Chapter One: The Investment EnvironmentMajor Classes of
Financial Assets or Securities: Three types: 1. Fixed income or
debt 2. Common stock or equity3. Derivative securities1. Debt:
Money market instruments- Bank certificates of deposit, T-bills,
commercial paper, etc. Bonds Preferred stock Payments fixed or
determined by a formula Money market debt: short term, highly
marketable, usually low credit risk Capital market debt: long term
bonds, can be safe or risky2. Common stock Ownership stake in the
entity, residual cash flow Common Stock is equity or ownership in a
corporation. Payments to stockholders are not fixed, but depend on
the success of the firm3. Derivatives A contract whose value is
derived from some underlying market condition. Value derives from
prices of other securities, such as stocks and bonds Used to
transfer riskReal assets versus financial assets The material
wealth of a society is determined ultimately by the productive
capacity of its economy, which is a function of the real assets of
the economy: the land, buildings, knowledge, and machines that are
used to produce goods and the workers whose skills are necessary to
use those resources. Financial assets, like stocks or bonds,
contribute to the productive capacity of the economy indirectly,
because they allow for separation of the ownership and management
of the firm and facilitate the transfer of funds to enterprise with
attractive investment opportunities. Financial assets are claims to
the income generated by real assets. Real vs. Financial assets: a)
Real assets produce goods and services, whereas financial assets
define the allocation of income or wealth among investors. b) They
are distinguished operationally by the balance sheets of
individuals and firms in the economy. Whereas real assets appear
only on the asset side of the balance sheet, financial assets
always appear on both sides of the balance sheet. Your financial
claim on a firm is an asset, but the firms issuance of that claim
is the firms liability. When we aggregate overall balance sheets,
financial assets will cancel out, leaving only the sum of real
assets as the net wealth of the aggregate economy. c) Financial
assets are created and destroyed in the ordinary course of doing
business. E.g. when a loan is paid off, both the creditors claim
and the debtors obligation cease to exist. In contrast, real assets
are destroyed only by accident or by wearing out over time.
Risk-Return Tradeoff: The principle that potential return rises
with an increase in risk. Low levels of uncertainty (low risk) are
associated with low potential returns, whereas high levels of
uncertainty (high risk) are associated with high potential returns.
According to the risk-return trade-off, invested money can make
higher profits only if it is subject to the possibility of being
lost.Because of the risk-return trade-off, investors must recognize
their personal risk tolerance when choosing investments. Taking on
additional risk is the price of achieving potentially higher
returns; therefore, if an investor wants to make money, he or she
cannot cut out all risk. The goal instead is to find an appropriate
balance that generates some profit but allows the investor to sleep
at night. Low levels of uncertainty (low risk) are associated with
low potential returns. High levels of uncertainty (high risk) are
associated with high potential returns. The risk/return tradeoff is
the balance between the desire for the lowest possible risk and the
highest possible return. A higher standard deviation means a higher
risk and higher possible return.A common misconception is that
higher risk equals greater return. The risk/return tradeoff tells
us that the higher risk gives us the possibility of higher returns.
There are no guarantees. Just as risk means higher potential
returns, it also means higher potential losses. Efficient Markets
Market efficiency: Securities should be neither underpriced nor
overpriced on average Security prices should reflect all
information available to investors Whether we believe markets are
efficient affects our choice of appropriate investment management
style.Active vs. Passive ManagementActive Management (inefficient
markets) Finding undervalued securities (Security Selection) Timing
the market (Asset Allocation)Passive Management (efficient markets)
No attempt to find undervalued securities IndexingConstructing an
efficient portfolioNo attempt to time Holding a diversified
portfolio: Here an efficient portfolio refers to the best
diversified portfolio at the chosen risk level, and in practice
should include administrative costs, and choice of investments to
include (based on cash flow desired, taxes, willingness to invest
in international & alternative investments, etc.)The Players:
From birds-eye, there would appear to be three major players in the
financial markets: Business Firms Firms are net borrowers. 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.
Households Households typically are net savers. They purchase the
securities issued by the firms that need to raise funds.
