runs tests 2. Tests of Trading Rules ▪

▪

Potential pitfalls 12 - 21

- Use only publicly available data - Include all transactions costs - Adjust for the results for risk 3. Results of Simulations of Specific Trading Rules ▪

▪

Filter rule - An investor trades a stock when the price change exceeds a filter value set for it. Results generally support weak-form EMH.

4. Semistrong-Form Hypothesis: Tests and Results ▪

▪

Studies to predict future rates of return using public information beyond pure market information, such as prices and trading volume - These studies involve time-series analysis of returns or the cross-section distribution of returns for individual stocks. Event studies that examine how fast stock prices adjust to specific significant economic events

▪

Adjustment for Market Effects - For any of these tests, the security’s rates of return must be adjusted for the rates of return of the overall market during the period considered.

▪

Alternate Semistrong Tests - Return prediction studies - Event studies - Results of return prediction studies - Risk premium proxies - Quarterly earnings reports - Quarterly earnings reports - The January anomaly - Other calendar effects - Monthly effect - Weekend effect - Intraday effect

▪

Predicting Cross-Sectional Returns - Price-earnings ratios - Price-earnings/growth rate (PEG) ratios - The size effect - Neglected firms and trading activity - Book value-market value ratio

▪

Results of Event Studies - Stock split studies 12 - 22

▪

Initial public offerings (IPOs) (Exhibit 5.1) Exchange listing Unexpected world events and economic news Announcement of accounting changes Corporate events

Summary on the Semistrong-Form EMH - Numerous event studies provide empirical support for the hypothesis. - The evidence from exchange listing studies is mixed. - Several studies on predicting rates of return over time or for a cross section of stocks provide evidence against the hypothesis.

5. Strong-Form Hypothesis: Tests and Results ▪

Tests whether any group can consistently enjoy abnormal returns - Corporate insider trading - Security analysts - The value line enigma - Analysts' recommendations - Performance of Professional Money Managers

▪

Conclusions Regarding the Strong-Form EMH - The tests of the strong-form EMH have generated mixed results. - The result for corporate insiders did not support the hypothesis because these individuals apparently have monopolistic access to important information and use it to derive above-average returns. - The results for Value Line rankings have changed over time and currently tend toward support for the EMH. - Recent performance by professional money managers provided support for the strong-form EMH.

5.2 Behavioral Finance ▪ Considers how various psychological traits of individuals and how these traits affect the manner in which they act as investors, analysts, and portfolio managers 5.2.1 Explaining biases ▪

Investors have a number of biases such as confirmation bias, self-attribution bias, hindsight bias, etc., that negatively affect their investment performance

5.2.2 Fusion investing ▪

This refers to the integration of two elements of investment valuation, namely, fundamental value and investor sentiment. 12 - 23

5.3 Implications of Efficient Capital Markets 5.3.1 Efficient Markets and Fundamental Analysis 1. Aggregate Market Analysis with Efficient Capital Markets ▪

Only using historical data to estimate future values and invest on the basis of these “old news” estimates, will not result in superior, risk-adjusted returns.

2. Industry and Company Analysis with Efficient Capital Markets ▪

EMH does not contradict the potential value of industry and copany analysis but implies that one needs to (1) understand the relevant variables that affect rates of return, and (2) do a superior job of estimating future values for these relevant valuation variables.

3. How to Evaluate Analysts or Investors ▪

Examine the performance of numerous securities that this analyst or investor recommends over time in relation to the performance of a set of randomly selected stocks of the same risk class

4. Conclusions about Fundamental Analysis ▪

The superior analyst or successful investor must understand what variables are relevant to the valuation process and have the ability and work ethic to do a superior job of estimating values for these important valuation variables.

5.3.2 Efficient Markets and Portfolio Management 1. Portfolio Managers with Superior Analysts ▪

Concentrate efforts in mid-cap and small-cap stocks that possess the liquidity required by institutional portfolio managers

2. Portfolio Managers without Superior Analysts ▪ ▪ ▪ ▪ ▪

Determine and quantify your risk preferences Construct the appropriate risk portfolio Diversify completely on a global basis to eliminate all unsystematic risk Maintain the desired risk level by rebalancing the portfolio whenever necessary Minimize total transaction costs

3. The Rationale and Use of Index Funds and Exchange-Traded Funds 12 - 24

▪

Many portfolios should be managed passively to match the performance of the aggregate market, thus minimizing the costs of research and trading.

4. Insights from Behavioral Finance ▪ ▪ ▪

Growth companies will usually not be growth stocks due to the overconfidence of analysts regarding future growth rates and valuations. Notion of “herd mentality” of analysts in stock recommendations or quarterly earnings estimates is confirmed. Valuation is a combination of fundamental value and investor sentiment.

5.4 Technical Analysis ▪ Technical analysts see no need to study the multitude of economic, industry, and company variables to arrive at an estimate of future value because they believe that past price and volume movements or some other market series will signal future price movements. 5.4.1 Underlying Assumption of Technical Analysis (Exhibit 5.2) ▪ The market value of any good or service is determined solely by the interaction of supply and demand. ▪ Supply and demand are governed by numerous rational and irrational factors. ▪ The prices for individual securities and the overall value of the market tend to move in trends, which persist for appreciable lengths of time. ▪ Changes in trend are caused by shifts in supply and demand factors, and these shifts can be detected by an analysis of the market itself. 5.5

Advantages of Technical Analysis

▪ ▪ ▪

5.6

Not heavily dependent on financial statements that can have problems or not contain sufficient information Technicians do not have to have information first; they only recognize movement to a new level for any reason. Technicians only invest when movement to a new equilibrium has begun.

Challenges to Technical Analysis

5.6.1 Challenges to the Assumptions of Technical Analysis ▪ Challenges are based upon the results of empirical tests of the efficient market hypothesis (EMH). 12 - 25

5.6.2 Challenges to Specific Trading Rules ▪ Moves may be self-fulfilling, but only temporary ▪ Competition will neutralize the value of a technique. ▪ Most rules are very subjective, and critical values can change over time.

5.7

Technical Trading Rules and Indicators ▪

Typical Stock Market Cycle (Exhibit 5.3)

5.7.1 Contrary-Opinion Rules ▪ The goal is to determine when the majority of investors is either strongly bullish or bearish and when the trade is in the opposite direction. 1. Mutual Fund Cash Positions ▪

A large cash balance will eventually be invested and will cause stock prices to increase. Alternatively, a low cash ratio would indicate that the institutions have little potential buying power.

2. Credit Balances in Brokerage Accounts ▪

A large cash balance will eventually be invested and will cause stock prices to increase. Alternatively, a low cash ratio would indicate that the institutions have little potential buying power.

3. Investment Advisory Opinions ▪

Technicians believe that when a large proportion of investment advisory services are bearish, this signals a market trough and the onset of a bull market.

4. Chicago Board Options Exchange (CBOE) Put-Call Ratio ▪

A higher put-call ratio indicates that investors are bearish, which technicians consider a bullish indicator.

5. Futures Traders Bullish on Stock Index Futures ▪

It is considered a bearish sign when more than 70 percent of the speculators are bullish and a bullish sign when this ratio declines to 30 percent or lower.

12 - 26

5.7.2 Follow the Smart Money 1. Confidence Index ▪

The Confidence Index (CI) is the ratio of the Barron’s average yield on the “Best Grade Bonds” to the average yield on the Dow Jones “Intermediate Grade Bonds” list. It is a bullish indicator because during periods of high confidence, investors are willing to increase their investment in lower-quality bonds for the added yield, which causes a decrease in the yield spread between the intermediate-grade bonds and best grade bonds.

2. T-Bill-Eurodollar Yield Spread ▪

This spread widens as the smart money experiences a “flight to safety” and flows to safe-haven U.S. T-bills, which causes lower T-Bill yields and a decline in this ratio.

3. Debit Balances in Brokerage Accounts (Margin Debt) ▪

An increase in debit balances implies buying by these investors and is a bullish sign, while a decline in debit balances would indicate selling and is a bearish indicator.

5.7.3 Momentum Indicators 1. Breadth of Market (Exhibit 5.4) Advance-decline series measures the number of issues that have increased each day and the number of issues that have declined.

2. Stocks above Their 200-Day Moving Average ▪

The market is considered to be overbought and subject to a negative correction when more than 80 percent of the stocks are trading above their 200-day moving average. In contrast, if less than 20 percent of the stocks are selling above their 200-day moving average, the market is considered to be oversold, which means investors should expect a positive correction.

5.7.4 Stock Price and Volume Techniques 1. Dow Theory (Exhibit 5.5) ▪

Oldest technical trading rule - Major trends - tides - Intermediate trends - waves - Short-run trends – ripples 12 - 27

▪

Importance of Volume - Indicators of changes in supply and demand - Ratio of upside-downside volume as an indicator of short-term momentum

▪

Support and Resistance Levels (Exhibit 5.6) - A support level is the price range at which a technician would expect a substantial increase in the demand for a stock. - A resistance level is the price range at which the technician would expect an increase in the supply of stock and a price reversal.

▪

Moving-Average Lines (Exhibit 5.7) - For a bullish trend, the 50-day MA line should be above the 200-day MA line. - When the 50-day MA line is below the 200-day MA line, it would be a bearish environment.

▪

Relative Strength (Exhibit 5.8) - The RS ratio is equal to the price of a stock or an industry index divided by the value for some stock-market index, such as the S&P 500.

▪

Bar Charts - Plots the high and low prices and connects the two points vertically to form a bar - A small horizontal line across the vertical bar indicates the closing price.

▪

Candlestick Charts (Exhibit 5.9) - In addition to high, low, and closing prices for each trading day, they also include the opening and closing price and indicate the change from open to close by shading whether the market or individual stock went down (black shading) or up (white bar) for the day.

▪

Multiple Indicator Charts - It is fairly typical for technical charts to contain several indicators that can be used together.

▪

Point-and-Figure Charts (Exhibit 5.10) - A point-and-figure chart includes only significant price changes, regardless of their timing.

5.7.5 Efficient Markets and Technical Analysis ▪ ▪

The assumptions of technical analysis directly oppose the notion of efficient markets. If the capital market is weak-form efficient, as indicated by most of the results, 12 - 28

then prices fully reflect all relevant market information, so technical trading systems that depend only on past trading data cannot have any value. CHAPTER 6 AN INTRODUCTION TO PORTFOLIO MANAGEMENT

6.1 Some Background Assumptions ▪ Investors want to maximize the returns from the total set of investments for a given level of risk. ▪ Portfolio should include all assets and liabilities. ▪ The full spectrum of investments must be considered because the returns from all these investments interact—this relationship among the returns for assets in the portfolio is important.

6.1.1 Risk Aversion ▪ ▪ ▪

Portfolio theory assumes that investors are risk averse. Given a choice between two assets with equal rates of return, most investors will select the asset with the lower level of risk. Combination of risk preference and risk aversion can be explained by an attitude toward risk that depends on the amount of money involved.

6.1.2 Definition of Risk ▪ Uncertainty of future outcomes ▪ Probability of an adverse outcome 6.2 The Markowitz Portfolio Theory ▪ The Markowitz model assumptions: 1. Investors consider each investment alternative as being represented by a probability distribution of potential returns over some holding period. 2. Investors maximize one-period expected utility, and their utility curves demonstrate diminishing marginal utility of wealth. 3. Investors estimate the risk of the portfolio on the basis of the variability of potential returns. 4. Investors base decisions solely on expected return and risk, so their utility curves are a function of expected return and the variance (or standard deviation) of returns only. 5. For a given risk level, investors prefer higher returns to lower returns. Similarly, for a given level of expected return, investors prefer less risk to more risk.

12 - 29

▪

Under these assumptions, a single asset or portfolio of assets is considered to be efficient if no other asset or portfolio of assets offers higher expected return with the same (or lower) risk or lower risk with the same (or higher) expected return.

6.2.1 Alternative Measures of Risk ▪ ▪ ▪ ▪ ▪ ▪

Variance or standard deviation of expected returns Range of returns Downside risk Semi-variance Below zero (negative returns) Measures of risk implicitly assume that investors want to minimize the damage from returns less than some target rate.

6.2.2 Expected Rates of Return ▪

▪

Individual investment - Sum of the potential returns multiplied with the corresponding probability of the returns (Exhibit 6.1) Portfolio of investments - Weighted average of the expected rates of return for the individual investments in the portfolio (Exhibit 6.2)

6.2.3 Variance (Standard Deviation) of Returns for an Individual Investment ▪

A measure of the variation of possible rates of return from the expected rate of return (Exhibit 6.3)

6.2.4 Variance (Standard Deviation) of Returns for a Portfolio 1. Covariance of Returns ▪ Measure of the degree to which two variables move together relative to their individual mean values over time ▪ Magnitude of the covariance depends on the variances of the individual return series and on the relationship between the series. (Exhibits 6.4, 6.5, 6.6, 6.7, 6.8)

2. Covariance and Correlation ▪ Correlation coefficient is obtained by standardizing (dividing) the covariance by the product of the individual standard deviations (Exhibit 6.9). ▪ Correlation coefficient—can vary only in the range –1 to +1 ▪ Value of +1 would indicate perfect positive correlation—returns, for the two assets move together in a completely linear manner. 12 - 30

▪

A value of –1 would indicate perfect negative correlation—returns, for the two assets have the same percentage movement, but in opposite directions

6.2.5 Standard Deviation of a Portfolio 1. Portfolio Standard Deviation Formula ▪ Standard deviation for a portfolio of assets is a function of the weighted average of the individual variances (in which the weights are squared), plus the weighted covariances between all the assets in the portfolio. a. Impact of a New Security in a Portfolio ▪ The important factor to consider when adding an investment to a portfolio that contains a number of other investments is not the new security’s own variance but the average covariance of this asset with all other investments in the portfolio. 2. Portfolio Standard Deviation Calculation ▪ Any asset or portfolio of assets can be described by two characteristics: the expected rate of return and the standard deviation of returns. a. Equal Risk and Return - Changing Correlations (Exhibit 6.10) - Diversification concept: the risk of the portfolio is lower than the risk of either of the assets held in the portfolio b. Combining Stocks with Different Returns and Risks (Exhibit 6.11) c. Constant Correlation with Changing Weights (Exhibit 6.12) - The benefits of diversification are critically dependent on the correlation between assets.

