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Typology

Along two broad dimensions: new or existing business & new or existing owners. Habitual founders: Serial, Portfolio // Inherit/buy-in, multiple corporate.

Typology explanation

Distinguish portfolio owners (quadrant 4 ) where ownership of the first venture is maintained when a subsequent venture is embarked upon, from serial owners who dispose of one venture before founding another (quadrant 2).

Novice founders vs habitual founders

Novice founders are not less likely to be as highly educated as habitual founders.

Portfolio vs serial and novice founders

Portfolio founders are more likey to have a greater number of partners in the industry.

Novice versus serial and portfolio founders

Novice founders have worked in fewer organizations.

Serial vs novice and portfolio founders

More likely to have worked in smaller firms.

Portfolio founders & tax

More likely to look at tax and indirect benefits.

Serial founders & uncertainty

More cautious in their approach, preferring opportunities with lower degrees of uncertainty.

Functions

The first function, which explained most of the variance, differentiated the serial founders from the other two types of founders. Serial founders were drawn from non- managerial parental backgrounds and they established their first busi…

Conclusion

In respect of portfolio and serial founders, significant differences were identified in terms of the age of the founders when starting their first businesses, parental background, and the work experiences of the founders. Differences bet…

Traditional Investments Covers

Security Analysis and Portfolio Management

Security Analysis

Involves estimating the merits of individual investments. A three-step process - 1. The analyst considers prospects for the economy, given the stage of the business cycle, 2. The analyst determines which industries are likel…

Portfolio Management

Deals with the construction and maintenance of a collection of investments.

Portfolio management literature supports the efficient markets paradigm

On a well-developed securities exchange, asset prices accurately reflect the tradeoff between relative risk and potential returns of a security. Efforts to identify undervalued securities are fruitless. Free lunches are difficult to find.

Market efficiency and Portfolio management

A properly constructed portfolio achieves a given level of expected return with the least possible risk

Stock categories and security analysis

Preferred stock, blue chips, defensive stocks, cyclical stocks, and valuation of stocks.

Security Screening

A screen is a logical protocol to reduce the security universe to a workable number for closer investigation.

Debt Securities

Pricing, duration - enables the portfolio manager to alter the risk of the fixed-income portfolio component, and bond diversification.

Pension Funds

These acquire funds by periodic contributions from employers or

valuation

The process of determining the current worth of an asset or company. There are many techniques that can be used to determine value, some are subjective and others are objective.

Growing Income Streams

A growing stream is one in which each successive cash flow is larger than the previous one. A common problem is one in which the cash flows grow by some fixed percentage.

Growing Annuity

A growing annuity is an annuity in which the cash flows grow at a constant rate g.

Growing Perpetuity

A growing perpetuity is an annuity where the cash flows continue indefinitely.

Safe Dollars and Risky Dollars

A safe dollar is worth more than a risky dollar. Most investors are risk averse - people will take a risk only if they expect to be adequately rewarded for taking it. People have diffe…

Covered Call

Strike = 50, Price = 250, Own stock, we gain as price goes up. We collect premium from option, but payout money to the owner as the price goes up, negating our gain from owning the stock.

Naked Call

Strike = 50, Price = 250, Do not own stock, as price goes up we have unlimited amount to payout, even though we keep premium, unlimited losses because the price could go up to inifinity.

Risk

Involves the chance of loss. If a particular horse will win at the track if you made a bet.

Uncertainty

The ex ante and the ex post returns of a project are likely to be different

Dispersion and Chance of Loss

There are two material factors we use in judging risk: the average outcome, and the scattering of the other possibilities around the average. Two securities have the same arithmetic mean, A has less dispersio…

Total risk

Refers to the overall variability of the returns of financial assets.

Non-diversifiable risk

The risk that must be borne by virtue of being in the market. Arises from systematic factors that affect all securities of a particular type.

Diversifiable risk

Can be removed by proper portfolio diversification (unsystematic risk). The ups and downs of individual securities due to company-specific events will cancel each other out. The only return variability that remains will be du…

Relationship between Risk and Return

Direct Relationship, Role of Utility, Diminishing Marginal Utility of Money, The Consumption Decision, Other Considerations

Direct Relationship

The more systematic risk someone bears, the higher the expected return, the more appropriate discount rate depends on the risk level of the investment, the risk-free rate of interest can be earned without bearing any risk.

