Summary INV2601_STUDY NOTES.

INV2601_STUDY NOTES. INV2601 - Investments: An Introduction. THE INVESTMENT SETTING Investment is the current commitment of dollars for a period of time in order to derive future payments that will compensate the investor for (1) the time the funds are committed, (2) the expected rate of inflation, and (3) the uncertainty of the future payments. Return is a profit on an investment. Rate of return is a profit on an investment over a period of time. Required Rate of Return, the minimum return the investor will accept for a particular investment. The required rate of return is supposed to compensate the investor for the riskiness of the investment. If the expected return of an investment does not meet or exceed the required rate of return, the investor will not invest. 2. Discuss the components of an Investor’s required rate of return: - The Real-risk free interest rate: return investor can earn without any risk, guaranteed rate - An Inflation Premium: the rate added to an investment to adjust for the markets expectation of future inflation. Example a 1 year bond interest rate will be lower than that of a 30 year bond because in the short run the inflation will be low and could raise in the future due to budget deficits, etc. - A Liquidity Premium: Family controlled company with stocks and bonds would require this if buyers are scarce. This is to ensure that should buyers not pay full value for an asset, the liquidity premium would compensate them for this loss. -Default Risk Premium: When investors see a company in trouble. The shares and bonds will collapse because the investors will request for the default risk premium. If the default risk premium is too large, investors can make a great deal of money because they purchased shares at a lower price than initially worth. -Maturity premium: Closer to the maturity of the bonds, the greater the price will fluctuate when the interest rate changes and this is the maturity premium. Just say for 30 years your bond is locked at 7% and at maturity its 9%. No investor will pay for the lower interest rate. Therefore there is greater risk with bonds with longer maturity. Real rate of return Rate of return after adjusting for inflation. Risk-free rate of return, often denoted in formulas as rf, is the rate of return associated with an asset that has no risk (that is, it provides a guaranteed return). Risks There are three types of risks that a firm might face and needs to overcome. 1. Business Risk: risks are taken by business enterprises themselves in order to maximize shareholder value and profits. As for example: Companies undertake high cost risks in marketing to launch new product in order to gain higher sales. 2. Non- Business Risk: These types of risks are not under the control of firms. Risks that arise out of political and economic imbalances. 3. Financial Risk: risk that involves financial loss to firms due to instability and losses in the financial market caused by movements in stock prices, currencies, interest rates and more. The risk and return principle: The greater the risk, the higher the investor’s required rate of return. The trade-off between risk and return (risk/return principle) In the investing world, risk is the chance that an investment's actual return will be different than expected. This is measured in statistics by standard deviation. Risk means you have the possibility of losing some, or even all, of your original investment. Low levels of uncertainty (low risk) are associated with low potential returns. High levels of uncertainty (high risk) are associated with high potential returns. The risk/return tradeoff is the balance between the desire for the lowest possible risk and the highest possible return. A higher standard deviation means a higher risk and higher possible return. The risk/return tradeoff tells us that the higher risk gives us the possibility of higher returns. There are no guarantees. Just as risk means higher potential returns, it also means higher potential losses. Risk vs Return Risk is the uncertainty about whether an investment will earn its expected rate of return. Measure of risk of a single asset: Standard deviation Coefficient of variation (CV) Return is the sum of the cash dividends, interest and any capital appreciation or loss resulting from the investment. Historical return can be calculated using the following: Holding Period Return/Yield' – HPR/HPY The total return received from holding an asset or portfolio of assets over a period of time, generally expressed as a percentage. Holding period return/yield is calculated on the basis of total returns from the asset or portfolio – i.e. income plus changes in value. It is particularly useful for comparing returns between investments held for different periods of time. Holding Period Return (HPR) and annualized HPR for returns over multiple years can be calculated as follows: Holding Period Return = Income + (End of Period Value – Initial Value) / Initial Value Annualized HPR = {[(Income + (End of Period Value – Initial Value)] / Initial Value+ 1}1/t – 1 where t = number of years. Returns for regular time periods such as quarters or years can be converted to a holding period return through the