6.2.6 A Three-Asset Portfolio ▪

Shows the dynamics of the portfolio formation process when assets are added and the rapid growth in the computations is required

6.2.7 Estimation Issues ▪

▪

For every asset (or asset class) being considered for inclusion in the portfolio, estimate: - Expected return and standard deviation - The correlation coefficient among the entire set of assets The potential source of error that arises from these approximations is referred to as estimation risk.

6.3 The Efficient Frontier 12 - 31

▪ ▪

▪

Set of risk-minimizing portfolios for each potential expected return goal is called the efficient frontier. The efficient frontier represents that set of portfolios that has the maximum rate of return for every given level of risk or the minimum risk for every level of return (Exhibit 6.13). The slope of efficient frontier curve decreases steadily as you move upward. This implies that adding equal increments of risk as you move up the efficient frontier gives you diminishing increments of expected return.

6.3.1 The Efficient Frontier: An Example ▪

The process works best when determining an investor’s optimal asset allocation strategy, in which the number of possible asset classes is smaller (Exhibits 6.14 and 6.15).

6.3.2 The Efficient Frontier and Investor Utility ▪ ▪ ▪ ▪

An investor will target a point along the efficient frontier based on utility function, which reflects attitude toward risk. In conjunction with the efficient frontier, utility curves determine which particular portfolio on the efficient frontier best suits an individual investor. The best portfolio is the mean-variance efficient portfolio that has the highest utility for a given investor. Lies at the point of tangency between the efficient frontier and the curve with the highest possible utility (Exhibit 6.16)

6.4 Capital Market Theory: An Overview ▪ Extends the Markowitz efficient frontier into a model for valuing all risky assets ▪ Market portfolio, a collection of all available risky assets

6.4.1 Background for Capital Market Theory ▪

Assumptions of Capital Market Theory: 1. All investors seek to invest in portfolios representing tangent points on the Markowitz efficient frontier. 2. Investors can borrow or lend any amount of money at the risk-free rate of return. 3. All investors have homogeneous expectations. 4. All investors have the same one-period time horizon. 5. All investments are infinitely divisible. 6. There are no taxes or transactions costs. 7. There is no inflation or change in the interest rates, or inflation is fully anticipated. 8. Capital markets are in equilibrium.

12 - 32

6.4.2 Developing the Capital Market Line ▪

A risky asset is one from which future returns are uncertain. 1. Covariance with a Risk-Free Asset ▪ Covariance of the risk-free asset with any risky asset or portfolio of assets will always equal zero. ▪ Correlation between any risky asset and the risk-free asset would also be zero. 2. Combining a Risk-Free Asset with a Risky Portfolio a. Expected Return ▪ Expected rate of return for a portfolio that combines a risk-free asset with a collection of risky assets (call it Portfolio M) is the weighted average of the two returns b. Standard deviation ▪ The standard deviation of a portfolio that combines the risk-free asset with risky assets is the linear proportion of the standard deviation of the risky asset portfolio. c. The Risk-Return Combination ▪ Investors who allocate their money between a riskless security and the risky Portfolio M can expect a return equal to the risk-free rate plus compensation for the number of risk units they accept. 3. The Capital Market Line ▪ There are various possibilities when a risk-free asset is combined with alternative risky combinations of assets along the Markowitz efficient frontier (Exhibit 6.17). ▪ The CML represents a new efficient frontier that combines the Markowitz efficient frontier of risky assets with the ability to invest in the risk-free security. ▪ The slope of the CML is the maximum risk premium compensation that investors can expect for each unit of risk they bear. 4. Risk–Return Possibilities with Leverage ▪ The range of portfolio possibilities can be extended by borrowing at the riskfree rate and investing the proceeds in the risky portfolio M (Exhibit 6.18).

6.4.3 Risk, Diversification, and the Market Portfolio ▪ ▪

▪

Market portfolio M is a completely diversified portfolio. Unique or unsystematic risk - Any single asset is completely offset by the unique variability of all of the other holdings in the portfolio. Systematic risk 12 - 33

The variability in all risky assets caused by market-wide variables Only systematic risk remains in the market portfolio M.

1. Diversification and the Elimination of Unsystematic Risk ▪ ▪ ▪

A well-diversified portfolio must contain at least 30–40 stocks (Exhibit 6.19) Overall standard deviation of the portfolio is reduced by adding to a portfolio new stocks that are not perfectly correlated with stocks already held. A lower level of systematic risk can be attained by diversifying globally.

2. The CML and the Separation Theorem ▪ ▪ ▪

The decision to invest in the market portfolio is the investment decision. The decision to borrow or to lend, based on personal risk preferences, in order to attain the preferred risk position on the CML is the financing decision. Tobin (1958) called this division of the investment decision from the financing decision the separation theorem.

3. A Risk Measure for the CML ▪ ▪

The relevant risk to consider when adding a security to a portfolio is its average covariance with all other assets in the portfolio. The only important consideration for any individual risky asset is its average covariance with all the risky assets in Portfolio M or the asset’s covariance with the market portfolio.

6.4.4 Investing with the CML: An Example Investment characteristics for six different combinations of risky assets (Exhibit 6.20) CHAPTER 7 ▪

ASSET PRICING MODELS

7.1 The Capital Asset Pricing Model ▪ Model extends capital market theory in a way that allows investors to evaluate the risk-return tradeoff for both diversified portfolios and individual securities. ▪ New risk measure is called the beta coefficient.

7.1.1 A Conceptual Development of the CAPM ▪ ▪

Conceptual development of the model emphasizes its role in the natural progression that began with the Markowitz portfolio theory. The CAPM redefines risk in terms of a security’s beta, which captures the 12 - 34

▪ ▪

nondiversifiable portion of that stock’s risk relative to the market as a whole. Beta can be thought of as indexing the asset’s systematic risk to that of the market portfolio. The CAPM states that only the overall market risk premium matters and that this quantity can then be adapted to any risky asset by scaling it up or down according to that asset’s riskiness relative to the market. 7.1.2 The Security Market Line

▪

The CAPM can also be illustrated in graphical form as the security market line (SML) (Exhibit 7.1).

1. Determining the Expected Rate of Return for a Risky Asset ▪ Determined by the risk-free rate plus a risk premium for the individual asset ▪ In equilibrium, all assets and all portfolios of assets should plot on the SML. ▪ All assets should be priced so that their estimated rates of return are consistent with their levels of systematic risk. ▪ Assets with estimated rates of return that plot above the SML would be considered undervalued. ▪ Assets with estimated rates of return that plot below the SML would be considered overvalued. 2. Identifying Undervalued and Overvalued Assets (Exhibits 7.2, 7.3, 7.4) ▪ Difference between estimated return and expected return is sometimes referred to as a stock’s expected alpha or its excess return. ▪ This alpha can be positive (the stock is undervalued) or negative (the stock is overvalued). ▪ If the alpha is zero (or nearly zero), the stock is on the SML and is properly valued in line with its systematic risk. 3. Calculating Systematic Risk a. The Impact of the Time Interval ▪ In practice, the number of observations and the time interval used in the calculation of beta vary widely. ▪ The major cause for the differences in beta is the use of monthly versus weekly return intervals. ▪ The shorter weekly intervals cause a larger beta for large firms and a smaller beta for small firms. b. The Effect of the Market Proxy ▪ The choice of the indicator series used as the market proxy makes a difference. 4. Computing a Characteristic Line: An Example (Exhibits 7.5, 7.6, 7.7) 12 - 35

5. Industry Characteristic Lines ▪ Characteristic lines can also be calculated for entire portfolios of stocks, such as market or sector indexes (Exhibit 7.8). 7.2 Empirical Tests of the CAPM ▪ How stable is the measure of systematic risk (beta)? ▪ Is there a positive linear relationship as hypothesized between beta and the rate of return on risky assets? 7.2.1 Stability of Beta ▪

▪

Beta was not stable for individual stocks but was stable for portfolios of stocks.

7.2.2 Relationship Between Systematic Risk and Return Black, Jensen, and Scholes (1972) examined the risk and return for portfolios of stocks and found a positive linear relationship between monthly excess return and portfolio beta, although the intercept was higher than zero (Exhibit 7.9).

1. Effect of a Zero-Beta Portfolio ▪ The characteristic line using a zero-beta portfolio instead of RFR should have a higher intercept and a lower slope coefficient. 2. Effect of Size, P/E, and Leverage ▪ Variables have an inverse impact on returns after considering the CAPM. ▪ Financial leverage also helps explain the cross-section of average returns after both beta and size are considered. 3. Effect of Book-to-Market Value ▪ Fama and French (1992) evaluated the joint roles of market beta, size, E/P, financial leverage, and the book-to-market equity ratio in the cross section of average returns on the NYSE, AMEX, and NASDAQ stocks. ▪ Concluded that size and book-to-market equity capture the cross-sectional variation in average stock returns 7.2.3 Additional Issues 1. Effect of Transaction Costs ▪ Transaction costs can reduce the slope of an asset pricing model. 2. Effect of Taxes ▪ The expected returns in the CAPM are pretax returns. 12 - 36

▪

This could cause major differences in the SML among investors.

7.2.4 Summary of Empirical Results for the CAPM ▪ There is now extensive evidence that size, the P/E ratio, financial leverage, and the book-to-market value ratio have explanatory power regarding returns beyond beta. ▪ Kothari, Shanken, and Sloan (1995) measured beta with annual returns and found substantial compensation for beta risk. Suggested that the results obtained by Fama and French may have been time-period specific. ▪ Jagannathan and Wang (1996) employed a conditional CAPM that allows for changes in betas and in the market risk premium. This model performed well in explaining the cross section of returns. ▪ Reilly and Wright (2004) examined the performance of 31 different asset classes with betas computed using a broad market portfolio proxy; the risk–return relationship was significant and as expected by theory. 7.3 The Market Portfolio: Theory versus Practice ▪ An incorrect market proxy will affect both the beta risk measure and the position and slope of the SML that is used to evaluate portfolio performance. ▪ Benchmark error: if benchmark is incorrectly specified, performance of a portfolio manager cannot be measured properly ▪ Effects for a misspecified market portfolio (Exhibits 7.10, 7.11) ▪ Benchmark problems do not invalidate the CAPM as a normative model of asset pricing; they only indicate a problem in measurement when attempting to test the theory and when using this model for evaluating portfolio performance. 7.4 Arbitrage Pricing Theory ▪ APT developed by Ross (1976, 1977) as an alternative to the Capital Asset Pricing Model ▪ Assumptions: - Capital markets are perfectly competitive. - Investors always prefer more wealth to less wealth with certainty. - The process of generating asset returns can be expressed as a linear function of a set of K risk factors (or indexes) and all unsystematic risk is diversified away. 7.4.1 Using the APT ▪ ▪

The primary challenge with using the APT in security valuation is identifying the risk factors. If the prices of the two assets do not reflect expected returns, expect investors to enter into arbitrage arrangements selling overpriced assets short and using the proceeds to purchase the underpriced assets until the relevant prices are corrected. (Exhibits 7.12, 7.13) 7.4.2 Security Valuation with the APT: An Example

▪

The idea of riskless arbitrage is to assemble a portfolio that: 12 - 37

Requires no net wealth invested initially Will bear no systematic or unsystematic risk Earns a profit

7.4.3 Empirical Tests of the APT 1. Roll and Ross Study: - Authors concluded that the evidence generally supported the APT but acknowledged that their tests were not conclusive. 2. Extensions of the Roll-Ross Tests - Cho, Elton, and Gruber (1984) - Dhrymes, Friend, and Gultekin (1984) - Ross and Ross (1984) - Connor and Korajczyk (1993) - Harding (2008) 3. The APT and Stock Market Anomalies - APT and the Small Firm Effect - APT and the January Effect 4. Is the APT Even Testable? - Shanken’s challenge to the testability of the APT - Alternative Techniques for Testing the APT 7.5 Multifactor Models and Risk Estimation ▪ Primary practical problem in implementing the APT is that neither the identity nor the exact number of underlying risk factors are developed by theory and therefore must be specified in an ad hoc manner. ▪ A different approach to developing an empirical model that captures the essence of the APT relies on the direct specification of the form of the relationship to be estimated. ▪ In a multifactor model, the investor chooses the exact number and identity of risk factors. 7.5.1 Multifactor Models in Practice 1. Macroeconomic-Based Risk Factor Models (Exhibits 7.14, 7.15) ▪ Burmeister, Roll, and Ross (1994) defined the following risk exposures: - Confidence risk - Time horizon risk - Inflation risk - Business cycle risk - Market-timing risk 2. Microeconomic-Based Risk Factor Models (Exhibit 7.16) ▪ Specify risk in microeconomic terms using proxy variables that concentrate on certain characteristics of the underlying sample of securities 12 - 38

3. Extensions of Characteristic-Based Risk Factor Models (Exhibits 7.17, 7.18) ▪ Defining systematic risk exposures by using index portfolios as common factors 7.5.2 Estimating Risk in a Multifactor Setting: Examples 1. Estimating Expected Returns for Individual Stocks (Exhibit 7.19) ▪ The following steps must be taken: - A specific set of common risk factors (or their proxies) must be identified. - The risk premia for the factors must be estimated. - The sensitivities of the ith stock to each of those K factors must be estimated. - The expected returns can be calculated by combining the results of the previous steps. 2. Comparing Mutual Fund Risk Exposures (Exhibits 7.20, 7.21, 7.22) ▪ Fidelity’s Contrafund versus T. Rowe Price’s Mid-Cap Value Fund - Differ substantially in their systematic risk - The multi-factor model gives a much better sense of how the risk exposures of the two funds actually differ from each other. - Some of the risk that the market beta is measuring in the single-factor model is better attributed to the size or value-growth risk factors. - Differ with in their sensitivity to the HML and SMB risk factors CHAPTER 8 EQUITY VALUATION

8.1

Important Distinctions ▪ Investment is a commitment of funds for a period of time to derive a rate of return that would compensate the investor for the time during which the funds are invested, for the expected rate of inflation during the investment horizon, and for the uncertainty involved.

