Investment Analysis and Portfolio Management

Lecture 1 Gareth Myles

Website
The

module website is people.ex.ac.uk/gdmyles/GDM.html The website provides

A complete set o !otes "owerpoi!t slides #xercises $olutio!s Assessme!ts/Assig!me!ts "ast exams

The

slides are added be ore each lecture

Financial Data
Ma!y

o the exercises use real i!a!cial data This is obtai!ed rom %ahoo &i!a!ce $hare prices are obtai!ed by typi!g compa!y !ame i!to the 'Get (uotes) box '*istorical "rices) provides data at a chose! re+ue!cy ,daily- weekly- mo!thly. The data ca! be dow!loaded to a spreadsheet

Gains and Losses

$ome i!vestme!ts ca! be very success ul. /10-000 i!vested i! $eptember 1001 i! Lastmi!ute.com would have bee! worth /123-132 i! August 1002 410-000 i!vested i! August 1556 i! 7ephalo! would have bee! worth 4108-059 i! $eptember 1002 ,a!d 4160-000 i! 1008.

Gains and Losses

:ut past per orma!ce is a very poor guide to uture per orma!ce A!d this is despite rece!t headli!es

;ctober 1005 $cie!ti ic America! Maga<i!e Turbocharging the Brain Pills to Ma!e "ou #marter$ % Previe& ' Will a (ill at brea!fast im(rove concentration and memory) and &ill it do so &ithout long term detriment to your health$

And Losses

Losses i! value ca! be eve! more spectacular 410-000 i!vested i! $eptember 1000 i! "alm =!c. would have bee! reduced to 451 by April 1002 A holdi!g i! >uly 1000 o /1? millio! i! #xeter #+uity Growth &u!d would have bee! worth /81-392 i! August 1002 ,the share price ell rom 102.?0 to 0.?0.

Gains and Losses

*ariability
The

esse!tially eature o stock prices is u!predictable variability #ve! whe! averaged i!to a! i!dex this variability is appare!t "ort olio ma!ageme!t is about copi!g with the variability =!vestme!t a!alysis is about u!derlyi!g lo!ger@term tre!ds The same pri!ciples apply to both

*ariability

*ariability

*ariability

*ariability

Today

+vervie&
This

semester is about i!vestme!t i! i!a!cial port olios =!vestme!t is de i!ed as a sacri ice made !ow to obtai! a retur! later

=t is curre!t co!sumptio! that is sacri iced

Two

orms o i!vestme!t ca! be de i!ed

Real investment is the purchase o la!d- machi!eryetc Financial investment is the purchase o a ApaperA co!tract

+vervie&
Beal

i!vestme!ts a!d i!a!cial i!vestme!ts are li!ked

The share issue o a irm i!a!ces the purchase o capital The commitme!t to a mortgage i!a!ces the purchase o property

&i!a!cial

i!vestme!t ca! provide i!a!ce or real i!vestme!t decisio!s &i!a!cial i!vestme!t ca! guide real i!vestme!t decisio!s

Financial Investment
There

are !umerous compo!e!ts to i!a!cial i!vestme!t MarketsC where assets are bought a!d solda!d the orms o trade SecuritiesC the ki!ds o securities availabletheir retur!s a!d risks Investment processC the decisio! about which securities- a!d how much o each Financial theoryC the actors that determi!e the rewards rom i!vestme!t ,a!d the risks.

Mar!ets
A

market is a!y orga!i<ed system or co!!ecti!g buyers a!d sellers There are ma!y security markets Markets may have a physical locatio!

The Dew %ork $tock #xcha!ge

;r

exist o!ly as computer !etworks

The Lo!do! $tock #xcha!ge

Markets

vary i! the securities that are traded a!d i! the way securities are traded

,haracteristics of Mar!ets
There

are a !umber o ways to classi y markets "rimary/$eco!dary

Primary markets are security markets where !ew issues o securities are traded A secondary market is a market where securities are resold

The

Lo!do! $tock #xcha!ge is a seco!dary market Most activity o! stock excha!ges is i! the seco!dary market

,haracteristics of Mar!ets
Trades

irms Trades o! the seco!dary market do !ot raise additio!al capital or irms The seco!dary market is still importa!t

o! the primary market raise capital or

=t gives li+uidity to primary issues. Dew securities would have a lower value i they could !ot be subse+ue!tly traded =t sig!i ies value. Tradi!g i! assets reveals i! ormatio! a!d provides a valuatio! o the assets. This helps to guide i!vestme!t decisio!s

,haracteristics of Mar!ets
A

seco!d way to classi y markets is the times o tradi!g 7all/co!ti!uous

=! a call market tradi!g takes place at a speci ied time i!tervals $ome call markets have a provisio! that limits moveme!t rom the prior price. This is to preve!t a temporary order imbala!ce rom dramatically movi!g the price =! a continuous market there is tradi!g at all times the market is ope!

