FM5-UNIT1 PDF: Investment Environment

1 UNIT INTRODUCTION 1 TARGET GOAL FOR THE UNIT o Analyze the given the investment environment. (AN) o Solve problems related to risk-return trade off. (AP) o Analyze a case i...

1 UNIT INTRODUCTION 1 TARGET GOAL FOR THE UNIT o Analyze the given the investment environment. (AN) o Solve problems related to risk-return trade off. (AP) o Analyze a case in investment and mutual funds. (AN) VALUES DESIRED: Openness and Perseverance LESSON 1 THE INVESTMENT ENVIRONMENT I. LEARNING OUTCOMES  Distinguish real and financial assets. (U)  Explain the role of financial markets in the economy. (U)  Point out the effects of the 2008 financial crisis in the investment environment. (App) II. INPUT REAL ASSETS VERSUS FINANCIAL ASSETS Bodie, Kane and Marcus (2018) define real and financial assets as follows: Real Assets  These are the productive capacity present in the society such as land, buildings, machines and knowledge that can be used to produce the goods and services.  Real assets generate net income to the economy. Financial Assets  These are assets of an entity characterized by a piece of paper or computer entries which do not contribute directly to the productive capacity of the economy.  These assets are the means by which individuals in well-developed economies hold their claims on real assets.  Financial assets are claims to the income generated by real assets (or claims on income from the government).  Financial assets simply define the allocation of income or wealth among investors.  Examples are: stocks and bonds. Individuals can choose between consuming their wealth today or investing for the future. If they choose to invest, they may place their wealth in financial assets by purchasing various securities. When investors buy these securities from companies, the firms use the money so raised to pay for real assets, such as plant, equipment,  2 technology, or inventory. So, investors’ returns on securities ultimately come from the income produced by the real assets that were financed by the issuance of those securities. FINANCIAL ASSETS There are three broad types of financial assets 1. Fixed income 2. Equity 3. Derivatives Fixed income  Fixed-income or debt securities promise either a fixed stream of income or a stream of income determined by a specified formula. For example, a corporate bond typically would promise that the bondholder will receive a fixed amount of interest each year.  This comes in a tremendous variety of maturities and payment provisions.  This includes long-term securities such as Treasury bonds, as well as bonds issued by federal agencies, state and local municipalities, and corporations.  They also are designed with extremely diverse provisions regarding payments provided to the investor and protection against the bankruptcy of the issuer. Equity  Common stock or equity in a firm represents an ownership share in the corporation.  Equity holders are not promised any particular payment. They receive any dividends the firm may pay and have prorated ownership in the real assets of the firm. If the firm is successful, the value of equity will increase; if not, it will decrease.  The performance of equity investments, therefore, is tied directly to the success of the firm and its real assets. For this reason, equity investments tend to be riskier than investments in debt securities. Derivatives  Derivative securities such as options and futures contracts provide payoffs that are determined by the prices of other assets such as bond or stock prices.  This becomes an integral part of the investment environment. One uses derivatives to hedge risks or transfer them to other parties.  This is done successfully every day, and the use of these securities for risk management is so commonplace that the multitrillion-dollar market in derivative assets is routinely taken for granted.  Derivatives also can be used to take highly speculative positions. However, one of these positions might blow up resulting in well-publicized losses of hundreds of millions of dollars.  3  Derivatives continues to play an important role in portfolio construction and the financial system. Financial Markets and the Economy We stated earlier that real assets determine the wealth of an economy, while financial assets merely represent claims on real assets. Nevertheless, financial assets and the markets in which they trade play several crucial roles in developed economies. Financial assets allow us to make the most of the economy’s real assets.  The Informational Role of Financial Markets Stock prices reflect investors’ collective assessment of a firm’s current performance and future prospects. When the market is more optimistic about the firm, its share price will rise. That higher price makes it easier for the firm to raise capital and therefore encourages investment. In this manner, stock prices play a major role in the allocation of capital in market economies, directing capital to the firms and applications with the greatest perceived potential. But we need to be careful about our standard of efficiency. No one knows with certainty which ventures will succeed and which will fail. It is therefore unreasonable to expect that markets will never make mistakes. The stock market encourages allocation of capital to those firms that appear at the time to have the best prospects. Many smart, well-trained, and well-paid professionals analyze the prospects of firms whose shares trade on the stock market. Stock prices reflect their collective judgment.  