MONASH
BUSINESS
SCHOOL
Investment and Portfolio Management
Lecture 1 – Part A - Chapter: 1
Topic Overview:
-Investment
-Financial Assets and Financial Market
-Investment Process
-Lessons from GFC
What is an Investment?
• Current commitment of money or other resources in the expectation of
reaping future benefits
• Key attribute central to all investments is …
• You sacrifice something of value now expecting to benefit from that
sacrifice later.
• Main focus of this unit is investments in financial assets
• So, we need to understand,
• Role of financial assets in the economy
• Role of financial markets in the economy (in which financial assets are
traded)
• Lessons provided by financial crisis such as GFC
2
Financial Assets
Main Features:
• Financial assets are claims to the income generated by real assets
• They are no more than sheets of paper …. or more likely to be computer entries
• They do not directly contribute to productive capacity of the economy
Real Assets:
Financial assets are claims on real assets. What are real assets?
• Real assets determine the productive capacity and net income of the economy.
• Examples: Land, buildings, machines, knowledge etc. used to produce goods and
services.
3
Financial Assets cont.
Types:
1. Fixed income or debt securities
• Promise either a fixed stream of income or a stream of income determined by a specified formula
2. Common stock or equity
• Represent an ownership share in the corporation
3. Derivative securities
• Provide payoffs that are determined by the prices of other assets
•Now, you can understand the link;
•even if you cannot own your own auto plant (real asset), you can still share in the income derived
from the production of automobiles by investing in shares of Ford or Toyota (financial asset).
4
Financial Markets and the Economy
• Financial assets trade in financial markets.
• So, what roles do the financial markets play in an economy?
• Informational role
• Consider a company with high growth prospects ... This is the information
investors have.
• Its share price will rise making it easier for that company to raise capital.
• Price rise will encourage the company to invest more.
• So, the capital flows to companies with best prospects
• Consumption Timing
• Investors can use securities to store wealth and transfer consumption to the
future
5
Financial markets cont.
• Allocation of Risk (that gives benefits to both investors and firms)
• Investors can select securities consistent with their tastes for risk
• So, firms that need to raise capital can sell securities for the best possible
price
• Separation of ownership and management
• With global financial markets and large scale production, the size and
capital requirements of firms has skyrocketed.
• Investors can own a share of a company (and have claims on the income
stream of it) without actively involved in the management of its day-to-day
affairs.
• Financial assets and markets have made this easy.
6
More about separation of ownership and management
Agency Problem:
• Conflict of interest:
• This arise when managers start pursuing their own interests instead of
maximising firm's value.
• Mechanisms to mitigate agency problems:
• Tie managers' income to the success of the firm (stock options)
• Monitoring from the board of directors
• Monitoring by outsiders such as large institutional investors and security
analysts
• Takeover threat
7
Are financial markets competitive?
•
•
Financial markets are highly competitive.
• Thousands of intelligent and well-backed analysts constantly scour securities markets
searching for the best buys. This competition means that it is hard to find ‘free lunches’.
This ‘no free lunch’ proposition implies that …
(1) There is a ‘risk-return trade-off’ in financial markets
• If you need a higher expected return, you need to pay the price of accepting higher
investment risk.
Expected
Return
Risk
8
Competitive financial markets cont.
(2) Markets are efficient … Efficient Market Hypothesis (EMH)
• Prices quickly adjust to all relevant information, and therefore there shouldn’t be either
underpriced or overpriced securities.
• One implication of EMH is the choice between active and passive management of
portfolios
• Passive management believes in EMH and calls for,
• Holding a highly diversified portfolio
• No attempt to find undervalued securities
• No attempt to time the market
• Active management is based on the notion that markets are not efficient and therefore
involves,
• Finding mispriced securities
• Timing the market
9
The players in the market
• Three major players (from a bird’ eye view)
• Firms - Demanders of capital
• Households - Suppliers of capital
• Governments – Can be both borrowers or lenders
• Financial Intermediaries: Bring the suppliers of capital (investors) together with
the demanders of capital (primarily corporations and the federal government)
• Examples: Investment Companies; Banks; Insurance companies; Credit unions
• Investment bankers: Specialise in the sale of new securities to the public, typically
by underwriting the issue
10
The players in the market cont.