following formula: (1 + HPR) = (1 + r1) x (1 + r2) x (1 + r3) x (1 + r4) where r1, r2, r3 and r4 are periodic returns. Thus, HPR = [(1 + r1) x (1 + r2) x (1 + r3) x (1 + r4)] – 1 Real Rate and Nominal of Return The annual percentage return realized on an investment, which is adjusted for changes in prices due to inflation or other external effects. This method expresses the nominal rate of return in real terms, which keeps the purchasing power of a given level of capital constant over time. For example, let's say your bank pays you interest of 5% per year on the funds in your savings account. If the inflation rate is currently 3% per year, then the real return on your savings today would be 2%. In other words, even though the nominal rate of return on your savings is 5%, the real rate of return is only 2%, which means that the real value of your savings only increases by 2% during a oneyear period. The expected return for an individual investment The expected rate of return on a stock represents the mean of a probability distribution of possible future returns on the stock. The table below provides a probability distribution for the returns on stocks A and B. Return on Return on State Probability Stock A Stock B 1 20% 5% 50% 2 30% 10% 30% 3 30% 15% 10% 4 20% 20% -10% There are four possible states of the world one period into the future. State 1 may correspond to a recession. A probability is assigned to each state. The probability reflects how likely it is that the state will occur. The sum of the probabilities must equal 100%, indicating that something must happen. The last two columns present the returns or outcomes for stocks A and B that will occur in the four states. Given a probability distribution of returns, the expected return can be calculated using the following equation:  E[R] = the expected return on the stock  N = the number of states,  pi = the probability of state i, and  Ri = the return on the stock in state i. Stock B offers a higher expected return than Stock A but we must still consider the risk. Measures of Risk One way to measure risk is to calculate the variance and standard deviation of the distribution of returns. Return on Return on State Probability Stock A Stock B 1 20% 5% 50% 2 30% 10% 30% 3 30% 15% 10% 4 20% 20% -10% The expected return on Stock A was found to be 12.5% and the expected return on Stock B was found to be 20%. Given an asset's expected return, its variance can be calculated using the following equation:  N = the number of states,  pi = the probability of state i,  Ri = the return on the stock in state i, and  E[R] = the expected return on the stock. Although Stock B offers a higher expected return than Stock A, it also is riskier since its variance and standard deviation are greater than Stock A's. This, however, is only part of the picture because most investors choose to hold securities as part of a diversified portfolio Coefficient of Variance Formula The Equation or Formula to find out the Coefficient of Variation is given below Coefficient of Variation Cv = Standard Deviation / Mean If the standard deviation is .20 and the mean is .50, then the cv = .20/.50 = .4 or 40%. So knowing nothing else about the data, the CV helps us see that even a lower standard deviation doesn't mean less variable data. Diversification Consider stocks C and D. Stock C has an expected return of 8% and a standard deviation of 10%. Stock D has an expected return of 16% and a standard deviation of 20%. The concept of diversification will be illustrated by forming portfolios of stocks C and D under three different assumptions regarding the correlation coefficient between the returns on stocks C and D Case 1: Correlation Coefficient = 1 The table below provides the expected return and standard deviation for portfolios formed from stocks C and D under the assumption that the correlation coefficient between their returns equals 1. Portfolio Portfolio Weight of Expected Standard Stock C Return Deviation 100% 8% 10% 90% 8.8% 11% 80% 9.6% 12% 70% 10.4% 13% 60% 11.2% 14% 50% 12% 15% 40% 12.8% 16% 30% 13.6% 17% 20% 14.4% 18% 10% 15.2% 19% 0% 16% 20% When the correlation coefficient between the returns on two securities is equal to +1 the returns are said to be perfectly positively correlated. As can be seen from the table and the plot of the opportunity set, when the returns on two securities are perfectly positively correlated, none of the risk of the individual stocks can be eliminated by diversification. In this case, forming a portfolio of stocks C and D simply provides additional risk/return choices for investors. Case 2: Correlation Coefficient = -1 The table below provides the expected return and standard deviation for portfolios formed from stocks C and D under the assumption that the correlation coefficient between their returns equals -1. Weight Portfolio Portfolio of Expected Standard Stock C Return Deviation 100% 8% 10% 90% 8.8% 7% 80% 9.6% 4% 70% 10.4% 1% 66.67% 10.67% 0% 60% 11.2% 2% 50% 12% 5% 40% 12.8% 8% 30% 13.6% 11% 20% 14.4% 14% 10% 15.2% 17% 0% 16% 20% When the correlation coefficient between the returns on two securities is equal to -1 the returns are said to be perfectly negatively correlated or perfectly inversely correlated. When