8.1.1 Fairly Valued, Overvalued, and Undervalued ▪

▪

Overvalued o Investments so expensive that investor will not receive a fair return if they buy them Undervalued o Investments that offer a rate of return that is a greater reward than the risk that the investor has taken

8.1.2 Top-Down Approach versus Bottom-Up Approach ▪

Top-down approach (Exhibit 8.1) 12 - 39

− − − ▪

The overall market and economy The industry The individual company

Bottom-up approach − Possible to find stocks that are undervalued and will provide superior returns regardless of the market and industry outlook

1. Does the Three-Step Process Work? ▪ Results from several academic studies support the use of the three-step investment process 8.2

An Introduction to Discounted Cash Flow and Relative Valuation ▪ Discounted cash flow analysis and relative valuation ▪ Intrinsic value ▪ Free cash flow to the firm (FCFF) valuation ▪ Weighted average cost of capital (WACC) analysis ▪ Free cash to equity (FCFE) model ▪ Dividend discount model (DDM)

8.2.1 The Foundations of Discounted Cash Flow Valuation ▪

Valuation of a financial asset: - Identify the cash flows that the asset will generate - Discount those cash flows to account for their riskiness

8.2.2 The Constant Growth Model (Gordon growth model) (Exhibit 8.2) ▪

Assumptions of the infinite period DDM: - Cash flow is a growing perpetuity. - The required rate of return (k) is greater than the infinite growth rate (g).

▪

Key takeaways: - If the cash flow is larger (because the company has higher earnings or can pay out a larger percentage of earnings), then the intrinsic value is greater. - If the cash flow is less risky, then it is discounted at a lower cost of equity (k), and the intrinsic value is greater. - If the cash flow grows at a faster rate (g), then the stock will be more valuable. - Model assumes that a company is relatively mature and in a steady state. - Growth rate reflects an average growth rate for the long term. - Growth rate for a large company is capped at the growth rate of the economy. - The highest economic growth rate that can be used is the nominal growth rate.

▪

Uses: - A general estimate of value - The basis for understanding fundamental multiples - The terminal value of a model 12 - 40

1. An Example of Using the Constant Growth Model to Estimate Value

8.2.3 The No-Growth Model (Exhibit 8.3) ▪ ▪

Assumption is that a company’s cash flows are not growing. Growth rate is zero

1. 100 Percent Payout ▪ Assumption is that a company can pay out all of its earnings

8.2.4 Multistage (or Two Stage) Growth Assumption (Exhibit 8.4) ▪ ▪

8.3

Assumption is that a company will frequently have different growth rates for time periods. The two-stage model can also be considered formulaically as PV of Abnormal Growth plus PV of Constant Growth.

Discounted Cash Flow

8.3.1 Method #1: The Dividend Discount Model (DDM) ▪ ▪

The numerator is next year’s dividend. The discount rate in the denominator is the cost of equity. .22

1. Constant Growth Examples ▪ Sometimes given the percentage of earnings that can be paid out (the payout ratio), while other times given the percentage of earnings that must be retained (known as the retention ratio or plowback ratio). 2. No-Growth Examples 3. Present Value of the Growth Opportunity (PVGO), Using Both the Constant Growth Model and the No-Growth Model ▪ The PVGO represents the portion of a stock’s intrinsic value that is attributable to the company’s growth. ▪ Calculated in three steps: − Calculate the intrinsic value of the stock − Calculate the no-growth value of the stock − Calculate the PVGO by subtracting the no-growth value from the intrinsic value

▪

PVGO as a Risk Factor − PVGO calculation is crucial in helping analysts understand the significance of growth in valuations.

▪

PVGO Can Be Negative 12 - 41

−

Value is created by earning more on capital than the capital costs.

4. Two-Stage DDM (Exhibit 8.5) − Analyst may assume two or three stages of growth or even irregular growth for some time period.

8.3.2 Method #2: Free Cash Flow to Equity—The Improved DDM (Exhibits 8.6, 8.7, 8.8) ▪

▪ ▪ ▪ ▪

Goal is to determine the free cash flow that is available to the stockholders after payments to all other capital suppliers and after providing for the continued growth of the firm. o Forecast: o Sales growth o Profit margin o Return on equity o Cost of equity o Solve sustainable growth rate equation for the plowback (the retention rate) Returning to DDM and PVGO o Calculate PVGO Framing Your Research o Valuation method helps to frame research What if the Stock Is Trading at Intrinsic Value? o Compensation is cost of equity FCFE for a Bank (Exhibit 8.9): o Forecast: o Asset growth o Return on asset o Return on equity o Cost of equity

8.3.3 Method #3: Discounted Cash Flow (FCFF) ▪ Discounted cash flow (DCF) or the weighted average cost of capital (WACC) approach 1. Steps in Calculating Free Cash Flow to the Firm (Exhibits 8.10, 8.11, 8.12, 8.13) ▪ Forecast the sales ▪ Forecast the operating profits ▪ Forecast the taxes as a percentage of the operating profit ▪ Calculate the net operating profit after taxes (NOPAT) ▪ Add back depreciation ▪ Subtract the capital expenditures ▪ Subtract the investment in additional net working capital (NWC) ▪ Calculate the free cash flow to the firm ▪ Calculate the weighted average cost of capital (the discount rate) ▪ Calculate the terminal value at the end of Year 5 ▪ Discount all of the free cash flow back to the present ▪ Sum the present values ▪ Add the value of any nonoperating assets 12 - 42

▪ ▪ ▪ ▪

Add the value of any excess cash Subtract the value of debt Subtract any other debt that was not captured by the DCF analysis Calculate the value of the equity on a per share basis 2. Putting Together the FCFF Model (Exhibit 8.14) 3. Why Didn’t the FCFF Model Value Equal the FCFE Model Value? (Exhibit 8.15) ▪ Assign values to debt based on the weights used in the WACC 8.4

Relative Valuation ▪ Multiples are typically used in one of the following ways: o Comparing multiples to comparable companies o Comparing a stock multiple to the market multiple o Comparing a stock’s multiple to its historic multiple o Comparing a stock’s multiple to recent transactions ▪ Equity multiples o Use to value the equity portion of the firm ▪ Trailing multiples o Use an underlying fundamental metric from the year that just ended ▪ Forward multiple o Use the expected earnings for the next year

8.4.1 Implementing Relative Valuation Step 1: Find Comparable Companies ▪ Common approach is to ask how they are different from a business risk perspective and financial risk perspective. Step 2: Determine the Appropriate Multiple ▪ Understand what multiples other analysts use ▪ Determine what underlying metric seems to move a stock Step 3: Apply the Multiple ▪ Fundamental multiples: Price–Earnings, Price–Sales, Price–Book ▪ How to Remember Fundamental Multiples o Understand how underlying fundamentals should drive these multiples 8.4.2 Relative Valuation with CSCO 8.4.3 Advantages of Multiples ▪ Easy to use ▪ For a money manager with a mandate to be fully invested, relative value is what matters. ▪ Relative value also incorporates sentiment. ▪ Confirm the value calculated with discounted cash flow analysis 8.4.4 Disadvantages of Multiples ▪ Difficult to use correctly - must find truly comparable companies, must make adjustments when using multiples ▪ Significant assumption when you conclude that the one stock is incorrectly priced. It is possible that the other stocks may be mispriced. 8.5

Ratio Analysis 12 - 43

▪

Helps make better estimates for discounted cash flow model and to better understand the business

8.5.1 Growth Rate of Sales 8.5.2 Gross Margins 8.5.3 Operating Margins 8.5.4 Net Margins 8.5.5 Accounts Receivable Turnover 8.5.6 Inventory Turnover 8.5.7 Net PP&E Turnover 8.5.8 Debt as a Percentage of Long-Term Capital 8.5.9 Changes in Reserve Accounts 8.5.10 Operating Earnings/GAAP Earnings 8.6 The Quality of Financial Statements 8.6.1 Balance Sheet ▪ A high-quality balance sheet typically has limited use of debt or leverage. 8.6.2 Income Statement ▪ High-quality earnings are repeatable earnings. 8.6.3 Footnotes ▪ Read the footnotes! (read an annual report backward) 8.7

Moving onto Chapter 9 ▪ Chapter 9 examines the top-down approach to investing.

CHAPTER 9 THE TOP-DOWN APPROACH TO MARKET, INDUSTRY, AND COMPANY ANALYSIS Introduction to Market Analysis (Exhibits 9.1, 9.2, 9.3) ▪ The macroanalysis of the relationship between the aggregate securities market and the aggregate economy ▪ The specific microvaluation of the stock market 9.2

Aggregate Market Analysis (Macroanalysis) ▪ A strong relationship exists between the economy and the stock market, and stock prices consistently turn before the economy does. ▪ Stock market as a leading indicator - Stock prices reflect expectations of earnings, dividends, and interest rates. - Stock market reacts to various leading indicator series. - Stock prices consistently turn before the economy does. 9.2.1 Leading, Coincident, and Lagging Indicators ▪ Cyclical indicator approach to monitoring and forecasting the economy 12 - 44

▪

This approach contends that the aggregate economy expands and contracts in discernable periods.

1. Leading indicators ▪ Economic series that usually reach peaks or troughs before corresponding peaks or troughs in aggregate economy activity (Exhibits 9.4, 9.5) 2. Coincident indicators ▪ Economic series that have peaks and troughs that roughly coincide with the peaks and troughs in the business cycle (Exhibits 9.6, 9.7) 3. Lagging indicators ▪ Economic series that experience their peaks and troughs after those of the aggregate economy (Exhibits 9.8, 9.9, 9.10) ▪

Conference Board acknowledges the following limitations: - False signals - Timeliness of the data and revisions - Economic sectors not represented

9.2.2 Sentiment and Expectations Surveys ▪ The University of Michigan Consumer Sentiment Index (Exhibit 9.11) ▪ The Conference Board Consumer Confidence Index 9.2.3 Interest Rates ▪ The final approach to tracking the economy is to follow interest rates 1. The real federal funds rate (Exhibit 9.12) 2. The yield curve (the term spread) (Exhibit 9.13) 3. The risk premium between Treasury bonds and BBB bonds (Exhibit 9.14) 4. The Fed model (Exhibit 9.15) 9.3

Microvaluation Analysis 9.3.1 FCFE to Value the Market ▪ Market valuation by using a constant growth model 1. Cash Flows (Exhibits 9.16, 9.17) - Growth Rate of Sales per Share - Operating Margin - Interest Expense - Tax Rate 2. The Discount Rate (Exhibit 9.18) 9.3.2 Multiplier Approach 1. P/E Multiple (Exhibit 9.19) ▪ In order to use a price–earnings multiple approach, an analyst needs to estimate two variables: the earnings per share and the multiplier. 12 - 45

▪

In order to estimate the multiplier, an analyst needs to estimate: - The growth rate - The cost of capital - The return on equity -

9.3.3 Shiller P/E Ratio (Exhibit 9.20 ▪ Another methodology for valuing the overall market is the Shiller P/E ratio, also known as the cyclically adjusted price–earnings (CAPE) multiple. 9.3.4 Macrovaluation and Microvaluation of World Markets ▪ The basic valuation model and concepts apply globally. ▪ While the models and concepts are the same, the input values can and will vary dramatically across countries, which means that values will differ and opportunities will differ. ▪ The valuation of nondomestic markets will almost certainly be more onerous because of several additional variables or constraints that must be considered. ▪ It is also necessary to consider country or political risk, which can be very significant in many countries. ▪ Therefore, country risk must be evaluated and estimated when investing outside the United States. ▪ Due to the two added risk factors (exchange rate risk and country risk), the required rate of return on foreign securities will generally be higher than for domestic stocks. ▪ But it must be noted that these added risks can be offset by higher growth expectations, such as in China and in India. ▪ As money management becomes more global and industry analysis requires global constituents, there is a need to evaluate stock markets and industries around the globe 9.4

Introduction to Industry Analysis: Why Industry Analysis Matters (Exhibit 9.21) ▪ The second step of top-down analysis is industry analysis. ▪ Four considerations in analyzing an industry: - How the business cycle impacts industries - Structural issues that impact industries - The life cycle of the industry - The competitive forces within an industry (Porter analysis)

9.5

Industry Analysis 9.5.1 The Business Cycle and Industry Sectors ▪ The business cycle refers to the period of time from which an economy’s output of goods and services peaks, contracts (in a recession), recovers from the prior expansion to reach the prior peak (recovery), and then grows further (expansion). ▪ Different industries tend to perform well or poorly in different parts of the business cycle

12 - 46

▪

Some investors try to engage in sector rotation, in which they monitor economic trends and attempt to move their investments from one sector (or industry within a sector) to another sector (or industry) as economic trends change. - Financial stocks - Consumer durable goods - Capital goods - Cyclical companies - Consumer staples

9.5.2 Structural Economic Changes Impact the Industry (Noncyclical Factors) ▪ As an analyst studies an industry, he has to search for major changes in the economy and how it functions. Four categories of changes: 1. Demographics 2. Lifestyles 3. Technology 4. Politics and Regulation 9.5.3 Industry Life Cycle ▪ Insight can be gained from viewing the industry over time and dividing its development into stages (Exhibits 9.22, 9.23). ▪ Five Stage Model - Pioneering Development - Rapid Accelerating Growth - Mature Growth - Stabilization and market maturity - Deceleration of growth and decline 9.5.4 Industry Competition (Exhibits 9.24, 9.25) ▪ Michael Porter’s concept of competitive strategy is described as the search by a firm for a favorable competitive position in an industry. ▪ To create a profitable competitive strategy, a firm must first examine the basic competitive structure of its industry. ▪ Porter’s Five Competitive Forces - Rivalry among the existing competitors - Threat of new entrants - Threat of substitute products - Bargaining power of buyers - Bargaining power of suppliers 9.6

Estimating Industry Rates of Return 9.6.1 Estimating the Cost of Capital ▪ Use capital asset pricing model or consider all of the significant risks: business risk, financial risk, liquidity risk, exchange rate risk, and country risk (Exhibit 9.26) 12 - 47

9.6.2 Sales Growth Estimates ▪ Three approaches: - Time series analysis - Input/output analysis - Industry–economy relationship 9.6.3 Other Considerations ▪ Difficult to apply regression and time-series analysis ▪ The industry tax rate may be vastly different from the overall market tax rate. ▪ Relative valuation often involves comparing the industry multiple to the market multiple. ▪ Always understand the underlying fundamentals that drive a multiple ▪ It’s always important to ask why the market views an industry in a particular way. 9.7

Global Industry Analysis ▪ Global industry analysis is growing in importance, as documented by Cavaglia, Brightman, ▪ and Aked (2000). ▪ Study presented evidence that industry factors have been growing in importance and currently dominate country factors. ▪ It is important to carry out industry analysis on a global scale.

