Transcript investment

Department of Banking and Finance
SPRING 2007-08
Investment, its background, Investors
and the Investment Process
by
Asst. Prof. Sami Fethi
ch: 1-21 Investment and Background
Define an investment

An investment is the current commitment of
money or other resources in the expectation of
reaping future benefits.
 For example, the time you spend for your
education is a kind of investment. Sometimes,
you can give up either current leisure or the
income for the sake of your future career. This
means that you sacrifice something of value
now and expecting to benefit from that sacrifice
later.
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Investment Management
© 2005, Sami Fethi, EMU, All Right Reserved.
ch: 1-21 Investment and Background
Essential nature of Investments & Assets

Essential nature of investment
– Reduced current consumption
– Planned later consumption

Real Assets
– Assets used to produce goods and services

Financial Assets
– Claims on real assets
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Investment Management
© 2005, Sami Fethi, EMU, All Right Reserved.
ch: 1-21 Investment and Background
Financial Assets
•
Financial Assets: claim on real assets or income
generated by them or financial assets are claims to the
income generated by real assets.
 Financial assets such as stocks and bonds do not
contribute directly to the productive capacity of the
economy (i.e. if we do not have our own auto plan (real
asset), we can buy shares in General motors or Toyota
(financial asset) and thereby, share in the income
derived from the production of automobiles).
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Investment Management
© 2005, Sami Fethi, EMU, All Right Reserved.
ch: 1-21 Investment and Background
Real Assets
Real Assets: Assets used to produce goods and
services. Real Assets refers the productive capacity
of an economy. (i.e. land, buildings, machines and
knowledge). These can be used to produce goods
and services.
While real assets generate net income to the
economy, financial assets simply define the
allocation of income or wealth among investors so
individuals can choose between consuming their
wealth or investing future.
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Investment Management
© 2005, Sami Fethi, EMU, All Right Reserved.
ch: 1-21 Investment and Background
Are the following assets real or financial?

a)
 b)
 c)
 d)
 e)
Patents (R)
Lease obligation (F)
Customer goodwill (R)
A college education (R)
A $ 5 bill (F)
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Investment Management
© 2005, Sami Fethi, EMU, All Right Reserved.
ch: 1-21 Investment and Background
Describe a derivative security and
understand how they are used in a market.

Derivative securities such as option and futures
providing pay-offs that are determined by the
prices of other assets such as bond or stock prices.
 One use of derivatives (i.e. primary use) is to
hedge risks or transfer them to the other parties.
The use of these securities for risk management is
so commonplace that the multitrilion-dollar
market in derivative assets is routinely taken for
granted. Derivatives also can be used to take
highly speculative positions in a market.
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Investment Management
© 2005, Sami Fethi, EMU, All Right Reserved.
ch: 1-21 Investment and Background
The Investment Process

Asset allocation
 Security selection
 Risk-return trade-off
 Market efficiency
 Active vs. passive management
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Investment Management
© 2005, Sami Fethi, EMU, All Right Reserved.
ch: 1-21 Investment and Background
Investors make two major steps or
decisions in constructing their own portfolios

Portfolio is simply collection of investment assets
 The asset allocation decision is the choice among
broad asset classes such as stocks, bonds, real
estate, commodities, and so on. Top-down portfolio
construction starts with asset allocation.
 The security selection decision is the choice of
which particular securities to hold within each asset
class. This is related with bottom-up strategy. i.e.,
the most attractive investment opportunities.
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Investment Management
© 2005, Sami Fethi, EMU, All Right Reserved.
ch: 1-21 Investment and Background
An understanding of the risk/return trade-off
Assets with higher expected returns have greater
risk. A risk-return trade-off in the securities
markets, with higher risk assets priced to offer
higher expected returns than lower-risk assets.
 Risk tolerance: The investor’s willingness to accept
higher risk to attain higher expected returns.
 Risk aversion: The investor is also reluctant to
accept risk
 An investor’s objectives can be classified as return
requirement and risk tolerance
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Investment Management
© 2005, Sami Fethi, EMU, All Right Reserved.
ch: 1-21 Investment and Background
Active vs. Passive Management
Active Management
 Finding undervalued securities
 Timing the market
Passive Management
 No attempt to find undervalued securities
 No attempt to time
 Holding an efficient portfolio
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Investment Management
© 2005, Sami Fethi, EMU, All Right Reserved.
ch: 1-21 Investment and Background
Active vs. Passive Management