Governments can be both borrowers and savers. Financial
Intermediaries Connectors of borrowers and lenders Commercial Banks
Traditional line of business: Make loans funded by deposits
Investment companies Insurance companies Pension funds Hedge
funds
Investment Bankers: Goldman Sachs, Citigroup, J.P.Morgan Perform
specialized services for businesses such as issuing securities for
firms Markets in the primary market Firms that specialize in
primary market transactions Primary market: A market where newly
issued securities are offered to the public. The investment banker
typically underwrites the issue. Secondary market: A market where
pre-existing securities are traded among investors.Definition of
'Financial Engineering'The use of mathematical techniques to solve
financial problems. Financial engineering uses tools and knowledge
from the fields of computer science, statistics, economics and
applied mathematics to address current financial issues as well as
to devise new and innovative financial products. Financial
engineering is sometimes referred to as quantitative analysis and
is used by regular commercial banks, investment banks, insurance
agencies and hedge funds.Financial engineering has led to the
explosion of derivative trading that we see today. Since the
Chicago Board Options Exchange was formed in 1973 and two of the
first financial engineers, Fischer Black and Myron Scholes,
published their option pricing model, trading in options and other
derivatives has grown dramatically.Investment Bankers: An
individual who works in a financial institution that is in the
business primarily of raising capital for companies, governments
and other entities, or who works in a large bank's division that is
involved with these activities. Investment bankers may also provide
other services to their clients such as mergers and acquisition
advice, or advice on specific transactions, such as a spin-off or
reorganization. In smaller organizations that do not have a
specific investment banking arm, corporate finance staff may
fulfill the duties of investment bankers. All investment bankers
must abide by their firm's stipulated code of conduct. Commercial
and investment banks functions and organizations were separated by
law from 1933 to 1999. In September 2008 major investment banks
either went bankrupt, reorganized as commercial banks or were
purchased by commercial banks as a result of the collapse of the
mortgage markets. Some investment banks chose to become commercial
banks to obtain deposit funding and government assistance All of
the major investment banks are now under the much stricter
commercial bank regulations. Financial Engineering Repackaging cash
flows of a security to enhance marketability Bundling and
unbundling of cash flows Use of mathematical models and
computer-based trading technology to synthesize new financial
products Bundling: Combining more than one asset into a composite
security, for example securities sold backed by a pool of
mortgages. Unbundling: Selling separate claims to the cash flows of
one security, for example a CMODefinition of financial
intermediariesA financial intermediary is a financial institution
such as bank, building society, insurance company, and investment
bank or pension fund. A financial intermediary offers a service to
help an individual/ firm to save or borrow money. A financial
intermediary helps to facilitate the different needs of lenders and
borrowers.For example, if you need to borrow 1,000 you could try to
find an individual who wants to lend 1,000. But, this would be very
time consuming and you would find it difficult to know how reliable
the lender was. Therefore, rather than look for individuals to
borrow a sum, it is more efficient to go to a bank (a financial
intermediary) to borrow money. The bank raises funds from people
looking to deposit money, and so can afford to lend out to those
individuals who need it.Examples of Financial Intermediaries1.
Insurance Companies: If you have a risky investment. You might wish
to insure, against the risk of default. Rather than trying to find
a particular individual to insure you, it is easier to go to an
insurance company who can offer insurance and help spread the risk
of default.2. Financial Advisers: A financial adviser doesnt
directly lend or borrow for you. They can offer specialist advice
on your behalf. It saves you understanding all the intricacies of
the financial markets and spending time looking for best
investment.3. Credit Union: Credit unions are informal types of
banks which provide facilities for lending and depositing within a
particular community.4. Mutual funds/ Investment trusts: These are
mutual investment schemes. These pool the small savings of
individual investors and enable a bigger investment fund.
Therefore, small investors can benefit from being part of a larger
investment trust. This enables small investors to benefit from
smaller commission rates available to big purchases.Benefits of
Financial IntermediariesPotential Problems of Financial
Intermediaries
1. Lower search costs. 2. Spreading risk. 3. Economies of scale.
4. Convenience of Amounts. There is no guarantee they will spread
the risk. Poor information. They rely on liquidity and
confidence.
Chapter Two: Financial InstrumentsFinancial markets are
segmented into money markets and capital markets. 1. Money market
instruments (they are called cash equivalents, or just cash for
short) include short-term, marketable, liquid, low-risk debt
securities. 2. Capital markets include longer-term and riskier
securities. We subdivide the capital market into four segments:
longer-term bond markets, equity markets, and the derivative
markets for options and futures. Money Market: 1. T-bills:
Investors buy the bills at a discount from the stated maturity
value and get the face value at the bills maturity. T-bills with
initial maturities of 91 days or 182 days are issued weekly.