Diminishing Marginal Utility of Money

Rational people prefer more money to less, money provides utility. Diminishing marginal utility of money, the relationship between money and added utility is not linear. "I hate to lose more than I like to win".

The Consumption Decision

The consumption decision is the choice to save or to borrow. If interest rates are high, we are inclined to save. e.g., open a new savings account. If interest rates are low, borrowing looks attract…

The Concept of Return

Return can mean various things, and it is important to be clear when discussing an investment. In most cases, return is measurable.

Holding period return

the total return received from holding an asset or portfolio of assets; not for different time frame and different investments.

arithmetic mean return

average of a series of periodic returns

Geometric Mean

[(1+R1) X (1+RT)]^(1/t)-1

Comparison of Arithmetic and Geometric Mean Returns

The geometric mean reduces the likelihood of nonsense answers. The geometric mean must be used to determine the rate of return that equates a present value with a series of future values. The greater…

Expected Return

Expected return refers to the future. In finance, what happened in the past is not as important as what happens in the future. We can use past information to make estimates about the future.

Return on Investment

Return on Investment (ROI) is a term that must be clearly defined. Return on Assets (ROA) = Return/Total Assets. Return on Equity (ROE) = Return/Total Stockholders' Equity. ROE is a leveraged version of ROA>

Standard Deviation and Variance

Standard deviation and variance are the most common measures of total risk. They measure the dispersion of a set of observations around the mean observation.

Semi-Variance

Semi-variance considers the dispersion only on the adverse side. Ignore all observations greater than the mean. Calculates variance using only "bad" returns that are less than average. Since risk means "chance of loss", positive disper…

Statistics Review

One has to understand key terms: "Constants", "Variables", "Populations", "Samples", and "Sample Statistics". Properties of Random variables, linear regression, R squared and standard errors.

Constants

A constant is a value that does not change. e.g., the number of sides of a cube. e.g., the sum of the interior angles of a triangle. A constant can be represented by a numeral or by a symbol.

Variable

A variable has no fixed value. It is useful only when it is considered in the context of other possible values it might assume.

Discrete random variables

Are countable, e.g., the number of bonds you buy.

Continuous random variables

Are measurable, e.g., realized return on these bonds.

Quantitative variables

Are measured by real numbers, e.g., numerical measurement: coupon rate on a bond.

Qualitative variables

Are categorical, e.g., bond rating, convertible, callable

Independent variables

Are measured directly, e.g., price, dividend on a stock.

Dependent variables

Can only be measured once other independent variables are measured. e.g., the total return (requires price paid and received and dividend amounts)

Populations

A population is the entire collection of a particular set of random variables. The nature of a population is described by its distribution. The median of a distribution is the point where half the observat…

Binomial distribution

Contains only two random variables, e.g., the toss of a coin (heads or tails).

Finite population

One in which each possible outcome is known. e.g., a card drawn from a deck of cards

Infinite population

Population where not all observations can be counted. e.g., the microorganisms in a cubic mile of ocean water.

Univariate population

Has one variable of interest.

Bivariate population

Has two variables of interest. e.g., weight and size.

Multivariate population

More than two variables of interest. e.g., weight, size, and color.

Samples

A sample is any subset of a population. e.g., a sample of past monthly stock returns of a particular stock.

Sample statistics

Sample statistics are characteristics of samples. A true population statistics is usually unobservable and must be estimated with a simple statistic. Expensive , statistically unnecessary.

Properties of Random Variables

Example, Central Tendency, Dispersion, Logarithms, Expectations, Correlation and Covariance.

Central Tendency

Central tendency is what a random variable looks like, on average. The usual measure of central tendency is the population's expected value (the mean).

Dispersion

Investors are interested in the variations of actual values around the average. A common measure of dispersion is the variance or standard deviation.

