3global Diversification and Asset Class[1]

8/8/2019 3global Diversification and Asset Class[1]

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Selecting Investments in aGlobal Market

Questions to be answered:

Why sh ould investors h ave a globalperspective regarding t h eir investments?


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Selecting Investments in aGlobal MarketQuestions to be answered:

Wh at are t h e differences in t h e rates of return on U.S. and foreign securitiesmarkets?


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Investments in a GlobalMarketQuestions to be answered:

H ow can c h anges in currenc y exc h angerates affect t h e returns


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Is t h ere an additional advantage of diversif ying in international marketsbe yond t h e benefits of domesticdiversification?


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Investments in a GlobalMarket

Questions to be answered:

Wh at alternative securities are available?Wh at are t h eir cas h flow and risk properties?


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Wh at is t h e h istorical return and risk ch aracteristics of t h e major investmentinstruments?


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Wh at is t h e relations h ip among returnsfor foreign and domestic investmentinstruments? Wh at is t h e implication of th ese relations h ips for portfoliodiversification?


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R easons for t h e expansion of investment opportunities

1. Growth and development of foreignfinancial markets

2. Advances in telecommunicationstechnology

3. Mergers of firms and security exchanges


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T h e Case for Constructing

Global Investment Portfolios1. Ignoring foreign markets can substantially

reduce the investment choices for investors

2. The rates of return on non-U.S. securitiesoften have substantially exceeded those for

U.S.-only securities3. The low correlation between U.S. stock markets and many foreign markets canhelp to substantially reduce portfolio risk


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T h e Case for GlobalInvestments

D iversification with foreign securities canhelp reduce portfolio risk because foreignmarkets have low correlation with U.S. capitalmarkets


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Global Bond Portfolio R isk 1. Macroeconomic differences cause the

correlation of bond returns between thecountries to differ

2. The correlation of returns between a single pair of countries changes over time

because the factors influencing thecorrelation change over time


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R isk of Combined Countr y Investments

D iversified portfolios reduce variability of

returns over time

for bonds and stocks


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Summary on Global InvestingR elatively high rates of return

combined with low correlation

coefficients indicate that adding

foreign stocks and bonds to a

portfolio will reduce risk and may

increase its average return


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Global Investment C h oicesFixed-income investments bonds and preferred stocks

Equity investmentsSpecial equity instruments warrants and options

Futures contractsInvestment companies

R eal assets


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F ixed- Income InvestmentsContractual payment scheduleR ecourse varies by instrument

Bonds investors are lenders expect interest payment and return of

principalPreferred stocks dividends require board of directors

approval


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Savings AccountsFixed earningsConvenientLiquidLow risk Low ratesCertificates of D eposit (C D s)

- instruments that require minimum depositsfor specified terms, and pay higher rates of interest than savings accounts. Penaltyimposed for early withdrawal


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Capital Market InstrumentsFixed income obligations that trade in

secondary market

U.S. Treasury securities

U.S. Government agency securities

Municipal bonds

Corporate bonds


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T reasur y SecuritiesBills, notes, or bonds - depending onmaturity

Bills mature in less than 1 year Notes mature in 1 - 10 years Bonds mature in over 10 yearsHighly liquidBacked by the full faith and credit of theGovernment


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Corporate BondsIssued by a corporation

Fixed income

Credit quality measured by ratingsMaturity

Features

Indenture Call provision

Sinking fund


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Corporate BondsSenior secured bonds most senior bonds in capital structure and have

the lowest risk of default

Mortgage bonds secured by liens on specific assets

Collateral trust bonds secured by financial assets

Equipment trust certificates secured by transportation equipment


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Corporate BondsIncome bonds Interest payment contingent upon earning

sufficient incomeConvertible bonds Offer the upside potential of common

stock and the downside protection of a bond

Usually have lower interest rates


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Corporate BondsWarrants Allows bondholder to purchase the firms

common stock at a fixed price for a given time period

Interest rates usually lower on bonds withwarrants attached

Zero coupon bond Offered at a deep discount from the face value No interest during the life of the bond, only the

principal payment at maturity


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Preferred Stock Hybrid securityFixed dividends

D ividend obligations are not legally binding, but must be voted on by the boardof directors to be paid

Most preferred stock is cumulativeCredit implications of missing dividendsCorporations may exclude 80% of dividendincome from taxable income


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International Bond InvestingBond identification characteristics Country of origin

Location of primary trading market Home country of the major buyers Currency of the security denomination

Eurobond An international bond denominated in a

currency not native to the country where it isissued


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International Bond InvestingYankee bonds Sold in the United States and denominated is

U.S. dollars, but issued by foreign corporationsor governments

Eliminates exchange risk to U.S. investors

International domestic bonds Sold by issuer within its own country in thatcountrys currency


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Eq uit y InvestmentsR eturns are not contractual and

may be better or worse than ona bond


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Eq uit y InvestmentsCommon Stock

R epresents ownership of a firm

Investors return tied to performance of the company and may result in loss or gain


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Classification of Common Stock Categorized B y General Business

LineIndustrial: manufacturers of automobiles,machinery, chemicals, beveragesUtilities: electrical power companies, gassuppliers, water industryTransportation: airlines, truck lines,

railroadsFinancial: banks, savings and loans, creditunions


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Ac q uiring F oreign Eq uities1. Purchase of American D epository R eceipts

(ADR s)

2. Purchase of American shares3. D irect purchase of foreign shares listed on a

U.S. or foreign stock exchange

4. Purchase of international mutual funds


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Purc h ase or Sale of Global MutualF unds or ETF s