this is the case, all risk can be eliminated by investing a positive amount in the two stocks. This is shown in the table above when the weight of Stock C is 66.67%. Case 3: Correlation Coefficient = 0 The table below provides the expected return and standard deviation for portfolios formed from stocks C and D under the assumption that the correlation coefficient between their returns equals 0. Weight Portfolio Portfolio of Expected Standard Stock C Return Deviation 100% 8% 10% 90% 8.8% 9.22% 80% 9.6% 8.94% 70% 10.4% 9.22% 60% 11.2% 10% 50% 12% 11.18% 40% 12.8% 12.65% 30% 13.6% 14.32% 20% 14.4% 16.12% 10% 15.2% 18.03% 0% 16% 20% When the correlation coefficient between the returns on two securities is equal to 0 the returns are said to be uncorrelated. In this case, some risk can be eliminated via diversification. Notice that when the weight of Stock C is between 100% and 60% the portfolios have a higher expected return than Stock C and a lower standard deviation than either Stocks C or D. This is depicted in the graph by the inward curve in the opportunity set. Investment Management Process The procedure is as follows: 1. Create a Policy Statement -A policy statement is the statement that contains the investor's goals and constraints as it relates to his investments. 2. Develop an Investment Strategy - This entails creating a strategy that combines the investor's goals and objectives with current financial market and economic conditions 3. Implement the Plan Created -This entails putting the investment strategy to work, investing in a portfolio that meets the client's goals and constraint requirements 4. Monitor and Update the Plan -Both markets and investors' needs change as time changes. As such, it is important to monitor for these changes as they occur and to update the plan to adjust for the changes that have occurred. STUDY UNIT 2 ORGANISATION AND FUNCTIONING OF SECURITIES MARKETS Securities market is made up of the equity, bond and derivatives market. It is a component of the wider financial market where securities can be bought and sold between participants both professional and non-professionals subjects. Securities markets can be split into two levels. Primary markets, where new securities are issued and secondary markets where existing securities can be bought and sold. Secondary markets can further be split into organised exchanges, such stock exchanges and over-the-counter where individual parties come together and buy or sell securities directly. For securities holders knowing that a secondary market exists in which their securities may be sold and converted into cash increases the willingness of people to hold stocks and bonds and thus increases the ability of firms to issue securities. Characteristics of a well-functioning securities market Efficient - Internal - Markets must be efficient internally. Efficient - External - Markets react quickly to new news; existing prices reflect all available information. Liquidity - Markets are liquid and as such, assets can be bought or sold easily. There are numerous buyers and sellers giving depth to the market. Continuity - In the context of liquidity, prices do not change substantially from one transaction to another unless significant new news arises. Marketability - In the context of liquidity, marketability is the ability to sell an asset quickly. Timely and accurate information - New information is brought to the market in a timely and accurate way. Exchange markets, over-the-counter markets and other related markets Exchanges, start at physical locations such as the JSE. They set rules that govern trading and information as well as the clearing facilities for post trade activities in the exchange. Trading over the counter are less formal, well-organized, networks of trading relationships with one or more dealers that quote to sell (ask or offer) or buy (bid) to other dealers and their clients. They do not quote the same price to all customers and can even withdraw from the market causing liquidity to dry up. Primary market, investors buy securities directly from the company issuing them. When a company publicly sells new stocks and bonds for the first time, it does so on the primary capital market. In many cases, this takes the form of an initial public offering, or IPO. When investors purchase securities on the primary capital market, the company offering the securities has already hired an underwriting firm to review the offering and created a prospectus outlining the price and other details of the securities to be issued. Secondary market, investors trade securities among themselves, and the company with the security being traded does not participate in the transaction. The secondary market is where securities are traded after the company has sold all the stocks and bonds offered on the primary market. Markets such as the New York Stock Exchange (NYSE), London Stock Exchange or Nasdaq are secondary markets. On the secondary market, small investors have a better chance of buying or selling securities, because they are no longer excluded from IPOs due to the small amount of money they represent. Anyone can purchase securities on the secondary market as long as they are willing to pay the price for