Logarithms

Logarithms reduce the impact of extreme values. e.g., takeover rumors may cause huge price swings. A logreturn is the logarithm of a return relative. Logarithms make other statistical tools more appropriate, e.g., linear regression. U…

Expectations

The expected value of a constant is a constant. The expected value of a constant times a random variable is the constant times the expected value of the random variable. The expected value of ra…

Correlations

The degree of association between two variables. Correlation and covariance are related and generally measure the same phenomenon. Correlation ranges from -1.0 to +1.0. Two random variables that are perfectly positively correlated have a correla…

Covariance

The product moment of two random variables about their mean. Correlation and covariance are related and generally measure the same phenomenon.

Linear Regression

Linear regression is a mathematical technique used to predict the value of one variable from a series of values of other variables. e.g., predict the return of an individual stock using a stock market in…

R Squared

R squared and standard error are used to assess the accuracy of calculated securities. R squared is a measure of how good a fit we get with the regression line. If every data point …

Standard Error

The standard error is equal to the standard deviation divided by the square root of the number of observations. The standard error enables us to determine the likelihood that the coefficient is statistically different …

Setting objectives is important

For every person and institution that uses the financial market. Too many investors have a casual attitude. It is easy to be imprecise in communicating with the portfolio manager. Gallup Survey finds 39% believe st…

Semantics, Indecision, Subjectivity, Multiple Beneficiaries

Why setting objectives can be difficult

Semantics

Growth, income, return on investment, and risk mean different things to different people. e.g., a savings account provides income only; it has no growth potential. There must be a clear understanding of the terms …

Indecision

The client's inability to make a decision, e.g., a bank customer wants to have interest compounded but have the interest sent home each month.

Multiple Beneficiaries

Investment portfolios often have more than one beneficiary, e.g., an endowment fund has a perpetual life. It is possible to increase current income from the portfolio. Benefits today's beneficiaries, may be at the expense of future beneficiaries.

Investment Policy

Deals with decisions that have been made about long-term investment activities, eligible investment categories, and the allocation of funds among the eligible investment categories. e.g., a pension fund decides never to place more than 30 percent in common stock.

Investment Strategy

Deals with short-term activities that are consistent with established policy and that will contribute positively toward obtaining the objective of the portfolio. e.g., a manager may be required to maintain at least 30 percent eq…

Portfolio Objectives

Preconditions, Traditional portfolio objectives, special situation of tax-free income.

Preconditions

Assess the existing situation. What are the current needs of the beneficiary? What is the investment horizon? Are there special liquidity needs? Are there ethical investing concerns established by the fund's owner or overseer?

Traditional Portfolio Objectives

Stability of Principal, income, growth of income, capital appreciation

Stability of principal

Emphasis is on preserving the "original" value of the fund. The most conservative portfolio objective, will generate the most modest return over the long run, e.g., bank certificates of deposit, other money market instruments.

Income

mature companies with high div. payout ratios (such as utilities)

Growth of Income

Differs from income objective. Sacrifices some current return for some purchasing power protection. Income lower in earlier years, income higher in later years. *requires some investment in equity securities.

Capital Appreciation

The goal is for the portfolio to grow in value rather than generate income. Appropriate for investors who have no income needs. A major benefit is tax savings. Unrealized capital gains are not taxed, divi…

Situation of Tax-Free Income

Accomplished by investing in municipal securities. Free from federal tax and may be free from state and local taxes. Invest directly in municipal bonds for an income strategy. Invest in a mix of municipal b…

The importance of Primary and Secondary Objectives

The secondary objectives indicates what is next in importance after specification of the primary objective. e.g., an investor chose income as the primary objective, but: does not want to take a lot of risk …

Other Factors to Consider in Established Objectives

Inconsistent objectives, portfolio splitting, liquidity, the role of cash

Inconsistent Objectives

Certain primary/secondary combinations are incompatible. Primary: stability of principal, secondary: capital appreciation. "I want no chance of a loss, but I do want capital gains"

Portfolio Splitting

A fund manager receives instructions that require that the portfolio be managed in more than one part. e.g., endowment funds. Components will have different objectives. A more convenient way of administering the fund that tr…

liquidity

the ability to be used as, or directly converted to, cash

The Role of Cash

Investment management firms routinely prescribe portfolio proportions for: equity securities, fixed-income securities, cash - arrives in portfolios naturally through the receipt of dividends and interest, includes currency, money market interests, short-term interest-bearing deposit accounts. *Pres…

Portfolio Dedication

Portfolio dedication (liability funding) involves managing an asset portfolio so that it services the requirements of a corresponding liability or portfolio of liabilities. Overlays the primary and secondary investment objectives. The two principal methods…

Cash Matching

The most common form of portfolio dedication. A manager assembles a portfolio of bonds whose cash flows match as nearly as possible the requirements of a particular liability.

