Investments
Practicalities
Why should you take this course?
- Value practical implementations, not a theory course, use the theory, valuable later in the
career
- Slide: questions that we will answer
Course overview: 4 parts
- 1. Introduction
- 2. Portfolio theory: active vs. passive investing
- 3. Fixed income investing
- 4. Applied portfolio management (also guest lecture here)
You will enjoy this course if…
- Risk and uncertainty is key in investments, that is why it is hard
- Not mathematical, but some basic calculations are necessary
- About the application, not the theory
- A lot of terms we already know will be thought
Activities
- Every week one topic
- Learn by doing: participate in class
- Discussion forum on Toledo
o Structure, per topic, about lecture material or about exercises
Lecture material
- Handbook investments, bodie, kane, Marcus (13th edition) -> buy it
Lecture material
- For each topic: the slides
- Solutions to the exercises that you need to be able to solve will be on toledo
o If the solution is not there, we don’t have to know the exercise
- Some extra literature
- Excel files with solution
- Video clips
- New material: available Friday 1pm
- Recordings of the lectures (always available)
Evaluation
- Januari: exam (80%) + group assignment (20%)
- Assignment: 2 or 3 students per group (specific or random team)
o REGISTER FOR A TEAM!!!!
o DEADLINES
o Assignment will be posted by the end of October
o She will help, but only if you come as a team to her, sometimes she will even give
part of the solution, important to work as a team
o Excel assignment -> you need to be good at excel for finance jobs
- Exam January: theory and exercises
- Exam September: assignment does not count anymore
1
, o Except for students that do not participate the January exam because of overlap, and
do the exam in September
- !! Most exam questions come from the handbook (80% of the questions)
o This says you the level that you need to know
Investments: capital markets and products
= an introductory topic to give you the broad context of the class
If we talk about investments, we talk about capital markets, we talk about the products that are
traded within these markets
On the slides: chapters in the BKM that you need to know!
Background reading: not compulsory, only if you want to know more about this topic
Financial markets
The class is about investments in financial instruments, financial products
Function
Why do these financial products exist? Multiple functions of investments of financial markets
1. Share/transfer risks
- It might be that you are exposed to a financial risk, but you are not willing or unable to take
this risk, then a financial product allows you to transfer that risk
- In practice: Most people tend to overestimate their risk bearing capacity. Most people think
that they like risk, that they can bear the risk; that their risk aversion is low; however in
reality, this is not the case. People take on risk, assuming that they can bare the risk, and
when the risk materializes, they panic. Panic is the worst environment to take decisions, the
worst decisions are made in a period of stress
- This is why it is important to understand your risk appetite
- How does it come that people tend to overestimate their risk bearing capacity?
o 1. Biases
▪ Behavioural finance, we do observe some difference in risk taking behaviour
vb. male vs. female
o 2. People are a bit blind for risk. There is a trade off between expected return and
risk, one thing does not come without the other. People tend to ignore the risk
component and are extremely focussed on the return component.
▪ Of course I prefer more return, but then they forget about the fact that more
return = more risk
▪ Overly focussed on the return, and forget the risk
o 3. Hard to understand what risk is
▪ What is risk? Two key concepts
▪ The fact that there are multiple outcomes -> no certainty, but probabilities;
you don’t know ex ante which outcome will materialize
▪ At least one of the outcomes is harmful.
• BUT being less than expected is not necessarily harmful
• Suppose: someone gives me 100, 200 or 300 euros, all with different
probabilities. I have an expected return (150), I could end up with
less than I expected => does not mean it is a risk; because all of the 3
scenario’s are good scenario’s
▪ Intuitive definition in normal situations: Risk is really about the likelihood
that something bad/harmful can happen to you -> this is not the definition of
risk in finance
▪ Definition in finance of risk:
2
, • We use volatility in the definition of risk. How does volatility fit in
that more intuitive definition of risk? Not straightforward, you need
statistical knowledge to do that. Many investors do not have that
knowledge, or they have the knowledge but they do not necessarily
make the translation.
