3 Investment Analysis and Portfolio Management First Canadian Edition

3

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

Copyright © 2010 by Nelson Education Ltd.

3-2

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


3-3

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


3-4

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


3-5

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


3-6

The Case for Global Investments


3-7

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.


3-8


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.


3-9


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.


3-10


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


3-11

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


3-12


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


3-13


Global Equity Portfolio

Low Positive

Correlation

• Correlation of world equity markets resembles that for bonds

• Canada–U.S. correlation is relatively low ranging from .537 to .635 but is a very low

.389 when comparing

Canada & Japan


3-14


Global Equity Portfolio & Risk Reduction

• Opportunities to reduce risk of a stock portfolio by including foreign stocks


3-15

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


3-16

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


3-17


• 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


3-18


• 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)


3-19

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


3-20

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


3-21

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


3-22


• 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


3-23


• 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


3-24


• International domestic bonds

• Sold by issuer within its own country in that country’s 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.


3-25

Equity Instruments

• Common Stock

• Represents ownership of a firm

• Investor’s return tied to the performance of the company and may result in loss or gain


3-26

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


3-27

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 firm’s home country


3-28


• Buy and sell in U.S. dollars

• Dividends in U.S. dollars

• May represent multiple shares

• Listed on U.S. exchanges


3-29


• Global Mutual Funds or ETFs

• Global funds: Invest in both U.S. and foreign stocks

• International funds: Invest mostly outside the U.S.


3-30


• 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


3-31

Equity Derivatives: Warrants

• Warrants

• An options issued by a company giving the holders the right to buy its common stock

• Normally issued with bonds


3-32

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


3-33

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


3-34

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


3-35

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


3-36


• 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


3-37


• 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


3-38


• 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


3-39


• 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


3-40

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


3-41

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


3-42

Low Liquidity Investments

• Some investments don’t 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


3-43


• 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


3-44


• 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


3-45


• 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


3-46


• 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


3-47

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)


3-48

Historical Risk Returns on Investments

• The expected relationship between annual rates of return and total risk

(standard deviation) of these securities was confirmed


3-49

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


3-50

Correlations Between

Various Capital Markets

• A good hedge should have a strong positive correlation with inflation


3-51

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