which the security is being traded. They also sell securities for cash to meet their liquidity. This secondary market has further two components. Spot market where securities are traded for immediate delivery and payment. Forward market where the securities are traded for future delivery and payment. Further divided into Futures and Options Market (Derivatives Markets). South African securities markets The Johannesburg Stock Exchange (JSE) The JSE supports a process of fully automated electronic trading. Corporate ownership of member firms is now permitted with both domestic and international banks at the forefront of such developments. Trading and Settlement Procedures Equity transactions are currently concluded on the JSE’s electronic trading system, known as JET, for settlement the following Tuesday. The net settlement of equity trading positions (broker to broker) takes place within the Equities Clearing House operated by the JSE. STRATE Share Transactions Totally Electronic, is the new electronic settlement system for transactions that have been concluded in South African equities. The Bond Exchange of South Africa (Besa) The process to immobilise bonds was initiated in October 1995 by BESA’s predecessor, the Bond Market Association of South Africa The Central Depository (CD) In 1989 the four major clearing banks in South Africa ABSA Bank, First National Bank, Nedcor Bank and Standard Corporate Bank and Merchant Bank joined forces to establish CD. National Payment System South Africa’s National Payment System provides the economy with avenues for processing the payments resulting from various economic activities - whether arising from South African businesses transacting in the global market or the individual payment requirements. Regulation The JSE is the frontline regulator for the exchange, setting and enforcing listing and membership requirements and trading rules. The Financial Services Board (FSB) supervises the JSE in the performance of its regulatory duties. Under the new system, prudential supervision will be transferred to the South African Reserve Bank (SARB) and market conduct regulation will be led by a bolstered FSB. South Africa JSE is currently ranked 1st out of 144 countries in terms of regulation of securities exchanges in the World Economic Forum’s Global Competitiveness Survey for . Benefits from listing and trading on this exchange include the following: For companies: Access to long-term investment capital for development of the business Access to a central trading facility thereby providing liquidity The ability to realise value through an effective price discovery mechanism Improved image amongst suppliers, customers, staff and other stakeholders due to the prestige associated with being a listed entity The opportunity to use the issue of shares as consideration for an acquisition For investors: The opportunity to diversify share portfolios by investing in a wide range of high-growth small and medium-sized companies Increased confidence due to the knowledge that AltX is regulated by the JSE, which provides substantial investor protection For the South African economy: Growth of the economy by providing growth opportunities to small and medium sized Companies. Promotion of black economic empowerment in South Africa Types of Orders Market order A market order is an order to buy or sell a stock at the best available price, executed immediately. However, the price at which a market order will be executed is not guaranteed. Limit order A limit order is an order to buy or sell a stock at a specific price or better. A buy limit order can only be executed at the limit price or lower, and a sell limit order can only be executed at the limit price or higher. Short sale A market transaction in which an investor sells borrowed securities in anticipation of a price decline and is required to return an equal number of shares at some point in the future. The payoff to selling short is the opposite of a long position. A short seller will make money if the stock goes down in price, while a long position makes money when the stock goes up. The profit that the investor receives is equal to the value of the sold borrowed shares less the cost of repurchasing the borrowed shares. Stop-loss order It is an order placed with a broker to buy or sell once the stock reaches a certain price. A stoploss is designed to limit an investor's loss on a security position. Setting a stop-loss order for 10% below the price at which you bought the stock will limit your loss to 10%. Stop-buy order An order to buy a security which is entered at a price above the current offering price. It is triggered when the market price touches or goes through the buy stop price. Equity market indices and bond market indices The debt market is where debt instruments are traded. Debt instruments are assets that require a fixed payment to the holder, usually with interest. Examples of debt instruments include bonds (government or corporate) and mortgages. The equity market (often referred to as the stock market) is the market for trading equity instruments. Stocks are securities that are a claim on the earnings and assets of a corporation. An example of an equity instrument would be common stock shares, such as those traded on the New York Stock Exchange. How are debt instruments different from equity instruments? There are important differences between stocks and bonds. 