Duration Matching

In a duration matched portfolio: a rise in interest rates results in a decline in the portfolio's value that is approximately offset by additional income earned from the higher reinvestment rate. A fall in inte…

Mutual Fund

A mutual fund is an existing portfolio of assets into which someone may invest directly. Facilitates diversification. Mutual funds are extremely popular investment vehicles for both the small and the large investor. Many institutions p…

Open-end funds

May grow in size as new investors open accounts, may grow in size as existing investors add to their accounts, have no set number of shares outstanding, buy back their shares from investors (redemption)

Closed-end funds

Have a fixed number of shares that trade like shares of common stock. Are unmanaged portfolios of stock with each share representing partial ownership of the portfolio. May trade on an exchange. Can be sold to other investors.

Net Asset value versus Market Value

You buy and sell an open-end fund based on its net asset value. Open-end fund: equals the fund's assets minus its liabilities divided by the number of shares currently existing in the fund. Closed-end f…

Load Funds

Have a sales charge associated with the purchase of new shares. A commission split between: a mutual fund salesperson, an investment firm, a national distributor, typically ranges between 1.0 percent and 8.5 percent.

No-load Funds

Have no sales charge, shares are bought and sold at net asset value

Management Fees

Management fees include: postage costs, clerical time, commissions on the underlying assets, redemption fee - a fee to pay redemption expenses, ranging between 1 percent and 2 percent. Management fees are paid to fund mana…

Buying Mutual Fund Shares

Fund prospectus outlines: the fund's purpose, the management team, the mailing address and phone number, the fund's intended investment activity. Funds also provide descriptive brochures and other correspondence to anyone who inquires. new account applica…

Mutual Fund Objectives

The fund objectives is the type of investment anticipated, capital appreciation and growth funds seek appreciation in the value of shares, income funds seek current income from fixed-income securities and from dividends, growth and in…

Investment management

The practice of attempting to achieve the objectives while staying within the established constraints.

The Purpose of Investment Policy

Outline Expectations and Responsibilities, Identify Objectives and Constraints, Outline Eligible Asset classes and their permissible use, and provide a mechanism for evaluation

Outline Expectations and Constraints

Investment policy is the responsibility of the client. e.g., an individual, an endowment fund's board. Investment management is the responsibility of the money manager, e.g., a bank trust department, a brokerage firm

The investment manager's responsibilities

Educate the client about infeasible objectives, develop an appropriate asset allocation and investment strategy, communicate the essential characteristics of the portfolio to the client, monitor and revise the portfolio as necessary, clients are entitle…

Identify Objectives and Constraints

Objective setting should include, a target return, an appropriate level of risk

Individual Investors

Guardians take forever to make a decision and then worry constantly about it, stability of principal or income are appropriate objectives. Celebrities make decisions quickly, like investment fads and worry about being left out. Adventu…

Charitable Portfolios

An endowment fund is a perpetual portfolio designed to benefit both current citizens and future generations. e.g., churches, the public library, the TWCA, environment groups, etc.. A foundation is an organization designed to aid…

Institutional Portfolios

Insurance Companies and pension funds have special needs: e.g., defined benefit retirement plans must ensure they will be able to meet payments.

Real Risk

The consequences of a loss vary widely, depending on the circumstances, e.g., a professional in his peak earning years versus a retired widow

Investment Committee's Knowledge

The investment committee: should be differentiated between fact and opinion, and should be honest in assessing the committee's ability and seek professional assistance when appropriate.

How important is the particular portfolio to the client's overall financial position?

There is no requirement that an investor keep all of his money with one brokerage firm, trust department, or money manager. The client may be diversified even if it does not appear so.