,haracteristics of Mar!ets
Markets

ca! also be characteri<ed by the li espa! o the assets traded Mo!ey/7apital

Money marketC the market or assets with a li e o less tha! 1 year Capital marketC the market or assets with a li e greater tha! 1 year

$ome

assets- such as most bo!ds- have a ixed li espa! 7ommo! stock have a! i!de i!ite li espa!

Bro!ers
A

broker is a represe!tative appoi!ted by a! i!dividual i!vestor :rokers have two co! licti!g roles
An advisorC a broker ca! o er i!vestme!t advice a!d i! ormatio! A sales personC brokers are rewarded through commissio! a!d have a! i!ce!tive to e!courage trade

full-service broker is a brokerage house that ca! o er a ull ra!ge o services i!cludi!g i!vestme!t advice a!d port olio ma!ageme!t

Bro!ers
A

discount broker o ers a restricted ra!ge o services at a lower price To complete a trade additio!al brokers are !eeded A floor broker is located o! the loor o the excha!ge a!d does the actual buyi!g a!d selli!g A specialist e!sures trade happe!s by holdi!g a! i!ve!tory o stock a!d posti!g prices

#ecurities

The sta!dard de i!itio! o a security isC "A le al contract representin the ri ht to receive future benefits under a stated set of conditions" The piece o paper de i!i!g the property rights held by the ow!er is the security

#ecurities
Mo!ey

market securities

$hort@term debt i!strume!ts sold by gover!me!tsi!a!cial i!stitutio!s a!d corporatio!s They have maturities whe! issued o o!e year or less The mi!imum si<e o tra!sactio!s is typically largeusually exceedi!g 4100-000
1.

Treasury :ills

E$ Treasury :ills are the least risky a!d the most marketable o all mo!ey markets i!strume!ts They represe!t a short@term =;E o the E$ ederal gover!me!t $imilar bills are issued by ma!y other gover!me!ts

#ecurities
Dew 51@ a!d 161@ day T@bills are issued weekly- by auctio! whereas ?1@week T@bills are issued mo!thly. A! active seco!dary market with very low tra!sactio!s costs exists or tradi!g T@bills T@bills are sold at a discou!t rom ace value a!d pay !o explicit i!terest payme!ts.

T@bills

are co!sidered to have !o risk o de ault- have very short@term maturities- a!d have a k!ow! retur! T@bills are the closest approximatio!s that exist to a risk@ ree i!vestme!t

#ecurities
7apital

market securities

=!strume!ts havi!g maturities greater tha! o!e year a!d those havi!g !o desig!ated maturity at all

1.

&ixed i!come securities

&ixed i!come securities have a speci ied payme!t schedule :o!ds promise to pay speci ic amou!ts at speci ic times &ailure to meet a!y speci ic payme!t puts the bo!d i!to de ault with all remai!i!g payme!ts. The creditor ca! put the de aulter i!to ba!kruptcy

#ecurities
&ixed

i!come securities di er rom each other i! promised retur! or several reaso!s

The

maturity o the bo!ds The creditworthi!ess o the issuer The taxable status o the bo!d
=!come

a!d capital gai!s are taxed di ere!tly i! ma!y cou!tries :o!ds are desig!ed to exploit these di ere!ces

#ecurities
1.1

Treasury !otes a!d bo!ds

The gover!me!t issues ixed i!come securities over a broad ra!ge o the maturity spectrum :oth !otes a!d bo!ds pay i!terest twice a year a!d repay pri!cipal o! the maturity date
1.1

7orporate bo!ds

These promise to pay i!terest at periodic i!tervals a!d to retur! pri!cipal at a ixed date These bo!ds are issued by busi!ess e!tities a!d thus have a risk o de ault

#ecurities
1.

7ommo! stock ,shares- e+uity.

7ommo! stock represe!ts a! ow!ership claim o! the ear!i!gs a!d assets o a corporatio! A ter holders o debt claims are paid- the ma!ageme!t o the compa!y ca! either pay out the remai!i!g ear!i!gs to stockholdi!gs i! the orm o divide!ds or rei!vest part or all o the ear!i!gs The holder o a commo! stock has limited liability F the most they ca! lose is the value o the shares

#ecurities
2.

