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time in order to derive future earnings that will compensate the investor for: 1. the
time for which the funds are committed. 2. The expected rate of inflation. 3.
Uncertainty of future flows of funds.
4. Total return: Investors seek to increase the portfolio value by both capital gains
and re-invest in current income.
1. Liquidity needs: Investors may have liquidity needs that must be considered
while making investment plan they may require liquidity to make various current
obligations without hampering the investment plan.
3. Tax concerns: Investment planning is complicated by the tax code of the govt.
For example: if the tax is calculated before paying dividends, investors require to
pay more tax. If it is calculated tax after paying dividend, they require to pay less
tax.
Holding period return: The return from the investment for the period for which
the investment is made
If an investor invests 200 at the beginning of the year and gets back 220 at the end
of the year, the holding period return= 220 ÷ 200 = 1.1, HPY= 1.1-1= .10
(1/n)
Annual Holding Period Return (AHPR): HPR (n= number of years)
If the investor invests 1000 and gets back 2500 after 3 years, what is the annual
HPR? HPR= 2500/1000=2.5, AHPR= 2.5 (1/3) = 1.36
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1. Time value of money of cash flows: It is the minimum rate of return that an
investor should accept from an investment to compensate for deferring
consumptions. Since the required returns from investments change over time,
investors should be aware of these components to determine the required rate of
return. These returns vary due to riskiness of investment so the investor must
consider risk factor that affect the required rate of return.
Real risk free rate of return: It is the basic interest rate assuming no inflation
and no uncertainty about the future cash flows. RRFR (Real Risk Free Rate) is
influenced by 2 factors: 1. Time preference for consumption of income. 2.
Investment opportunities in the economy.
Nominal risk free rate: It is the quoted rate of interest for a financial asset and it
is determined by the real rate of interest plus factors depending on: 1. Conditions in
the capital market. 2. Expected rate of inflation
i) Conditions in the capital market: A change in supply for money and demand
for money changes the nominal rate of interest.
ii) Expected rate of inflation: If investor expects the price level to increase
during the investment period, they would require the rate of return to compensate
the expected rate of inflation.
There is a relationship between nominal rate of interest and real interest rate.
Example: assume that the nominal return of T-bill is 9% during a given year when
the rate of inflation is 5%. What is the RRFR? Ans: 9% = (1+RRFR) (1+5%) – 1. So,
RRFR= 3.8%
Security Market Line: When there are changes is one of the following factors: 1.
Expected growth rate of economy. 2. Capital market condition. 3. Expected rate of
inflation. If one of these factors changes, there is parallel upward shift of SML. If
parallel shift occurs, it occurs because, changes in these factors affect the
economy’s nominal risk free rate that impacts all investments.
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Asset Allocation:
4. Gifting phase: In this phase, individuals believe that they have sufficient
income and assets to cover their current and future expenses and excess income
can be used to provide financial assistance: 1. To relatives and friends. 2. To
establish charitable trust or to fund trusts.
All investment decisions are based on policy statement to ensure that, they
(investments) are appropriate for the investors
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Reasons:
5.1 Treasury securities: there are 2 types of treasury securities: treasury notes,
treasury bonds.
Advantages of treasury notes and bonds: highly liquid and are backed by govt.
5.2 Govt. agency securities: issued by govt. agencies: govt. mortgage bank,
home loan bank, national housing authorities, govt. agency securities are not direct
obligation of the treasury and they are considered default free and fairly liquid.
Debentures: are unsecured promises to pay interest and the principal amount. In
case of default, debenture owner can claim any unpledged assets to pay off the
bonds.
Sub-ordinate bonds: are unsecured like debentures but the holders of this bonds
may claim asset after debenture holders claim
Income bonds: are issued by financially troubled company and the company
doesn’t have to pay the interest unless the company earns sufficient income to pay
the interest. Interest payment depends upon the firm’s income.
Zero-coupon bond: It is offered at a high discount from the free value and
company does not pay interest during the life of the bond and the principal amount
(face value) is re-paid after the maturity
International Bonds: These types of bonds offer fixed income outside the country
and also offer additional opportunities for diversification.
2. Yankee bond: are sold in the US and denominated in US dollars but issued by
foreign corporations or governments. It eliminates exchange risk of the US investors
3. International Domestic Bonds: These are offered by the issuer within its own
country in that country’s currency but foreign national can also buy these bonds.
2. Equity Investment:
1. Warrants: These are options issued by a company that gives the holders right
to buy common stock from the company at a specified price within a specified time
period. Warrant does not represent ownership of the stock but only the option to
buy the stock
2. Call option: A call option gives the right to buy the common stock of a company
within a certain period at a specified price
3. Put option: it gives the right to sell a given stock of a company within a certain
period at a specified price. It is useful to the investors when stock price declines
during the specified period
Investment Companies: sell shares to the public and uses proceeds to buy
securities. There are different types of funds of investments companies.
1. Money market fund: invest in short term high quality money market asset
such as: treasury bill, bank certificate of deposit, banker’s acceptance, commercial
papers
2. Bond funds: invest in long term govt. and corporate bonds. Govt. bonds are
default free but the expected returns from corporate bonds vary with degree of risk
of bonds
4. International funds: These funds are invested in securities outside the country
5. Global funds: global funds are invested in the home country and other
countries
Purchase of home: Investors hope to sell the house for cost plus gain
Purchase of raw land: It provides very high return in the future. It provides low
liquidity and there is a risk from selling for an uncertain price
Land development: Investors buy raw land and divide it to individual plots. They
build houses, shopping mall on it and returns from successful development are
significant.