Legal Restrictions

Some states have a legal list outlining permissible investment. e.g., insurance companies may not buy corporate bonds without an investment-grade rating.

Unanticipated Consquences of Interims Fluctuations

Fluctuations may not matter in the short run in theory, but this may not be the best case in practice. e.g., an endowment fund that needs to generate money for annual scholarships.

Outline Eligible Asset Classes and Their Permissible Uses

Asset allocation decision is the single most important investment decision investors make. Affects long-term rates of return than security selection, market timing, or taxes.

Determining the benchmark is an integral part of setting investment policy

A benchmark can be absolute, e.g., a 10% rate of return, a benchmark can be relative, e.g., top quarter

A good benchmark should:

Be investable - it should be a viable investment alternative. Be specified in advance, e.g., median manager performance is not known until the end of the evaluation period: this is not a good benchmark…

Examples of feasible return objectives

A long-term average rate of return of 10 percent. Over a five-year period, achieve a rate of return of at least 80 percent of the S&P 500 index. Generate a cash flow of $25,00…

Examples of infeasible return objectives

Maintain purchasing power with 100 percent probability. Earn at least a 10 percent rate of return each calendar year. Ensure that the value of the fund never falls below the principal and produce an annual yield of 7 percent.

Constraints

Time Horizon, Tax situation, liquidity needs, legal considerations, unique needs and special circumstances.

Time Horizon

The length of time the investment will be at work is critical to proper asset allocation. In the long run, daily fluctuations in security values do not matter. The growth of earnings is most important in the long run.

Tax situation

If client is in low tax bracket, then taxable investments may be appropriate.

Liquidity Needs

Some portfolios must produce a steady stream of income to the owner or to a set of beneficiaries. The manager must ensure the required funds are available in a timely fashion.

Legal Considerations

Some types of investment portfolios face a legal list of eligible assets. e.g., restricted to investment-grade bonds or a minimum payout ratio of fund assets to maintain tax-exempt status.

Unique Needs and Special Circumstances

Social investing, e.g., clients may not want to invest in tobacco stocks or in electric utilities using nuclear power sources. Empirical evidence on whether or not social investing influences realized investment returns is mixed.

Institutional Investors

Mutual Funds, Endowment Funds, Pension Funds, Life Insurance Companies, Property and Casualty Insurance Companies.

Mutual Funds

These are companies or divisions of an investment bank that sell shares of itself to investors and then use the proceeds to invest in different company stocks

Endowment Funds

An endowment fund is a long-term investment portfolio designed to assist the organization in carrying out its charitable purpose. An endowment fund has three purposes: help maintain operating independence, provide operational stability, provide a ma…

Defined Contribution Plans

The employer established a set dollar contribution to be made on the employee's behalf. The employee makes the asset allocation decision.

Defined Benefit Plans

The employer guarantees a specific level of retirement benefits regardless of the performance of the market. e.g., when the employee reaches age 65, the firm will pay its retirees 75 percent of the averag…

Life Insurance Companies

Contractual Savings Institution

Property and Casualty Insurance Companies

Property and casualty companies differ significantly from life insurance companies: Disasters strike without warning and vary in scope. With many policies, there is never a claim. Liquidity is especially important at a property and casualty company.

Characteristics of a Good Investment Policy statement

It is realistic - the return objectives are reasonably attainable in ordinary market conditions, the target return and the statements about risk should be logically consistent. It should be unambiguous to an outsider - spe…

Procedures for Modifying the Statement

Changes should be made when necessary and when legally required. An annual policy review provides a useful mechanism for discussing possible changes. It may be necessary to accelerate the policy review if there are mate…

The reason for portfolio theory mathematics

Why diversification is a good idea, why diversification makes sense logically

Harry Markowitz's efficient portfolios

Those portfolios providing the maximum return for their level of risk, those portfolios providing the minimum risk for a certain level of return.