9.8

Company Analysis 9.8.1 Growth Companies and Growth Stocks ▪ Growth companies are those that consistently experience above-average increases in sales and earnings. ▪ Growth stocks are stocks with a higher expected rate of return than other stocks in the market with similar risk characteristics. ▪ An undervalued stock has an intrinsic value (estimated by alternative valuation models) that is greater than its current market price. 9.8.2 Defensive Companies and Stocks ▪ Defensive companies are those whose future earnings are likely to withstand an economic downturn. ▪ Defensive stocks are those whose rate of return is not expected to decline during an overall market decline or decline less than the overall market. 9.8.3 Cyclical Companies and Stocks ▪ A cyclical company’s sales and earnings will be heavily influenced by aggregate business activity. ▪ Stock will experience changes in its rates of return greater than changes in overall market rates of return. 12 - 48

9.8.4 Speculative Companies and Stocks ▪ Speculative companies are those whose assets involve great risk but those that also have a possibility of great gain. ▪ Speculative stocks possess a high probability of low or negative rates of return and a low probability of normal or high rates of return. 9.8.5 Value versus Growth Investing ▪ Value investing involved identifying and investing in stocks that appear to be undervalued for reasons other than earnings growth potential. ▪ Growth stock investing involves identifying and investing in the stock of companies that are experiencing rapid growth of sales and earnings. Connecting Industry Analysis to Company Analysis

9.9

9.9.1 Firm Competitive Strategies ▪ Defensive or offensive competitive strategies - Defensive strategy involves positioning a firm so that it its capabilities provide the best means to deflect the effect of competitive forces in the industry. - Offensive strategy involves using the company’s strength to affect the competitive industry forces, thus improving the firm’s relative industry position. 1. Low-Cost Strategy ▪ Firm is determined to be the low-cost producer, and hence the cost leader in its industry. 2. Differentiation Strategy ▪ Firm positions itself as unique in the industry. 3. Focusing a Strategy (Exhibit 9.27) ▪ Whichever strategy it selects, a firm must determine where it will focus this strategy. ▪ A firm must select segments in the industry and tailor its strategy to serve these specific groups. 9.9.2 SWOT Analysis ▪ Strengths – give the firm a comparative advantage in the marketplace ▪ Weaknesses –when competitors have potentially exploitable advantages over the firm ▪ Opportunities – environmental factors that could favor the firm ▪ Threats – environmental factors that could hinder the firm in achieving its goals 9.10

Calculating Intrinsic Value 12 - 49

9.10.1 Some Additional Insights on Valuation—For Individual Companies ▪ Blindly using historic growth rates or margins is incorrect. ▪ When examining the sales of a company, always study how the sales mix is changing ▪ The growth rate of a company is going to be influenced by where the industry is in its life cycle, structural changes, industry competition, and economic trends. ▪ When looking at historic growth, always try to distinguish between organic growth and acquired growth. ▪ Remember what cost of equity represents ▪ When estimating the profit margin of a specific company, be sure to understand the competitive strategy (low cost or differentiation) ▪ Realize that it is important for you to have quarterly estimates for the next year ▪ When doing relative valuation, compare the company to its historic multiple, competitors in ▪ the industry, an overall industry multiple, and the market multiple 9.10.2 Analyzing Growth Companies ▪ A growth company is a company that has the opportunity to reinvest significant amounts of capital at rates of return that are higher than the firm’s cost of capital. ▪ Analyst must consider three issues: - The amount of capital invested in growth investments - The relative rate of return earned on funds retained - The time period for these growth companies ▪

Assumptions: - Earnings and dividends are growing at a constant rate. - The firm is investing larger and larger dollar amounts in projects that generate returns greater than their cost of capital. - The firm can do this for an infinite amount of time.

▪

Stock’s P/E ratio is a function of three factors: - The firm’s expected rate of growth of earnings per share - The stock’s required rate of return - The firm’s dividend payout ratio

▪

The growth duration model is based on two assumptions: - Equal risk between the firms that you’re analyzing - No significant differences in the payout ratios The growth duration model answers the question of how long the earnings of the growth stock must grow at this expected high rate, relative to the nongrowth stock, to justify its prevailing above-average P/E ratio (Exhibit 9.28).

▪

1. An Alternative Use of T 2. Factors to Consider 12 - 50

9.11

Lessons from Some Legends

9.11.1 Some Lessons from Lynch ▪ ▪ ▪ ▪ ▪

Firm’s product should not be faddish. Firm should have some sustainable comparative advantage over its rivals. Firm’s industry or product has market stability. Firm can benefit from cost reductions. Firms buys back shares, or management purchases shares, which indicates that its insiders are putting their money into the firm.

9.11.2 Tenets of Warren Buffett 1. Business Tenets 2. Management Tenets 3. Financial Tenets 4. Market Tenets 9.11.3 Tenets of Howard Marks ▪ Howard Marks is the co-chair of Oaktree Capital Management. ▪ He recently used many of the ideas from his memos to write the book The Most Important Thing. ▪ Various important ideas from his book, including: - To be a successful investor, you must understand intrinsic value, be able to act when prices deviate from value, understand past cycles, understand how bad behavior can hurt you, and remember the idea that when things seem too good to be true, they are. CHAPTER 10

THE PRACTICE OF FUNDAMENTAL INVESTING

Initial Public Offerings 10.1.1 Why Go Public ▪

Advantages: - More capital to finance growth - Original investors and the management team would like liquidity. - Easier to use public stock as currency to acquire other companies - Publicly traded stock can be valuable compensation that is useful in attracting the best personnel. - Being public also brings a certain level of prestige. 12 - 51

▪

Publicly traded stock provides valuable signaling information concerning the health of the company, as well as how the market values decisions made by management.

Disadvantages: - Management has to answer to outside shareholders. - Management will spend significant time meeting with analysts to discuss the company and earnings. - Management may have to disclose more of its strategy than they prefer. - There are also direct costs, such as those associated with Sarbanes-Oxley compliance.

10.1.2 The IPO Process ▪ The investment bank can do the offering as a firm commitment or a best efforts offering ▪ Registration statement ( SEC Form S-1 or S-1) ▪ Preliminary prospectus also known as a red herring (See Exhibit 10.1) ▪ Once the offering has been deemed effective, the investment bank and the issuing firm have a pricing meeting. ▪ A successful offering is oversubscribed. ▪ For most offerings in the United States, the fee is 7 percent of the offering proceeds (gross spread or the underwriting spread) 10.1.3 Underpricing (Exhibit 10.2) ▪ Normally, the stock ends its first day of trading at a price that is higher than the IPO price. 10.1.4 Market Stabilization ▪ ▪ ▪

SEC allows the investment bank to help stabilize the price. The investment bank stabilizes the price by purchasing shares in the open market. Most offerings have an overallotment option (also known as the green shoe option).

10.1.5 Reasons for Underpricing ▪ Theories: - A way to compensate institutional investors for providing pricing information - Winner’s curse - to the extent that the investor trusts the banker to systematically underprice the security based on the best available information; the investor will again provide an accurate assessment of the value - Bankers believe that the issuing company’s managers estimate their personal wealth based on the midpoint of the initial range. - Bankers set prices low in order to minimize their litigation risk and/or to protect their reputational capital. - There is some evidence that investment banks receive “kickbacks” from allocating cheap IPOs to some clients. 12 - 52

10.1.6 Bookbuilt Offering versus Auction ▪ Underwriters “building a book” of offers to buy the stock ▪ An offering could be run as an auction in which investors can bid for shares at particular prices. ▪ Reasons That Auctions Are Not More Popular - Auctions are less profitable – gross spread is lower, bank loses discretion over the allocation - From investors’ perspective, an auction IPO may be less attractive because it allows uninformed retail investors to bid, which could eliminate some of the underpricing. - Ultimately, the company issuing the security drives the decision as to whether to hire a bank to conduct a bookbuilt offering or an auction. 10.1.7 Longer-Term Performance of IPOs (Exhibit 10.3) Buy-Side Analysts and Sell-Side Analysts 10.2.1 Sell-Side Analysts 1. How Does the Sell-Side Make Forecasts? 2. What Companies Does the Sell-Side Cover? 3. Why Does a Sell-Side Analyst Want to Be Known as the Best Analyst Within an Industry? 4. How Does the Sell-Side Get Paid? 5. Why Is It Difficult to Be a Sell-Side Analyst? 6. What Kind of Pressure Does Management Put on the Sell-Side? 7. What Does the Buy-Side Value Most About the Sell-Side? 10.2.2 Buy-Side Analysts 1. Does the Buy-Side Use Sell-Side Research? 2. In General, Does a Sell-Side Analyst or a Buy-Side Analyst Cover More Stocks? 3. Do Analysts Move from the Sell-Side to the Buy-Side? 4. What Are the Primary Reasons a Buy-Side Analyst Talks to a Sell-Side Analyst? How Does the Sell-Side Help the Buy-Side Understand What’s Going On with the Buy-Side? 5. What Does a Buy-Side Analyst Do? 6. How Are Buy-Side Analysts Compensated? 10.2.3 Financial Analyst Forecasting Literature 1. Sell-Side Research Clearly Matters 2. Analysts Obtain Much Value from Segment Reports 12 - 53

3. Sell-Side Analysts Tend to Rely On Multiples (for Valuation) More Than Discounted Cash Flow 4. Forecast Accuracy Seems to Improve with Experience and Decrease When an Analyst Follows Too Many Industries and Firms 5. As an Investor, It Is Particularly Interesting When There Is a Wide Dispersion of Analyst Forecasts 10.2.4 Snap Inc. IPO and Analysts Capital Allocation ▪ Capital allocation is the description of how management uses resources to create value on behalf of shareholders. 10.3.1 The Seven Places That Capital Can Be Allocated (Exhibit 10.4) ▪

Seven primary ways to allocate capital: 1. Mergers and Acquisitions 2. Capital Expenditures 3. Dividends 4. Research and Development 5. Share Repurchases 6. Net Working 7. Returning Cash to Debtholders

10.3.2 Dividends versus Repurchases ▪ ▪

Management should repurchase shares when they are trading below intrinsic value and pay a dividend when the shares are trading above intrinsic value. When the stock is trading at intrinsic value, management should be indifferent between a repurchase and a dividend.