• Venture Capital (VC) and Private Equity
• Venture capital: Money invested to finance a new, not yet publicly traded firm
• Private equity: Investments in companies whose shares are not publicly
traded in a stock market
• Fintech and Financial Innovation
• Application of technology to financial markets that challenges conventional
centralised financial networks
• Examples: Peer-to peer lending; Cryptocurrencies
11
Investment process
• A basic advice to investors: Don't put all your eggs in one basket
• Invest in a portfolio of securities (assets)
• What is a Portfolio?: A Collection of investment assets.
• Once a portfolio is established, it needs to be updated or rebalanced by
• selling existing securities and replacing them with new ones,
• Investing additional funds and increasing the size of the portfolio or
• Selling securities and decreasing the size of the portfolio
12
Investment process cont.
•
Asset allocation and security selection are central decisions in portfolio construction
• Assets allocation: Choice among broad asset classes
• Security selection?: Choice of securities within each asset class
•
•
If an investor starts with assets allocation … then
• it’s a ‘top down’ portfolio construction approach
• asset allocation followed by security analysis to evaluate which particular securities
to be included in the portfolio
If an investor starts with security selection … then
• it’s a ‘bottom-up’ approach
• investment based solely on the price-attractiveness of securities without much
concern for assets allocation
13
Financial crisis of 2008
Antecedents of the Crisis:
• “The Great Moderation”: A time in which the U.S. had a stable economy with low interest rates
and a tame business cycle with only mild recessions
• Historic boom in housing market
• Changes in housing finance – from “Originate to hold” to “Originate to distribute”
The Shoe Drops
•2000-2006: Sharp increase in housing prices caused many investors to believe that continually
rising home prices would bail out poorly performing loans
•2004: Interest rates began rising
•2006: Home prices peaked
•2007: Housing defaults and losses on mortgage-backed securities surged
•2008: Troubled firms include Bear Stearns, Fannie Mae, Freddie Mac, Merrill Lynch, Lehman
Brothers, and AIG
14
Copyright statement for items made available via Moodle
Copyright © (2022). NOT FOR RESALE. All materials produced for
this course of study are reproduced under Part VB of the Copyright
Act 1968, or with permission of the copyright owner or under
terms of database agreements. These materials are protected by
copyright. Monash students are permitted to use these materials
for personal study and research only. Use of these materials for any
other purposes, including copying or resale, without express
permission of the copyright owner, may infringe copyright. The
copyright owner may take action against you for infringement.
15
MONASH
BUSINESS
SCHOOL
Investment and Portfolio Management
Lecture 1 – Part B - Chapter: 2
Topic Overview:
-Financial Markets
-Financial Instruments
-Market Indices
One Important Question for an Investor
What are the securities in which I can invest and where are they traded?
• Why?
Because investor has to decide how to allocate money across a broad range of assets.
This involves assets allocation and security selection decisions.
•An understanding on the following is important:
• Money markets → Types of money market instruments
• Capital markets → Types of capital market securities
2
The Money Market
• The market where short-term, liquid and low risk securities are traded
• Often traded in large denominations
→So, out of the reach of individual investors
• Money market mutual funds allow individuals to access the money market
3
Money Market Instruments
• Treasury bills:
• Short-term debt of U.S. (or any) government
• Most marketable of money market securities
• Investors buy at a discount from face value
• Bid and asked price are reported by financial press
• Bid-ask spread is dealer’s profit
• Certificates of deposit
• Time deposit with a bank
• May not be withdrawn on demand – but the investor can sell it to another investor
• Bank pays interest plus principal on maturity to investor
4
Money Market Instruments
• Commercial Paper
• Short-term, unsecured debt of a company
• Asset-backed commercial papers – Issued by financial firms to raise funds to
invest in other assets
• Bankers’ Acceptances
• An order to a bank by a bank’s customer to pay a sum of money on a future date
• Once the bank endorses the order for payment as ‘accepted’, it can be traded in
secondary market
• Widely used in foreign trade
5
Money Market Instruments
• Eurodollars
• Dollar-denominated time deposits in foreign banks or foreign branches of
domestic banks
• Repos and reverses
• Short-term loan backed by government securities.