Derivative i!strume!ts

Derivative i!strume!ts are securities whose value derives rom the value o a! u!derlyi!g security or basket o securities The i!strume!ts are also k!ow! as co!ti!ge!t claims- si!ce their values are co!ti!ge!t o! the per orma!ce o u!derlyi!g assets The most commo! co!ti!ge!t claims are options a!d futures 2.1 A! option o! a security gives the holder the right to either buy ,a call optio!. or sell ,a put optio!. a particular asset at a uture date or duri!g a particular period o time or a speci ied price

#ecurities
2.1 A future is the obligatio! to buy or sell a particular security or bu!dle o securities at a particular time or a stated price A uture is simply a delayed purchase or sale o a security 2.2 The corporatio! ca! issue contin ent claims. 7orporate@issued co!ti!ge!t claims i!clude rights a!d warra!ts- which allow the holder to purchase commo! stocks rom the corporatio! at a set price or a particular period o time

#ecurities
?.

=!direct i!vesti!g

The purchase o a shares o a! i!vestme!t port olio A mutual fund holds a port olio o securities- usually i! li!e with a stated policy obGective. !nit trusts i!vest depositorsH u!ds i! bo!ds or e+uities. $i<e is determi!ed by i! low o u!ds. Investment trusts =ssue a certai! ixed sum o stock to raise capital. This ixed capital is the! ma!aged by the trust. The i!itial i!vestors purchase shares- which are the! traded o! the stock market "ed e funds actively ma!age deposits i! excess o /100-000. Trade i! all i!a!cial markets- i!cludi!g derivatives.

-eturn
Return = end - of - period wealth -- beginning - of - period wealth beginning - of - period wealth

V0 =!itial value o i!vestme!t V1 &i!al value o i!vestme!t Betur! is ;r as a perce!tage

V1 V0 r= V0

V1 V0 r= 100 V0

-eturn
#xample
A!

i!itial i!vestme!t o 410-000 is made. ;!e year later- the value o the i!vestme!t has rise! to 411-?00. The retur! o! the i!vestme!t is

#xample
A!

12500 10000 r= 100 = 25% 10000

i!vestme!t i!itially costs 4?-000. Three mo!ths later- the i!vestme!t is sold or 49-000. The retur! o! the i!vestme!t per three mo!ths is
6000 5000 r= 100 = 20% 5000

-eturn and -is!

The

risk i!here!t i! holdi!g a security is the variability- or the u!certai!ty- o its retur! &actors that a ect risk are 1. Maturity
E!derlyi!g

actors have more cha!ce to cha!ge over a lo!ger hori<o! Maturity value o the security may be eroded by i! latio! or curre!cy luctuatio!s =!creased cha!ce o the issuer de aulti!g the lo!ger is the time hori<o!

-eturn and -is!

1.

7reditworthi!ess

The

gover!me!ts o the E$- EI a!d other developed cou!tries are all Gudged as sa e si!ce they have !o history o de ault i! the payme!t o their liabilities $ome other cou!tries have de aulted i! the rece!t past 7orporatio!s vary eve! more i! their creditworthi!ess. $ome are so lacki!g i! creditworthi!ess that a! active HHGu!k bo!dHH market exists or high retur!- high risk corporate bo!ds that are Gudged very likely to de ault

-eturn and -is!

2.

"riority

:o!d

holders have the irst claim o! the assets o a li+uidated irm :o!d holders are also able to put the corporatio! i!to ba!kruptcy i it de aults o! payme!t
3.

Li+uidity

Li+uidity

relates to how easy it is to sell a! asset The existe!ce o a highly developed a!d active seco!dary market raises li+uidity A securityHs risk is raised i it is lacki!g li+uidity

-is! and -eturn

?.

E!derlyi!g Activities

The

eco!omic activities o the issuer o the security ca! a ect how risky it is $tock i! small irms a!d i! irms operati!g i! high@tech!ology sectors are o! average more risky tha! those o large irms i! traditio!al sectors

-eturn and -is!

The

greater the risk o a security- the higher is expected retur! Betur! is the compe!satio! that has to be paid to i!duce i!vestors to accept risk $uccess i! i!vesti!g is about bala!ci!g risk a!d retur! to achieve a! optimal combi!atio! The risk always remai!s because o u!predictable variability i! the retur!s o! assets

The Investment Process

A

descriptio! o the process isC

1. Set investment policy
;bGectives Amou!t 7hoice o assets

1. Conduct security analysis

#xami!e securities ,ide!ti y those which are mispricedJ.