Global funds - invest in both U.S. andforeign stocksInternational funds - invest mostly outside

the U.S.Funds can specialize D iversification across many countries Concentrate in a segment of the world

Concentrate in a specific country Concentrate in types of marketsExchange-traded funds or ETFs are a recentinnovation in the world of index products


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Special Eq uit y InstrumentsEquity-derivative securities have a claim oncommon stock of a firm

Options are rights to buy or sell at a stated price for a period of timeWarrants are options to buy from thecompanyPuts are options to sell to an investor Calls are options to buy from a stockholder


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F utures ContractsExchange of a particular asset at a specifieddelivery date for a stated price paid at the

time of deliveryD eposit (10% margin) is made by buyer atcontract to protect the seller

Commodities trading is largely in futurescontractsCurrent price depends on expectations


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Investment CompaniesMoney market funds Acquire high-quality, short-term investments

Yields are higher than normal bank C D s Typical minimum investment is $1,000

No sales commission charges

Withdrawal is by check with no penalty Investments usually are not insured


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Investment CompaniesBond funds Invest in long-term government,

corporate, or municipal bonds

Bond funds vary in bond quality selectedfor investment

Expected returns vary with risk of bonds


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Investment CompaniesCommon stock funds Many different funds with varying stated

investment objectives

Aggressive growth, income, precious metals,international stocks

Offer diversification to smaller investors Sector funds concentrate in an industry

International funds invest outside the UnitedStates Global funds invest in the U.S. and other

countries


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Investment CompaniesBalanced funds Invest in a combination of stocks and

bonds depending on their statedobjectives


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Investment CompaniesIndex Funds These are mutual funds created to equal

the performance of a market index likethe S&P 500


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Investment CompaniesExchange-Traded Funds (ETFs) These are depository receipts for a portfolio of

securities deposited at a financial institution ina unit trust that issues a certificate of ownershipfor the portfolio of stocks

The stocks in a portfolio are those in an indexlike the S&P 500 and dozens of country or industry indexes

ETFs can be bought and sold continuously onan exchange like common stock


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R eal E state Investment T rusts(REIT s)

Investment fund that invests in a variety of real estate propertiesConstruction and development trusts

provide builders with constructionfinancingMortgage trusts provide long-termfinancing for propertiesEquity trusts own various income-

producing properties


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Direct R eal E state Investment

Purchase of a home

Average cost of a single-family house can beexpensive

Financing by mortgage requires down payment

Homeowner hopes to sell the house for cost plus a gain


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Purchase of raw land

Intention of selling in future for a profit

Ownership provides a negative cash flow due tomortgage payments, taxes, and propertymaintenance

R isk from selling for an uncertain price and lowliquidity


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R ental Property

Acquire apartment buildings or houses with lowdown payments

D erive enough income from the rents to pay theexpenses of the structure, including the

mortgage payments, and generate a good return

R ental property provides a cash flow and anopportunity to profit from the sale of the

property


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Low-Li q uidit y InvestmentsSome investments dont trade on securitiesmarkets

Lack of liquidity keeps many investorsaway

Auction sales create wide fluctuations in

pricesWithout markets, dealers incur hightransaction costs


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Anti q uesD ealers buy at estate sales, refurbish, andsell at a profit

Serious collectors may enjoy good returns

Individuals buying a few pieces to decorate

a home may have difficulty overcomingtransaction costs to ever enjoy a profit


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Art

Investment requires substantial knowledgeof art and the art world

Acquisition of work from a well-knownartist requires large capital commitmentsand patience

High transaction costs

Uncertainty and illiquidity


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Coins and StampsEnjoyed by many as hobby and as aninvestmentMarket is more fragmented than stock market, but more liquid than art andantiques marketsPrice lists are published weekly and

monthlyGrading specifications aid salesWide spread between bid and ask prices


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D iamonds

Can be illiquid

Grading determines value, but is subjectiveInvestment-grade gems require substantialinvestments

No positive cash flow until soldCosts of insurance, storage, and appraisal


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H istorical R isk- R eturns on

Alternative InvestmentsW orld Portfolio Performance

R eilly and Wright (2004) examined the

performance of various investment alternativesfrom the United States, Canada, Europe, Japan,and the emerging markets for the period 1980-2001


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R eill y and W rig h ts 2004 Stud y

Asset R eturns and Total R isk The expected relationship between annual rates

of return and total risk (standard deviation) of these securities was confirmed


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R eturn and Systematic R isk The systematic risk measure (beta) did a better

job of explaining the returns during the periodthan did the total risk measure

The beta risk measure that used the Brinsonindex as a market proxy was somewhat better than the beta that used the S&P 500 Index


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Correlations between Asset R eturns U.S. equities have a reasonably high correlation

with Canadian and U.K. stocks but lowcorrelation with emerging market stocks andJapanese stocks

U.S. equities show almost zero correlation withworld government bonds, except U.S. bonds


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Art and Anti q uesMarket data is limited

R esults vary widely, and change over time,making generalization impossible, butshowing a reasonably consistentrelationship between risk and returnCorrelation coefficients vary widely,allowing for great diversification potentialLiquidity is still a concern


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R eal E stateR eturns are difficult to derive due to lack of consistent dataR esidential shows lower risk and returnthan commercial real estateD uring some short time periods R EITs haveshown higher returns than stock with lower risk measuresLong term returns for real estate are lower than stocks, and have lower risk


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Correlationrelative measure of agiven relationship

3global Diversification and Asset Class[1]

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