• Dealer sells govt. securities to an investor on an overnight basis promising to buy
back on the following day at a higher price.
• Dealer takes a one day loan from the investor using govt. securities as a collateral
• Fed funds
• Banks maintain deposits with Federal Reserve Bank
• Banks with excess funds lend to those with shortages
6
Money Market Instruments
• Broker’s calls
• Investors borrow from brokers for margin trading
• Brokers borrow from banks agreeing to repay on call
• Yields on money market securities
• They are low risk – but not risk free
• So, their yield is higher than T-bill rate.
• Money market funds
• Mutual funds that invest in money market securities
• Provide an avenue for individual investors to invest in money market securities
7
Capital Market Securities
Capital Market is used to raise long-term capital funding.
• Primary Market
• Securities are traded/sold for the first time
• Secondary Market
• Securities are bought and sold after the first/primary issue
Capital Market Instruments:
• Bond
• Equity
• Derivatives
8
The Bond Market
Bond Market is comprised of longer term borrowings or debt instruments
• Treasury Notes and Bonds
• Issued by the U.S (or any) government for borrowing funds
• Treasure notes – maturities up to 10 years
• Treasury bonds – maturities from 10-30 years
• Makes semi-annual interest payments named coupon payments
• Inflation-Protected Treasury Bonds
• Income is hedged against inflation
• Face value is adjusted in proportion to increase in CPI
• Provide a constant real income
• Federal Agency Debt
• Government agencies issuing their own securities to finance their activities
9
The Bond Market
• International Bonds
• Form of borrowing in international markets
• Eurobond – e.g. a US$ denominated bond sold in Britain
• Yankee bond – e.g. a US$ denominated bond sold in the USA by a non-U.S. issuer.
• Municipal Bonds
• Issued by state and local governments
• Interest is exempt from federal income tax and sometimes from state and local tax (in USA)
• Types
▪ General obligation bonds: Backed by taxing power of issuer
▪ Revenue bonds: backed by project’s revenues or by the municipal agency operating the
project.
10
The Bond Market
Choosing between taxable and tax-exempt bonds:
• Let t equals the investor’s marginal tax bracket
• r is the before-tax return on taxable bond and rm is the municipal bond rate
• If r(1 - t ) > rm, then the taxable bond gives a higher return; otherwise, the municipal bond is
preferred.
11
The Bond Market
Corporate Bonds
• Issued by companies
• Secured bonds – if backed by collaterals
• Debentures – if unsecured
• Pay semi-annual coupons until maturity and the face value on maturity
• Subject to larger default risk than government securities
• May come with options
• Callable – issuing firm gets the option to repurchase from the bondholder at a call price
• Convertible – bondholder gets the option to convert into equity shares
12
The Bond Market
Mortgage-Backed Securities
• Proportional ownership of a mortgage pool or a specified obligation secured by a pool
• Produced by securitising mortgages
• Mortgage-backed securities are called pass-throughs because the cash flows produced by
homeowners paying off their mortgages are passed through to investors.
