Investment Analysis and Portfolio Management

First Canadian Edition By Reilly, Brown, Hedges, Chang

Chapter 3
Selecting Investments in a Global Market
The Case for Global Investments Global Investment Choices Historical Risk-Returns on Alternative Investments

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Global Investment Opportunities

More investment instruments available in the financial markets as a results of technological advances and new regulations Ability to invest from a global perspective thanks to the globalization or integration of domestic and foreign financial markets
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Global Investment Opportunities

Investment vehicles with a variety of maturities, risk-return characteristics, and cash flow patterns being spawned due to competition and deregulations in the financial sector

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The Case for Global Investment

Three reasons Canadian investors should think of constructing global investment portfolios 1. Ignoring foreign markets can substantially reduce the investment choices for all investors 2. Rates of return on foreign securities often substantially exceed those on Canadian investments 3. Low correlation between Canadian securities markets and many foreign markets can help to substantially reduce portfolio risk

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The Case for Global Investment

Relative Size of Financial Markets
Share of U.S. in world stock and bond markets has dropped from about 65% of the total in 1969 to about 46% in 2006 Growing importance of foreign securities in world capital markets is likely to continue Overall value of securities available in world capital market has increased from $2.3 trillion in 1969 to $103 trillion in 2006 U.S. portion has declined to less than half
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The Case for Global Investments

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The Case for Global Investments: Bond Markets

The performance of the Canadian bond market ranked higher than the U.S. bond market due to the weaker Canadian dollar during the period.
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The Case for Global Investments: Equity Markets

Investors that limit themselves to domestic markets may experience below average ROI. Notice that Canadian and Mexican equity markets produced comparatively high returns in the 2003-06 period.
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The Case for Global Investments: Diversification

Diversification with foreign securities can help reduce portfolio risk because foreign markets have low correlation with Canadian capital markets. The correlation of returns between a single pair of countries changes over time because the factors influencing the correlation change over time.

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The Case for Global Investments: Diversification

Diversified portfolios reduce variability of returns over time. Correlation coefficients measure diversification contribution. Correlations range from -1.00 to +1.00 Combining investments with perfect positive correlation will NOT help diversification. Combining two assets with negative correlation is ideal for diversification

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The Case for Global Investment: Global Bond Portfolio

Low Positive Correlation
Low positive correlations among returns indicates substantial opportunities for risk reduction Why? International trade patterns, economic growth & fiscal & monetary policies differ between countries

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The Case for Global Investment: Global Bond Portfolio

Low Positive Correlation

Opportunities for investors to reduce risk

Correlation changes over time Adding non-correlated foreign bonds to a portfolio of Canadian bonds increases rate of return & reduces portfolio risk

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The Case for Global Investment: Global Equity Portfolio

Low Positive Correlation
Correlation of world equity markets resembles that for bonds CanadaU.S. correlation is relatively low ranging from .537 to .635 but is a very low .389 when comparing Canada & Japan

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The Case for Global Investment: Global Equity Portfolio & Risk Reduction
Opportunities to reduce risk of a stock portfolio by including foreign stocks

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Global Investment Choices

Fixed-Income Investments Bonds and preferred stocks International Bond Investing
Eurobond, Maple bonds, international domestic bonds

Equity Instruments Special Equity Instruments Warrants and options Futures Contracts Investment Companies Real Estate Low-Liquidity Investments
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Fixed-Income Investments
Basic concepts of fixed-income investments Contractual payment schedule Recourse varies by instrument Bonds Investors are lenders Expect interest payment and return of principal Preferred stocks Dividends require board of directors approval

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Fixed-Income Investments
Savings Accounts Fixed earnings Convenient Liquid and low risk Low rates Certificates of Deposit (CDs) Usually less than 1 year in maturity Usually insured by CDIC Guaranteed Investment Certificates (GICs) Usually issued with terms greater than 1 year Usually insured by CDIC

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Fixed-Income Investments
Fixed income obligations that trade in secondary market Corporate bonds issued by corporations to fund long-term commitments Bankers Acceptances issued by banks to fund short term (less than 1 year) obligations Government of Canada bonds & T-bills Provincial government bonds Agency bonds are issued by Crown corporations
Example: Canada Mortgage and Housing Corporation (CMHC)

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Corporate Bonds
Issued by a corporation Fixed income Credit quality measured by ratings Maturity Features:
Indenture legal agreement stating obligations of issue Call provision specify when bonds can be called away from investors before maturity Sinking fund provision for payments to pay down bond debt

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Preferred Stock (Equity)

Hybrid security Fixed dividends Dividend obligations are not legally binding, but must be voted on by the board of directors to be paid Most preferred stock is cumulative Credit implications of missing dividends

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International Bond Investing

Eurobonds
An international bond denominated in a currency other than the country where it is issued
Example: Eurodollar bond is issued in USD but sold outside of the U.S. to non-U.S. investors

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International Bond Investing

Maple bonds
A Canadian dollar denominated bond sold in Canada by a foreign corporation or government Interest payments are made in CAD$
Example: Maple bond issued by British Airways in Canada to Canadian investors

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International Bond Investing

Yankee bonds
Sold in the United States and denominated is US$, but issued by foreign corporations or governments Eliminates exchange risk to U.S. investors

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International Bond Investing

International domestic bonds
Sold by issuer within its own country in that countrys currency
Example: bond sold by Nippon Steel, denominated in yen. A Canadian investor could purchase this bond by exchanging Canadian dollars for yen and then purchase the bond. However, the Canadian investor would be exposed to foreign exchange rate risk.

