Principles of Investments Lecture Notes



Principles of Investments Lecture Notes

Set 2

What is Investment

This course looks at investment from the perspective of a saver. That is, the individual that has money that he wants to save and on which he wants to get a rate of return. This is what we term financial investment. This is slightly different from the way investment is used in economics. In economics, investment is from the perspective of the economy. It refers to the creation of capital goods, which are those goods that are used to produce consumption goods. For example, equipment, machinery, buildings, etc. may all be considered capital goods. These two types of investment (financial and economic) are really two sides to the same coin. On one side we have the saver that uses his money in an attempt to get a return by buying stocks, bonds, etc. The other side of that transaction though is the business that acquires the money from the saver in exchange for a future rate of return. Of course, that business will afford to pay this rate of return because it will take the funds from the saver and make economic investment in capital goods. This is displayed in the figure below.

[pic]

In economics we would be ultimately interested in the investment that occurs at the end of the above transaction. This of course is influenced by savings, financial markets, and technology.

In finance we are interested in investment from the perspective of investors. We will focus on how financial investment actually occurs, and how investors can make good decisions regarding investment.

Some Definitions

Financial Assets: Pieces of paper that are a claim on the company that issued the paper. For example, a bond is a piece of paper that entitles the owner to the principle and interest as specified on the bond. Equity/Stock is a piece of paper that entitle the owner to dividends from the company that issued the equity. Sometimes we refer to financial assets as financial instruments or securities.

Debt vs. Equity: Debt is when a company has borrowed money. It is a liability for the company, and a financial asset for the investor that holds the debt.Equity is a share of ownership of the company. It is a liability for the company, and a financial asset for the holder of the equity. The big difference between these two involve differences in risk and return.

Marketable Securities: Marketable securities are financial assets that are traded on organized markets; for example, stock markets and bond markets.

Derivatives: Derivatives are assets that derive their value from some underlying financial assets. Examples include put options, call options, futures contracts, and swaps.

Portfolio: A portfolio refers to a group of financial assets owned by an investor. We will later talk about the significance of portfolios, and the optimal selection of a portfolio.

Indirect vs. Direct Investment: Direct investment is when the investor owns the financial assets of the issuer. Indirect investment is when the investor deposits savings with a financial intermediary, and the financial intermediary purchases financial assets of the issuer. Essentially, the finanical intermediary makes the investment decisions for the investor.

Financial Intermediaries: Financial intermediaries (or Institutional Investors) are middlemen between savers and firms issuing debt or equity. They accept deposits from individual investors and use the deposits to acquire financial assets. Examples include banks, mutual funds, insurance companies, etc.

Types of Investments

Below we discuss the alterternatives for long-run investment. These are

1. fixed income securities

2. equity

3. indirect investment through mutual funds.

1. Fixed Income Securities

Securities that specify the dates of payments and amounts. Bonds are the most prominent example of fixed income securities and thus most are time is spent discussing bonds.

A bond is a long-term (more than one year) debt instrument. The bond holder is the lender, and the bond issuer is the borrower. Some features of bonds are below.

Bond Features

1. Maturity: The maturity date is when the bond issuer finishes his repayment of debt to the bond holder.

2. Par Value/Face Value: The amount paid to the bond holder at maturity

3. Coupon Bonds: Most bonds are coupon bonds. The coupons represent the interest payments (or coupon payment) prior to maturity. Most coupon bonds pay interest every six months. The interest rate used to calculate the coupon payment is called the coupon rate is specified on the bond, and is applied to the face value, in annual terms, even though the payments are semi-annual. For example, suppose you have a 10 year, RO10,000 coupon bond that has a 5% annual coupon rate. This means the annual coupon payments must equal 5% of RO10,000, or RO500. But since the interest is paid semiannually, each coupon payment will be for RO250.