10.3.3 What Do Investors Want to See? ▪ Ultimately, investors want to see management engaged in a process that truly indicates value creation. Corporate Governance ▪ Corporate governance refers to the rules, policies, and procedures that are used to direct and control a company. ▪ Institutional investors are integrating environmental, social, and governance (ESG) factors into their investment decisions. 10.4.1 The Board of Directors 1. CEO/Chair of the Board 2. Board Size 12 - 54

3. Board Independence 4. Board Compensation 5. Responses to Shareholder Proposals 10.4.2 Anti-Takeover Provisions ▪ Corporations can use many tools in order to prevent takeovers, including: - Poison pills - Requiring a supermajority of shareholder votes to approve selling the firm - Selling the most profitable part of the company - Staggered boards (so that it takes several years for an opponent to gain control of the board) 10.4.3 Compensation (Exhibits 10.5, 10.6) ▪ ▪

A highly controversial subject Compensation is often used to try to remedy the principal–agent conflict 1. Level of Compensation 2. How Compensation Is Set 3. Where to Find Compensation Information

Creating a Stock Pitch ▪ Pitching stocks is a crucial skill in both asset management and investment banking ▪ Normally includes: - Background information about the company - Merits - Model and multiples - Risks 10.5.1 Air Lease Pitch ▪ ▪ ▪ ▪

Background Information Merits Valuation Risks

10.5.2 A Few Closing Points Concerning Stock Pitches ▪ When doing a stock pitch, always remember that you are making an argument ▪ The tone of the pitch should convince the audience to buy the stock; it isn’t a book report or a news report. ▪ Make assertions and back them up with numbers ▪ Recognize that risks are real CHAPTER 11

12 - 55

EQUITY PORTFOLIO MANAGEMENT STRATEGIES

6.3 Passive versus Active Management (Exhibit 11.1) ▪ ▪ ▪ ▪ ▪ ▪

Passive equity portfolio management is a long-term buy-and-hold strategy. It is also known as indexing. Active equity portfolio management refers to attempts to outperform an equity benchmark on a risk-adjusted basis. The difference between the actual and expected return is called the portfolio’s alpha. Two main ways to try to add alpha: tactical adjustments or security selection skills Hedge funds are actively managed portfolios that often pursue a “pure alpha” (or absolute return) strategy. Trade-off between indexing versus active investing is higher management fees and trading costs: - Sharpe (1991) - higher expenses will always make active management the inferior alternative - Sorensen, Miller, and Samak (1998) - critical factor in this evaluation is the stock-picking skill of the portfolio manager, and optimal allocation to indexing declines as managerial skill increases - Alford, Jones, and Winkelmann (2003) - a disciplined approach to active management—which they term structured portfolio management—is likely to be the most effective method for investors - Harlow and Brown (2006) - active versus passive management decision for many investors comes down to their ability to identify superior managers in advance - Pastor, Stambaugh, and Taylor (2015) - active investment management industry has become more skilled over time

6.4 An Overview of Passive Equity Portfolio Management Strategies ▪ Passive equity portfolio management attempts to design a portfolio to replicate the performance of a specific index

11.2.1 Index Portfolio Strategy Construction Techniques ▪ ▪ ▪ ▪

Full replication Sampling Quadratic optimization or programming Completeness funds

11.2.2 Tracking Error and Index Portfolio Construction (Exhibit 11.2) ▪

The goal of the passive manager should be to minimize the portfolio’s return volatility relative to the index. The manager should try to minimize tracking error. 12 - 56

▪

Ammann and Zimmermann (2001) - tracking error can be defined as the extent to which return fluctuations in the managed portfolio are not correlated with return fluctuations in the benchmark Alford, Jones, and Winkelmann (2003) - tracking error can be a useful way to categorize a fund’s investment style

11.2.3 Methods of Index Portfolio Investing (Exhibits 11.3, 11.4) 1. Index Funds ▪ For an indexed portfolio, the fund manager will typically attempt to replicate the composition of the particular index exactly—will buy the exact securities comprising the index in their exact weights and then alter those positions anytime the composition of the index itself is changed. 2. Exchange-Traded Funds ▪ Depository receipts that give investors a pro rata claim on the capital gains and cash flows of the securities that are held in deposit by the financial institution that issued the certificates. 6.5 An Overview of Active Equity Portfolio Management Strategies (Exhibits

11.5, 11.6) ▪

▪

The goal of active equity management is to earn a portfolio return that exceeds the return of a passive benchmark portfolio, net of transaction costs, on a risk-adjusted basis. Brown and Goetzmann (1995) and Chen, Jegadeesh, and Wermers (2000) show that fund managers possess significant stock-picking skills that can translate into superior and persistent investment returns.

11.3.1 Fundamental Strategies (Exhibits 11.7, 11.8) ▪

▪ ▪

Top-down investment process begins with an analysis of broad country and asset class allocations and progresses down through sector allocation decisions to the bottom level, where individual securities are selected. A bottom-up process emphasizes the selection of securities without any initial market or sector analysis An tactical asset allocation shifts funds in and out of the stock market depending on the manager’s perception of how the stock market is valued compared to the various alternative asset classes A sector rotation strategy positions the portfolio to take advantage of the market’s next move. A 130/30 strategy takes long positions up to 130 percent of the portfolio’s original capital and have short positions of up to 30 percent.

12 - 57

11.3.2 Technical Strategies (Exhibits 11.9, 11.10)

▪ ▪

A contrarian investment strategy assumes that stock returns are mean reverting, indicating that, over time, stocks will be priced so as to produce returns consistent with their risk-adjusted expected (or, mean) returns A price momentum strategy assumes that stocks that have been hot will stay hot, while cold stocks will also remain cold

11.3.3 Factors, Attributes and Anomalies (Exhibits 11.11, 11.12) ▪

Factor investing - Manager forms portfolios that emphasize certain characteristics of a collection of securities are believed to produce higher risk-adjusted returns than those in a traditional benchmark that is weighted by the market capitalization of the stocks in the index, - Also known as a smart beta approach

▪

Earnings momentum strategy - Purchases stocks that have accelerating earnings and sells (or short sells) stocks with disappointing earnings

▪

Anomalies - Investment strategies can also be based on anomalies that are believed to occur in financial markets on a regular basis (the weekend effect, the January effect).

11.3.4 Forming Momentum-Based Stock Portfolios: Two Examples (Exhibit 11.13)

11.3.5 Tax Efficiency and Active Equity Management (Exhibit 11.14) ▪

▪ ▪

▪

Reichenstein (2006) and Horan and Adler (2009) note that many other investors need to worry about the tax efficiency of the active portfolio because this is an expense that they will ultimately bear. Portfolio turnover is an indirect measure of the amount of trading that could lead to a higher tax bill for a taxable investor. Tax cost ratio - compares a fund’s pretax return (PTR) with this same return adjusted for taxes (TAR), assuming that investors pay taxes on net short-term and long-term capital gains at the highest rate Expense ratio - includes all management, operating, and administrative fees as a percentage of the funds’ assets

12 - 58

11.3.6 Active Share and Measuring the Level of Active Management (Exhibit 11.15) ▪

Active share statistic - the percentage of security holdings in the manager’s portfolio that differ from those in the benchmark index

6.6 Value versus Growth Investing: A Closer Look (Exhibits 11.16, 11.17,

11.18, 11.19, 11.20) ▪

Growth Investing - A growth-oriented investor focuses on the current and future economic “story” of a company, with less regard for share valuation. - Focus on the EPS component (that is, the denominator) of the P/E ratio and its economic determinants - Often implicitly assume that the P/E ratio will remain constant over the near term, meaning that the stock price will rise as forecast earnings growth is realized

▪

Value Investing - A value-oriented investor focuses on share price in anticipation of a market correction and, possibly, improving company fundamentals. - Focus on the price component of the P/E ratio; must be convinced that the price of the stock is “cheap” by some means of comparison - Often implicitly assumes that the P/E ratio is below its natural level and that the market will soon “correct” this situation by increasing the stock price with little or no change in earnings

6.7 An Overview of Style Analysis (Exhibits 11.21, 11.22, 11.23) ▪ Style analysis - Attempts to explain the variability in the observed returns to a security portfolio in terms of the movements in the returns to a series of benchmark portfolios capturing the essence of a particular security characteristic - Determines the combination of long positions in a collection of passive indexes that best mimics the past performance of a security portfolio ▪ Style grid - Used to classify a manager’s performance along two dimensions: firm size (large cap, mid cap, small cap) and relative value (value, blend, growth) characteristics 6.8 Asset Allocation Strategies

11.6.1 Integrated Asset Allocation (Exhibits 11.24, 11.25) Separately examines capital market conditions and the investor’s objectives and constraints Factors are combined to establish the portfolio asset mix that offers the best opportunity 12 - 59

for meeting the investor’s needs.

11.6.2 Strategic Asset Allocation (Exhibit 11.26) Used to determine the long-term policy asset weights in a portfolio Typically, long-term average asset returns, risk, and covariances are used as estimates of future capital market results. Efficient frontiers are generated using this historical information, and the investor decides which asset mix is appropriate for his or her needs during the planning horizon. Results in a constant-mix asset allocation with periodic rebalancing to adjust the portfolio asset weights

11.6.3 Tactical Asset Allocation Frequently adjusts the asset class mix in the portfolio to take advantage of changing market condition Adjustments are driven solely by perceived changes in the relative values of the various asset classes Often based on the premise of mean reversion An inherently contrarian method of investing

11.6.4 Insured Asset Allocation Results in frequent adjustments in the portfolio allocation, assuming that expected market returns and risks are constant over time, while the investor’s objectives and constraints change as his or her wealth position changes Involves only two assets, such as common stocks and T-bills - As stock prices rise, the asset allocation increases the stock component - As stock prices fall, the stock component of the mix falls while the T-bill component increases. CHAPTER 12 BOND FUNDAMENTALS AND VALUATION

6.9 Basic Features of a Bond ▪ Public bonds - long-term, fixed-obligation debt securities packaged in convenient, affordable denominations for sale to individuals and financial institutions ▪

Issuer of a bond agrees to: - Pay a fixed amount of interest periodically to the holder - Repay a fixed amount of principal at the date of maturity

12 - 60

▪

Term to maturity - Short-term (money market) – 1 year or less - Intermediate-term (notes) – greater than 1 year but less than 10 years - Long-term (bonds) – greater than 10 years

12.1.1 Bond Characteristics 1. Intrinsic Features ▪ Coupon - The income that the bond investor will receive over the life (or holding period) of the issue - Interest income or coupon income ▪ Term to maturity – date or number of years before a bond matures - Term vs. serial obligation bond ▪ Principal or par value – the original value of the obligation ▪ Types of ownership - Bearer vs. registered bond 2. Types of Issues ▪ Secured (senior) bonds – backed by legal claim on some specified property - For example, mortgage bonds, equipment trust certificates, etc. ▪ Unsecured bonds (debentures) – backed only by the promise of the issuer to pay interest and principal on a timely basis ▪ Subordinate (junior) debentures – claim on income and assets that is subordinated to other debentures ▪ Income bonds (revenue bonds for municipal issues) – interest is paid only if earned 3. Indenture Provisions ▪ Contract between the issuer and the bondholder specifying the issuer’s legal requirements 4. Features Affecting a Bond's Maturity ▪ Call features - Freely callable, noncallable, deferred call - Call premium - amount above par value that the issuer must pay to the bondholder for prematurely retiring the bond ▪ Nonrefunding provision - prohibits a call and premature retirement of an issue from the proceeds of a lower-coupon refunding bond ▪ Sinking fund - specifies that a bond must be paid off systematically over its life 6.10

The Global Bond Market Structure (Exhibit 12.1) 12 - 61

12.2.1 Participating Issuers (Exhibit 12.2) 1. 2. 3. 4. 5.

Sovereigns Quasi-governments (Agencies) and Foreign Governments Securitized/Collateralized Issues Corporations High Yield/Emerging Market

12.2.2 Participating Investors

▪ ▪

Individual Investors Institutional Investors - Life insurance companies - Commercial banks - Property and liability insurance companies - Private and government pension funds - Fixed-income mutual funds

12.2.3 Bond Ratings

▪ ▪ ▪ ▪

12.3

Primary risk that a bondholder faces is that the borrower will not be able to pay the promised coupons and principal refunding. When this occurs, the borrower is said to be in default on the loan. Nearly all bonds are rated by professional analysts for the creditworthiness of the issuer. Exceptions are known as nonrated bonds. Rating agencies – major rating agencies are: Fitch Investors Service, Moody’s, and Standard & Poor’s (S&P) Description of bond ratings (Exhibit 12.3) - Investment-grade securities - Speculative bonds - Income obligations or revenue bonds - Default - High yield or “junk bonds”

Survey of Bond Issues

12.3.1 Domestic Government Bonds (Exhibit 12.4) 1. 2. 3. 4.

United States - Treasury Inflation Protected Securities (TIPS) (Exhibit 12.5) Japan - Japanese government bonds (JGBs) United Kingdom - Gilts Eurozone

12 - 62

12.3.2 Government Agency Issues (Exhibit 12.6)

▪

Agency securities are obligations issued by the government through either a specific agency or a government sponsored enterprise (GSE).

12.3.3 Municipal Bonds

▪ ▪ ▪ ▪

Types: general obligation bonds (GOs) and revenue bonds Tax-free interest Equivalent taxable yield (ETY) Municipal bond insurance – irrevocable over life of issue

12 - 63

12.3.4 Corporate Bonds (Exhibit 12.7) 1. U.S. Corporate Bond Market - includes utilities, industrials, rail and transportation, and financial issues ▪ Debentures ▪ First-mortgage issues ▪ Debentures ▪ Convertible obligations ▪ Bonds with warrants ▪ Subordinated debentures ▪ Income bonds (similar to municipal revenue bonds) ▪ Collateral trust bonds backed by financial assets ▪ Equipment trust certificates ▪ Asset-backed securities (ABS) - including mortgage-backed securities (MBS) ▪ Collateralized mortgage obligations (CMOs) ▪ Certificates for automobile receivables (CARs) ▪ Credit card–backed securities ▪ Collateralized debt obligations (CDOs) 12.3.5 Nontraditional Bond Coupon Structures

▪ ▪

Variable-rate (or floating-rate) notes Zero-coupon bonds

12.3.6 High-Yield Bonds (Exhibits 12.8, 12.9) ▪ ▪

History of high-yield bond market High-yield bonds - speculative-grade bonds or junk bonds

12.3.7 International Bonds 1. United States ▪ Eurodollar bonds ▪ Yankee bonds 2. Japan ▪ Samurai bonds ▪ Euroyen bonds 3. United Kingdom ▪ Bulldog bonds ▪ Eurosterling bonds 4. Eurozone ▪ Growth of eurobonds 12.4

Bond Yield Curves

richard@qwconsultancy.com

64 | P a g e

12.4.1 The Determinants of Bond Yields 1. Effect of Economic Factors 2. The Impact of Bond Characteristics ▪ Factors impacting risk premium: − The quality of the issue as determined by its risk of default relative to other bonds − The term to maturity of the issue, which can affect price volatility − Indenture provisions, including collateral, call features, and sinking-fund provisions − Foreign bond risk, including exchange rate risk and country risk ▪ Credit spread

12.4.2 Yield Curves and the Term Structure of Interest Rates

▪ ▪ ▪

Term structure of interest rates – yield curve Relates the term to maturity to the yield to maturity for a sample of bonds at a given point in time Yield curves (Exhibits 12.10, 12.11) − rising yield curve − declining yield curve − flat yield curve − humped yield curve

12.4.3 Par versus Spot Yield Curves (Exhibit 12.12)

▪ ▪

Par yield - bond can only trade at par value if it pays periodic coupons Spot yield - yield on a zero-coupon bond

12.4.4 Yield Curves for Credit-Risky Bonds (Exhibit 12.13)

▪

Credit spread – yield differential representing the risk premium associated with the possibility that the corporate issuer will be unable to pay back what it has promised to the investor

12.4.5 Determining the Shape of the Term Structure 1. Expectations Hypothesis ▪ Any long-term interest rate simply represents the geometric mean of current and future one-year interest rates expected to prevail over the maturity of the issue. ▪ Consistent Investor Actions − Investor actions would be consistent when rates are expected to rise or to fall. 2. Liquidity Preference (Term Premium) Hypothesis The bond’s call price plus a small premium that increases with time to call holds that long-term securities should provide higher returns than short-term richard@qwconsultancy.com

65 | P a g e

obligations because investors are willing to accept lower yields for short-maturity obligations to avoid the higher price volatility of long-maturity bonds.

