Topic 1: Introduction
What is investment?
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Traditional view: the current commitment of
resources (monies) to achieve later benefits.
A broader view: tailor the pattern of cash flows over
time to be as desirable as possible.
Tailoring cash flow pattern
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Suppose that there are two one-year investments.
They both require $1 initial capital today. There is
50% chance that the economy is going to accelerate
and the first (second) investment will have a return of
$3 ($0) when the economy is good. There is 50%
chance that the economy is going to decelerate and
the first (second) investment will have a return of $0
($3) when the economy is bad.
Which investment has a more desirable cash flow
pattern? Would you pay more for it?
This example is related to asset pricing.
Risk aversion
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Individuals seeking investment rather than
outright speculation/gambling will elect a
more certain wealth stream over a less
certain one, holding average payoffs and
returns constant. This is the risk aversion
principle.
Investments and public markets
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Investment decisions differ from other
business decisions in an important aspect:
investment decisions are usually made with
respect to alternatives available in public
(financial) markets.
Example: suppose that your mother-in-law
would like to borrow $$$ from you at 10%
interest rate. Would you do it?
The comparison principle
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The previous borrowing scenario is an
example of the comparison principle.
Another example: residential appraisals are
usually done with the framework of the
comparison principle.
Arbitrage
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Arbitrage: earning (almost sure) monies
without investing anything.
When two similar (almost identical)
investment alternatives are available in the
market, conclusions about arbitrage, i.e.,
those stronger than the comparison principle,
may hold.
The law of one price.
A real-life example of arbitrage
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Interest rate parity: the forward premium
(discount) is equal (close) to the interest rate
differential.
(F – S) / S ≈ rF – rD
Example: Suppose that the current spot, S,
€/$ = 0.80000, the 1-year forward, F, €/$ =
0.80800, r€ = 14%, and r$ = 10%.
The no-arbitrage principle
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In academic finance it is often assumed that no
arbitrage opportunity exists.
The reason for this assumption is that financial
markets are competitive. When there are many
computer algorithms looking for arbitrage
opportunities, those arbitrage-based trades ensure
that the no-arbitrage principle is largely correct.
Many modern asset pricing relationships, e.g., option
pricing, utilize this principle.
Major investment problems:
pricing/valuation
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Asset pricing can be addressed in two
seemingly different ways (actually closely
related): (1) what is the right price, i.e., the
intrinsic/fundamental price? and/or (2) what
is the expected rate of return?
Asset pricing is related to risk. Holding other
factors constant, higher risk leads to higher
expected return and lower price.
Major investment problems: hedging
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Hedging is the process of reducing the risk that
either arise in the course of corporate operations or
are associated with investments.
An example of hedging: insurance.
Another example: a bakery buys flour futures to lock
in current flour futures price to eliminate flour price
uncertainty in the future.
The major use of futures and options is for hedging-not for speculation.
Major investment problems: asset
allocation
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Determine more than 90% of return
variability for a typical institutional portfolio
(Brinson, Hood, and Beebower, 1986).
Asset allocation is the allocation of capital at
the asset class level.
Asset class: a group of securities/assets with
similar characteristics.
A major task for fund/plan sponsors.
Strategic asset allocation
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It establishes acceptable exposures (i.e.,
portfolio weights) to investment policy
statement (IPS)-pemissible asset classes to
achieve the clients long-term objectives and
constraints.
An example of strategic asset allocation
(policy portfolio): MIP, Chapter 5, Exhibit 5-1,
p. 232.
IPS
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A written document that sets out a client’s
return objectives and risk tolerance over the
client’s relevant time horizon, along with
applicable constraints such as liquidity
needs, tax considerations, regulatory
requirements, and unique circumstances.
The elements of an IPS
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A brief client/institution description.
The purpose of establishing policies and guidelines.
The duties and responsibilities of parties involved.
Investment goals, objectives, and constraints.
The schedule for review.
Performance measures and benchmarks.
Considerations for developing the strategic asset
allocation.
Investment strategies (passive or active) and styles.
Guidelines for rebalancing.
Asset classes
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Criteria for specifying asset classes (MIP,
5.4.1, p. 248-249.
Assignment
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Please study Calpers 2014 asset allocation
strategy.
http://www.calpers.ca.gov/eipdocs/investments/policies/assetallocation/asset-alloc-strgy.pdf
Submit a report that includes (1) a summary,
and (2) the things that you learned from this
reading. 2-3 pages. Due in a week.
Major investment problems: security
selection
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Security selection is related to asset pricing.
Security selection is done mainly by comparing
perceived intrinsic/fundamental value (VE) to market
price (P) or, equivalently, by comparing required rate
of return to expected rate of return.
In practice, security selection is not purely
quantitative; social responsibility, informational
availability, institutional restrictions (e.g., size,
liquidity), trade behavior (e.g., momentum) and other
factors are also important.