• What does she mean by that? If you think about probabilities of
different outcomes and one of the outcomes being negative/harmful
-> this means that you end op with a description that is more
broader than just volatility
• Expected return is the first moment. Volatility is ultimately the
second moment of your distribution
• But the intuitive definition is more about the whole distribution.
Why do we typically work with expected return and volatilities?
Because we assume normal distributions. And we have normal
distributions the first two moments define our distribution. But if
you just limit yourself to these two moments, you might forget what
it really means in terms of the different outcomes that can happen
to you and the likelihood of these outcomes. But it is still there.
• Simple example about this
Vb. we have an investment, vb. you buy a stock
- Typical expected return on an annual basis
o ! always work on an annual basis, if an expected return of volatility is not annualized,
annualize it, because you typically have intuition for annual numbers
- What would be a typical expected return and volatiltiy on a single stock investment?
o E(R) = 13% = expected return on an annual basis
o σ(R) = 33% = volatility on an annual basis (not of a diversified portfolio, but on a
single investment)
- What does that mean if you invest in this asset? Lets impose a normal distribution
- Tekening
o So this is probably much more informative than just looking at the expected returns
and volatilities to understand whether your able to bear a particular amount of riks
o Now you know that If you take on this investment, it means that you have a 16%
chance to end up with a return lower than -20%
o Once you impose a distribution and you look at the probabilities associated with the
different outcomes, it becomes much more easy to grasp whether you are able to
bear the risk
o ! in reality returns are not normally distributed, it is worse, because there is more
mass in the tails (extreme negative or extreme positive returns)
▪ Being skewed is not necessarily bad, only if it is to the left (more negative
probabilities)
3
, VERDER: why do these products exist
2. Financial markets allow to separate the timing of income (when you get the income) and
consumption (when you want to consume the income): store wealth to transfer to the future
o Financial products allow you to make an advance on future income
o Vb. taking out a loan or obligation
o If you buy a bond, you transfer your storewealth to the future
o Transferring wealth over time allows you to smooth consumption (no peaks and
valleys in the consumption pattern)
3. Financial markets allow to separate ownership and management in support of large-scale
businesses (but be careful with associated agency problems)
o Without financial markets, companies would not be able to grow as much as they do
today.
o A firm might not have sufficient means to take the next step in their growth process,
because they don’t have the funding that they need. Financial markets can help
them secure that funding to grow
4. Financial markets allow to allocate resources efficiently i.e. to most productive real
investments (= informational role of financial markets)
o Efficiency of a market
o Which crucially depends upon the degree of efficiency
o Market efficiency: markets are efficient if all relevant information is reflected in
prices
o Often when we think about market efficiency, we immediately think about arbitrage
opportunities; if a market is not efficient, there are arbitrage opportunities
o But the degree of market efficiency is much more important than trading
opportunities, whether you can re… arbitrage profits; it all has to do with an
allocation of resources -> if the market is not efficient, too few money goes to
particular investments, and too much money to others -> only when the market is
efficient, the different opportunities get the money that they deserve
o Market efficiency is really important -> not just for the investors or for arbitrage, but
for the economy to grow in a sustainable way
Asset classes
If you think about the different products/instruments that are traded/that exist, there exists a large
range of products.
In this opleidingsonderdeel, we will limit to very standard products, mainly two big asset classes
- Money market instruments
o = short term debt security with low risk
o She will talk about it as ‘the risk free’
o Some are actually riskier than others within this class, but as compared to other
assets in the economy, they are the risk free instruments
o Vb. cash, products that allow you to save
- Capital market instruments
o Here we typically have longer term instruments, could be debt (bonds ) and equity
(stocks)
o When prof refers to investing, she means this
Each instrument is unique in terms of (un-)certainty of payments (how likely the payments are) and
timing of payments (when you can receive the payements) and has a distinct contribution to the
investment portfolio
- Unique risk return profile
- This makes that the different instruments all have a different role to play in a portfolio
4
Practicalities
Why should you take this course?
