Topic 1: Introduction

What is investment?

Traditional view: the current commitment of resources (monies) to achieve later benefits.

A broader view: tailor the pattern of cash flows over time to be as desirable as possible.

Tailoring cash flow pattern

Suppose that there are two one-year investments. They both require $1 initial capital today. There is 50% chance that the economy is going to accelerate and the first (second) investment will have a return of $3 ($0) when the economy is good. There is 50% chance that the economy is going to decelerate and the first (second) investment will have a return of $0 ($3) when the economy is bad.

Which investment has a more desirable cash flow pattern? Would you pay more for it?

This example is related to asset pricing.

Risk aversion

Individuals seeking investment rather than outright speculation/gambling will elect a more certain wealth stream over a less certain one, holding average payoffs and returns constant. This is the risk aversion principle.

Investments and public markets

Investment decisions differ from other business decisions in an important aspect: investment decisions are usually made with respect to alternatives available in public (financial) markets.

Example: suppose that your mother-in-law would like to borrow $$$ from you at 10% interest rate. Would you do it?

The comparison principle

The previous borrowing scenario is an example of the comparison principle.

Another example: residential appraisals are usually done with the framework of the comparison principle.

Arbitrage

Arbitrage: earning (almost sure) monies without investing anything.

When two similar (almost identical) investment alternatives are available in the market, conclusions about arbitrage, i.e., those stronger than the comparison principle, may hold.

The law of one price.

A real-life example of arbitrage

Interest rate parity: the forward premium (discount) is equal (close) to the interest rate differential.

(F – S) / S ≈ rF – rD Example: Suppose that the current spot, S,

€/$ = 0.80000, the 1-year forward, F, €/$ = 0.80800, r€ = 14%, and r$ = 10%.

The no-arbitrage principle

In academic finance it is often assumed that no arbitrage opportunity exists.

The reason for this assumption is that financial markets are competitive. When there are many computer algorithms looking for arbitrage opportunities, those arbitrage-based trades ensure that the no-arbitrage principle is largely correct.

Many modern asset pricing relationships, e.g., option pricing, utilize this principle.

Major investment problems: pricing/valuation

Asset pricing can be addressed in two seemingly different ways (actually closely related): (1) what is the right price, i.e., the intrinsic/fundamental price? and/or (2) what is the expected rate of return?

Asset pricing is related to risk. Holding other factors constant, higher risk leads to higher expected return and lower price.

Major investment problems: hedging

Hedging is the process of reducing the risk that either arise in the course of corporate operations or are associated with investments.

An example of hedging: insurance. Another example: a bakery buys flour futures to lock

in current flour futures price to eliminate flour price uncertainty in the future.

The major use of futures and options is for hedging--not for speculation.

Major investment problems: asset allocation

Determine more than 90% of return variability for a typical institutional portfolio (Brinson, Hood, and Beebower, 1986).

Asset allocation is the allocation of capital at the asset class level.

Asset class: a group of securities/assets with similar characteristics.

A major task for fund/plan sponsors.

Strategic asset allocation

It establishes acceptable exposures (i.e., portfolio weights) to investment policy statement (IPS)-pemissible asset classes to achieve the clients long-term objectives and constraints.

An example of strategic asset allocation (policy portfolio): MIP, Chapter 5, Exhibit 5-1, p. 232.

IPS

A written document that sets out a client’s return objectives and risk tolerance over the client’s relevant time horizon, along with applicable constraints such as liquidity needs, tax considerations, regulatory requirements, and unique circumstances.

The elements of an IPS

A brief client/institution description. The purpose of establishing policies and guidelines. The duties and responsibilities of parties involved. Investment goals, objectives, and constraints. The schedule for review. Performance measures and benchmarks. Considerations for developing the strategic asset allocation. Investment strategies (passive or active) and styles. Guidelines for rebalancing.

Asset classes

Criteria for specifying asset classes (MIP, 5.4.1, p. 248-249.

Assignment

Please study Calpers 2014 asset allocation strategy.

http://www.calpers.ca.gov/eip-docs/investments/policies/asset-allocation/asset-alloc-strgy.pdf

Submit a report that includes (1) a summary, and (2) the things that you learned from this reading. 2-3 pages. Due in a week.

Major investment problems: security selection

Security selection is related to asset pricing. Security selection is done mainly by comparing

perceived intrinsic/fundamental value (VE) to market price (P) or, equivalently, by comparing required rate of return to expected rate of return.

In practice, security selection is not purely quantitative; social responsibility, informational availability, institutional restrictions (e.g., size, liquidity), trade behavior (e.g., momentum) and other factors are also important.