1. Equity financing allows a company to acquire funds (often for investment) without incurring debt. On the other hand, issuing a bond does increase the debt burden of the bond issuer because contractual interest payments must be paid— unlike dividends, they cannot be reduced or suspended. 2. Those who purchase equity instruments (stocks) gain ownership of the business whose shares they hold (in other words, they gain the right to vote on the issues important to the firm). In addition, equity holders have claims on the future earnings of the firm. In contrast, bondholders do not gain ownership in the business or have any claims to the future profits of the borrower. The borrower’s only obligation is to repay the loan with interest. 3. Bonds are considered to be less risky investments for at least two reasons. First, bond market returns are less volatile than stock market returns. Second, should the company run into trouble, bondholders are paid first, before other expenses are paid. Shareholders are less likely to receive any compensation in this scenario. Why are these markets important? they are the central importance to economic activity. The bond market is vital for economic activity because it is the market where interest rates are determined. Interest rates are important on a personal level, because they guide our decisions to save to finance major purchases (such as houses, cars, and appliances). From a macroeconomic standpoint, interest rates have an impact on consumer spending and on business investment. Weighting schemes used in constructing market indices Price-weighted indices aren’t particularly common anymore. Still, one of the world’s most widely tracked indices – the Dow Jones Industrial Average – uses price weighting, so the process is worth understanding. A price-weighted index is one which includes an equal number of shares for each security in its basket – meaning the higher a security’s price goes, the more it will drive the index’s overall value. For example, let’s look at a hypothetical five member priceweighted index basket: Security Price Share Weighting A $3 10 10% B $1 10 3% C $7 10 23% D $9 10 30% E $10 10 33% At $10/share, Security E has the highest price and therefore the highest weighting in the index. Security B, on the other hand, costs only $1/share; its weighting barely makes a blip in the overall basket. A price-weighted index has many advantages: its weighting scheme is simple to understand and its daily value easy to calculate (it’s simply the sum of all the security prices divided by the total number of constituents). The problem is, a security’s price alone doesn’t necessarily communicate its true market value. It ignores market forces of supply and demand. To fix this, we need a different weighting scheme. Market-capitalization weighted indices (or market cap- or cap-weighted indices) weigh their securities by market value as measured by capitalization: that is, current security price * outstanding shares. The vast majority of equity indices today are cap-weighted, including the S&P 500 and the FTSE 100. In a cap-weighted index, changes in the market value of larger securities move the index’s overall trajectory more than those of smaller ones. Let’s look at the same hypothetical five member index, this time cap-weighted: Security CurrentPrice Outstanding Shares Market cap Weighting A $% B $1 50 50 5% C $% D $% E $% Total market cap 970 100% At $7/share, Security C doesn’t have the highest price, but it does have the largest market capitalization and thus the highest weighting in our index. Meanwhile, Security E, the highest priced security but also the one with the smallest number of outstanding shares, has fallen from the largest piece of the pie to second smallest. The advantage of a cap-weighted index is obvious: It reflects the way markets actually behave. Larger companies do in fact have more dramatic effects on the overall market than smaller companies. It’s also a self-rebalancing methodology, in that as a company’s price or outstanding share quantity changes, so too does the proportions of stocks in the index basket. But cap-weighted schemes aren’t perfect. For example, sometimes companies have shares that aren’t fully available for trade on the open market (such as government-held shares, or large privately-controlled holdings). In this case, pure cap weighted schemes would misrepresent the actual investible market cap available. Most index providers adjust their cap-weighted indices accordingly using a free float factor, or the percentage of shares available for trading. Free Float Shares = (Shares x Free Float Factor) So the free float market cap would be: Float Market Cap = (Price x Shares x Free Float Factor) There’s a more systemic downside to cap weighting, in that such indices inherently assume that the EMH always holds. Recent research shows that cap weighted indices tend to give too much weight to securities the market has overvalued and too little weight to ones it has undervalued. As a result, true market value is