4. Call Provision: Most bonds have a call provision. This allows the bond issuer to pay off the bond early, before the maturity date. This is a useful provision for the bond issuer in case the market interest rate drops. It allows them to replace higher interest debt with lower interest debt. The call provision usually applies only some period of time after the bond is intially issued. For example, maybe 2 years after a 10 year bond is issued. So when buying a previously issued bond the investor should know if that bond can be called. If it can he needs to calculate the return on the bond under the assumption it is called, or not called.

5. Conventions in Bond Prices: Bond prices are quoted as a percentage of their par value, where it is convention to use 1,000 as the par value. So a price of 90 represents 90% of par value, or 90% of 1,000, which is equal to 900. Of if the price is 105, this means that the price is 105% of 1,000, or 1050.

6. Accrued Interest: Bonds are traded on an accrued interest basis. When you buy a bond, you must pay the price of the bond and the interest that would be owed to seller of the bond if he holds it to the next coupon payment.

Types of Bonds

1. Government: Any government may issue a bond. This includes national governments, and some local governments. For example, in the U.S. both states and cities issue bonds.

2. Corporate: Large corporations issue corporate bonds. Some features and terms relating to bonds one should know are as follows:

a. Senior Securities: This means that the corporation must pay off its bonds before its other obligations.

b. Debenture: A debenture is an unsecured bond; i.e. not backed by an asset.

c. Convertible Bonds: Some bonds are convertible into common stock. These are really two assets in one; a bond and an option on stocks.

d. Bond Ratings: Investor Services (such as Standard and Poor’s) offer ratings of bond meant to provide and investor with the riskiness of debault on the bond. A high rating implies low risk of default, and a low rating implies high risk of default. The ratings are given in letters, with AAA being the best, then AA, then A, BBB, BB, and so forth until you get to the rating of D.

e. Junk Bonds: Bonds rated BB or lower are considered high risk/high return bonds.

An Aside: Asset Backed Securities

Suppose someone buys a large number of assets, such as home mortgages. This person can then issue a security linked to the performance of the portfolio. The security issued is thus an asset backed security.

Why would someone issue an asset backed security? The idea is the the portfolio of assets, say home mortgages, would have a lower default risk than any inidividual home mortgage. For instance, suppose a mortgage has an average default risk of 10%, meaning 10% of the time the borrower will default on the loan. This means a relatively high risk for the lender, so they are less likely to lend without sufficient collateral, strict income requirements, etc. However, if I take 100 different mortgages, all with individual 10% default risk, the portfolio of 100 mortgages in total has a lower than 10% default risk. The reason is, I know with near certainty that 10 of the 100 mortgages will default. So I know almost exactly what will be the payoff to this portfolio; that is, risk is removed. Hence an asset backed security is a relatively lower risk portfolio of individually risky assets.

Because risk is reduced investors tend to invest more in asset backed securities. As a result, lenders would be more eager to issue home mortgages, thus making getting a mortgage easier for borrowers. In fact, the interest rates, collateral, terms of loans, down payments, were all reduced because of asset back securities.

So how did the asset backed securities cause a financial crisis? Basically, the U.S. government subsidized these asset backed securities. Government created lending agencies became a ready market for asset backed securities. The difference was, because the government stood ready to buy these securities, the individual lenders no longer were as concerned about risk of individual mortgages. So instead of the default risk being 10%, the default risk became, say, 25%. In other words, the asset backed securities became a portfolio of individually bad assets. And eventually these assets stopped performing (i.e. high rate of default), and investors in these securities lost billions of dollars.

It should be noted that the primary cause of the financial crisis was NOT asset backed securities. Such securities have existed for almost 30 years. The problem was the U.S. government subsidizing these securities, causing lenders to make risky loans. There is an important lesson for investors. The government backing of investment assets, including banks, on one hand reduces risk becaue the government has the power of taxation to make sure the assets pay off. On the other hand, the government backing of investment assets causes the lenders to make very risky loans, and eventually these loans will not pay off. So if the government is not perfectly committed to supporting these assets, the investors will eventually lose if the assets do not pay off.