Offerings of 52-week bills are made monthly. Sales of bills are
conducted via auction, at which investors can submit competitive or
noncompetitive bids. T-bills sell in minimum denominations of only
$10,000. The income earned on T-bills is tax-free. 2. CD:
Certificate of deposit is a time deposit with a bank. CDs issued in
denominations greater than $100,000 are usually negotiable.
Short-term CDs are highly marketable. What Is LIBOR?LIBOR is a
benchmark rate that is used in international money markets and
published daily by the British Bankers Association (BBA), a banking
industry trade group. LIBOR approximates the rate at which banks
could borrow one another in the marketplace. This rate, which is
quoted on dollar-denominated loans, has become the premier
short-term rate quoted in the European money market, and it serves
as a reference rate for a wide range of transactions.LIBOR is
determined from responses by BBA members to the following question:
"At what rate could you borrow funds, were you to do so by asking
for and then accepting inter-bank offers in a reasonable market
size just prior to 11 am?"The rates are not actual transactions but
are indicative of the credit risk and liquidity in the marketplace.
LIBOR is quoted at an annualized rate, so a 3 percent LIBOR would
be divided by 365 to get the actual cost of borrowing. LIBOR is
calculated in 10 different currencies and with 15 maturities
ranging from overnight to one year.Stock and bond market indexes:
1. Dow Jones Averages: Price-weighted average, measures the return
(excluding dividends) on a portfolio that holds one share of each
stock. It gives higher-priced shares more weight in determining
performance of the index. Divisor, d now is .146, instead of 30,
because of splits or dividents. The averaging procedure is adjusted
whenever a stock splits or pays a stock dividend of more than 10%,
or there is a company changes. 2. Definition Of 'Standard &
Poor's 500 Index - S&P 500'An index of 500 stocks chosen for
market size, liquidity and industry grouping, among other factors.
The S&P 500 is designed to be a leading indicator of U.S.
equities and is meant to reflect the risk/return characteristics of
the large cap universe. TheStandard & Poor's 500Stock Index is
a larger and more diverse index than the DJIA. Made up of 500 of
the most widely traded stocks in the U.S., it represents about 70%
of the total value of U.S. stock markets. In general, the S&P
500 index gives a good indication of movement in the U.S.
marketplace as a whole.Companies included in the index are selected
by the S&P Index Committee, a team of analysts and economists
at Standard & Poor's. The S&P 500 is a market value
weighted index - each stock's weight is proportionate to its market
value.The S&P 500 is one of the most commonly used benchmarks
for the overall U.S. stock market. The Dow Jones Industrial Average
(DJIA) was at one time the most renowned index for U.S. stocks, but
because the DJIA contains only 30 companies, most people agree that
the S&P 500 is a better representation of the U.S. market. A
number of financial products based on the S&P 500 are available
to investors. These include index funds and exchange-traded funds.
However, it would be difficult for individual investors to buy the
index, as this would entail buying 500 different stocks.Chapter
3Primary vs. Secondary Market Security Sales Primary New issue is
created and sold Key factor: issuer receives the proceeds from the
sale Public offerings: registered with the SEC and sale is made to
the investing public Private offerings: not registered, and sold to
only a limited number of investors, with restrictions on resale
Secondary Existing owner sells to another party Issuing firm doesnt
receive proceeds and is not directly involved
Investment Banking ArrangementsA specific division of banking
related to the creation of capital for other companies. Investment
banks underwrite new debt and equity securities for all types of
corporations. Investment banks also provide guidance to issuers
regarding the issue and placement of stock. Investment banks also
aid in the sale of securities in some instances. They also help to
facilitate mergers and acquisitions, reorganizations and broker
trades for both institutions and private investors. They can also
trade securities for their own accounts.Underwritten vs. Best
Efforts Red Herring: preliminary registration with SEC ( Securities
and Exchange Commission) Underwritten: banker makes a firm
commitment on proceeds to the issuing firm(underwriter assumes the
risk) Best Efforts: banker(s) helps sell but makes no firm
commitmentNegotiated vs. Competitive Bid Negotiated: issuing firm
negotiates terms with investment banker Competitive bid: issuer
structures the offering and secures bidsPublic Offerings Public
offerings: registered with the SEC and sale is made to the
investing public Shelf registration (Rule 415, since 1982) Initial
Public Offerings (IPOs) Road shows to publicize the imminent
offering Evidence of underpricing ( to reward investors for
offering true information) Performance (IPOs have been poor long
term investments)Shelf Registrations (SEC Rule
415):AsimplifiedmethodofregisteringsecuritiesthatpermitscorporationstofilearelativelyuncomplicatedregistrationformwiththeSECand,duringthesubsequenttwoyears,issuethesecurities.Shelfregistrationissupposedtoprovidemoreflexibilityforcorporationswhentheyareraisingfundsinthecapitalmarkets.ShelfregistrationispermittedbySECRule415.