AM: Buying and holding a diversified portfolio
without attempting to identify mispriced securities.
 PM: Attempting to identify mispriced securities or
to forecast broad market trends.
 For example: Individuals can follow passive
strategy if markets are efficient and prices reflect
all relevant information.
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Investment Management
© 2005, Sami Fethi, EMU, All Right Reserved.
ch: 1-21 Investment and Background
Financial Intermediaries

Institutions that connect borrowers and
lenders by accepting funds from lenders and
loaning funds to borrowers.
– Such as banks, investment companies,
insurance companies and credit unions.
– FI’s issue their own securities to raise funds to
purchase the securities of other corporation.
– Why? An individuals lender can able to reduce
risk, and monitor the credit risk of borrowers.
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Investment Management
© 2005, Sami Fethi, EMU, All Right Reserved.
ch: 1-21 Investment and Background
Investments and Innovation
Technology and Delivery of Service
 Computer advancements
 More complete and timely information
Globalization
 Domestic firms compete in global markets
 Performance in regions depends on other regions
 Causes additional elements of risk
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Investment Management
© 2005, Sami Fethi, EMU, All Right Reserved.
ch: 1-21 Investment and Background
Key Trends - Globalization
International and Global Markets Continue
Developing
 Managing foreign exchange
 Diversification to improve performance
 Instruments and vehicles continue to
develop.World equity benchmark shares
(WEBs)
 Information and analysis improves
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Investment Management
© 2005, Sami Fethi, EMU, All Right Reserved.
ch: 1-21 Investment and Background
Key Trends - Securitization
Securitization & Credit Enhancement
 Securitization: Pooling loans into standardized
securities back by those loans which can be
traded like other security
 Offers opportunities for investors and originators
 Changes in financial institutions and regulation
 Improvement in information capabilities
 Credit enhancement and its role
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Investment Management
© 2005, Sami Fethi, EMU, All Right Reserved.
ch: 1-21 Investment and Background
Key Trends - Financial Engineering
Repackaging Services of Financial Intermediaries
 FE is the process of bundling and unbundling of
cash flows which refers to the creation and design
of securities with custom tailor characteristics.
 UB: breaking up and allocating the cash flows
from one security to create several new securities.
 B: combining more than one security into a
composite security.
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Investment Management
© 2005, Sami Fethi, EMU, All Right Reserved.
ch: 1-21 Investment and Background
The Future





Globalization continues and offers more
opportunities
Securitization continues to develop
Continued development of derivatives and
exotics
Strong fundamental foundation is critical
Integration of investments & corporate finance
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Investment Management
© 2005, Sami Fethi, EMU, All Right Reserved.
ch: 1-21 Investment and Background
Overview of the Investment Process

Specify objectives
 Identify constraints
 Formulate an investment policy
 Monitor performance
 Reevaluate and modify portfolio as
determined from monitoring
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Investment Management
© 2005, Sami Fethi, EMU, All Right Reserved.
ch: 1-21 Investment and Background
The basic factors affecting an individual investor usually
arise from that investor’s stage in the life cycle
Major asset: Education or investment in human
capital: earning power derived from their skill; at
this point financial risk due to illness or injury is
greater than that associated with the rate of return on
their portfolios of financial assets-insurance.
 Major economic asset: is to buy their own house;
first risk is the risk of increases rental rates; second
risk is availability.
 Age concern: in the middle age most investor will be
willingly to take on a meaningful amount of portfolio
risk in order to increase their expected rate of return.
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Investment Management
© 2005, Sami Fethi, EMU, All Right Reserved.
ch: 1-21 Investment and Background
Individual Investors