2. Equities

Equities represent ownership in the company. When you buy an equity, you buy a share of the company. The company is not obligated, legally, to pay you back anything at any point in time. As a part owner of the company you share in the profits and losses of the company. In other words, you as a part owner are a residual claimant to the company’s assets. That is, only after the company has paid for all other obligations, including debt to bondholders, may the equity holders receive anything.

There are two types of equities, or stocks: Preferred Stock and Common Stock. Common stock is that we have been discussing. Preferred Stock is a kind of mix of both common stock and bonds. Preferred stock promises the stockholder a fixed dividend payment indefinitely into the future. Often the dividend payment is tied to the market interest rate. Like bonds preferred stock can be called by company and retired. Also, there is often an option for converting the preferred stock to common stock.

Common Stock

However most stock is common stock, and we use the term interchangeably with equities. The reason a company issues common stock is to raise funds, usually for some capital investment. When a company issues stock for the public to buy we say the company is “going public”.

Aside: Note that a company can raise funds by either issuing bonds (i.e. borrowing) or by issuing stock (i.e. selling ownership of the company). The question of which is the best decision is a significant question for corporations, and is studied in the field of corporate finance.

If a company issues stock it is either traded on an exchange (if it meets some requirements) or it is traded on the “over-the-counter market”.

A stock holder is a residual claimant, meaning they can only receive dividends after all other obligations are met. Also, if the company fails they can split any assets only after other obligations are satisfied first. However, any stockholder is limited in liability to what he has invested. In other words, as an investor you cannot lose more than what you invested. For this reason, this is attractive to investors and has enabled corporations to be a very successful form of business organization and raise substantial amounts of funds for capital investment.

Characteristics of Common Stock

Market Value: The market value is simply the observed price of the stock.

Dividends: Payments made by the company to stockholders. For instance, if a company pays out $1,000,000 in dividends and there are 100,000 shares, then each share receives $10. Note that dividends is reported as the amount per share. So the dividend in this case is $10. It is important to realize that there is not any obligation for a company to pay dividends.

Dividend Yield: Dividends divided by the current stock price. If the current stock price is $200 and the dividend is $10, then the dividend yield is $10/$200 = 0.05 = 5%

Payout Ratio: Dividends divided by earnings per share. If earnings per share is $20, then the payot ratio is $10/$20 = 50%.

Stock Dividend: While dividends are usually paid in cash, it is possible to declare a dividend and pay it in the equivalent value of stock. Note this is not newly issued stock, but instead reapportions the stock from the company to stockholders. A 5% stock dividend would entitle an owner of 100 shares to 5 more shares.

Stock Split: These are new issues of stock, where the new stock is given to existing stockholders proportional to total shares outstanding. For example, a 2 to 1 stock split means every share will now be worth 2 shares.

Derivative Securities

Derivatives are securities that derive their value from another underlying security. The most important examples are options and futures. Both options and futures contracts are traded on organized stock exchanges.

The main purpose of options and futures is that an investor can manage risk by proper use of these derivatives. While their ultimate purpose is similar, these securities are different. The option security gives the holder of the security the right to either buy or sell the underlying security. A futures contract is an obligation to buy or sell the underlying security.

Options

The are two types of options; an option to buy a stock or an option to sell a stock.

Put Option: A put option is the option sell a specific number of shares of stock at a specified price within a specified period of time. For example, you may have the option to sell 10 shares of microsoft stock at a price of $10/share, and this option lasts for the next three months. So no matter what the current price of the stock is, you can sell at $10/share.

Call Option: A call option is the option to buy a specific number of shares of stock at a specified price within a specified period of time. For example, you may have the option to buy 10 shares of microsoft stock at a price of $10/share, and this option lasts for the next three months. So no matter what the current price of the stock is, you can buy at $10/share.

Option Prices

We first must understand that the value of the option is determined by movements in the price of the underlying stock. If the price of the stock rises in the short-term, then the call option will rise in value (since the call option would give you the right to buy the stock at a below market price). Similarly if the price of the stock falls in the short-term, the call option will decline in value.