Consumption Timing In high-earnings periods, you can invest your savings in financial assets such as stocks and bonds. In low-earnings periods, you can sell these assets to provide funds for your consumption needs. By so doing, you can “shift” your consumption over the course of your lifetime, thereby allocating your consumption to periods that provide the greatest satisfaction. Thus, financial markets allow individuals to separate decisions concerning current consumption from constraints that otherwise would be imposed by current earnings.  Allocation of Risk Virtually all real assets involve some risk. Financial markets and the diverse financial instruments traded in those markets allow investors with the greatest taste for risk to bear that risk, while other, less risk-tolerant individuals can, to a greater extent, stay on the sidelines. This allocation of risk also benefits the firms that need to raise capital to finance their investments. When investors are able to select security types with the risk-return characteristics that best suit their preferences, each security can be sold for the best possible price. This facilitates the process of building the economy’s stock of real assets.  4  Separation of Ownership and Management Many businesses are owned and managed by the same individual. This simple organization is well suited to small businesses and, in fact, was the most common form of business organization before the Industrial Revolution. Today, however, with global markets and large-scale production, the size and capital requirements of firms have skyrocketed. Such a large group of individuals obviously cannot actively participate in the day-today management of the firm. Instead, they elect a board of directors that in turn hires and supervises the management of the firm. This structure means that the owners and managers of the firm are different parties. This gives the firm a stability that the owner-managed firm cannot achieve.  Corporate Governance and Corporate Ethics We’ve argued that securities markets can play an important role in facilitating the deployment of capital resources to their most productive uses. But market signals will help to allocate capital efficiently only if investors are acting on accurate information. We say that markets need to be transparent for investors to make informed decisions. If firms can mislead the public about their prospects, then much can go wrong. In 2002, in response to the spate of ethics scandals, Congress passed the Sarbanes-Oxley Act to tighten the rules of corporate governance. For example, the act requires corporations to have more independent directors, that is, more directors who are not themselves managers (or affiliated with managers). The act also requires each CFO to personally vouch for the corporation’s accounting statements, provides for an oversight board to oversee the auditing of public companies, and prohibits auditors from providing various other services to clients. The Investment Process An investor’s portfolio is simply his collection of investment assets. Once the portfolio is established, it is updated or “rebalanced” by selling existing securities and using the proceeds to buy new securities, by investing additional funds to increase the overall size of the portfolio, or by selling securities to decrease the size of the portfolio. Investment assets can be categorized into broad asset classes, such as stocks, bonds, real estate, commodities, and so on. Investors make two types of decisions in constructing their portfolios. The asset allocation decision is the choice among these broad asset classes, while the security selection decision is the choice of which particular securities to hold within each asset class. Market are Competitive Financial markets are highly competitive. Thousands of intelligent and well-backed analysts constantly scour securities markets searching for the best buys. This competition  5 means that we should expect to find few, if any, “free lunches,” securities that are so underpriced that they represent obvious bargains.  The Risk-Return Trade-off Investors invest for anticipated future returns, but those returns rarely can be predicted precisely. There will almost always be risk associated with investments. Actual or realized returns will almost always deviate from the expected return anticipated at the start of the investment period. Naturally, if all else could be held equal, investors would prefer investments with the highest expected return. However, the no-free-lunch rule tells us that all else cannot be held equal. If you want higher expected returns, you will have to pay a price in terms of accepting higher investment risk. If higher expected return can be achieved without bearing extra risk, there will be a rush to buy the high- return assets, with the result that their prices will be driven up. There should be a risk–return trade-off in the securities markets, with higher-risk assets priced to offer higher expected returns than lower-risk assets.  Efficient Markets Another implication of the no-free-lunch proposition is that we should rarely expect to find bargains in the security markets. According to this hypothesis, as new information about a security becomes available, its price quickly adjusts so that at any time, the security price equals the market consensus estimate of the value of the security. If this were so, there would be neither underpriced nor overpriced securities Passive management calls for holding highly diversified portfolios without spending effort or other resources attempting to improve investment performance through security analysis. Active management is the attempt to improve performance either by identifying mispriced securities or by timing the performance of broad asset classes The Players From a bird’s-eye view, there would appear to be three major players in the financial markets: 1. Firms are net demanders of capital. They raise capital now to pay for investments in plant and equipment. The income generated by those real assets provides the returns to investors who purchase the securities issued by the firm. 2. Households typically are net suppliers of capital. They purchase the securities issued by firms that need to raise funds. 