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Equity Instruments
Common Stock
Represents ownership of a firm Investors return tied to the performance of the company and may result in loss or gain

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Equity Instruments
Common Stock Classifications Industrial: manufacturers of automobiles, machinery, chemicals, beverages Utilities: electrical power companies, gas suppliers, water industry Transportation: airlines, truck lines, railroads Financial: banks, savings and loans, credit unions

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Buying Foreign Equities

American Depository Receipts (ADRs)
Easiest way to directly acquire foreign shares Certificates of ownership issued by a U.S. bank that represents indirect ownership of a certain number of shares of a specific foreign firm on deposit in a U.S. bank in the firms home country

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Buying Foreign Equities

Buy and sell in U.S. dollars Dividends in U.S. dollars May represent multiple shares Listed on U.S. exchanges

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Buying Foreign Equities

Global Mutual Funds or ETFs
Global funds: Invest in both U.S. and foreign stocks International funds: Invest mostly outside the U.S.

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Buying Foreign Equities

Funds can specialize
Diversification across many countries Concentrate in a segment of the world Concentrate in a specific country Concentrate in types of markets

Exchange-traded funds (ETFs) are a recent innovation in the world of index products

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Equity Derivatives: Warrants

Warrants
An options issued by a company giving the holders the right to buy its common stock Normally issued with bonds

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Equity Derivatives: Options

Equity-derivative securities which have a claim on the common stock of a firm Rights to buy or sell common stock or other underlying assets at a stated price for a period of time
Puts are options to sell Calls are options to buy

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Futures Contracts
Exchange of a particular asset at a specified delivery date for a stated price paid at the time of delivery Deposit (10% margin) is made by buyer at contract to protect the seller Commodities trading is largely in futures contracts Current price depends on expectations Example: Corn, soybeans, oil
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Financial Futures
Recent development of contracts on financial instruments such as T-bills, Treasury bonds, and Eurobonds Traded mostly on Chicago Mercantile Exchange (CME) and Chicago Board of Trade (CBOT) Allow investors and portfolio managers to protect against volatile interest rates Currency futures allow protection against changes in exchange rates Various stock futures on market indexes such as the S&P 500 and Value Line Index
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Investment Companies
Mutual Funds
Rather than buy individual securities directly from the issuer they can be acquired indirectly through shares in an investment company Investment companies sell shares in itself and uses proceeds to buy securities Investors own part of the portfolio of investments

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Investment Companies
Money-Market Funds
Acquire high-quality, short-term investments Yields are higher than normal bank CDs or GICs Typical minimum investment is $1,000 No sales commission charges Withdrawal is by cheque with no penalty Investments usually are not insured Total value reached more than $2.5 trillion in 2007
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Investment Companies
Bond Funds
Invest in long-term government or corporate bonds

Vary in bond quality from risk-free government bonds to high-yield or junk bonds Expected returns also differ reflecting the risk level of bonds in the fund
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Investment Companies
Bond Funds
Invest in a combination of stocks and bonds depending on their stated objectives Numerous non-stock indexes including various bond indexes have been created

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Investment Companies
Index Funds
These are mutual funds created to track the performance of a market index like the S&P/TSX Composite Appeal to passive investors who want to simply experience returns equal to some market index Lower costs to investors as management expense fees are lower than actively managed mutual funds

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Real Estate
Real Estate Investment Trusts (REITs)
Investment fund that invests in variety of real estate properties, similar to stock or bond mutual fund Construction and development trusts provide builders with construction financing Mortgage trusts provide long-term financing for properties Equity trusts own various income-producing properties
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Real Estate
Direct Real Estate Investment
Purchase of a home Purchase of raw land
Intention of selling in future for a profit Ownership provides a negative cash flow due to mortgage payments, taxes, and property maintenance

Land Development
Divide the land into individual lots Build houses or a shopping mall on it Requires capital, time, and expertise

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Low Liquidity Investments

Some investments dont trade on securities markets Lack of liquidity keeps many investors away Auction sales create wide fluctuations in prices Without notional markets, dealers incur high transaction costs Some may consider them more as hobbies than investments

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Low Liquidity Investments

Antiques
Dealers buy at estate sales, refurbish, and sell at a profit Serious collectors may enjoy good returns

Individuals buying a few pieces to decorate a home may have difficulty overcoming transaction costs to ever enjoy a profit them more as hobbies than investments

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Low Liquidity Investments

Art
Investment requires substantial knowledge of art and the art world Acquisition of work from a well-known artist requires large capital commitments and patience High transaction costs

Uncertainty and illiquidity

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Low Liquidity Investments

Coins and Stamps
Enjoyed by many as hobby and as an investment

Market is more fragmented than stock market, but more liquid than art and antiques markets
Price lists are published weekly and monthly Grading specifications aid sales Widespread between bid and ask prices

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Low Liquidity Investments

Diamonds
Can be illiquid Grading determines value, but is subjective Investment-grade gems require substantial investments No positive cash flow until sold Costs of insurance, storage, and appraisal

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Historical Risk Returns on Investments

Reilly and Wright (2004) examined the performance of various investment alternatives from the Canada, the U.S, Europe, Japan, and the emerging markets for the period 1993-2009 (CAD)
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Historical Risk Returns on Investments

The expected relationship between annual rates of return and total risk (standard deviation) of these securities was confirmed
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Comparing the TSX & Other Stock Markets

The systematic risk measure (beta) did a better job of explaining the returns during the period than did the total risk measure

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Correlations Between Various Capital Markets

A good hedge should have a strong positive correlation with inflation

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