Department of Banking and Finance SPRING 200 7 -0 8 Investment, its background, Investors and the Investment Process Investment, its background, Investors

Department of Banking and Finance

SPRING 2007-08

Investment, its background, Investors Investment, its background, Investors and the Investment Process and the Investment Process

by

Asst. Prof. Sami Fethi

2

Investment Management © 2005, Sami Fethi, EMU, All Right Reserved.

ch: 1-21 Investment and Background

Define an investmentDefine 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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Essential nature of Investments & AssetsEssential 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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Financial AssetsFinancial 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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Real AssetsReal 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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Are the following assets real or financial?Are the following assets real or financial?

a) Patents (R)b) Lease obligation (F)c) Customer goodwill (R)d) A college education (R)e) A $ 5 bill (F)

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Describe a Describe a derivative securityderivative security and and

understand how they are used in a market.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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The Investment ProcessThe Investment Process

Asset allocationSecurity selectionRisk-return trade-offMarket efficiencyActive vs. passive management

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Investors make two major steps or Investors make two major steps or

decisions in constructing their own portfoliosdecisions 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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An understanding of the risk/return trade-offAn 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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ch: 1-21 Investment and Background Active vs. Passive ManagementActive vs. Passive Management

Active ManagementFinding undervalued securitiesTiming the market

Passive ManagementNo attempt to find undervalued securitiesNo attempt to timeHolding an efficient portfolio

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Active vs. Passive ManagementActive 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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Financial Intermediaries 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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Investments and InnovationInvestments 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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Key Trends - GlobalizationKey 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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Key Trends - SecuritizationKey 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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Key Trends - Financial EngineeringKey Trends - Financial Engineering

Repackaging Services of Financial IntermediariesFE 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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The FutureThe 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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Overview of the Investment ProcessOverview of the Investment Process

Specify objectivesIdentify constraintsFormulate an investment policyMonitor performance Reevaluate and modify portfolio as

determined from monitoring

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The basic factors affecting an individual investor usually The basic factors affecting an individual investor usually arise from that investor’s stage in the life cyclearise 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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Individual InvestorsIndividual 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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Specifying Objectives: Individual Specifying Objectives: Individual InvestorsInvestors

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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Specifying Objectives: Personal Trusts Specifying Objectives: Personal Trusts and Mutual Fundsand 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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Personal trust and Mutual fundsPersonal 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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Specifying Objectives: Pension Specifying Objectives: Pension Funds and EndowmentsFunds 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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Specifying Objectives: Insurance Specifying Objectives: Insurance CompaniesCompanies

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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Specify Objectives: BanksSpecify 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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Investors ConstraintsInvestors 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 cashInvestment 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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Investors ConstraintsInvestors 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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ch: 1-21 Investment and Background Investment Policy: Asset Allocation Investment Policy: Asset Allocation

DecisionDecision

Individual - depends on life cycleYounger 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 Policy: Active or PassiveInvestment Policy: Active or Passive

ActiveTrying to secure better than average performanceMust balance returns and costs

PassiveTrying to get average returns rather than do better than the market

Mix of Passive and Active

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The EndThe End

Thanks

Documents

Department of Banking and Finance SPRING 200 7 -0 8 Investment, its background, Investors and the Investment Process Investment, its background, Investors