3. Segmented-Market Hypothesis ▪ Also known as the preferred habitat theory ▪ Different institutional investors have different maturity needs that lead them to confine their security selections to specific maturity segments. 12.5

Bond Valuation 12.5.1 Par versus Spot Bond Valuation

▪ ▪

Par yield is often referred to as the bond’s yield to maturity. Present value of bond - discounted value of any particular set of future bond cash flows using the spot yield or the par yield 12.5.2 Bond Valuation and Yields with Semiannual Coupons Valuation formula can be adjusted for this convention by converting all of the relevant variables to a periodic basis.

1. The Yield Model ▪ Expected yield on the bond - use the observed current market price and the promised cash flows ▪ Internal rate of return (IRR) - the discount rate that equates the present value of cash outflows for an investment with the present value of its cash inflows 12.5.3 Relationship between Bond Yields, Coupon Rates, and Bond Prices (Exhibit 12.14)

▪ ▪ ▪ ▪

When the yield to maturity is less than the coupon rate, the bond will be priced at a premium to its par value. When the yield to maturity is greater than the coupon rate, the bond will be priced at a discount to its par value. The price–yield relationship is not a straight line; rather, it is convex. As yields decline, the price increases at an increasing rate; and, as yields increase, the price declines at a declining rate. Concept of a convex price–yield trade-off is referred to as convexity.

1. Bond Characteristics and Price Change Magnitude (Exhibit 12.15) ▪ A bond’s value is inversely related to its yield to maturity. ▪ Bonds with a fixed coupon rate and no embedded options (such as a call feature) will demonstrate this negative direction effect. ▪ Magnitude of the value change (expressed in percentage terms) in response to a given yield change will depend on the other characteristics of the security, such as the coupon rate and time to maturity. richard@qwconsultancy.com

66 | P a g e

▪

These magnitude effects can be summarized by two additional facts: − For two bonds with the same maturity, the one with the lower coupon rate will experience the greater percentage price change for a given shift in yields. − Generally, for two bonds with the same coupon rate, the one with the longer maturity will experience the greater percentage price change for a given shift in yields. 12.5.4 Bond Valuation between Coupon Dates (Exhibits 12.16, 12.17)

▪

When an investor acquires a bond from an existing owner between coupon dates, they will actually have to pay an amount that represents: − The actual value of the bond itself, which is the discounted value of the remaining future cash flows, and − The interest that has accrued since the last coupon date (accrued interest) 12.5.5 Computing Other Bond Yield Measures

1. Current Yield ▪ Annual coupon payment divided by the current market price of the bond ▪ It is to bonds what dividend yield is to stocks. 2. Yield to Call ▪ Whenever a bond with a call feature is selling for a price above par equal to or greater than its call price, a bond investor should consider valuing the bond in terms of YTC rather than YTM. ▪ The present value method used assumes that the bond is held until the first call date and that all the coupon payments are reinvested at the YTC rate. ▪ Crossover price - approximately the bond’s call price plus a small premium that increases with time to call ▪ If an issue has multiple call dates at different prices, it will be necessary to compute which of these scenarios provides the lowest yield - yield to worst. 3. Realized (Horizon) Yield ▪ Measures the rate of return of a bond that you anticipate selling prior to maturity CHAPTER 13 BOND ANALYSIS AND PORTFOLIO MANAGEMENT STRATEGIES 6.11

Bond Analysis Tools

13.1.1 Implied Forward Rates ▪

After deriving the theoretical spot rate curve, it is possible to determine what this curve implies regarding the market’s expectations of future short-term rates, which are referred to as the breakeven yield, or the implied forward rate.

richard@qwconsultancy.com

67 | P a g e

13.1.2 Bond Duration ▪

A bond’s duration can be interpreted as a measure of the bond’s price volatility (interest rate sensitivity).

1. Calculating Bond Duration (Exhibits 13.1, 13.2) ▪ Macaulay duration - calculates a weighted average of the payment dates associated with an N-period bond 2. Measuring Bond Price Volatility ▪ A useful property of the duration statistic comes from its interpretation as the bond’s price elasticity coefficient with respect to yield changes. ▪ Modified duration (Mod D) ▪ Basis point value (BPV) 3. Duration of a Portfolio ▪ The weighted average of the payment dates for all of the cash flows across the entire collection of bonds. 13.1.3 Bond Convexity (Exhibits 13.4, 13.5) ▪ ▪ ▪

The price-yield relationship is not a straight line but a curvilinear relationship (i.e., convex). This relationship can be applied to a single bond, a portfolio of bonds, etc. The convex price-yield relationship will differ depending on the nature of the cash flows, that is, coupon and maturity. - Inverse relationship between convexity and coupon - Direct relationship between convexity and maturity - Inverse relationship between convexity and yield

13.1.4 Bonds with Embedded Options (Exhibit 13.6) ▪ ▪ ▪

A noncallable bond is said to have positive convexity because as yields decline, the price of the bond increases at a faster rate. With a callable bond when rates decline, the price increases at a slower rate and ultimately does not change at all. This pattern of price-yield change for a callable bond when yields decline is referred to as negative convexity.

13.1.5 Yield Spread Analysis 1. Static Yield Spreads (Exhibit 13.7) ▪ Static spread (also called the zero-volatility spread) is the number that will make the present value of the cash flows from the corporate bond, when discounted at the Treasury spot rate plus this static spread, equal to the corporate bond’s market price. 2. Option-Adjusted Spread richard@qwconsultancy.com

68 | P a g e

▪

The OAS is the spread after taking account of the compensation required for the embedded option making it comparable to a spread for an option-free bond.

6.12

An Overview of Bond Portfolio Management: Performance, Style, and Strategy (Exhibits 13.8, 13.9, 13.10) ▪ The investment style of a bond portfolio can be summarized by its two most important characteristics: credit quality and interest rate sensitivity. ▪ Credit quality of the bond portfolio: - High grade (government, agency, AAA-rated or AA-rated corporate bonds) - Medium grade (A-rated or BBB-rated) - Low grade (below BBB-rated) ▪ Interest rate sensitivity of the bond portfolio: - Short term (duration less than 3.0 years) - Intermediate term (duration between 3.0 and 6.5 years) - Long term (duration more than 6.5 years)

6.13

Passive Management Strategies 13.3.1 Buy-and-Hold Strategy ▪ ▪

A manager selects a portfolio of bonds based on the objectives and constraints of the client with the intent of holding these bonds to maturity. Bond ladder – dividing investment funds evenly into instruments that mature at regular intervals 13.3.2 Indexing Strategy

▪ ▪

When designing a bond portfolio to mimic a hypothetical index, managers can follow two different paths: full replication or stratified sampling. Goal of the stratified sampling approach is to create a bond portfolio that matches the important characteristics of the underlying index while maintaining a portfolio that is more cost effective to manage. 13.3.3 Bond Indexing in Practice: An Example (Exhibit 13.11)

6.14

Active Management Strategies (Exhibit 13.12) 13.4.1 Interest Rate Anticipation (Exhibit 13.13) ▪

Riskiest strategy because it involves relying on uncertain forecasts of future interest rates 13.4.2 Credit Analysis

▪

Involves detailed analysis of the bond issuer to determine expected changes in its default risk

richard@qwconsultancy.com

69 | P a g e

1. Credit Analysis of High-Yield (Junk) Bonds (Exhibits 13.14, 13.15) ▪ Investing in Defaulted Debt 2. Credit Analysis Models (Exhibit 13.16) ▪ The Z-score model combines traditional financial measures with a multivariate technique known as multiple discriminant analysis to derive a set of weights for the specified variables. 13.4.3 Implementing an Active Bond Transaction (Exhibit 13.17) ▪ ▪

Bond swaps Pure yield pickup swap 13.4.4 Active Global Bond Investing: An Example (Exhibit 13.18)

6.15

Core-Plus Portfolio Management Strategies (Exhibit 13.19) ▪ Core-plus bond portfolio management places a significant part of the available funds in a passively managed portfolio of high-grade securities, thus reflecting a broad representation of the overall bond market; this is the “core” of the strategy. ▪ The remainder of the funds would then be managed actively in the “plus” portion of the portfolio. ▪ A core-plus approach to bond management can also be considered a form of enhanced indexing.

6.16

Matched-Funding Management Strategies 13.6.1 Dedicated Portfolios (Exhibit 13.20) ▪ ▪

Pure cash-matched dedicated portfolio is the most conservative strategy. Dedication with reinvestment is similar to the pure cash-matched technique except it allows that the bonds and other cash flows do not have to exactly match the liability stream. 13.6.2 Immunization Strategies

1. Components of Interest Rate Risk ▪ Price risk ▪ Coupon reinvestment risk 2. Classical Immunization and Interest Rate Risk 3. The Mechanics of Bond Immunization: A Simple Illustration ▪ Given that bond risk caused by changing interest rates can be split into price risk and reinvestment risk, the following general statements can be made: − If duration > investment horizon, then the investor faces net price risk. − If duration < investment horizon, then the investor faces net reinvestment risk. − If duration = investment horizon, then the investor is immunized. 4. Application of Classical Immunization (Exhibit 13.21) − Immunization is neither a simple nor a passive strategy. richard@qwconsultancy.com

70 | P a g e

−

An immunized portfolio requires frequent rebalancing because the modified duration of the portfolio always should be equal to the remaining time horizon (except in the case of the zero-coupon bond).

13.6.3 Horizon matching (Exhibit 13.22) ▪

6.17

▪ ▪ ▪ ▪ ▪

▪

Combination of cash-matching dedication and immunization

Contingent and Structured Management Strategies (Exhibits 13.23, 13.24, 13.25)

Contingent procedures for managing bond portfolios are a form of what has come to be called structured active management. The contingent immunization strategy allows the bond manager flexibility to actively manage the portfolio subject to an overriding constraint that the portfolio remains immunized at some predetermined yield level. Cushion spread - the difference between the current market return and some floor rate Safety margin - a portfolio value above the required value When the value of the portfolio reaches a point of minimum return (referred to as a trigger point), it is necessary to stop active portfolio management and use classical immunization with the remaining assets to ensure desired terminal wealth value is attained. Potential return - the return the portfolio would achieve over the entire investment horizon if, at any point, the assets on hand were immunized at the prevailing market rate CHAPTER 14 AN INTRODUCTION TO DERIVATIVE MARKETS AND SECURITIES

6.18

Overview of Derivative Markets

14.1.1 The Language and Structure of Forward and Futures Markets (Exhibit 14.1) ▪

Terminology − Forward contract - gives its holder both the right and the full obligation to conduct a transaction involving another security or commodity (the underlying asset) at a predetermined future date and at a predetermined price − Future date - contract’s maturity (or expiration) date − Forward contract price - predetermined price at which the trade takes place − Counterparties: o The eventual buyer (or long position), who will pay the contract price and receives the underlying security

richard@qwconsultancy.com

71 | P a g e

The eventual seller (or short position), who delivers the security for the fixed price

Forward and Spot Markets Forward contracts - trade agreements negotiated directly between two parties for a transaction that is scheduled to take place in the future Settlement date agreed to in the contract is in the future Contract price – usually different from the prevailing spot price Spot market transaction - settles immediately Forward and Futures Markets Forward contracts Negotiated in the over-the-counter market Terms of the contract are flexible Arrangements may not require collateral Involve credit (or default) risk Often illiquid Futures contracts (Exhibit 14.2) Terms are standardized (expiration date, identity, and amount of the underlying asset). Trade on futures exchange Counterparties can unwind a previous commitment prior to expiration by trading their existing position back to the exchange at the prevailing market price. Counterparties have to post collateral or margin. Margin accounts are held by the exchange’s clearinghouse and are marked to market daily.

14.1.2 Interpreting Futures Price Quotations: An Example (Exhibits 14.3, 14.4)

14.1.3 The Language and Structure of Option Markets An option contract gives its holder the right—but not the obligation—to conduct a transaction involving an underlying security or commodity at a predetermined future date and at a predetermined price. Seller (or writer) of the option must perform on his side of the agreement if the buyer chooses to exercise the option. Call option - the right to buy the underlying security Put option - the right to sell the underlying security Option Contract Terms Exercise (strike) price - price the call buyer will pay to—or the put buyer will receive from—the option seller if the option is exercised Option premium - what the option buyer must pay to the seller at Date 0 to acquire the contract itself European options can be exercised only at maturity. richard@qwconsultancy.com

72 | P a g e

American options can be executed any time up to expiration. Option Valuation Basics Option premium: intrinsic value and time premium Intrinsic value - the value that the buyer could extract from the option if exercised immediately In the money - an option with positive intrinsic value Out of the money - an option with zero intrinsic value At the money – an option in which the underlying asset and the exercise price are equal Option Trading Markets (Exhibit 14.5) Options trade both in over-the-counter markets and on exchanges.

