intensive actuarial training for bulgaria january 2007
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Intensive Actuarial Training for Bulgaria
January 2007
Lecture 15 – Principles and Types of Investment
By Michael Sze, PhD, FSA, CFA
Agenda
• Different types of investment
• Organization and functioning of securities markets
• Different methods of investments
Different Types of Investment
• Fixed income investment
• Stocks
• Derivative securities
• Investment companies
• Real estate
• Low liquid investments
Historical Investement Data 1926-1998, USA
Series Annual Return Standard DeviationSmall Cap Stocks 17.40% 33.80%Large Cap Stocks 13.20% 20.30%Long-term Corporate Bonds 6.10% 8.60%Long-term Governemnt Bonds 5.70% 9.20%US Treasury Bills 3.80% 3.20%
US Investment Data, 1926 - 1988
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
30.00%
35.00%
40.00%
Small Cap Stocks Large Cap Stocks Long-termCorporate Bonds
Long-termGovernemnt Bonds
US Treasury Bills
Investment Classes
Ret
urn
s an
d S
tan
dar
d D
evia
tio
ns
Annual Return Standard Deviation
Correlation of S&P 500 With Other Indices, 1980 -1997
Correlation with S&P 500
Wilshire 5000 0.989Russell 1000 Value 0.970Russell 1000 Growth 0.976Nikkie Index 0.378Frankfurt Index 0.467World Government Bonds 0.079US Real Estate 0.661US Commodities 0.045
Fixed Income Investments
• Contractual repayment schedule
• By purchasing an instrument, you are LENDING money to the issuer– This money is known as PRINCIPAL
• In return, the borrower promises to make periodic payments (INTEREST)
• At maturity, repay the principal
Fixed Income Investments
• Savings accounts– Convenient, liquid, low risk, low return
– Two basic types: passbook, certificates of deposit
• Capital market instruments– Traded on stock exchanges
– Three basic types:• Bonds of various levels of government
• Corporate bonds
• International bonds
Stocks
• Basic principles of common stocks– Common stock represents ownership of a firm– Shares the companies’ successes and failures– Higher risk and return, relative to fixed income
securities
• Classified by industry, domestic, or foreign • Buying foreign equities: actual investment,
ADR, mutual funds
Valuation: Two Approaches
Stock Valuation
DiscountedCash Flow Market Multiples
ZeroGrowth inDividends
ConstantGrowth inDividends
2-Stage Growth inDividends
P/B; P/CF;
P/E; P/S
Stock Purchase Decision
1. Estimate future expected cash flows D1
2. Estimate required rate of return (CAPM): k
3. Estimate future growth: g
4. Discount future expected cash flows
Estimated price P0 = D1 ÷ (ke – g)
Make investment decision by looking at estimated price versus market price
Price Earning Ratio P/E Multiple
• P/Eestimate = (D1/E1) ÷ (ke – g)
• (D1/E1) = Dividend payout rate DPR
• Earnings per share EPS
= [(per share sales estimate times EBDIT%) – D – I] times (1-T)
• EBDIT is earnings before depreciation, interest and taxes (more stable)
Derivative Securities
• Derives its value from other securities, such as stocks and bonds
• Options – Warrants:issued by a firm giving holder right to buy
firm’s stock at specified price in a period– Call:right to buy stock of a firm in a given period at a
specified price – Put:right to sell stock of a firm in a given period at a
specified price – Call and put are not issued by the firm
Derivative Securities (continued)
• Futures– Contracts for delivery of a commodity at some
future date – Price of futures is determined by belief about
future price of the commodity– Difference of futures from underlying asset
• High leverage• Maturity date
– Sold on stock exchanges
Investment Companies • Sell and manage mutual funds• Investors buy shares of these, instead of buying
shares in firms • Types:
– Money market funds– Stock funds– Bond funds– Balance funds
• Diversification, professional management, liquidity, greater flexibility
Real Estate
• Low correlation with stocks and bonds• Easiest form of investment is purchase of shares of
a REIT– Investment pools specializing in a particular type of
real estate
– Not directly involved with property management
– Traded like other securities
– More liquid than direct real estate investments
Low Liquidity Assets
• Investments in art, antiques, stamps, coins
• Low liquidity, high transaction costs, high price variability
• High storage costs, no dividends or cash flows
Characteristics of a well-functioning securities market
• Provides timely and accurate information on– Price and volume of past transactions– Supply/demand for goods and services
• Provides liquidity, ability to buy/sell quickly at a known price
• Provides internal efficiency, ability to get the lowest possible transaction cost
• Provides external efficiency, prices rapidly adjust to new information
Organization of Securities Markets
• Primary capital markets – Sale:NEW issues of bonds, preferred/common stocks
– Help of underwriter • Origination – design, plan, and register the issue
• Risk bearing – guarantees price: purchase securities
• Distribution – sale of the issue
• Secondary financial markets – Bond dealers
– Stock exchanges
Short Sale
• Sell security seller does not own– Seller borrows securities from a broker– Inform broker that of the short sale– Return securities at request of the lender or when short
sale is closed out
• Three rules of short selling – Uptick rule: shorted in an up market – Dividend payments: by short seller– Margin: deposit margin money to guarantee the
eventual repurchase
Margin Transactions• Buy securities with borrowed money • Brokerage firms lend their customers money with
securities as collateral • Margin requirement – required equity position
– Initial margin requirement – e.g. 50%– Maintenance margin – e.g. 25%
• Margin call – Long: [(orig. price)(1 – initial margin %)]/[1 –
maintenance margin %]– Short:[(orig. price)(1 + initial margin %)]/[1 +
maintenance margin %]
Special Orders
• Stop loss– Sell order below current market price
– Used to prevent greater loss of stock the person holds
• Stop buy– Buy order above current market price
– Used in conjunction with a short sale
– Used to prevent greater loss of short sale on stock price increases
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