Linear Combinations

A portfolio's performance is the result of the performance of its components. The return realized on a portfolio is a linear combination of the returns on the individual investments. The variance of the portfoli…

return

interest or similar

minimum variance portfolio

smallest variance among all portfolios with identical expected return

Correlation and Risk Reduction

Portfolio risk decreases as the correlation coefficient in the returns of two securities decreases. Risk reduction is greatest when the securities are perfectly negatively correlated. If the securities are perfectly positively correlated, there i…

A Covariance matrix

Is a tabular presentation of the pairwise combinations of all portfolio components. The required number of covariances to compute a portfolio variance is (n^2 -…

Single-Index model

The single-index model compares all securities to a single benchmark. By observing how two independent securities behave relative to a third value, we learn something about how the securities are likely to behave relative to each other.

Multi-Index model

A multi-index model considers independent variables other than the performance of an overall market index. Of particular interest are industry effects. Factors associated with a particular line of business, e.g., the performance of grocery st…

The concept of Risk Aversion revisited

Diversification is logical. If you drop the basket, all eggs break. Volatility of individual firms has increased (investors need more stocks to adequately diversify). Diversification is mathematically sound. Most people are risk averse, people …

Variance of a Linear Combination

most investors want portfolio variance to be as low as possible without having to give up any return.

Portfolio Programming

Various portfolio combinations may result in a given return. The investor wants to choose the portfolio combination that provides the least amount of variance.

Concept of Dominance

Dominance is a situation in which investors universally prefer one alternative over another. All rational investors will clearly prefer one alternative.

A portfolio dominates all others it:

For its level of expected return, there is no other portfolio with less risk. For its level of risk, there is no other portfolio with a higher expected return.

Harry Markowitz: The Father of Portfolio Theory

Harry Markowitz's "Portfolio Selection" Journal of Finance article (1952) set the stage for modern portfolio theory. The first major publication indicating the importance of security return correlation in the construction of stock portfolios. Markowitz sh…

Security Universe

The security universe is the collection of all possible investments. For some institutions, only certain investments may be eligible.

efficient frontier

developed by Prof Harry Markowitz 1952

Capital Market Line and Market Portfolio

The tangent line passing from the risk-free rate through point B is the capital market line (CML). When a security universe includes all possible investments, point B is the market portfolio. It contains every r…

Security Market Line

The positively sloped straight line displaying the relations between expected return and beta.

Expansion of the SML to Four Quadrants

There are securities with negative betas and negative expected returns. A reason for purchasing these securities is their risk-reduction potential. e.g., buy car insurance without expecting an accident. e.g., buy fire insurance without expecting a fire.

Quadratic Programming

The Markowitz algorithm is an application of quadratic programming. The objective function involves portfolio variance. Quadratic programming is very similar to linear programming.

Lessons from Evans and Archer

Evan's and Archer 1968 Journal of Finance article. Very consequential research regarding portfolio construction. Shows how naive diversification reduces the dispersion of returns in a stock portfolio.

Naive diversification

Refers to the selection of portfolio components randomly without any serious security analysis.

Evans and Archer Methodology

Measured the average variances of portfolios of different sizes, up to portfolios with dozens of components. Purpose was to investigate the effects of portfolio size on portfolio risk when securities are randomly selected.

Strength in Numbers

Portfolio variance (total risk) declines as the number of securities included in the portfolio increases. On average, a randomly selected ten-security portfolio will have less risk than a randomly selected three-security portfolio. Risk-averse investors sh…

Biggest Benefits come first from diversifying

Increasing the number of portfolio components provides diminishing benefits as the number of components increases. Adding a security to a one-security portfolio provides substantial risk reduction. Adding a security to a twenty-security portfolio provides only modest additional benefits.

Implications of Evans and Archer

Very effective diversification occurs when the investor owns only a small fraction of the total number of available securities. Institutional investors may not be able to avoid superfluous diversification due to the dollar siz…

Implications for Mutual Funds

Things to consider for mutual fund managers: owning all possible securities would require high commission costs. It is difficult to follow every stock.

Words of caution

Selecting securities at random usually gives good diversification but not always. Industry effects may prevent proper diversification. Although naive diversification reduces risk, it can also reduce return. Unlike Markowitz's efficient diversification.

Diversification and Beta

Beta measures systematic risk. Diversification does not mean to reduce beta. Investors differ in the extent to which they will take risk, so they choose securities with different betas. e.g., an aggressive investor could ch…

Capital Asset Pricing Model

The capital asset pricing model is a theoretical description of the way in which the market prices investment assets.