3. Governments can be borrowers or lenders, depending on the relationship between tax revenue and government expenditures.  Financial Intermediaries  6 Financial intermediaries have evolved to bring the suppliers of capital (investors) together with the demanders of capital (primarily corporations and the federal government). These financial intermediaries include banks, investment companies, insurance companies, and credit unions. Financial intermediaries issue their own securities to raise funds to purchase the securities of other corporations.  Investment Bankers Investment bankers act as underwriters. Investment bankers advise the issuing corporation on the prices it can charge for the securities issued, appropriate interest rates, and so forth. Ultimately, the investment banking firm handles the marketing of the security in the primary market, where new issues of securities are offered to the public. Later, investors can trade previously issued securities among themselves in the so-called secondary market.  Venture Capital and Private Equity Sources of venture capital are dedicated venture capital funds, wealthy individuals known as angel investors, and institutions such as pension funds. Most venture capital funds are set up as limited partnerships. A management company starts with its own money and raises additional capital from limited partners such as pension funds. That capital may then be invested in a variety of start-up companies. Venture capital investors commonly take an active role in the management of a start-up firm. Other active investors may engage in similar hands-on management but focus instead on firms that are in distress or firms that may be bought up, “improved,” and sold for a profit. Collectively, these investments in firms that do not trade on public stock exchanges are known as private equity investments. The Financial Crisis of 2008 The financial crisis of 2008 showed the importance of systemic risk. Systemic risk can be limited by transparency that allows traders and investors to assess the risk of their counterparties; capital requirements to prevent trading participants from being brought down by potential losses; frequent settlement of gains or losses to prevent losses from accumulating beyond an institution’s ability to bear them; incentives to discourage excessive risk taking; and accurate and unbiased analysis by those charged with evaluating security risk.  7 LESSON 1 ASSET CLASSES AND FINANCIAL INSTRUMENTS I. LEARNING OUTCOMES  Point out the bond-related investment prices and yield. (U)  Calculate the equity-related investment yields. (App)  Distinguish the derivative contracts and payoffs. (An) II. INPUT The Money Market The money market is a subsector of the fixed-income market. It consists of very short-term debt securities that usually are highly marketable. Many of these securities trade in large denominations and so are out of the reach of individual investors. Money market funds, however, are easily accessible to small investors. These mutual funds pool the resources of many investors and purchase a wide variety of money market securities on their behalf (Bodie, Kane & Marcus, 2018). a. Treasury Bills - Treasury bills (T-bills) are the most marketable of all money market instruments. - T-bills represent the simplest form of borrowing: The government raises money by selling bills to the public. - Investors buy the bills at a discount from the stated maturity value. At the bill’s maturity, the government pays the investor the face value of the bill. - The difference between the purchase price and ultimate maturity value constitutes the investor’s earnings. - The ask price is the price you would have to pay to buy a T-bill from a securities dealer. The bid price is the slightly lower price you would receive if you wanted to sell a bill to a dealer. The bid–ask spread is the difference in these prices, which is the dealer’s source of profit.  8 b. Certificate of Deposit - A certificate of deposit, or CD, is a time deposit with a bank. Time deposits may not be withdrawn on demand. The bank pays interest and principal to the depositor only at the end of the fixed term of the CD. Short-term CDs are highly marketable, although the market significantly thins out for maturities of 3 months or more. c. Commercial Paper - A commercial paper (CP) is an unsecured and negotiable market instrument issued in form of a promissory note. CPs are issued by companies to raise short-term funds for meeting working capital requirements. - Large, well-known companies, often issue their own short-term unsecured debt notes rather than borrow directly from banks. Very often, commercial paper is backed by a bank line of credit, which gives the borrower access to cash that can be used (if needed) to pay off the paper at maturity. d. Banker’s Acceptances - A banker’s acceptance starts as an order to a bank by a bank’s customer to pay a sum of money at a future date, typically within 6 months. At this