Issuu

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

▪

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

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

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