If the price of the stock falls in the short-term, then the put option will rise in value (since the put option would give you the right to sell the stock at an above market price). Similarly if the price of the stock rises in the short-term, the put option will decline in value.

Thus we can see that options can be used to speculate on changes in the stock prices. The other implication is that options can be used to reduce, or hedge, risk. For instance, suppose you own a stock. The risk is the stock may fall in value. But if you buy a put option on the stock, the value of the put option will rise when the value of the stock is falling. Hence your portfolio is not nearly as risky. Of course, this also means that you reduce your gains if the value of the stock rises. If your stock rises in value, then your put option would decline in value, meaning you don’t get that gain in the value of the stock. So we see that you can hedge your risk in a portfolio of stocks by buying options on stocks.

Futures

A futures contract will also allow you to hedge risk because its value will also change as the price of the underlying stock changes. For example, if you have a contract in which you must buy mircosoft stock in the future at a particular price, and the price of the stock falls, then the futures contract is worth more. Or if you have a contract in which you must sell microsoft stock at a particular price in the future, and the price of the stock rises, then the futures contract is worth more.

3. Indirect Investing Through Mutual Funds

For any individual investor we can characterize 3 types of investment:

1. Hold liabilities of traditional intermediaries, such as banks.

2. Hold securities directly, such as stocks and bonds.

3. Hold securities indirectly, such as through a mutual fund.

Indirect investment is number 3. In indirect investment the individual buys shares of an investment company’s fund. The number of shares they buy determines the amount of gains the shareholders gets, as well as the expenses of the company they must contribute to.

The benefit for an investor is they can participate in the securities market, while not having to manage a portfolio themselves.

Investment Company

An investment company is a financial company selling shares of itself to the public. The funds raised through the selling of shares is used then to invest in a portfolio of securities. The portfolio can include money market securities, government bonds, corporate bonds, domestic stocks, international stocks, or any other traded securities.

For example, Fidelity Investments is a company that offers about 100 equity funds and over 100 bond and money market funds.

Types of Investment Companies

1. Unit Investment Trusts: An unmanaged form of investment company. They typically hold fixed-income secruities (such as bonds). The main objective is to offer a low risk, low transaction cost investment to those who simply want to preserve their capital.

2. Closed-End Investment Company: An investment company that offers shares one time to the public, so their capitalization is fixed. The shares of such companies can be bought and sold in the stock market like other companies.

3. Open-End Investment Company or Mutual Fund: These companies continually sells shares to new investors, expanding their capitalization. As their funds grow they can offer a wider array of funds to investors.

Mutual Funds

Because mutual funds are the most popular type of investment company most of our attention is given to them. The reason for their success stems from being able to increase their capitalization. This is important as there are significant economies of scale in portfolio management. While the same level of expertise is required for a small fund, or a large fund, the large fund can spread those costs of management over a large number of people, implying the average cost per person is very small. This shows up as higher returns for large investment companies.

Owners of shares of mutual funds can sell them back to the company (redeem them) at any time, and the investment company is legally obligated to buy them back. The redemption value (essentially the price you can sell your shares back to the investment company) is the net asset value.

The net asset value is the total value of the securities in the investment company’s portfolio divided by the number of shares of the investment company currently outstanding. (The total value of the securities held by the investment company is simply the sum of each securities price multiplied by the number of that security held. ). So the net asset value basically is the value of one share of the investment company.

Types of Mutual Funds

The following chart shows the major types of mutual funds and categorizes them by risk/return.

[pic]

Money Market Funds

Money market funds (MMFs) are open-ended investment companies whose portfolio consists of money market securities. These funds are a relatively recent innovation, created in the 1970s. Over the years the deregulation of financial institutions have increased short-term interest rates, and MMFs allow investors to take advantage of this. Moreover, MMFs also offer high liquidity as they can easily, at low cost, be sold back to the fund. Given the high short-term interest rates and liquidity it would seem they are always better than savings deposits. However, one advantage of deposits at financial institutions is that the deposits are likely to be insured, while MMFs are not. So if the MMF collapses, investors lose their money. But if you deposit in a bank, and the bank fails, you do not lose your deposit.