stage, it is similar to a postdated check. When the bank endorses the order for payment as “accepted,” it assumes responsibility for ultimate payment to the holder of  9 the acceptance. At this point, the acceptance may be traded in secondary markets like any other claim on the bank. Bankers’ acceptances are considered very safe assets because traders can substitute the bank’s credit standing for their own. - They are used widely in foreign trade where the creditworthiness of one trader is unknown to the trading partner. Acceptances sell at a discount from the face value of the payment order, just as T-bills sell at a discount from par value. e. Eurodollars - Eurodollars are dollar-denominated deposits at foreign banks or foreign branches of American banks. By locating outside the United States, these banks escape regulation by the Federal Reserve. Despite the tag “Euro,” these accounts need not be in European banks, although that is where the practice of accepting dollar-denominated deposits outside the United States began. f. Repos and Reverses - Dealers in government securities use repurchase agreements, also called “repos” or “RPs,” as a form of short-term, usually overnight, and borrowing. The dealer sells government securities to an investor on an overnight basis, with an agreement to buy back those securities the next day at a slightly higher price. The increase in the price is the overnight interest. The dealer thus takes out a 1-day loan from the investor, and the securities serve as collateral. - A term repo is essentially an identical transaction, except that the term of the implicit loan can be 30 days or more. Repos are considered very safe in terms of credit risk because the loans are backed by the government securities. A reverse repo is the mirror image of a repo. Here, the dealer finds an investor holding government securities and buys them, agreeing to sell them back at a specified higher price on a future date. g. Federal Funds - Funds in the bank’s reserve account are called federal funds or fed funds. At any time, some banks have more funds than required at the Fed. Other banks, primarily big banks in New York and other financial centers, tend to have a shortage of federal funds. In the federal funds market, banks with excess funds lend to those with a shortage. These loans, which are usually overnight transactions, are arranged at a rate of interest called the federal funds rate. h. Brokers’ Calls - Individuals who buy stocks on margin borrow part of the funds to pay for the stocks from their broker. The broker in turn may borrow the funds from a bank, agreeing to repay the bank immediately (on call) if the bank requests it. The rate paid on such loans is usually about 1% higher than the rate on short-term T-bills. i. The LIBOR Market  10 - The London Interbank Offered Rate (LIBOR) is the rate at which large banks in London are willing to lend money among themselves. This rate, which is quoted on dollar-denominated loans, has become the premier short-term interest rate quoted in the European money market, and it serves as a reference rate for a wide range of transactions. j. Yields on Money Market Instruments - Although most money market securities are low risk, they are not risk-free. The securities of the money market promise yields greater than those on default- free T-bills, at least in part because of greater relative riskiness. In addition, many investors require more liquidity; thus they will accept lower yields on securities such as T-bills that can be quickly and cheaply sold for cash. The Bond Market The bond market is composed of longer term borrowing or debt instruments than those that trade in the money market. This market includes Treasury notes and bonds, corporate bonds, municipal bonds, mortgage securities, and federal agency debt. These instruments are sometimes said to comprise the fixed-income capital market, because most of them promise either a fixed stream of income or a stream of income that is determined according to a specific formula. In practice, these formulas can result in a flow of income that is far from fixed. Therefore, the term fixed income is probably not fully appropriate. It is simpler and more straightforward to call these securities either debt instruments or bonds.  Treasury Notes and Bonds T-notes are issued with maturities ranging up to 10 years, while bonds are issued with maturities ranging from 10 to 30 years. Both notes and bonds may be issued in increments of $100 but far more commonly trade in denominations of $1,000. Both notes and bonds make semiannual interest payments called coupon payments, a name derived from pre-computer days, when investors would literally clip coupons attached to the bond and present a coupon to receive the interest payment. The yield to maturity (YTM) reported in the last column is calculated by determining the semiannual yield and then doubling it, rather than compounding it for two half-year periods. This use of a simple interest technique to annualize means that the yield is quoted on an annual percentage rate (APR) basis rather than as an effective annual yield. The APR method in this context is also called the bond equivalent yield.  Inflation-Protected Treasury Bonds The best place to start building an investment portfolio is at the least risky end of the spectrum. Around the world, governments of many countries, including the United States, have issued bonds that are linked to an index of the cost of living in order to provide their citizens with an effective way to hedge inflation risk.  11  Federal Agency Debt Some government agencies issue their own securities to finance their activities. These agencies usually are formed to channel credit to a particular sector of the economy that Congress believes might not receive adequate credit through normal private sources.  