Systematic Risk

Cannot be diversified and is relevant. Measured by beta. Beta determines the level of expected return on a security or portfolio (SML)

Unsystematic Risk

The risk that effects at most a small number of assets; it is also called unique or asset-specific risk. For example, oil strike by a single company.

CAPM

a model that simplifies a complex investment environment and which allows investors to understand the relationship between risk and return

CAPM assumptions

investors only need to know expected returns, variances and covariances

SML and CAPM

If you show the security market line with excess returns on the vertical axis, the equation of the SML is the CAPM. The intercept is zero, the slope of the line is the expected market risk premium.

Note on the CAPM assumptions

Several assumptions are unrealistic: people pay taxes and commissions, many people look ahead more than one period, not all investors forecast the same distribution of returns for the market. Theory is useful to the ex…

Stationarity of Beta

Beta is not stationary. Evidence that weekly betas are less than monthly betas, especially for high-beta stocks. Evidence that the stationarity of beta increases as the estimation period increases. The informed investment managers knows that betas change.

Equity Risk Premium

Refers to the difference in the average return between stocks and some measure of the risk-free rate. The equity risk premium in the CAPM is the excess expected return on the market. Some researchers…

Correlations of Returns

Much of the daily news is of a general economic nature and affects all securities. Stock prices often move as a group. Some stocks routinely move more than the others regardless of whether the ma…

Linear Regression and Beta

To obtain beta with a linear regression: plot a stock's return against the market return. Use Microsoft Excel to run a linear regression and obtain the coefficients. The coefficient for the market return is…

Statistical Significance

Published betas are not always useful numbers. Individual securities have substantial unsystematic risk and will behave differently than beta predicts. Portfolio betas are more useful since some unsystematic risk is diversified away.

International Opportunities

Institutional investors are well aware of the possibilities international investments offer. U.S. equities represent only about 45 percent of the world's equity capitalization. Over the period 1980-2000, the U.S. was the best performing market …

Why International Diversification?

International investments carry additional sources of risk. Managers can reduce total portfolio risk via global investment

Remembering Evans and Archer

Portfolio theory works to the investor's benefit even if he selects securities at random. Ideally, the portfolio manager selects securities because of their fit with the rest of the portfolio. By choosing poorly correlated securit…

Remember Capital Market Theory

Unsystematic risk reduction is possible with more than 20 securities. For a given level of return, any reduction in risk, no matter how small, is a worthy goal. A rational investor will reduce risk if given the opportunity.

Relationship of World Exchanges

For U.S. securities, market risk accounts for about one-fourth of a security's total risk. For less developed countries, market risk tends to be higher because: fewer securities make up the market and the securities…

Considerations.

Optimum portfolio size involves a trade-off between: the benefits of additional diversification, commissions and capital constraints, there also is a limit to an investor's time, foreign exchange risk: modest changes in exchange rates can result in significant dollar differences.

Forward Rates

The forward rate is a conceptual rate between a commercial bank and a client for the future delivery of a specified quantity of foreign currency. Typically quoted on the basis of 1, 2, 3…

Interest Rate Parity

Interest rate parity states that differences in national interest rates will be reflected in the currency forward market

Covered Interest Arbitrage

Covered interest arbitrage is possible when the conditions of interest rate parity are violated. If the foreign interest rate is too high, convert dollars to the foreign currency and invest in the foreign country…

Purchasing Power Parity (PPP)

Refers to the situation in which the the exchange rate equals the ratio of domestic and foreign price levels. A relative change in the prevailing inflation rate in one country will be reflected a…

Absolute Purchasing Power Parity

Follows from "the law of one price". A basket of goods in one country should cost the same in another country after conversion to a common currency. Not very accurate due to: transportation costs, trade barriers, and cultural differences.

Relative Purchasing Power Parity

States that differences in countries' inflation rates determine exchange rates.

Exports decline, imports increase, there is less demands of goods from that country

A country with an increase in inflation will experience a depreciation of its currency because:

Foreign Exchange Exposure

If the dollar is expected to appreciate dramatically, an investor may reduce or eliminate foreign currency holdings. Hedging involves taking one position in the market that offsets another position. Covering foreign exchange risk means hedging foreign exchange risk.