14.1.4 Interpreting Option Price Quotations: An Example (Exhibit 14.6) 6.19

Investing with Derivative Securities

14.2.1 The Basic Nature of Derivative Investing (Exhibit 14.7)

14.2.2 Basic Payoff and Profit Diagrams for Forward Contracts (Exhibits 14.8, 14.9, 14.10)

▪ ▪

Symmetric payoffs Zero-sum games

14.2.3 Basic Payoff and Profit Diagrams for Call and Put Options (Exhibits 14.11, 14.12)

▪ ▪ ▪

Asymmetric payoffs Differences between call and put payoffs Options are directional views on movements in the price of the underlying security.

14.2.4 Option Profit Diagrams: An Example (Exhibits 14.13, 14.14) 1. Options and Leverage (Exhibit 14.15) 6.20

The Relationship between Forward and Option Contracts ▪ Put–call parity specifies how the put and call premia should be set relative to one another. ▪ Conditions can be expressed in terms of these two option types and either the spot or the forward market price for the underlying asset.

richard@qwconsultancy.com

73 | P a g e

▪

They depend on the assumption that financial markets are free from arbitrage opportunities.

14.3.1 Put-Call-Spot Parity (Exhibit 14.16)

14.3.2 Put-Call Parity: An Example (Exhibit 14.17)

14.3.3 Creating Synthetic Securities Using Put-Call Parity (Exhibit 14.18)

14.3.4 Adjusting Put-Call Spot Parity for Dividends

▪ ▪

Holders of the two derivative contracts will not participate directly in the payment of dividends to the stockholder. Current stock price must be adjusted downward by the present value of the dividend.

14.3.5 Put-Call-Forward Parity (Exhibit 14.19) 6.21

An Introduction to the Use of Derivatives in Portfolio Management ▪ Three prominent derivative applications in the management of equity positions are shorting forward contracts, purchasing protective puts, and purchasing equity collars.

14.4.1 Restructuring Asset Portfolios with Forward Contracts (Exhibits 14.20, 14.21)

▪ ▪ ▪

Tactical asset allocation Two methods of restructuring: sell stock portfolio and invest in T-bills or acquire hedge position with payoffs that are negatively correlated with the existing exposure Benefits - quicker and more cost-effective to convert the portfolio’s asset allocation using this synthetic approach, effect on systematic risk—or beta—of the portfolio

14.4.2 Protecting Portfolio Value with Put Options (Exhibits 14.22, 14.23)

▪ ▪

Protective put position - the purchase of a put option to hedge the downside risk of an underlying security holding Portfolio insurance

richard@qwconsultancy.com

74 | P a g e

14.4.3 An Alternative Way to Pay for a Protective Put (Exhibits 14.24, 14.25)

▪

Collar agreement - the simultaneous purchase of an out-of-the-money put and sale of an out-of-the-money call on the same underlying asset and with the same expiration date and market price CHAPTER 15

Forward, Futures, AND SWAP Contracts 6.22

An Overview of Forward and Futures Trading (Exhibits 15.1, 15.2, 15.3) ▪ Forward contracts are agreements negotiated directly between two parties in the OTC markets. Tailored to the specific needs of the ultimate end user ▪ Futures contracts are standardized in terms of the amount and type of the commodity involved and the available dates on which it can be delivered. ▪ After a futures trade has been agreed on, details of the deal are passed to the exchange clearinghouse, which catalogs the transaction.

15.1.1 Futures Contract Mechanics ▪ ▪ ▪ ▪

▪ ▪

Futures exchange requires each customer to post an initial margin account in the form of cash or government securities when the contract is originated. Margin account is adjusted, or marked to market, at the end of each trading day, according to that day’s price movements. Outstanding positions are adjusted to the settlement price, which is set by the exchange after trading ends to reflect the midpoint of the closing price range. Marked-to-market process credits or debits each customer’s margin account for daily trading gains or losses as if the customer had closed out her position, even though the contract remains open. Collateral accounts are not allowed to fall below a predetermined maintenance level. Margin call - required to restore the account to its full initial level or face involuntary liquidation

15.1.2 Comparing Forward and Future Contracts ▪

6.23

Main trade-off between forward and futures contracts is design flexibility versus credit and liquidity risks.

Hedging with Forwards and Futures

15.2.1 Hedging and the Basis ▪ ▪

The goal of a hedge transaction is to create a position that will offset the price risk of another holding. The word offset is used rather than eliminate because the hedge transaction attempts to neutralize an exposure that remains on the balance sheet.

richard@qwconsultancy.com

75 | P a g e

▪ ▪

Short hedge – holding a short forward position Long hedge - holding with a long forward position

Defining the Basis ▪ Basis is the spot price minus the forward price for a contract. Initial basis - is known since both the current spot and the forward contract prices can be observed Maturity basis – is always is zero whenever the commodity underlying the forward contract matches the asset held exactly The forward price converges to the spot price as the contract expires.

15.2.2 Understanding Basis Risk ▪

Investor is exposed to basis risk because the terminal value of her combined position is defined as the cover basis minus the initial basis.

15.2.3 Calculating the Optimal Hedge Ratio Definition: The ratio of the spot and forward price standard deviations multiplied by the correlation coefficient between the two series () Cross hedge can be measured as (1 - 2)

6.24

Forward and Futures Contracts: Basic Valuation Concepts ▪ Forward and futures contracts are not securities but, rather, trade agreements that enable both buyers and sellers of an underlying commodity or security to lock in the eventual price of their transaction.

15.3.1 Valuing Forwards and Futures (Exhibit 15.4)

15.3.2 The Relationship between Spot and Forward Prices ▪

▪ ▪ ▪ 6.25

In the absence of arbitrage opportunities, the forward contract price should be equal to the current spot price plus the cost of carry necessary to transport the asset to the future delivery date. Contango - F0,T > S0 Convenience yield - can occur when there is a premium placed on currently owning the commodity Backwardated - F0,T < S0

Financial Forwards and Futures: Applications and Strategies (Exhibit 15.5) ▪ Originally, forward and futures markets were organized largely around trading agricultural commodities, such as corn and wheat. ▪ The most significant recent developments involve the use of financial securities as the asset underlying the contract. richard@qwconsultancy.com

76 | P a g e

15.4.1 Interest Rate Forwards and Futures – were among the first derivatives to specify a financial security as the underlying asset

15.4.2 Long-Term Interest Rate Futures (Exhibit 15.6) Treasury Bond and Note Contract Mechanics ▪ Both the T-bond and the longer-term T-note contracts traded at the CBOT call for the delivery of $100,000 face value of the respective instrument. ▪ For the T-bond contract, any Treasury bond that has between 15 and 25 years to maturity can be used for delivery. ▪ Bonds with maturities ranging from 6.5 to 10 years and 4.17 to 5.25 years can be used to satisfy the 10-year and 5-year T-note contracts, respectively. ▪ Delivery can take place on any day during the month of maturity, with the last trading day of the contract falling seven business days prior to the end of the month. A Duration-Based Approach to Hedging Treasury Futures Applications: Hedging a Funding Commitment

15.4.3 Short-Term Interest Rate Futures (Exhibit 15.7) ▪

A rapidly expanding segment of the exchange traded market. Currently, investors can hedge their exposures to various different money market rates (for example, LIBOR, federal funds rate) denominated in a multitude of currencies (for example, U.S. dollar, Japanese yen, euro).

Eurodollar Contract Mechanics ▪ A Eurodollar contract requires the long position to make a $1,000,000, 90day bank deposit with the short position at the maturity date. ▪ Contract requires all outstanding obligations to be settled in cash.

Short-Term Interest Rate Future Application: Creating a Synthetic Fixed-Rate Funding With a Eurodollar Strip

15.4.4 Stock Index Futures Stock Index Futures Contract Fundamentals (Exhibit 15.8) ▪ The underlying financial asset for a stock index futures contract is a hypothetical creation that does not exist in practice and therefore cannot be delivered to settle a contract. ▪ Stock index futures can only be settled in cash, similar to the Eurodollar (LIBOR) contract.

richard@qwconsultancy.com

77 | P a g e

ii Stock Index Futures Valuation and Index Arbitrage (Exhibit 15.9) ▪

▪

Stock index futures often are used to convert entire stock portfolios into synthetic riskless positions to exploit an apparent mispricing between stock in the cash and futures markets. This strategy, commonly called stock index arbitrage, is the most prominent example of a wider class of computer-assisted trading schemes known as program trading.

iii Implementing an Index Arbitrage Strategy (Exhibit 15.10) iv A Stock Index Futures Application: Isolating Unsystematic Risk ▪

Using stock index futures to adjust the stock’s beta to zero effectively isolates the unsystematic portion of risk.

15.4.5 Currency Forwards and Futures ▪

Foreign exchange (FX) transactions often involve a confusing blend of unique terminology and market conventions.

The Mechanics of Currency Transactions (Exhibits 15.11 and 15.12) ▪ Buyer and seller negotiate for the exchange of a certain amount of a predetermined commodity at a fixed cash price. ▪ The “commodity” involved is someone else’s currency. ▪ Direct, or American, convention - the foreign currency is treated as the commodity, and its price per unit is expressed in terms of dollars. ▪ Indirect, or European, quotation - treats the dollar as the commodity ▪ Direct and indirect quotes are reciprocals of one another. ▪ In the situation in which it costs increasingly more dollars to buy the same euro the farther out in the future it is delivered, the dollar is said to be trading at a forward discount to the euro. Conversely, the euro is at a forward premium to the dollar

v ▪

A Currency Futures Application: Covered Interest Arbitrage Interest rate parity specifies the “no arbitrage” relationship between spot and forward FX rates and the level of interest rates in each currency. Covered interest arbitrage - arbitrageur will always hold the security denominated in the currency that is the least expensive to deliver in the futures market. The arbitrage position is hedged, or covered, against adverse foreign exchange movements while receiving the largest amount of net interest income.

richard@qwconsultancy.com

78 | P a g e

6.26

OTC Forward Contracts 15.5.1 Interest Rate Contracts (Exhibit 15.14) Forward Rate Agreements (FRAs) ▪ Two parties agree today to a future exchange of cash flows based on two different interest rates. ▪ On the contract’s settlement date, the difference between the two interest rates is multiplied by the FRA’s notional principal and prorated to the length of the holding period. ▪ LIBOR is frequently used as the floating rate index, making FRAs the OTC equivalent of Eurodollar futures contracts. Interest Rate Swaps (Exhibits 15.15, 15.16, 15.17, 15.18, 15.19, 15.20) ▪ Investors and borrowers are routinely exposed to interest rate movements at regular intervals over an extended period of time, such as with a floating-rate note (FRN) that resets its coupon rate twice annually for several years according to movements in six-month LIBOR ▪ Swaps can be viewed as a prepackaged series of forward contracts to buy or sell LIBOR (i.e., FRAs) at the same fixed rate. ▪ Plain vanilla agreement - “fixed-for-floating” transaction used to restructure the cash flows of an interest-sensitive asset or liability

15.5.2 Equity Index-Linked Swaps (Exhibit 15.21) Equity swaps are equivalent to portfolios of forward contracts calling for the exchange of cash flows based on two different investment rates: - A variable-debt rate (e.g., three-month LIBOR) - The return to an equity index (e.g., Standard and Poor’s 500) CHAPTER 16 ▪

Option Contracts

An Overview of Option Markets and Contracts

16.1.1 Option Market Conventions ▪ ▪ ▪ ▪ ▪

Option contracts have been traded for centuries. Customized options were traded on the OTC market. In April 1973, standardized options began trading on the Chicago Board Option Exchange. The enactment of the Dodd-Frank Act in 2011 has created a new level of regulatory oversight for OTC options. Options Clearing Corporation (OCC) acts as guarantor of each CBOE -traded options.

richard@qwconsultancy.com

79 | P a g e

16.1.2 Price Quotations for Exchange-Traded Options Equity Options ▪ Other option markets include American (AMEX), Philadelphia (PHLX) and International Securities (ISE) Exchanges. ▪ Understanding a quotation (Exhibit 16.1) Stock Index and Index ETF Options (Exhibit 16.2) Foreign Currency Options (Exhibit 16.3) The Fundamentals of Option Valuation 16.2.1 The Basic Approach ▪ ▪ ▪

Design riskless hedge with one share of stock held long and some number (h) of call options Calculate the formula’s certain values Rearrange values in the equation and solve for the call value (C0)

16.2.2 Improving Forecast Accuracy Creating a Stock Price Tree (Exhibit 16.4) Valuing in Other Subintervals (Exhibit 16.5)

16.2.3 The Binomial Option Pricing Model 1. Forecasting Price Changes (Exhibit 16.6) 2. Generalizing the Model

16.2.4 The Black-Scholes Valuation Model 1. Properties of the Model (Exhibit 16.7) - Current security price - Exercise price - Time to expiration - Risk-free rate - Security price volatility (measured by standard deviation) 2. An Example (Exhibits 16.8, 16.9)

16.2.5 Estimating Volatility (Exhibit 16.10) ▪ ▪ ▪

Historical: price movements Implied: volatility (use current market price of option and rearrange Black-Scholes model to solve for volatility measure) Volatility Index (VIX) is calculated as a weighted average of the implied volatility estimates from options on the Standard & Poor’s 500 Index using a wide range of exercise prices.

richard@qwconsultancy.com

80 | P a g e

16.2.6 Problems with Black-Scholes Valuation ▪ ▪

Empirical studies showed that the Black-Scholes model overvalued out-of-themoney call options and undervalued in-the-money contracts. Any violation of the assumptions upon which the Black-Scholes model is based could lead to a misvaluation of the option contract.