Security is preregistered and then may be offered at any time
within the next two years. 24 hour notice, any part or all of the
preregistered amount may be offered Introduced in 1982 Allows
timing of the issuesFigure 3.1 Relationships among a Firm Issuing
Securities, the Underwriters and the Public
Private Placements: Aprivate placementis anofferingof securities
that is not registered with the U.S.Securities and Exchange
Commission (SEC) Sale to a limited number of sophisticated
investors not requiring the protection of registration Allowed
under Rule 144A Less costly because registration statements are not
required Less liquid and lower price due to absence of general
public Very active market for debt securities Not active for stock
offerings Dominated by institutionsInitial public offering
(IPO):Aninitial public offering (IPO)refers to the first time a
company publicly sellssharesof itsstockon theopenmarket. It is also
known as "going public." Process Road shows: distribute and gather
info Bookbuilding: finally decide price Underpricing Post sale
returns Cost to the issuing firm Long term poor performer?How it
works/Example:IPOsareintroduced to themarketby
anunderwritinginvestment bank, which aids the issuing company by
soliciting potential investors. In addition, theunderwriterhelps
the issuing company to settle on the price at which the stock
should be offered to investors. IPOs represent the first time an
issuing companywillfinancially benefit fromthe publicsale ofits
stock. Following theIPO, shares trade between buyers and sellers on
theopenmarket, whereby the underlying company receives no
compensation.For a company, thecapitalearned from selling
itssharesto the public act can act as a major boost the the
business' growth, making the idea of an initialpublic
offeringattractive. For investors, IPOs are a significantly higher
risk as opposed to a currently tradedstock. Types of Secondary
Markets: There are four types of financial markets meeting the
needs of particular trader.1. Direct Search
Markets:Asituationinwhichbuyersandsellers,especiallyofsecuritiesbutalsoofothergoodsandservicesseekeachotheroutandconducttradeswithoutbrokersorotherfinancialinstitutionsmediating.Thisistheoppositeofanintermediated
market. Buyers and sellers locate one another on their own Least
organized2. Brokered Markets: A marketplace where buyers and
sellers are brought together by agents or intermediaries to
facilitate price discovery and transaction execution. 3rd party
assistance in location buyer or seller Trading in a good is active
e.g. primary market; broker=underwriter3. Dealer
Markets:Amarketinwhichsecuritiesareboughtandsoldthroughanetworkofdealerswhobuy,sell,andtakepositionsinvarioussecurityissues.
3rd party acts as intermediate buyer/seller Trading in a particular
type of asset increases; 4. Auction Markets:
Amarketinwhichbuyersandsellersgathertotransactbusinessthroughannouncedbidandaskprices.Theorganizedsecuritiesexchangesareexamplesofauctionmarkets.suchastheNewYorkStockExchange(NYSE)andtheChicagoMercantileExchange(CME),havetraditionallyhandledbuyingandselling.