Antiques: Serious collectors may enjoy good returns from antiques but individuals
buying a few pieces to decorate house may have difficulty to earn profit
Art: Investors require substantial knowledge on art and art world. Acquisition of
work from well known artists requires large capital investment and patience to earn
profit. Its market data is limited and has low liquidity
1. It does not require physical location. It only requires that, buyers and sellers can
communicate with each other
1. Good market provides timely and accurate information that is buyers and sellers
must have timely and accurate information on the volume and prices of past
transaction and all current outstanding offers.
3. In a good market, transaction cost is low which makes market more efficient
1. Primary market: It is the market where the new issues/ securities are sold by
the government or corporations to raise new capital. Funds go directly to the issuing
unit.
Underwriting function: the investment banking firm purchases the entire issue
from the corporations and resells the security to the investors. Underwriting
function involves 3 services: 1. Organization 2. Risk bearing 3. Distribution
Organization: involves the design of security issues. The design includes: the
maturity period, face value, coupon rate
Risk Bearing: Underwriter acquires the total issues at a price set in a competitive
bid or negotiations.
Distribution: involves selling the issue to the investors with the help of other
investment banking firms or commercial banks
1.2.1 Corporate Stock Issues: New corporate stocks are issued into 2 issues: 1.
Seasoned new issues 2. Initial public offerings
Seasoned New Issues: are new issues offered by firms that already have stock
outstanding i.e. a firm which has stock outstanding could sell additional share to the
public at a price very close to the current price of the firm’s stock.
IPO: it involves a firm selling its common stock to public for the first time. The new
issues are usually underwritten by the company and sell the security to the
interested investors.
a. Negotiated: This form involves the contractual arrangement between the issues
and the underwriter. The underwriter helps the issuer prepare stock issue, set the
price and has the exclusive right to sell the issue
b. Competitive bids: It involves competitive bids. The issue is sold to the bidder
who submits the bid with highest price.
c. Best effort: This is usually done with new issues. Investment banker agrees to
sell issue on a best effort basis. Investment banker acts as a broker to sell whatever
it can by giving the best effort.
Trading system in the secondary market: There are 2 major trading systems.
1. Pure auction market. 2. Dealer market
Pure auction market: Interested buyers and sellers submit bids and ask price for
a given stock. A broker acts as a facilitating agent. It is also called the price driven
market because shares of stock are sold to the highest bidder and bought from the
seller who offers lowest selling price
Dealer market: Dealers provide liquidity to the investors by buying and selling
shares of stock and dealers compete with each other to provide the highest bid
price to the seller and lowest ask price to the buyer. A stock exchange can use
anyone or combination of both. There are other 2 types of markets for buying and
selling auctions. 1. Call market. 2. Continuous market
1. Call market: gather all bids and ask orders at a point in time to determine a
single price to satisfy the most orders. Call markets are used during early stage of
development of an exchange in which there are few stocks listed and small number
of investors.
Portfolio Theory:
Portfolio: includes all investments of an investor. There are 2 factors that affect an
investor’s choice in making investment decision: 1. Risk 2. Rate of return
An investor wants to minimize the rate of return for a given level of risk. If 2 assets
give the same rate of return, the investor will prefer the asset with lower level of
risk.
Markwitz portfolio model: is used to calculate the expected rate of return from a
portfolio of assets and risk of the portfolio.
2. Investors try to maximize one period expected utility and their utility curves
demonstrate diminishingly marginal utility of wealth.
3. Investors estimate the risk of the portfolio on the basis of the variability of
expected returns from portfolio.
4. Investors base decision depends solely on the expected return and risk so their
utility curves are the function of expected return and the expected variance of
standard deviation of returns.
5. For a given level risk, investors prefer higher returns to lower returns. Similarly
for a given level of expected returns, investors prefer lower risk to higher risk.
For an individual asset, the expected return is the sum of the potential returns
multiplied by the corresponding probabilities of the return. E (R) = ∑ PiRi
How to calculate the expected return: Portfolio weight: (a 20%, b 30%, c 30%,
d 20%); return: (a 10%, B 11%, C 12%, D 13%). Expected return: (20% × 10%) +
(30% × 11%) + (30% × 12%) + (20% × 13%) = 11.5%
Variance: δ2= ∑(Ri – E(R))2 × pi where Ri=return from asset, E(R)= Expected return
(E (R) = ∑ PiRi), Pi=probability
Observation: 1. Low correlation reduces portfolio risk but expected return is not
affected. 2. Negative correlation exactly offsets the individual risk and makes the
standard deviation of the portfolio 0 and this is the risk free portfolio
Efficient Frontier: It is the envelop curve that contains best of all possible
combinations of various weights of 2 assets. The portfolio A dominates C because it
has equal rate of return at substantially lower risk and the portfolio B dominates C
because it has higher expected return at an equal risk
1. The efficient frontier represents the set of portfolios with the maximum rate of
return for every given level of risk or the minimum risk for every level of return
2. Every portfolio that lies on efficient frontier has either a higher rate of return for
equal risk or lower risk with equal rate of return than some portfolios below the
frontier
3. The slope of the efficient frontier curve decreases steadily as we move upward. It
implies that, adding equal increment of risk, the efficient frontier gives diminishing
increments of expected returns
4. No portfolio on the efficient frontier can dominate any other portfolio on the
frontier. That means all of the portfolios have different risk and return with expected
return that increases with higher risk.
Optimum portfolio is the efficient portfolio that has the highest utility for an
investor. It lies at the point of tangency between the efficient frontier and the utility
curve with the highest possible utility. A conservative investor’s highest utility is at
point M where the utility curve just touches the efficient frontier. So this point is the
highest utility for conservative investor. A less risk averse investor’s highest utility
occurs at point N where the utility curve just touches the efficient frontier which
represents a portfolio with high expected return and higher risk than the portfolio at
M.