- Value practical implementations, not a theory course, use the theory, valuable later in the
career
- Slide: questions that we will answer
Course overview: 4 parts
- 1. Introduction
- 2. Portfolio theory: active vs. passive investing
- 3. Fixed income investing
- 4. Applied portfolio management (also guest lecture here)
You will enjoy this course if…
- Risk and uncertainty is key in investments, that is why it is hard
- Not mathematical, but some basic calculations are necessary
- About the application, not the theory
- A lot of terms we already know will be thought
Activities
- Every week one topic
- Learn by doing: participate in class
- Discussion forum on Toledo
o Structure, per topic, about lecture material or about exercises
Lecture material
- Handbook investments, bodie, kane, Marcus (13th edition) -> buy it
Lecture material
- For each topic: the slides
- Solutions to the exercises that you need to be able to solve will be on toledo
o If the solution is not there, we don’t have to know the exercise
- Some extra literature
- Excel files with solution
- Video clips
- New material: available Friday 1pm
- Recordings of the lectures (always available)
Evaluation
- Januari: exam (80%) + group assignment (20%)
- Assignment: 2 or 3 students per group (specific or random team)
o REGISTER FOR A TEAM!!!!
o DEADLINES
o Assignment will be posted by the end of October
o She will help, but only if you come as a team to her, sometimes she will even give
part of the solution, important to work as a team
o Excel assignment -> you need to be good at excel for finance jobs
- Exam January: theory and exercises
- Exam September: assignment does not count anymore
1
, o Except for students that do not participate the January exam because of overlap, and
do the exam in September
- !! Most exam questions come from the handbook (80% of the questions)
o This says you the level that you need to know
Investments: capital markets and products
= an introductory topic to give you the broad context of the class
If we talk about investments, we talk about capital markets, we talk about the products that are
traded within these markets
On the slides: chapters in the BKM that you need to know!
Background reading: not compulsory, only if you want to know more about this topic
Financial markets
The class is about investments in financial instruments, financial products
Function
Why do these financial products exist? Multiple functions of investments of financial markets
1. Share/transfer risks
- It might be that you are exposed to a financial risk, but you are not willing or unable to take
this risk, then a financial product allows you to transfer that risk
- In practice: Most people tend to overestimate their risk bearing capacity. Most people think
that they like risk, that they can bear the risk; that their risk aversion is low; however in
reality, this is not the case. People take on risk, assuming that they can bare the risk, and
when the risk materializes, they panic. Panic is the worst environment to take decisions, the
worst decisions are made in a period of stress
- This is why it is important to understand your risk appetite
- How does it come that people tend to overestimate their risk bearing capacity?
o 1. Biases
▪ Behavioural finance, we do observe some difference in risk taking behaviour
vb. male vs. female
o 2. People are a bit blind for risk. There is a trade off between expected return and
risk, one thing does not come without the other. People tend to ignore the risk
component and are extremely focussed on the return component.
▪ Of course I prefer more return, but then they forget about the fact that more
return = more risk
▪ Overly focussed on the return, and forget the risk
o 3. Hard to understand what risk is
▪ What is risk? Two key concepts
▪ The fact that there are multiple outcomes -> no certainty, but probabilities;
you don’t know ex ante which outcome will materialize
▪ At least one of the outcomes is harmful.
• BUT being less than expected is not necessarily harmful
• Suppose: someone gives me 100, 200 or 300 euros, all with different
probabilities. I have an expected return (150), I could end up with
less than I expected => does not mean it is a risk; because all of the 3
scenario’s are good scenario’s
▪ Intuitive definition in normal situations: Risk is really about the likelihood
that something bad/harmful can happen to you -> this is not the definition of
risk in finance
▪ Definition in finance of risk:
2
, • We use volatility in the definition of risk. How does volatility fit in
that more intuitive definition of risk? Not straightforward, you need
statistical knowledge to do that. Many investors do not have that
knowledge, or they have the knowledge but they do not necessarily
make the translation.