International Bonds Many firms borrow abroad and many investors buy bonds from foreign issuers. In addition to national capital markets, there is a thriving international capital market, largely centered in London. A Eurobond is a bond denominated in a currency other than that of the country in which it is issued.  Municipal Bonds Municipal bonds are issued by state and local governments. They are similar to Treasury and corporate bonds except that their interest income is exempt from federal income taxation. The interest income also is usually exempt from state and local taxation in the issuing state. Capital gains taxes, however, must be paid on “munis” when the bonds mature or if they are sold for more than the investor’s purchase price. General obligation bonds are backed by the “full faith and credit” (i.e., the taxing power) of the issuer, while revenue bonds are issued to finance particular projects and are backed either by the revenues from that project or by the particular municipal agency operating the project. Typical issuers of revenue bonds are airports, hospitals, and turnpike or port authorities. Obviously, revenue bonds are riskier in terms of default than general obligation bonds. An industrial development bond is a revenue bond that is issued to finance commercial enterprises, such as the construction of a factory that can be operated by a private firm. Equivalent taxable yield of the tax-exempt bond.  Corporate Bonds Corporate bonds are the means by which private firms borrow money directly from the public. These bonds are similar in structure to Treasury issues—they typically pay semiannual coupons over their lives and return the face value to the bondholder at maturity. They differ most importantly from Treasury bonds in degree of risk. Default risk is a real consideration in the purchase of corporate bonds.  12 Secure bonds have specific collateral backing them in the event of firm bankruptcy; unsecured bonds, called debentures, which have no collateral; and subordinated debentures, which have a lower priority claim to the firm’s assets in the event of bankruptcy. Corporate bonds sometimes come with options attached. Callable bonds give the firm the option to repurchase the bond from the holder at a stipulated call price. Convertible bonds give the bondholder the option to convert each bond into a stipulated number of shares of stock.  Mortgages and Mortgage-Backed Securities Because of the explosion in mortgage-backed securities, almost anyone can invest in a portfolio of mortgage loans, and these securities have become a major component of the fixed-income market. A mortgage-backed security is either an ownership claim in a pool of mortgages or an obligation that is secured by such a pool. Most pass-through have traditionally been comprised of conforming mortgages, which means that the loans must satisfy certain underwriting guidelines (standards for the creditworthiness of the borrower) before they may be purchased by Fannie Mae or Freddie Mac. In the years leading up to the financial crisis, however, a large amount of subprime mortgages, that is, riskier loans made to financially weaker borrowers, were bundled and sold by “private-label” issuers. Equity Securities  Common Stock as Ownership Shares Common stocks, also known as equity securities or equities, represent ownership shares in a corporation. Each share of common stock entitles its owner to one vote on any matters of corporate governance that are put to a vote at the corporation’s annual meeting and to a share in the financial benefits of ownership.  Characteristics of Common Stock The two most important characteristics of common stock as an investment are its residual claim and limited liability features. - Residual claim means that stockholders are the last in line of all those who have a claim on the assets and income of the corporation. In a liquidation of the firm’s assets the shareholders have a claim to what is left after all other claimants such as the tax authorities, employees, suppliers, bondholders, and other creditors have been paid. For a firm not in liquidation, shareholders have claim to the part of operating income left over after interest and taxes have been paid. Management can either pay this residual as cash dividends to shareholders or reinvest it in the business to increase the value of the shares. - Limited liability means that the most shareholders can lose in the event of failure of the corporation is their original investment. Unlike owners of unincorporated businesses, whose creditors can lay claim to the personal  13 assets of the owner (house, car, furniture), corporate shareholders may at worst have worthless stock. They are not personally liable for the firm’s obligations.  Stock Market Listings The NYSE is one of several markets in which investors may buy or sell shares of stock. The dividend yield is only part of the return on a stock investment. It ignores prospective capital gains (i.e., price increases) or losses. Low-dividend firms presumably offer greater prospects for capital gains, or investors would not be willing to hold these stocks in their portfolios. The P/E ratio, or price–earnings ratio, is the ratio of the current stock price to last year’s earnings per share. The P/E ratio tells us how much stock purchasers must pay per dollar of earnings that the firm generates.  