Brokers & dealers trade in one location, trading is more or
less continuous Most integrated, e.g. NYSE No need to compare
prices bet. dealersDefinition Insider trading:Insider trading is
defined as a malpractice wherein trade of a company's securities is
undertaken by people who by virtue of their work have access to the
otherwise non public information. Insider trading is defined as a
malpractice wherein trade of a company's securities is undertaken
by people who by virtue of their work have access to the otherwise
non public information which can be crucial for making investment
decisions. When insiders, e.g. key employees or executives who have
access to the strategic information about the company, use the same
for trading in the company's stocks or securities, it is called
insider trading and is highly discouraged by the Securities and
Exchange Board of India to promote fair trading in the market for
the benefit of the common investor.Insider trading is an unfair
practice, wherein the other stock holders are at a great
disadvantage due to lack of important insider non-public
information. However, in certain cases if the information has been
made public, in a way that all concerned investors have access to
it that will not be a case of illegal insider trading. Officers,
directors, major stockholders must report all transactions in firms
stock Insiders do exploit their knowledge-Criminal
conviction-Leakage of useful information to some traders before
public announcement-Study reports that insiders make abnormal gains
over share trade.'NASDAQ': A global electronic marketplace for
buying and selling securities, as well as the benchmark index for
U.S. technology stocks. Nasdaq was created by the National
Association of Securities Dealers (NASD) to enable investors to
trade securities on a computerized, speedy and transparent system,
and commenced operations on February 8, 1971. The term Nasdaq is
also used to refer to the Nasdaq Composite, an index of more than
3,000 stocks listed on the Nasdaq exchange that includes the worlds
foremost technology and biotech giants such as Apple, Google,
Microsoft, Oracle, Amazon, Intel and Amgen.The NASDAQ is an
electronic exchange where stocks are traded through an automated
network. It stands for National Association of Securities Dealers
Automated Quotations System. As a general rule of thumb, it is
where most technology stocks are traded. A quick way to tell if a
company is listed on the NASDAQ is to check out the ticker
symbol... those made up of four letters are listed here (e.g.
Microsoft = MSFT, Dell Computers = DELL, Cisco = CSCO) NASDAQ:
largest organized stock market for OTC trading; information system
for individuals, brokers and dealersLevels of subscribers to Nasdaq
quotation system Level 1: only receives inside quotes Level 2:
receives all quotes but they cant enter quotes Level 3: can enter
all quotes; are dealers making markets SuperMontage: Centralized
limit order book for Nasdaq securities that allows automatic trade
executionNew York Stock Exchange How it works Investor sends order
to brokers, who contact Floor brokers go to Specialists try to find
party to accept order license of floor broker is bought by the
year. Block houses: brokers who match big block trades. SuperDot:
electronic trading system Merged with Archipelago ECN in 2006
Merged with Euronext in 2007 Acquired the ASE in 2008 Entering
Indian and Japanese stock marketsBuying on Margin Defined:
borrowing money to purchase stock. Initial Margin Requirement IMR
(minimum set by Federal Reserve under Regulation T), currently 50%
for stocks The IMR is the minimum % initial investor equity. Paying
only part of price and borrowing rest from broker Margin in the
account is part payed by investor Broker borrows that money from
bank at broker's call rate and charges investor with that rate plus
service charge. Securities bought this are kept at brokers as
collateral for the loan. Margin arrangements differ for stocks and
futures Using only a portion of the proceeds for an investment
Borrow remaining component Margin arrangements differ for stocks
and futures Maximum margin is currently 50%; you can borrow up to
50% of the stock value Set by the Fed Maintenance margin: minimum
amount equity in trading can be before additional funds must be put
into the account Margin call: notification from broker you must put
up additional funds
What is a short sale?By definition, a short sale is a
transaction in which the seller does not actually own the stock
that is being sold, but borrows it from the broker-dealer through
which he or she is placing the sell order. The seller, of course,
then has the obligation to buy back the stock at some point in the
future. Short sales are margin transactions, and their equity
reserve requirements are more stringent than for purchases.Short
sales are executed by investors who think the price of the stock
being sold will decrease, usually in the short term (such as a few
months). Sell security without having it Mechanics Borrow stock
from a broker/dealer, must post margin Broker sells stock and
deposits proceeds and margin in a margin account (you are not
allowed to withdraw the sale proceeds until you cover) Covering or
closing out the position: Buy the stock and broker returns the
stock title to the party from which it was borrowed Purpose: profit
from a decline in the price of securitySolution of the
problems:9.a.You buy 200 shares of Telecom for $10,000. These
shares increase in value by 10%, or $1,000. You pay interest of:
0.08 $5,000 = $400
The rate of return will be: b.The value of the 200 shares is
200P. Equity is (200P $5,000). You will receive a margin call
when:
= 0.30 when P = $35.71 or lower10.a.Initial margin is 50% of
$5,000 or $2,500.b.Total assets are $7,500 ($5,000 from the sale of
the stock and $2,500 put up for margin). Liabilities are 100P.