Mispricing
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Perceived mispricing ( VE – P ≠ 0) motivates
active selection.
Decomposition: VE – P = (V – P) + (VE – V) =
(true mispricing) + (estimation error).
Analysts try to minimize the second
component so that they can discover the true
mispricing.
Mispricing and the EMH
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The EMH did not say that there is no
mispricing for individual securities.
The EMH says that on average exploiting
those perceived mispricing will not lead to
abnormal return or alpha, net of transaction
costs.
That is, the EMH says that active selection is
useless.
Alpha: excess risk-adjusted return.
The valuation process (5 steps)
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Understanding the business (and the
economy).
Forecasting company performance (e.g. pro
forma).
Selecting the appropriate valuation model
(e.g., dividend discounting model).
Converting forecasts to a valuation.
Applying the valuation conclusions.
Analysts
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Sell-side analysts: analysts who work at
brokerage firms.
Buy-side analysts: analysts who work at
investment management firms, trusts and
bank trust departments, and similar
institutions.
Analysts’ due diligence
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Due diligence: investigation and analysis in
support of a recommendation.
See EAV, Example 1-8, pp. 27-28.
Format of a (long) research report
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EAV, Exhibit 1-2, pp. 31-32.
6 sections: (1) Table of Contents, (2)
Summary and Investment Conclusion, (3)
Business Summary, (4) Risks, (5) Valuation,
(6) Historical and Pro Forma Tables.
Characteristics of a good report
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EAV, P. 29.
Timely information.
Clear, incisive writing.
Objective; well researched; assumptions
acknowledged.
Facts vs. opinions well distinguished.
Internally consistent.
Sufficient info for reader critique.
Clear about key risk factors.
Potential conflicts of interest disclosed.
Selected CFA standards
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EAV, Exhibit 1-3, p. 33.
Quality of earnings
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Quality of earnings analysis: the scrutiny of
all financial statements to evaluate both the
sustainability of a company’s performance
and how accurately the reported information
reflects economic reality.
Financial Shenanigans, by Schilit, McGraw
Hill.
EAV, Exhibit 1-1, p. 14.
End-of-chapter
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EAV, Chapter 1: Problems 1-8
EAV, Chapter 3: Discounted
dividend (model) valuation
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You should have learned DDM in your BSAD
180.
Please read and study EAV, Chapter 3, pp.
83-143.
Zero-growth DDM
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The easiest assumption one can make is to assume
that there is no growth in dividends, i.e., D1 = D2 = …
= D.
Because this is a perpetuity, the pricing is rather
straightforward: PV = D / i.
Suppose that GE paid $2 dividend per share last
year. Investors expect no growth in GE’s future
dividends. The applicable discount rate is 10%.
PV = $2 / 10% = $20.
Constant-growth DDM
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Another easy assumption one can make is to
assume that there is a constant growth rate,
g, in dividends, i.e., D1 = D0 × (1 + g), D2 =
D0 × (1 + g)2, etc.
That is, this is a growing perpetuity.
Recall from BSAD 180, the PV of a growing
perpetuity is: PVt = Dt+1 / (i – g).
Constant-growth DDM example
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Vermont Financial Inc. paid a dividend of $1
last year. The constant growth rate of
dividends is 5%, and the required rate of
return is 10%.
PV = [D0 × (1 + g)] / (i – g) = [$1 × (1 +
5%)] / (10% – 5%) = $21.
Multiple-stage DDM model
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This model allows different growth rates for
different stages.
Typically, it takes care of recent, supernormal
growth.
There are formulas for PV. However, they do
not look neat.
Let us use Excel to visualize the discounting
process.
Multiple-stage example, I
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HP has a cost of equity at 14%. HP just paid
an annual dividend of $2.
The expected dividend growth rate between
year 1-3 is 25%. The expected dividend
growth rate between year 4-5 is 15%. The
expected dividend growth rate for year 6 and
afterwards is 5%.
Multiple-stage example, II
Year Dividend Growth rate Discount rate
PV5
PV
0
2
0.14
1
2.5
0.25
2.1929825
2
3.125
0.25
2.404586
3
3.90625
0.25
2.6366075
4
4.492188
0.15
2.6597356
5
5.166016
0.15
60.2701823 33.985511
6
5.424316
0.05
43.879422
Now, let’s take a look at the entire
portfolio management process
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MIP, Chapter 1, Exhibit 1-1, p. 6.
3 steps: (1) the planning step: (i) investor’s
objectives and constraints, (ii) creating the
investment policy statemet (IPS), (iii) forming
capital market expectations, (iv) creating the
strategic asset allocation.
(2) The execution step (security selection).
(3) The feedback step: (i) monitoring and
rebalancing, (ii)performance evaluation.