Preferred Stock Preferred stock has features similar to both equity and debt. Like a bond, it promises to pay to its holder a fixed amount of income each year. In this sense, preferred stock is similar to an infinite-maturity bond, that is, a perpetuity. It also resembles a bond in that it does not convey voting power regarding the management of the firm. Preferred stock is an equity investment, however, the firm retains discretion to make the dividend payments to the preferred stockholders; it has no contractual obligation to pay those dividends. Instead, preferred dividends are usually cumulative; that is, unpaid dividends cumulate and must be paid in full before any dividends may be paid to holders of common stock. In contrast, the firm does have a contractual obligation to make the interest payments on the debt. Failure to make these payments sets off corporate bankruptcy proceedings. Preferred stock is issued in variations similar to those of corporate bonds. It may be callable by the issuing firm, in which case it is said to be redeemable. It also may be convertible into common stock at some specified conversion ratio. Adjustable-rate preferred stock is another variation that, like adjustable-rate bonds, ties the dividend to current market interest rates. Stock and Bonds Market Indexes  Stock Market Indexes The daily performance of the Dow Jones Industrial Average is a staple portion of the evening news report. Although the Dow is the best-known measure of the performance of the stock market, it is only one of several indicators. Other more broadly based indexes are computed and published daily. In addition, several indexes of bond market performance are widely available. The ever-increasing role of international trade and investments has made indexes of foreign financial markets part of the general news as well. Thus foreign  14 stock exchange indexes such as the Nikkei Average of Tokyo and the Financial Times index of London are fast becoming household names. o Dow Jones Industrial Average o The Standard & Poor’s 500 Index o Other U.S. Market-Value Indexes o Equally Weighted Indexes o Foreign and International Stock Market Indexes  Bond Market Indicators Just as stock market indexes provide guidance concerning the performance of the overall stock market, several bond market indicators measure the performance of various categories of bonds. The three most well-known indexes are those of Merrill Lynch, Barclays, and the Citi Broad Investment Grade Bond Index. The major problem with bond market indexes is that true rates of return on many bonds are difficult to compute because the infrequency with which the bonds trade makes reliable up-to-date prices difficult to obtain. In practice, some prices must be estimated from bond-valuation models. These “matrix” prices may differ from true market values. Derivative Markets Futures, options, and related derivatives contracts provide payoffs that depend on the values of other variables such as commodity prices, bond and stock prices, interest rates, or market index values. For this reason, these instruments sometimes are called derivative assets: Their values derive from the values of other assets. These assets are also called contingent claims because their payoffs are contingent on the value of other values. Options A call option gives its holder the right to purchase an asset for a specified price, called the exercise or strike price, on or before a specified expiration date. When the market price exceeds the exercise price, the option holder may “call away” the asset for the exercise price and reap a payoff equal to the difference between the stock price and the exercise price. Otherwise, the option will be left unexercised. If not exercised before the expiration date of the contract, the option simply expires and no longer has value. Calls therefore provide greater profits when stock prices increase and thus represent bullish investment vehicles In contrast, a put option gives its holder the right to sell an asset for a specified exercise price on or before a specified expiration date. Notice that the prices of call options decrease as the exercise price increases. Option prices also increase with time until expiration.  15 Futures Contracts A futures contract calls for 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. The long position is held by the trader who commits to purchasing the asset on the delivery date. The trader who takes the short position commits to delivering the asset at contract maturity. The right to purchase the asset at an agreed-upon price, as opposed to the obligation, distinguishes call options from long positions in futures contracts. A futures contract obliges the long position to purchase the asset at the futures price; the call option, in contrast, conveys the right to purchase the asset at the exercise price. The purchase will be made only if it yields a profit. A holder of a call has a better position than the holder of a long position on a futures contract with a futures price equal to the option’s exercise price. This advantage, of course, comes only at a price. Call options must be purchased; futures contracts are entered into without cost. The purchase price of an option is called the premium. It represents the compensation the purchaser of the call must pay for the ability to exercise the option only when it is profitable to do so. Similarly, the difference between a put option and a short futures position is the right, as opposed to the obligation, to sell an asset at an agreed- upon price.