Therefore, equity is ($7,500 100P). A margin call will be issued
when:
= 0.30 when P = $57.69 or higher11.The total cost of the
purchase is: $40 500 = $20,000You borrow $5,000 from your broker,
and invest $15,000 of your own funds. Your margin account starts
out with equity of $15,000.a.(i)Equity increases to: ($44 500)
$5,000 = $17,000Percentage gain = $2,000/$15,000 = 0.1333 =
13.33%(ii)With price unchanged, equity is unchanged.Percentage gain
= zero(iii)Equity falls to ($36 500) $5,000 = $13,000Percentage
gain = ($2,000/$15,000) = 0.1333 = 13.33%The relationship between
the percentage return and the percentage change in the price of the
stock is given by:% return = % change in price = % change in price
1.333
For example, when the stock price rises from $40 to $44, the
percentage change in price is 10%, while the percentage gain for
the investor is:
% return = 10% = 13.33%b.The value of the 500 shares is 500P.
Equity is (500P $5,000). You will receive a margin call when:
= 0.25 when P = $13.33 or lowerc.The value of the 500 shares is
500P. But now you have borrowed $10,000 instead of $5,000.
Therefore, equity is (500P $10,000). You will receive a margin call
when:
= 0.25 when P = $26.67 or lowerWith less equity in the account,
you are far more vulnerable to a margin call.d. By the end of the
year, the amount of the loan owed to the broker grows to:$5,000
1.08 = $5,400The equity in your account is (500P $5,400). Initial
equity was $15,000. Therefore, your rate of return after one year
is as follows:
(i)= 0.1067 = 10.67%
(ii)= 0.0267 = 2.67%(iii) = 0.1600 = 16.00%The relationship
between the percentage return and the percentage change in the
price of Intel is given by:
% return =
For example, when the stock price rises from $40 to $44, the
percentage change in price is 10%, while the percentage gain for
the investor is:
=10.67%e.The value of the 500 shares is 500P. Equity is (500P
$5,400). You will receive a margin call when:
= 0.25 when P = $14.40 or lower12.a.The gain or loss on the
short position is: (500 P)Invested funds = $15,000Therefore: rate
of return = (500 P)/15,000The rate of return in each of the three
scenarios is:(i)rate of return = (500 $4)/$15,000 = 0.1333 =
13.33%(ii)rate of return = (500 $0)/$15,000 = 0%(iii)rate of return
= [500 ($4)]/$15,000 = +0.1333 = +13.33%b.Total assets in the
margin account equal:$20,000 (from the sale of the stock) + $15,000
(the initial margin) = $35,000Liabilities are 500P. You will
receive a margin call when:
= 0.25 when P = $56 or higherc. With a $1 dividend, the short
position must now pay on the borrowed shares: ($1/share 500 shares)
= $500. Rate of return is now:[(500 P) 500]/15,000(i)rate of return
= [(500 $4) $500]/$15,000 = 0.1667 = 16.67%(ii)rate of return =
[(500 $0) $500]/$15,000 = 0.0333 = 3.33%(iii)rate of return =
[(500) ($4) $500]/$15,000 = +0.1000 = +10.00%Total assets are
$35,000, and liabilities are (500P + 500). A margin call will be
issued when:
= 0.25 when P = $55.20 or higher13.The broker is instructed to
attempt to sell your Marriott stock as soon as the Marriott stock
trades at a bid price of $20 or less. Here, the broker will attempt
to execute, but may not be able to sell at $20, since the bid price
is now $19.95. The price at which you sell may be more or less than
$20 because the stop-loss becomes a market order to sell at current
market prices.16.a.You will not receive a margin call. You borrowed
$20,000 and with another $20,000 of your own equity you bought
1,000 shares of Disney at $40 per share. At $35 per share, the
market value of the stock is $35,000, your equity is $15,000, and
the percentage margin is: $15,000/$35,000 = 42.9%Your percentage
margin exceeds the required maintenance margin.b. You will receive
a margin call when:
= 0.35 when P = $30.77 or lower
Chapter 7Diversification and Portfolio Risk: A nave
Diversification strategy in which you include additional securities
in your portfolio. For example place half your funds in ExxonMobil
and half in Dell. To the extent that the firm specific influences
on the two stocks differ, diversification should reduce portfolio
risk. For example oil prices fall hurting ExxonMobil, computer
prices rise, helping Dell. Two effects are offsetting and stabilize