Stock Funds and Bond and Income Funds

Generally, speaking the above two types of funds invest in different types of securities for different reasons. For instance, some invest in stocks for the purpose of realizing gains of capital appreciation. Others invest in stocks for the purpose of dividend gains, or realization of income.

For instance, when considering objectives, is the objective to be aggressive and choose stocks one believes will appreciate quickly, or is the objective to be safe and capture the gains of dividends from established companies. Of course, a combination of these is also possible. Other objectives included liquidity. The essential trade-offs between risk, return, and liquidity offers a wide variety of portfolios and asset to meet any individual investors desires. The attached table (Exhibit 3.1) demonstrates a wide variety of funds and the objectives of each fund.

One newer system classifies funds by one of five objectives:

• aggressive equity

• growth equity

• general equity

• value equity

• income equity

Two important ones include value and growth funds. Value funds try to find stocks that are of low price, but are expected to increase in price over time. Hence they currently represent good value. Growth funds are stocks of companies that are expected to show rapid growth in earnings, and hence dividends, even if current earnings are low. These types of funds tend to do well at different times, so holding a combination of both is probably wise.

Expenses and Fees for Mutual Funds

Load Fund: A load fund refers to a mutual funds that charges a sales of fee at the time one invests in the mutual fund. Many mutual funds now are agressively marketed and sold on a commission basis by brokers and agents. The sales fee is meant to compensate for these marketing expenses.

The load fee is usually expressed as a percentage of the initial investment in the mutual funs. For instance, if the fee is 5% and the amount invested is $1,000, then the load fee is $50. However, as with other products sold on commission, the larger the purchase the lower the percentage charged for commission.

Apart from the front-end sales fees, other fees include annual fees for distibribution, marketing, advertising. Notice that even though such expenses are incurred to attract new investors to the fund, all current investors must pay. The rationale is that current investors benefit when new investors are added, because this lowers the average cost to all investors.

Finally, another way of offsetting the sales expense is called a redemption fee. This is a fee that is charged when one liquidates their investment in the mutual fund. It can be thought of as a deferred load fee. Generally, the redemption fee declines as the length of time one invests in the mutual fund increases.

It should be noted that there are some funds which use all three kinds of fees; load fees, annual fees, and redemption fees. An investor needs to be aware of all fees charged on a mutual fund before a decision is made.

No-Load Fund: A no-load fund that does not charge a sales fee at the time of initial investment. The reason is that there is simply no sales force to compensate for selling the mutual fund to investors. In this case the mutual fund is simply purchased at its Net Asset Value. Marketing of no-load funds is done simply through advertisement in the financial press. Since there is no load fee, the marketing cost is covered by operating expenses, which the mutual fund covers out of the return on the assets in which it invests.

Comparing Load and No-Load Funds

Since load funds charge an up front fee for marketing, which no-load funds take it out of operating expenses, it is not clear one is better than the other. However, the lack of a sales staff for no-load funds should reduce their expenses and make the returns higher.

This begs the question as to why anyone would by a load fund. The basic reason is that many people fee more comfortable having a sales person explain mutual funds to them. A sales person, while not an investment analyst, can explain the different types of funds to an individual. So if the individual is unfamiliar with mutual funds, they may prefer buying from a salesperson.

As of today, both load and no-load funds are important in the market place, with no-load funds having a little over 50% of all new investment in mutual funds.

Performance of Mutual Funds

The performance of a mutual fund, like any asset, is based on returns. The returns include all returns; returns from income (such as dividends) and returns from capital gain/loss (changes in price of assets).

The returns of mutual funds can be reported over the past year, or to get a longer term perspective cumulative returns can also be reported for multiple years, such as 5 years, or 10 years.