Option Valuation: Extensions (Exhibit 16.11)

16.3.1 Valuing European-Style Put Options 16.3.2 Valuing Options on Dividend-Bearing Securities 16.3.3 Valuing American-Style Options Option Trading Strategies (Exhibit 16.12) ▪ Options are a leveraged alternative to making a direct investment in the asset on which the contract is based. ▪ Put options could be used in conjunction with an existing portfolio to limit the portfolio’s loss potential.

16.4.1 Protective Put Options (Exhibits 16.13, 16.14) 16.4.2 Covered Call Options (Exhibits 16.15, 16.16) 16.4.3 Straddles, Strips, and Straps (Exhibits 16.17, 16.18, 16.19) 16.4.4 Strangles (Exhibit 16.20) 16.4.5 Spreads (Exhibits 16.21, 16.22, 16.23) 16.4.6 Range Forwards (Exhibits 16.24, 16.25)

Other Option Applications 16.5.1 Convertible bonds (Exhibits 16.26, 16.27) ▪

▪ ▪

Can be viewed as a prepackaged portfolio containing two distinct securities: a regular bond and an option to exchange the bond for a pre-specified number of shares of the issuing firm’s common stock Conversion Ratio = number of common shares into which a bond is convertible Conversion parity price = Bond price/Conversion ratio

richard@qwconsultancy.com

81 | P a g e

▪ ▪

Callable – forcing conversion Payback (or break-even time) – measures how long the higher interest income from the convertible bond (compared to the dividend income from the common stock) must persist to make up for the difference between the price of the bond and its conversion value (i.e., the conversion premium)

16.5.2 Credit Default Swaps (Exhibit 16.28) A credit default swap (CDS) is better regarded as an option-like arrangement because it does require one party to pay an initial premium (or a series of premiums) to the other, and any subsequent settlement payment is not obligatory but contingent on the occurrence of a future event. CHAPTER 17 ▪

PROFESSIONAL PORTFOLIO MANAGEMENT, ALTERNATIVE ASSETS, AND INDUSTRY ETHICS

The Asset Management Industry: Structure and Evolution ▪

Two basic ways that traditional asset management firms are organized (Exhibit 17.1, 17.2) - Individuals as well as institutional investors make contracts directly with a management and advisory firm for its services. - An investment company invests a pool of funds belonging to many individuals in a single portfolio of securities.

Private Management and Advisory Firms (Exhibits 17.3 and 17.4)

17.2.1 Investment Strategy at a Private Money Management Firm (Exhibit 17.5) Organization and Management of Investment Companies ▪ Portfolio management and most of the other administrative duties are handled by a separate investment management company hired by the board of directors of the investment company.

17.3.1 Valuing Investment Company Shares (Total Market Value of Fund Portfolio) – (Fund Expenses) Net Asset Value = (NAV) richard@qwconsultancy.com

Total Fund Shares Outstanding 82 | P a g e

17.3.2 Closed-End versus Open-End Investment Companies ▪

Closed-End Investment Companies (Exhibit 17.6) - Operate like any other public company - Offers no additional shares after initial issue and does not repurchase shares on demand - The NAV and market price of closed-end funds are almost never the same.

▪

Open-End Investment Companies (Exhibit 17.7) - Continue to sell and repurchase shares after their initial public offerings - Provide service for almost 200 million accounts

▪

Load Versus No-Load Open-End Funds - No-load Fund - Low-load Fund - 12b-1 Plan - Contingent, Deferred Sales Loads

17.3.3 Fund Management Fees ▪ ▪

Charged to compensate managers of the fund Typically is a percentage of the average net assets of the fund varying from 0.25 to 1.00 percent

17.3.4 Investment Company Portfolio Objectives (Exhibit 17.8) ▪ ▪ ▪ ▪

Equity funds Balanced funds Bond funds Money market funds

17.3.5 Breakdown by Fund Characteristics (Exhibits 17.9, 17.10)

17.3.6 Global Investment Companies ▪ ▪

Funds that invest in non-U.S. securities are generally called either international funds or global funds. A large number of non-U.S. investment companies that offer both domestic and global products in their local markets.

17.3.7 Mutual Fund Organization and Strategy: An Example (Exhibit 17.11)

richard@qwconsultancy.com

83 | P a g e

Investing in Alternative Asset Classes (Exhibit 17.12)

17.4.1 Hedge Funds (Exhibit 17.13) ▪

By 2016, there were almost 10,000 active funds, controlling an estimated $3 trillion in assets.

17.4.2 Characteristics of a Hedge Fund (Exhibit 17.14) ▪

▪

As a private partnership, hedge funds are generally less restricted in how and where they can make investments, which is perhaps the biggest reason investors believe that these vehicles have the ability to deliver abnormally large returns. They also tend to be less correlated with traditional asset class investments, providing investors with additional diversification benefits.

17.4.3 Hedge Fund Strategies

I. Equity-based Strategies

- Long-short equity - Equity market neutral II. Arbitrage-based Strategies - Fixed-income arbitrage - Convertible arbitrage - Merger (risk) arbitrage III. Opportunistic Strategies - High yield and distressed - Global macro - Managed futures - Special situations IV. Multiple Strategies - Fund of funds

17.4.4 Risk Arbitrage and Investing: A Closer Look (Exhibits 17.15) 17.4.5 Hedge Fund Performance (Exhibits 17.16, 17.17)

17.4.6 Private Equity (Exhibits 17.18, 17.19, 17.20) ▪ ▪ ▪

PE can also include a wide variety of different investment vehicles and strategies. A PE investment refers to any ownership interest in an asset (or collection of assets) that is not tradable in a public market. Development and Organization of the Private Equity Market - Venture Capital - Seed

richard@qwconsultancy.com

84 | P a g e

- Early Stage - Later Stage Buyouts - Special Situations - Distressed Debt - Mezzanine Financing

▪

The Private Equity Investment Process (Exhibit 17.21)

▪

Returns to Private Equity Funds (Exhibits 17.22, 17.23)

Ethics and Regulation in the Professional Asset Management Industry ▪ Agency conflict occurs frequently in financial relationships. 17.5.1 Regulation in the Asset Management Industry (Exhibit 17.24) ▪ ▪ ▪ ▪ ▪ ▪ ▪ ▪

The Securities Act of 1933 The Securities Exchange Act of 1934 The Investment Company Act of 1940 The Investment Advisers Act of 1940 The Employees Retirement Income Security Act of 1974 The Sarbanes-Oxley Act of 2002 The Pension Protection Act of 2006 The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010

17.5.2 Standards for Ethical Behavior ▪ The CFA (i.e., Chartered Financial Analysts) Institute has developed for its worldwide membership of security analysts and money managers a rigorous Code of Ethics and Standards of Professional Conduct. ▪ These are available online at www.cfainstitute.org. 17.5.3 Examples of Ethical Conflicts ▪ Incentive Compensation Schemes ▪ Soft Dollar Arrangements ▪ Marketing Investment Management Services What do you want from a Professional Asset Manager? ▪ List probably includes the following items: - Help determine your investment objectives and constraints (return goals, risk tolerance) and develop a portfolio that is consistent with them - Maintain your portfolio diversification within your desired risk class, while allowing flexibility so that you can shift between alternative investment instruments as desired - Attempt to achieve a risk-adjusted performance level that is superior to that of your relevant benchmark; some investors may be willing to sacrifice diversification for superior returns in limited segments of their portfolios. richard@qwconsultancy.com

85 | P a g e

CHAPTER 18

Administer the account, keep records of costs and transactions, provide timely information for tax purposes, and reinvest dividends if desired Maintain ethical standards of behavior at all times

EVALUATION OF PORTFOLIO PERFORMANCE

18.1 The Two Questions of Performance Measurement (Exhibit 18.1) ▪ There are two main questions that an investor attempts to answer when assessing the performance of an investment manager: - First, how did the portfolio manager actually perform? - Second, why did the portfolio manager perform as he or she did? 18.2 Simple Performance Measurement Techniques 18.2.1 Peer Group Comparisons (Exhibit 18.2) ▪

A peer group comparison collects the returns produced by a representative set of investors over a specific period of time and displays them in a simple boxplot format.

18.2.2 Portfolio Drawdown (Exhibit 18.3) ▪

One way to gauge the job a portfolio manager has done is to consider how well he has protected the investor against losses over time.

18.3 Risk-Adjusted Portfolio Performance Measures

18.3.1 Sharpe Portfolio Performance Measure ▪ ▪

Definition: Risk premium return earned per unit of total risk Demonstration of Composite Sharpe Measures (Exhibit 18.4)

18.3.2 Treynor Portfolio Performance Measure ▪

▪ ▪

Postulated two components of risk: - Risk produced by general market fluctuations - Risk resulting from unique fluctuations in the portfolio securities Definition: Risk premium return per unit of systematic risk Demonstration of Comparative Treynor Measures (Exhibit 18.5)

18.3.3 Jensen Portfolio Performance Measure ▪ ▪

Originally based upon the Capital Asset Pricing Model (CAPM) Applying the Jensen Measure

richard@qwconsultancy.com

86 | P a g e

The Jensen’s alpha measure of performance requires using a different RFR for each time interval during the sample period. The Jensen measure does not directly consider the portfolio manager’s ability to diversify because it calculates risk premiums in terms of systematic risk. The Jensen performance measure is flexible enough to allow for alternative models of risk and expected return than the CAPM.

18.3.4 The Information Ratio Performance Measure ▪

Measures a portfolio’s average return in excess of that for a benchmark portfolio divided by the standard deviation of this excess return (Exhibits 18.5, 18.6).

18.3.5 Sortino Performance Measure ▪

▪ ▪

Measures the portfolio’s average return in excess of a user-selected minimum acceptable return threshold, which is often the risk-free rate used in the S statistic although it need not be. Captures just the downside risk (DR) in the portfolio Comparing the Sharpe and Sortino Ratios

18.3.6 Summarizing the Risk-Adjusted Performance Measures (Exhibit 18.7) Each of the risk-adjusted performance statistics just described is widely used in practice and has strengths and weaknesses.

18.4 Application of Portfolio Performance Measures ▪ Total Sample Results (Exhibits 18.8, 18.9, 18.10) ▪ Measuring Performance with Multiple Risk Factors (Exhibit 18.11) ▪ Relationship between Performance Measures (Exhibit 18.12) 18.5 Holdings-Based Portfolio Performance Measurement 18.5.1 Grinblatt-Titman (GT) Performance Measure (Exhibit 18.13) ▪

Assuming that an investor knows the exact investment proportions of each security position in her portfolio on two consecutive reporting dates, Grinblatt and Titman (1993) showed that the manager’s security selection ability can be established by how he adjusted these weights.

18.5.2 Characteristic Selectivity Performance Measure (Exhibit 18.14) ▪

Daniel et al. (1997) developed the characteristic selectivity (CS) performance statistic that compares the returns of each stock held in an actively managed portfolio to the return of a benchmark portfolio that has the same aggregate investment characteristics.

richard@qwconsultancy.com

87 | P a g e

18.6 The Decomposition of Portfolio Returns 18.6.1 Performance Attribution Analysis ▪ ▪

▪ ▪

▪

Attribution analysis attempts to distinguish the source of the portfolio’s overall performance. This method compares the manager’s total return to the return for a predetermined benchmark policy portfolio and decomposes the difference into an allocation effect and a selection effect. An Example (Exhibit 18.15) A Performance Attribution Extension (Exhibit 18.16) - The attribution methodology can also be used to distinguish security selection skills from other decisions that an investor may make. Measuring Market Timing Skills - The relevant performance measurement criterion for a TAA manager is how well he is able to time broad market movements. 18.6.2 Fama Selectivity Performance Measure (Exhibit 18.17)

▪

▪ ▪ ▪

Fama (1972) suggested that overall performance in a portfolio, in excess of the riskfree rate, can be decomposed into measures of risk-taking and security selection skill. Evaluating Selectivity Evaluating Diversification Example of Fama Performance Measure

18.7 Factors That Affect Use of Performance Measures 18.7.1 Demonstration of the Global Benchmark Problem (Exhibit 18.18) ▪

▪

Reilly and Akhtar (1995) examined the effect of the choice of a benchmark on global performance measurement by plotting SMLs for six different indexes over three time horizons. Their results show that using alternative market proxies for different countries generates SMLs that differ substantially during a given time period and are very unstable over time. 18.7.2 Implications of the Benchmark Problems Problems noted by Roll, which are increased with global investing, do not negate the value of the CAPM as a normative model of equilibrium pricing; the theory may still be viable. 18.7.3 Required Characteristics of Benchmarks

▪ ▪ ▪ ▪ ▪ ▪ ▪

Unambiguous Investable Measurable Appropriate Reflective of current investment opinions Specified in advance Owned

richard@qwconsultancy.com

88 | P a g e

18.8 Reporting Investment Performance 18.8.1 Time-Weighted and Money-Weighted Returns ▪

▪

Money-weighted returns are the discount rates that set the present value of future cash flows (including future investment contributions and withdrawals) equal to the level of the initial investment. Time-weighted return is simply the geometric average of (one plus) the periodic returns. 18.8.2 Performance Presentation Standards (Exhibit 18.19)

▪ ▪

Introduced in 1987 and formally adopted in 1993, the CFA Institute has developed the comprehensive Performance Presentation Standards (PPS). In 1999, the CFA Institute adopted the companion Global Investment Performance Standards (GIPS), which were intended to accomplish the following goals: - To establish investment industry best practices for calculating and presenting investment performance that promote investor interests and instill investor confidence - To obtain worldwide acceptance of a single standard for the calculation and presentation of investment performance based on the principles of fair representation and full disclosure - To promote the use of accurate and consistent investment performance data - To encourage fair, global competition among investment firms without creating barriers to entry - To foster the notion of industry “self-regulation” on a global basis

richard@qwconsultancy.com

89 | P a g e