Hedging with Future Contracts

A futures contract is a promise to buy or sell a specified quantity of a particular good at a predetermined price by a specified delivery date. On the delivery date, there will be a …

Hedging with Foreign Currency Options

There are two types of foreign currency options: call options give their owner the right to buy a set quantity of foreign currency. A put options give their owner the right to sell a…

Currency options characteristics

A call option with an exercise price quoted in dollars for the purchase of euros is the same as a put option on dollars with an exercise price quoted in euros. Put-call parity for for…

Key Issues in Foreign Exchange Risk Management

The steps in foreign exchange risk management: 1. Define and measure foreign exchange exposure, 2. Organize a system that monitors this exposure and exchange rate changes, 3. Assign a responsibility for hedging, 4. Formulate a strategy for hedging.

Reducing Risk

Low correlations are attractive as a means of reducing portfolio variability. Emerging markets show low correlation with developed markets, emerging markets show low correlation with each other.

Following the Crowd

Some professional money managers carefully analyze emerging markets for: profit potential, portfolio risk reduction. Some professional money managers "follow the crowd" because they feel they must invest in emerging markets.

Additional Risks arising from Foreign Investment

Incomplete accounting information, foreign currency risk, fraud and scandals, weak legal system

Asymmetric Correlations

Correlation between emerging and developed markets: increases during bear markets, is low during bull markets, the extent of portfolio managers' diversification depends on whether they are experiencing an up or down market.

Market Microstructure Considerations

Liquidity risk, trading costs, market pressure, marketability risk, and country risk

Liquidity risk

Risk that a security can only be sold by incurring large transaction costs. Easiest to sell are large cap issues traded on NYSE. Small cap stocks are inactively traded and have a high level of liquidity risk.

Trading Costs

Foreign market trading costs are more than 1 percent higher than domestic trading costs. e.g.,…

Market Pressure

An order to buy or sell a large number of shares might cause a substantial su…

Marketability Risk

An investor may be unable to close out a position at a reasonable price

Country Risk

Refers to a country's ability and willingness to meet its foreign exchange obligations, especially important in emerging markets. Country risk has two components: political risk and economic risk.

Multinational Corporations

Investing in a multinational corporation may provide a ready-made means of getting the risk-reduction benefits of international diversification. Research is unclear whether MNCs are better investments than purely domestic firms.

American Depository Receipts

American depository Receipts (ADRs) are receipts representing shares of stock that are held on the ADR holder's behalf in a bank in the country of origin. An alternative to purchasing shares in a foreign com…

International Mutual Funds

Mutual funds permit diversification to an extent that would not otherwise be possible. Some mutual funds invest only in securities issued outside the U.S.. Buying an international mutual fund is a good way to ach…

Debt

Obligation to repay

Markets

Money Market

Debt Instruments

Money Market Holds:

Bonds

Capital Market Holds:

Track average returns

Stock Market Indexes Uses:

Representative?

Factors in constructing or using and index

Contruction of Indexed

How are they weighted?

Price Weighted (DJIA)

How are they weighted?

Arithmetic (DJIA, S&P500)

How Returns are Averaged?

Effectiveness of an index depends on:

Which securities rre included in the index and how many

Index

Indexes can be considered as a portfolio of securities

How are indexes contructed as?

Index = The sum of (Quantity*Price)

Price Weighted Index Characteristics:

Quantity of each security is equal to one another.

Find the weight for a price weighted index

Weight = Price / The sum of all prices

Higher price stocks have greater impacts on the index because:

Their changes in price has a larger percentage change overall in the index.

What is the impact of a stock split on the index?

that stock would become less influential because it has a lower price.

Value-Weighted Index

The weight for individual component security is baed on the total market value of each components security rather than just the price of each share.

Effects from a stock split:

Stock splits don't affect the value of the index, or the impact of a stock on the index.

The greater its influence.

The greater the market capitalization of a stock

Weight of a security in a value-weighted index:

Weight = Market Value / The sum of the total market values

Equally Weighted Index

Calculated by giving each security the same weight regardless of its price or market capitalization.