skewed. Alternative weighting schemes to cap-weighting have gained more favour in recent years. In an equally-weighted index, all the securities in the basket are, as it sounds, weighted in equal amounts. For example, take our hypothetical example index: Stock Price Share Weighting A $3 2 20% B $1 6 20% C $7 0.86 20% D $9 0.67 20% E $10 0.60 20% Equal weighting is a highly diversified scheme, and one that avoids the cap-weighting pitfall of overweighting overpriced stocks and underweighting under-priced stocks. But it’s hard to maintain long-term, as fund managers must constantly rebalance their portfolios due to daily price fluctuations. Basket turnover is much higher than a cap-weighted index, meaning that any funds tracking it will often be more expensive than comparable cap-weighted ones. What’s more, the need to invest equally all securities can cause problems in more illiquid markets or asset classes, as substantial investment by any one player can sometimes end up moving those markets instead of reflecting them. Recently, new types of indices have been introduced that schew market pricing altogether as a means of weighting, and thus determine the value of their securities via other metrics. Risk-weighted indices, for example, assign security weights based on common assessments of risk. In a risk-weighted index, securities are weighted by the inverse of their variance, so that securities with lower historical volatility end up with higher weights in the index. Thus you end up with an index whose securities, if replicated in a fund, would offer as little portfolio risk as possible. Fundamentally-weighted indices instead weight their constituents based on their financial health as measured by accounting figures, such as sales, earnings, book value, cash flow and dividends. The assumption here is that these descriptors offer a better estimation of a company’s intrinsic value than market capitalization. Global securities markets Development of the financial system globally has been very rapid and related to the revolution in the field of electronics. This has especially been the case for securities markets which have benefitted from vast advances in information processing, both hardware and software systems, and telecommunications. This technology is particularly well suited for securities markets. Investors require timely information on prices and underlying factors influencing prices and the ability to complete transactions quickly. Also, in recognition of the risks associated with such transactions—in particular, the prospect of failure of the transaction for a variety of reasons— accurate information on the parties transacting and terms of the transaction are required as well as systems that provide for timely transfer of ownership and payment. Modern electronic technology enables this information to be gathered and disseminated quickly, and highly complex transactions to be processed promptly and accurately. STUDY UNIT 3 DEVELOPMENTS IN INVESTMENT THEORY Efficient capital market A market where information regarding the value of securities are incorporated into its prices accurately and in real time. Since the value of securities fluctuates depending on the present value of future cash flows, an efficient capital market enables these fluctuations to be reflected in the securities' current price The Three Basic Forms of the EMH The efficient market hypothesis assumes that markets are efficient. However, the efficient market hypothesis (EMH) can be categorized into three basic levels: 1. The "Weak" form asserts that all past market prices and data are fully reflected in securities prices. In other words, technical analysis is of no use. 2. The "Semistrong" form asserts that all publicly available information is fully reflected in securities prices. In other words, fundamental analysis is of no use. 3. The "Strong" form asserts that all information is fully reflected in securities prices. In other words, even insider information is of no use. Share market efficiency for fundamental analysis and technical analysis Investors use techniques of fundamental analysis or technical analysis (or often both) to make stock trading decisions. Fundamental analysis attempts to calculate the intrinsic value of a stock using data such as revenue, expenses, growth prospects and the competitive landscape, while technical analysis uses past market activity and stock price trends to predict activity in the future. Uses price movement of security factors, called fundamentals. To predict future price movements. Data gathered from financial statements and Charts. Stock bought when price falls below intrinsic value or when trader believes they can sell it on for a higher price. Time horizon either Long-term approach or Short-term approach. Function Investing Trade. Concepts used are Return on Equity (ROE) and Return on Dow Theory, Price Data Assets (ROA) Efficient Markets signalled the end of Technical Analysis (technical analysis violates weak form efficiency ), and Fundamental Analysis (fundamental analysis violates semi-strong efficiency) in mainstream finance. Modern Portfolio Theory was essentially a triumph of “if you can’t beat the market, join it,” over any kind of security analysis.