Ese
a. Tech!ical a!alysis F the exami!atio! o past prices or tre!ds b. &u!dame!tal a!alysis F true value based o! uture expected retur!s

The Investment Process

2.

Portfolio Construction

=de!ti

y assets 7hoose exte!t o diversi icatio!

3. ?.

Portfolio #valuation
the per orma!ce o port olio previous three steps

Assess

Portfolio Revision

Bepeat

Buying ,ommon #toc!s

;pe!

a! accou!t with a brokerage a!d speci y 1. Dame o irm 1. :uy or sell 2. $i<e o order 3. *ow lo!g u!til order is ca!celled ?. Type o order

Buying ,ommon #toc!s

Time

Limit

This

is the time withi! which the broker should attempt to ill the order $ay order % ill duri!g the day it is e!tered or else ca!cel &pen order ,or 'ood (ill Cancelled. % remai!s i! e ect u!til illed or ca!celled Fill-or-kill F ca!celled i !ot executed immediately $iscriminatory order F le t to broker

Buying ,ommon #toc!s

Type

o ;rder

Market
price

&rder F buy or sell- with broker maki!g best e ort

u!certai! executio! certai!

)imit
a

&rder F A limit price is speci ied

maximum i buyi!g a mi!imum i selli!g executio! u!certai! price certai!

Buying ,ommon #toc!s

Type

o ;rder

Stop &rder % a stop price is speci ied

$ell i price alls below the stop price ,A stop@loss is used to lock@i! pro its. :uy i price rises above the stop price #xecutio! is certai! i stop price passed "rice is u!certai!

Stop )imit &rder

A mi!imum price is placed below the stop@price or a sell

or A maximum price is placed above the stop@price or a buy "rice is certai! withi! a ra!ge #xecutio! is u!certai!

Margin Account
A

mar in account with a broker allows or limited borrowi!g to purchase assets A margi! accou!t !eeds a hypothecatio! agreeme!t

a. broker ca! pledge securities as collateral b. broker ca! le!d the securities to others

&or

a. a!d b.- shares are held i! street name

;w!ed legally by brokerage Divide!ds- voti!g rights- reports go to i!vestor

Margin Account
Margi!

"urchase

:orrow mo!ey rom broker to i!vest The cost o borrowi!g is i!terest plus a service charge
Initial

mar in re*uirement

The mi!imum K o i!vestme!t rom i!vestorLs ow! u!ds

Actual

mar in

market value of assets - loan A tual Margin = market value of assets

Margin Account
A

margi! accou!t is marked to market at the e!d o each tradi!g day

A daily calculatio! o actual margi!

margi! accou!t is subGect to a maintenance mar in re*uirement

The mi!imum acceptable value o the actual margi!

actual margi! M mai!te!a!ce margi! the! a mar in call is issued The i!vestor is obliged to add cash or securities to the margi! accou!t

Margin and -eturn

:uyi!g
Let

o! the margi! raises retur! #xample

purchase price o a security be /?0 Let price o security !ow be /9? Assume 100 u!its were purchased a!d !o divide!ds were paid Betur! o! cash purchase

Margin and -eturn

Betur!
Total

o! margi! purchase

cost N /?0 x 100 N /?000 =!terest rate N 11K =!itial margi! N 90K so loa! N /1000

Betur!

is i!creased

Margin and -eturn

:ut

i price alls

Assume price !ow is /30 rather tha! /9?

( !0 - 50) 100 2000 0$11 Margin Re turn = = !0$#$#%

5000 0$6
*e!ce buyi!g o! the margi! also mag!i ies losses 7o!clusio!C use margi! whe! belie is that prices will rise

!0 - 50 "ash Re turn = = 20% 50

#hort #ales
A

short sale is the sale o a security you do !ot ow! This is achieved by borrowi!g share certi icates rom someo!e else The borrowi!g process is arra!ged by a broker To allow shares to be borrowed the broker either
a. Eses shares held i! street !ame b. :orrows rom a!other broker

#hort #ales
%roker
+rovides margin -ends sto k +a&s pri e Re eives sto k ,old C owns sto k

*hort *eller A

'nitial (wner B
%roker

%u&er C

)irm

"ash for dividends

.ividends/ reports/ voting rights

Reports

*hort *eller A

'nitial (wner B

%u&er C

)irm

.ividends/ reports/ voting rights

#hort #ales
Margi!
There

is a risk i!volved so short seller ,A. must make a! i!itial margi! adva!ce to the broker The broker the! calculates the margi! each day $hort sales should be used whe! prices are expected to all