portfolio return.The reduction of risk to very low levels in case
of independent risk sources is sometimes called the insurance
principle, because of the notion that the insurance company depends
on the risk reduction achieved through diversification when it
writes many policies insuring against many independent sources of
risk, each policy being a small part of the companys overall
portfolio.The risk that remains even after extensive
diversification is called market risk, risk that attributable to
market wide risk sources. Such risk is also called systematic risk
or non-diversifiable risk. In contrast, the risk can be eliminated
by diversification is called unique risk, Firm-specific risk,
Diversifiable or nonsystematic risk._ diversification = investing
in a larger number of assets_ sources of risk: economy-wide factors
(inflation, business cycles, exchange rates etc.) _ market
(systematic) risk firm- or asset-specific factors _ idiosyncratic
(nonsystematic) risk_ if the firm-specific risk of the assets in
the portfolio is independent, diversification can reduce the
idiosyncratic risk (to zero), but not the market risk
Markowitz Portfolio Selection Model Security Selection The first
step is to determine the risk-return opportunities available. All
portfolios that lie on the minimum-variance frontier from the
global minimum-variance portfolio and upward provide the best
risk-return combinations We now search for the CAL with the highest
reward-to-variability ratio many risky assets and a risk-free asset
minimum-variance frontier = the set of portfolios with the lowest
variance given an expected rate of return efficient frontier = the
set of portfolios on the minimum-variance frontier, with expected
return higher than that of the global minimum variance portfolio
when short-sales are allowed, all individual assets lie inside the
minimum-variance frontierFigure 7.10 the Minimum-Variance Frontier
of Risky Assets
Figure 7.11 The Efficient Frontier of Risky Assets with the
Optimal CAL
Everyone invests in P, regardless of their degree of risk
aversion. More risk averse investors put more in the risk-free
asset. Less risk averse investors put more in P.Solution of the
problems:4.The parameters of the opportunity set are:E(rS) = 20%,
E(rB) = 12%, S = 30%, B = 15%, = 0.10
From the standard deviations and the correlation coefficient we
generate the covariance matrix [note that]:BondsStocks
Bonds22545
Stocks45900
The minimum-variance portfolio is computed as follows:
wMin(S) =wMin(B) = 1 0.1739 = 0.8261The minimum variance
portfolio mean and standard deviation are:E(rMin) = (0.1739 .20) +
(0.8261 .12) = .1339 = 13.39%
Min = = [(0.17392 900) + (0.82612 225) + (2 0.1739 0.8261
45)]1/2 = 13.92%5.Proportionin stock fundProportionin bond
fundExpectedreturnStandardDeviation
0.00%100.00%12.00%15.00%
17.39%82.61%13.39%13.92%minimum variance
20.00%80.00%13.60%13.94%
40.00%60.00%15.20%15.70%
45.16%54.84%15.61%16.54%tangency portfolio
60.00%40.00%16.80%19.53%
80.00%20.00%18.40%24.48%
100.00%0.00%20.00%30.00%
Graph shown below:
6. The above graph indicates that the optimal portfolio is the
tangency portfolio with expected return approximately 15.6% and
standard deviation approximately 16.5%.7.The proportion of the
optimal risky portfolio invested in the stock fund is given by:
The mean and standard deviation of the optimal risky portfolio
are:E(rP) = (0.4516 .20) + (0.5484 .12) = .1561 = 15.61% p =
[(0.45162 900) + (0.54842 225) + (2 0.4516 0.5484 45)]1/2 =
16.54%8.The reward-to-volatility ratio of the optimal CAL is:
9.a.If you require that your portfolio yield an expected return
of 14%, then you can find the corresponding standard deviation from
the optimal CAL. The equation for this CAL is:
If E(rC) is equal to 14%, then the standard deviation of the
portfolio is 13.04%.b.To find the proportion invested in the T-bill
fund, remember that the mean of the complete portfolio (i.e., 14%)
is an average of the T-bill rate and the optimal combination of
stocks and bonds (P). Let y be the proportion invested in the
portfolio P. The mean of any portfolio along the optimal CAL
is:
Setting E(rC) = 14% we find: y = 0.7884 and (1 y) = 0.2116 (the
proportion invested in the T-bill fund).To find the proportions
invested in each of the funds, multiply 0.7884 times the respective