Mispricing

Perceived mispricing ( VE – P ≠ 0) motivates active selection.

Decomposition: VE – P = (V – P) + (VE – V) = (true mispricing) + (estimation error).

Analysts try to minimize the second component so that they can discover the true mispricing.

Mispricing and the EMH

The EMH did not say that there is no mispricing for individual securities.

The EMH says that on average exploiting those perceived mispricing will not lead to abnormal return or alpha, net of transaction costs.

That is, the EMH says that active selection is useless.

Alpha: excess risk-adjusted return.

The valuation process (5 steps)

Understanding the business (and the economy).

Forecasting company performance (e.g. pro forma).

Selecting the appropriate valuation model (e.g., dividend discounting model).

Converting forecasts to a valuation. Applying the valuation conclusions.

Analysts

Sell-side analysts: analysts who work at brokerage firms.

Buy-side analysts: analysts who work at investment management firms, trusts and bank trust departments, and similar institutions.

Analysts’ due diligence

Due diligence: investigation and analysis in support of a recommendation.

See EAV, Example 1-8, pp. 27-28.

Format of a (long) research report

EAV, Exhibit 1-2, pp. 31-32. 6 sections: (1) Table of Contents, (2)

Summary and Investment Conclusion, (3) Business Summary, (4) Risks, (5) Valuation, (6) Historical and Pro Forma Tables.

Characteristics of a good report

EAV, P. 29. Timely information. Clear, incisive writing. Objective; well researched; assumptions acknowledged. Facts vs. opinions well distinguished. Internally consistent. Sufficient info for reader critique. Clear about key risk factors. Potential conflicts of interest disclosed.

Selected CFA standards

EAV, Exhibit 1-3, p. 33.

Quality of earnings

Quality of earnings analysis: the scrutiny of all financial statements to evaluate both the sustainability of a company’s performance and how accurately the reported information reflects economic reality.

Financial Shenanigans, by Schilit, McGraw Hill.

EAV, Exhibit 1-1, p. 14.

End-of-chapter

EAV, Chapter 1: Problems 1-8

EAV, Chapter 3: Discounted dividend (model) valuation

You should have learned DDM in your BSAD 180.

Please read and study EAV, Chapter 3, pp. 83-143.

Zero-growth DDM

The easiest assumption one can make is to assume that there is no growth in dividends, i.e., D1 = D2 = … = D.

Because this is a perpetuity, the pricing is rather straightforward: PV = D / i.

Suppose that GE paid $2 dividend per share last year. Investors expect no growth in GE’s future dividends. The applicable discount rate is 10%.

PV = $2 / 10% = $20.

Constant-growth DDM

Another easy assumption one can make is to assume that there is a constant growth rate, g, in dividends, i.e., D1 = D0 × (1 + g), D2 = D0 × (1 + g)2, etc.

That is, this is a growing perpetuity. Recall from BSAD 180, the PV of a growing

perpetuity is: PVt = Dt+1 / (i – g).

Constant-growth DDM example

Vermont Financial Inc. paid a dividend of $1 last year. The constant growth rate of dividends is 5%, and the required rate of return is 10%.

PV = [D0 × (1 + g)] / (i – g) = [$1 × (1 + 5%)] / (10% – 5%) = $21.

Multiple-stage DDM model

This model allows different growth rates for different stages.

Typically, it takes care of recent, supernormal growth.

There are formulas for PV. However, they do not look neat.

Let us use Excel to visualize the discounting process.

Multiple-stage example, I

HP has a cost of equity at 14%. HP just paid an annual dividend of $2.

The expected dividend growth rate between year 1-3 is 25%. The expected dividend growth rate between year 4-5 is 15%. The expected dividend growth rate for year 6 and afterwards is 5%.

Multiple-stage example, II

Year Dividend Growth rate Discount rate PV5 PV0 2 0.141 2.5 0.25 2.19298252 3.125 0.25 2.4045863 3.90625 0.25 2.63660754 4.492188 0.15 2.65973565 5.166016 0.15 60.2701823 33.9855116 5.424316 0.05 43.879422

Now, let’s take a look at the entire portfolio management process

MIP, Chapter 1, Exhibit 1-1, p. 6. 3 steps: (1) the planning step: (i) investor’s

objectives and constraints, (ii) creating the investment policy statemet (IPS), (iii) forming capital market expectations, (iv) creating the strategic asset allocation.

(2) The execution step (security selection). (3) The feedback step: (i) monitoring and

rebalancing, (ii)performance evaluation.