Introduction

Overview of Financial Markets and Investment

Risk and Return

Investment Management Process

1. Setting investment Objective

2. Establishing Investment Policy

3. Selecting a portfolio strategy

4. Selecting the assets

5. Measuring and Evaluating Performance

1.Setting investment Objective Understand profiles and risk tolerant level

in order to set objective to satisfy the obligations stipulated in the policy.

i.e. pension fund, insurance company, retirement person etc.

2.Establishing Investment Policy Must be correspond with the objectives Make asset allocation decision

Investment Management Process

Investment AlternativesMajor

Categories

Financial Assets

Real Assets

Direct Investing

Indirect Investing

Real Estate

Precious Metals

Fix Assets

Mutual Funds

Hedge Funds

Non marketable Money market Capital market Derivative Securities

-Saving deposit

-CD

-Whole Life Insurance

-T-bill

-NCD

-Commercial Paper i.e. B/E and P/N

-Foreign Exchange

-Fixed Income i.e. Gov.bond, State Enterprise bond, Corporate bond, T-note, Prefer stocks, Mortgage pass-through

-Common Stock

- Options i.e.Calls/Puts

- Corporate created i.e Convertibles, Warrants

- Forward

- Futures

Investment Alternatives

The Historical Record:A First Look

McGraw Hill / Irwin

Investment Alternatives

McGraw Hill / Irwin

Average Returns: The First Lesson

Market sizes of developed stock markets

Market coverage of developed stock market

Market capitalization of emerging markets

Size of govy bond market

3. Selecting a portfolio strategy

4.Selecting the assets Picking securities to build your portfolio Efficient portfolio – provides the greatest

expected return at a given level of risk

Actives - use information and forecasting techniques to seek a better performance

Passives – diversification Structured – match the funds received from

contributions to the future liabilities

Investment Management Process

5. Measuring and Evaluating Performance

Benchmark Return vs. Risk Risk management

Investment Management Process

Risk and Return Two key observations emerge

There is a reward for bearing risk, and at least on average, that reward has been substantial.

Greater rewards are usually accompanied by greater risks.

In summary, high risk should compensated by high return

Return Components

Returns consist of two elements:– Periodic cash flows such as interest or

dividends (income return)– Price appreciation or depreciation (capital

gain or loss)

Total Return =Yield +Price Change

B

BEt

P)P(PCF

TR

B

BEt

P)P(PCF

TR

Measuring Returns

For comparing performance over time or across different securities

Total Return is a percentage relating all cash flows received during a given time period, denoted CFt +(PE - PB), to the start of period price, PB

Example: Calculating Returns Suppose you invested $1,000 in a stock at

$25 per share. After one year, the price increases to $35. For each share, you also received $2 in dividends.

Total dollar return = 48% of $1,000 = $480 At the end of the year, the value of your

$1,000 investment is $1,480.

$2+($35-$25) = 48%

$25

t E B

B

CF (P P )TR

P

$2+($35-$25) = 48%

$25

t E B

B

CF (P P )TR

P

Measuring Returns

RR CF PPt E

B

1 TR RR CF PPt E

B

1 TR

Total Return can be either positive or negative– When cumulating or compounding,

negative returns are problem

A Return Relative solves the problem because it is always positive

Measuring Returns

Example: What is Relative Return in the previous

example?

1 =1+48%=1.48RR TR 1 =1+48%=1.48RR TR

Measuring Returns

)nTR1)...(2TR1)(1TR1(0WI

To measure the level of wealth created by an investment rather than the change in wealth, need to cumulate returns over time

Cumulative Wealth Index, CWIn, over

n periods, =

Measuring Returns

Example: The Return Relatives of a particular stock

investment in two consecutive years are 1.48 and 0.95, assume CW0 is $1000, what is Cumulative Wealth Index, CWI2, over these 2 years?

C (1 )(1 ) $1000*1.48*0.95 $14062 0 1 2

WI WI TR TR

Measuring Returns

nX

X

Measures Describing a Return Series Arithmetic mean, or simply mean,

Arithmetic Versus Geometric

Arithmetic mean does not measure the compound growth rate over time– Does not capture the realized change in

wealth over multiple periods– Does capture typical return in a single

period

Geometric mean reflects compound, cumulative returns over more than one period

Defined as the n-th root of the product of n return relatives minus one or G =

Difference between Geometric mean and Arithmetic mean depends on the variability of returns, s

1)TR1)...(TR1)(TR1( n/1n21

sX1G1 222

Geometric Mean

TR IA

TRCPI

11

1

Adjusting Returns for Inflation

Returns measures are not adjusted for inflation

– Purchasing power of investment may change over time

– Consumer Price Index (CPI) is possible measure of inflation

s

X X

n 1

2 1/2

Measuring Risk

Risk is the chance that the actual outcome is different than the expected outcome

Standard Deviation measures the deviation of returns from the mean

Financial Risk– Tied to debt

financing

Liquidity Risk– Marketability with-

out sale prices

Exchange Rate Risk

Country Risk– Political stability

Risk Sources Interest Rate Risk

– Affects income return

Market Risk– Overall market

effects

Inflation Risk– Purchasing power

variability

Business Risk

Risk Types

Two general types:– Systematic (general) risk

• Pervasive, affecting all securities, cannot be avoided

• Interest rate or market or inflation risks

– Nonsystematic (specific) risk• Unique characteristics specific to issuer

Total Risk =General Risk +Specific Risk

Risk Premiums Premium is additional return earned or

expected for taking additional risk

Equity risk premium is the difference between stock and risk-free returns

Equity Risk Premium, ERP, =

1RF1

CSTR1

Risk and Return

McGraw Hill / Irwin

The Lesson

The greater the potential reward, the greater the risk.