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