13
Equity Market and Equity Securities
Common Stock – known as equity securities or equities or shares
•
•
•
•
Represent ownership
Come with a residual claim and limited liability
Have no maturity
Traded on stock markets
Preferred Stock – Have both equity and debt features
• Promised fixed dividend
• Similar to an infinite maturity bond - Perpetuity
• Firm has no contractual obligation to pay dividend – but dividend is cumulative
• Priority over common stock
American Depository Receipts (ADRs)
• Certificates traded in U.S. markets that represent ownership in shares of a foreign company
• Each ADR may correspond to ownership of a fraction of a foreign share, one share, or several
shares of the foreign corporation
14
Derivatives Markets
A derivative is a security that gets its value from the values of another asset, such as bond and stock
prices, commodity prices, or market index values
Options
An agreement/contract where buyer pays anon-refundable premium and locks in a contract price (strike)
with a specified maturity date. The buyer of the option has no obligation to execute the contract whereas
the seller is bound to honor the contract (if executed by buyer)
• Call: Right to buy underlying asset at the strike or exercise price
• Put: Right to sell underlying asset at the strike or exercise price
Futures Contracts
An agreement made today regarding the delivery of an asset (or in some cases, its cash value) at a
specified delivery or maturity date for an agreed-upon price, called the futures price, to be paid at
contract maturity
• Long position: Take delivery at maturity
• Short position: Make delivery at maturity
15
Comparison – Options vs Futures
Options
Futures Contract
• Right, but not obligation, to buy or sell;
option is exercised only when it is profitable
• Options must be purchased
• The premium is the price of the option itself.
• Obliged to make or take delivery; long position
must buy at the futures price, short position
must sell at futures price
• Futures contracts are entered into without cost
16
Stock Market Indices
• A market index is a hypothetical portfolio of investment holdings that
represents a segment of the financial market.
• Investors follow different market indices to gauge market movements.
• The three most popular stock indexes for tracking the performance of the U.S.
markets are,
• Dow Jones Industrial Average (DJIA)
• Standard & Poor’s 500 (S&P 500) index
• Nasdaq composite index
• ASX200/ASX500
(Source: Investopedia)
17
Stock Market Indices
• Market indices in other countries … some examples
• Nikkei (Japan)
• FTSE (U.K.; pronounced “footsie”)
• Hang Seng (Hong Kong)
• All ordinaries (AU)
• Hang Seng Index (China)
• Market indices can be
• Price weighted,
• Value weighted
• Unweighted (equally weighted)
• Fundamental weighted
18
DJIA – An example of a price weighted index
• Includes 30 large blue-chip companies
• Computed since 1896
• The weight allocated to each stock is based on their price
• Method of calculation
• Add the current price of the 30 stocks and divide it by a divisor
(adjusted for stock splits and changes in the sample)
19
DJIA – An example of a price weighted index
• Divisor … an example
Index value before split=(25+100)/2=62.5
Index value after split=(25+50)/d=62.5
Divisor=1.2
20
S&P 500 – an example of a value-weighted index
• Broadly based index of 500 firms
• Method of calculation
Index t
PQ

=
 Beginning Index Value
PQ
t
t
h
h
where:
Index t = index value on day t
Pt = ending prices for stocks on day t
Qt = number of outstanding shares on day t
Ph = ending price for stocks on base day
Qh = number of outstanding shares on base day
21
Value-weighted index … calculation example
December 31, 2019
December 31, 2020
Stock
No of shares
Price ($)
Value ($)
Price ($)
Value ($)
A
1,000,000
10
10,000,000
12
12,000,000
B
6,000,000
15
90,000,000
14
84,000,000
C
5,000,000
20
100,000,000
24
120,000,000
200,000,000
216,000,000
100
108
Index
216,000,000
=
× 100
200,000,000
22
Copyright statement for items made available via Moodle
Copyright © (2022). NOT FOR RESALE. All materials produced for
this course of study are reproduced under Part VB of the Copyright
Act 1968, or with permission of the copyright owner or under
terms of database agreements. These materials are protected by
copyright. Monash students are permitted to use these materials
for personal study and research only. Use of these materials for any
other purposes, including copying or resale, without express
permission of the copyright owner, may infringe copyright. The
copyright owner may take action against you for infringement.
23