Professional investors provide investment
management services for a fee. Most of
them are either pool many individual
investor funds and manage them or serve
institutional investors.
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Investment Management
© 2005, Sami Fethi, EMU, All Right Reserved.
ch: 1-21 Investment and Background
Specifying Objectives: Individual Investors
Balance risk and return
Life Cycle is critical to the process of
determining the risk/return trade-off
Younger investors - willing to bear more risk
for higher returns
Older investors - willing to accept lower
returns for lower risk
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Investment Management
© 2005, Sami Fethi, EMU, All Right Reserved.
ch: 1-21 Investment and Background
Specifying Objectives: Personal Trusts
and Mutual Funds

Personal Trusts
– Determined by the individual for whom the
funds are being managed

Mutual Funds
– Varies with type of fund
– More detailed in the next chapter
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Investment Management
© 2005, Sami Fethi, EMU, All Right Reserved.
ch: 1-21 Investment and Background
Personal trust and Mutual funds

Personal trust: the objectives of personal trusts
normally are more limited in scope than those of
the individual investor. They are usually risk avers
person.
 Mutual funds: the objectives of mutual funds is to
invest such shares that the income generated by
the funds.
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Investment Management
© 2005, Sami Fethi, EMU, All Right Reserved.
ch: 1-21 Investment and Background
Specifying Objectives: Pension
Funds and Endowments

Pension Funds
– Defined contribution - shifted to the individual
– Defined benefit - depends on average time to
retirement of individuals

Endowment Funds
– Gifts to nonprofits are invested
– Funds from the endowment used by the
nonprofit
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Investment Management
© 2005, Sami Fethi, EMU, All Right Reserved.
ch: 1-21 Investment and Background
Specifying Objectives: Insurance
Companies

Life Companies
– Investments are hedged against potential claims
of policy holders

Non-Life Companies
– Invest premiums not paid back to policyholders
for loss
– Hedge against potential claims
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Investment Management
© 2005, Sami Fethi, EMU, All Right Reserved.
ch: 1-21 Investment and Background
Specify Objectives: Banks

Sources of funds: deposits and borrowed
funds
 Investment of funds: predominately in loans
and fixed income securities
 Active in the securitized loan and asset
markets
 Not active in equity except in the Trust
Function
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Investment Management
© 2005, Sami Fethi, EMU, All Right Reserved.
ch: 1-21 Investment and Background
Investors Constraints

Constraints are the kind of financial circumstances
impose on investor’s choice.
 Five common types of constraints are:
Liquidity: refers an asset can be converted to cash
Investment horizon: is the planned liquidation date
of investment.
Regulations: Only professional and institutional
investors are constrained by regulations- prudent
investor rule-professional investors who manage
other people’s money have fiduciary responsibility
to restrict investment to assets that would have
been approved by a prudent investor.
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Investment Management
© 2005, Sami Fethi, EMU, All Right Reserved.
ch: 1-21 Investment and Background
Investors Constraints
Tax considerations: special considerations
related to tax position of the investor. The
performance of any investment strategy are
always measured by its ror after tax.
Unique needs; are often centre around their
stage in the life cycle such as retirement,
housing and children’s education.
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Investment Management
© 2005, Sami Fethi, EMU, All Right Reserved.
ch: 1-21 Investment and Background
Investment Policy: Asset Allocation
Decision
Individual - depends on life cycle
Younger
Higher equity
75%
Lower safe assets 25%
Older
Lower equity
40%
Higher safe assets 60%
Institutional - depends on objectives
Example -all stock mutual fund would want nearly
100% in stock
Sector or Region allocations
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Investment Management
© 2005, Sami Fethi, EMU, All Right Reserved.
ch: 1-21 Investment and Background
Investment Policy: Active or Passive
Active
Trying to secure better than average
performance
Must balance returns and costs
Passive
Trying to get average returns rather than do
better than the market
Mix of Passive and Active
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Investment Management
© 2005, Sami Fethi, EMU, All Right Reserved.
ch: 1-21 Investment and Background
The End
Thanks
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Investment Management
© 2005, Sami Fethi, EMU, All Right Reserved.