proportions of stocks and bonds in the optimal risky
portfolio:Proportion of stocks in complete portfolio = 0.7884
0.4516 = 0.3560Proportion of bonds in complete portfolio = 0.7884
0.5484 = 0.432410.Using only the stock and bond funds to achieve a
portfolio expected return of 14%, we must find the appropriate
proportion in the stock fund (wS) and the appropriate proportion in
the bond fund (wB = 1 wS) as follows:.14 = .20 wS + .12 (1 wS) =
.12 + .08 wS wS = 0.25So the proportions are 25% invested in the
stock fund and 75% in the bond fund. The standard deviation of this
portfolio will be:P = [(0.252 900) + (0.752 225) + (2 0.25 0.75
45)]1/2 = 14.13%This is considerably greater than the standard
deviation of 13.04% achieved using T-bills and the optimal
portfolio.12.Since Stock A and Stock B are perfectly negatively
correlated, a risk-free portfolio can be created and the rate of
return for this portfolio, in equilibrium, will be the risk-free
rate. To find the proportions of this portfolio [with the
proportion wA invested in Stock A and wB = (1 wA ) invested in
Stock B], set the standard deviation equal to zero. With perfect
negative correlation, the portfolio standard deviation is:P =
Absolute value [wAA wBB]0 = 5 wA [10 (1 wA)] wA = 0.6667The
expected rate of return for this risk-free portfolio is:E(r) =
(0.6667 10) + (0.3333 15) = 11.667%Therefore, the risk-free rate
is: 11.667%
CFA PROBLEMS 1.a. Restricting the portfolio to 20 stocks, rather
than 40 to 50 stocks, will increase the risk of the portfolio, but
it is possible that the increase in risk will be minimal. Suppose
that, for instance, the 50 stocks in a universe have the same
standard deviation () and the correlations between each pair are
identical, with correlation coefficient . Then, the covariance
between each pair of stocks would be 2, and the variance of an
equally weighted portfolio would be:
The effect of the reduction in n on the second term on the
right-hand side would be relatively small (since 49/50 is close to
19/20 and 2 is smaller than 2), but the denominator of the first
term would be 20 instead of 50. For example, if = 45% and = 0.2,
then the standard deviation with 50 stocks would be 20.91%, and
would rise to 22.05% when only 20 stocks are held. Such an increase
might be acceptable if the expected return is increased
sufficiently. Hennessy could contain the increase in risk by making
sure that he maintains reasonable diversification among the 20
stocks that remain in his portfolio. This entails maintaining a low
correlation among the remaining stocks. For example, in part (a),
with = 0.2, the increase in portfolio risk was minimal. As a
practical matter, this means that Hennessy would have to spread his
portfolio among many industries; concentrating on just a few
industries would result in higher correlations among the included
stocks.2.Risk reduction benefits from diversification are not a
linear function of the number of issues in the portfolio. Rather,
the incremental benefits from additional diversification are most
important when you are least diversified. Restricting Hennessy to
10 instead of 20 issues would increase the risk of his portfolio by
a greater amount than would a reduction in the size of the
portfolio from 30 to 20 stocks. In our example, restricting the
number of stocks to 10 will increase the standard deviation to
23.81%. The 1.76% increase in standard deviation resulting from
giving up 10 of 20 stocks is greater than the 1.14% increase that
result from giving up 30 of 50 stocks.3.The point is well taken
because the committee should be concerned with the volatility of
the entire portfolio. Since Hennessys portfolio is only one of six
well-diversified portfolios and is smaller than the average, the
concentration in fewer issues might have a minimal effect on the
diversification of the total fund. Hence, unleashing Hennessy to do
stock picking may be advantageous.4.d.Portfolio Y cannot be
efficient because it is dominated by another portfolio. For
example, Portfolio X has both higher expected return and lower
standard deviation.
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Tangency
Portfolio
Minimum
Variance
Portfolio
Efficient frontier
of risky assets
CML
INVESTMENT OPPORTUNITY SET
rf = 8.00