For instance, consider the table below:

| |Past 1 Year |Past 5 Years |Past 10 Years |

|Fund A |-10% |25% |75% |

The above table says the return last year was negative; a 10% loss. However, over the past five years the return was a positive 25%, and over the past 10 years a positive 75%.

To understand the returns, it should be understood these are net returns. It represents the increase in wealth due to investment in the mutual funds, and does not include the initial investment. For example, suppose you had invested $1,000 10 years ago. How much would you have today? You would have $1,000 + 0.75*1,000 = $1,750. Or notice if we factor out the initial investment of $1,000, we have

$1,000(1+0.75) = $1,000(1.75)

So we see we simply take the initial investment and multiply by 1one plus the net return.

Measuring Performance

has a star rating system, where five stars is the best. The ratings are based on risk and return, and are issued for all the various categories of funds. So each funds is compared against only other funds in the same category.

Also, there is a clear meaning to the ratings. After all funds are rated, the top 10% receive 5 stars, the next 22.5 percent receive 4 starts, the next 35 percent receive three starts, the next 22.5 percent receive 2 stars, and the bottom 10% receive 1 star.

Expenses and Performance

It is worthwhile to investigate all expenses of a mutual fund. Not suprisingly, much of the difference in performance of mutual funds can be attributed to variation in expenses. Hence, poor management skills can lead to high operating expenses, and thus to low performance.

Consistency of Performance.

While the 5 and 10 year past performance is given, a question is whether or not this is meaningful information. In other words, is past performance and indicator of future performance? Though the answer is inconclusive, the evidence seems to suggest there is little correlation between past and future performance. For this reason some prefer to buy non-managed funds; or index funds such as the S&P 500. The rationale is if the performance is just as good, but the operating expenses are lower, performance should be higher with such funds.

Exchange Traded Funds (ETFs)

ETFs are index funds that are traded on organized exchanges.

Like an index mutual funds, an ETF is a portfolio of securities that is passively managed. Unlike the mutual fund, but like the closed-end fund, an ETF is traded on stock exchanges. The price one pays is simply the market price, but this is generally the NAV. Like a closed-end fund, the purchase of an ETF does not increase the money in the fund because for every buyer there is a seller.

While an ETF is an index fund, there is a wide range of ETFs available. Some are merely based on stock market index, like the Standard and Poor’s 500. Others hold stocks of a particular sector (such as oil and gas, biotechnology, etc.), or stocks of a particular region of the world. And while the majority of ETFs hold only equity securities, some also hold debt securities.

Given the similarity to mutual funds one may wonder why would a person invest in an ETF instead of a mutual fund. There a a few reasons.

1. Liquidity: Since ETF’s are traded on organized exchanges, they can be bought and sold throughout the day, whereas a mutual fund can only be bought and sold at the end of the day, when NAV can be computed.

2. Same Features as Trading in Stocks: With individual stocks, an investor can buy on margin (which means buy with borrowed funds). Also, with individual stocks and investor can sell short (this means committing to selling even though you do not own the stock). Both of these are features useful for speculators and professional investors. These same features apply to ETFs, but not to mutual funds. Hence ETFs are more popular with such professional investors than mutual funds.

3. Trading ETFs does not create capital gains/losses for other investors: When one sells an ETF, another person is buying the ETF with no change in the total quantity invested in the fund. However, when one sells there share of a mutual fund, the mutual fund must sell of its securities. This, potentially, could create capital gains for the fund, which implies the shareholders of the fund will be liable in taxes.

4. ETFs have lower operating expenses leading to greater returns for investors: We know passively managed funds will have lower expenses than actively managed funds. Since ETFs are passively managed, there expenses are low. However, even when we compare passive mutual funds to ETFs, still the ETFs have lower operating expenses.

For these reasons ETFs have become a popular fund, and that popularity is likely to continue to grow.

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Households/ Savers

Financial Transactions

Businesses Buy Capital

Savings

Debt/Equity

Money Market Funds

Bond

Funds

Stock

Funds

Int’l Stock Funds

Low Risk/Return

High Risk/Return

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