• What does she mean by that? If you think about probabilities of
different outcomes and one of the outcomes being negative/harmful
-> this means that you end op with a description that is more
broader than just volatility
• Expected return is the first moment. Volatility is ultimately the
second moment of your distribution
• But the intuitive definition is more about the whole distribution.
Why do we typically work with expected return and volatilities?
Because we assume normal distributions. And we have normal
distributions the first two moments define our distribution. But if
you just limit yourself to these two moments, you might forget what
it really means in terms of the different outcomes that can happen
to you and the likelihood of these outcomes. But it is still there.
• Simple example about this
Vb. we have an investment, vb. you buy a stock
- Typical expected return on an annual basis
o ! always work on an annual basis, if an expected return of volatility is not annualized,
annualize it, because you typically have intuition for annual numbers
- What would be a typical expected return and volatiltiy on a single stock investment?
o E(R) = 13% = expected return on an annual basis
o σ(R) = 33% = volatility on an annual basis (not of a diversified portfolio, but on a
single investment)
- What does that mean if you invest in this asset? Lets impose a normal distribution
- Tekening
o So this is probably much more informative than just looking at the expected returns
and volatilities to understand whether your able to bear a particular amount of riks
o Now you know that If you take on this investment, it means that you have a 16%
chance to end up with a return lower than -20%
o Once you impose a distribution and you look at the probabilities associated with the
different outcomes, it becomes much more easy to grasp whether you are able to
bear the risk
o ! in reality returns are not normally distributed, it is worse, because there is more
mass in the tails (extreme negative or extreme positive returns)
▪ Being skewed is not necessarily bad, only if it is to the left (more negative
probabilities)
3
, VERDER: why do these products exist
2. Financial markets allow to separate the timing of income (when you get the income) and
consumption (when you want to consume the income): store wealth to transfer to the future
o Financial products allow you to make an advance on future income
o Vb. taking out a loan or obligation
o If you buy a bond, you transfer your storewealth to the future
o Transferring wealth over time allows you to smooth consumption (no peaks and
valleys in the consumption pattern)
3. Financial markets allow to separate ownership and management in support of large-scale
businesses (but be careful with associated agency problems)
o Without financial markets, companies would not be able to grow as much as they do
today.
o A firm might not have sufficient means to take the next step in their growth process,
because they don’t have the funding that they need. Financial markets can help
them secure that funding to grow
4. Financial markets allow to allocate resources efficiently i.e. to most productive real
investments (= informational role of financial markets)
o Efficiency of a market
o Which crucially depends upon the degree of efficiency
o Market efficiency: markets are efficient if all relevant information is reflected in
prices
o Often when we think about market efficiency, we immediately think about arbitrage
opportunities; if a market is not efficient, there are arbitrage opportunities
o But the degree of market efficiency is much more important than trading
opportunities, whether you can re… arbitrage profits; it all has to do with an
allocation of resources -> if the market is not efficient, too few money goes to
particular investments, and too much money to others -> only when the market is
efficient, the different opportunities get the money that they deserve
o Market efficiency is really important -> not just for the investors or for arbitrage, but
for the economy to grow in a sustainable way
Asset classes
If you think about the different products/instruments that are traded/that exist, there exists a large
range of products.
In this opleidingsonderdeel, we will limit to very standard products, mainly two big asset classes
- Money market instruments
o = short term debt security with low risk
o She will talk about it as ‘the risk free’
o Some are actually riskier than others within this class, but as compared to other
assets in the economy, they are the risk free instruments
o Vb. cash, products that allow you to save
- Capital market instruments
o Here we typically have longer term instruments, could be debt (bonds ) and equity
(stocks)
o When prof refers to investing, she means this
Each instrument is unique in terms of (un-)certainty of payments (how likely the payments are) and
timing of payments (when you can receive the payements) and has a distinct contribution to the
investment portfolio
- Unique risk return profile
- This makes that the different instruments all have a different role to play in a portfolio
4
