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3rd Year - Investment Management > Lecture 1 - Introduction to Investment Management > Flashcards

Lecture 1 - Introduction to Investment Management Flashcards

1
Q

Rarely we have a balance between what two things?

A

Saving and spending.

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2
Q

If our current income is greater than our consumption desire then…

A

We will save the extra money and put it in the bank, bond market or stock market etc. That saving process is actually an investment.

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3
Q

If our income is less than the spending need…

A

Then we need to borrow money from banks, for example.

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4
Q

An investment is the…

A

Current commitment of money (or any other resource like time or energy) in order to derive future (greater) benefits that will compensate the investor for:

  • the time the funds are committed. Also called pure time value of money.
  • the expected inflation rate.
  • the uncertainty of future payment. Also called investment risk.
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5
Q

Redefine investment.

A

An investment is the current commitment of money in order to derive the required rate of return/expected rate of return (E(r)).

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6
Q

What are the three components of required rate of return?

A

Pure time value of money - real risk free rate (real rf) - without risk and inflation.

Nominal risk free rate (nominal rf) considering inflation rate. This is (1+real rf)(1+I^e) according to the Fisher equation. I^e is the expected inflation rate.

Risk premium represents the uncertainty of future payments.

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7
Q

Expected/required rate of return equals…

A

Nominal risk free rate + risk premium.

Risk premium is affected by levels of risk (e.g. business, operational risk etc).

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8
Q

What are the different types of investors?

A

Individual, pension fund, mutual fund, insurance companies, banks etc.

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9
Q

Real assets can be tangible or intangible. What are they used for?

A

To produce goods and services.

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10
Q

What are some examples of real assets?

A

Land, buildings, machines, intellectual property.

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11
Q

Real assets generate…

A

Net income to the economy.

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12
Q

On the other hand, financial assets do not directly…

A

Contribute to the productive capacity of the economy.

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13
Q

Financial assets simply…

A

Define the allocation of wealth or income among different investors.

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14
Q

Examples of financial assets include…

A

Equities (stocks), fixed income assets (bonds), and derivatives.

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15
Q

Financial assets are claims to the…

A

Income generated by real assets or claims on income from the government.

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16
Q

What are examples of derivative securities?

A

Futures, options, and swaps

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17
Q

Explain derivative securities.

A

The payoff depends on the value of other financial variables such as stock prices, interest rates, or exchange rates.

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18
Q

Explain employee stock option.

A

Sometimes in companies, employees are offered stock options. They are a type of asset. The value of stock options depends on the price. If the stock price increases then the value of the stock option increases and the employees can have more money. It works as an incentive scheme, encouraging employees to work harder. This way the interests of employees and managers can be aligned.

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19
Q

Explain fixed income/debt securities.

A

They promise either a fixed stream of income or a stream of income determined by a specified formula.

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20
Q

Give an example of fixed income/debt securities.

A

Bonds.

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21
Q

What are vanilla bonds?

A

Bonds where future cash flows, coupons and face values are fixed.

22
Q

What are floating rate bonds?

A

Bonds where the coupon rate is not fixed. Instead the coupon rate is floating, determined by the current market interest rate. Even though the coupon payments and cash flows are not fixed, the cash flows are determined by a fixed formula so it is still considered fixed income securities.

23
Q

Explain equity.

A

Represents ownership share in a firm.

24
Q

Give examples of equity.

A

Preferred and common stock.

25
Q

Stock holders are residual claimants so they receive…

A

What is left in the firm. Compared with bonds, stocks are more risky.

26
Q

What is a portfolio?

A

A collection of investment assets.

27
Q

What are the two important decisions that need to be taken in the investment process?

A
  • Asset allocation.

- Security selection.

28
Q

What is asset allocation?

A

The choice among broad asset classes (e.g. stocks, bonds, real estate, derivatives. etc). How much to allocate between each asset. Macro level.

29
Q

What is security selection?

A

The choice of specific securities within each asset class. For example, within stocks which stocks should we invest in, such as Apple. Micro level.

30
Q

What is security analysis?

A

It involves the valuation of particular securities that might be included in the portfolio. It evaluates different securities, questioning whether it is correctly priced.

31
Q

If a security is underpriced then the investor should…

A

Buy.

32
Q

If a security is overpriced then the investor should…

A

Sell.

33
Q

What are the two strategies used for security selection?

A

Top down and bottom up.

34
Q

What is the top down strategy?

A

Asset allocation and then security selection.

35
Q

What is the bottom up strategy?

A

Security selection first and then asset allocation.

36
Q

What are the three main elements of the investment process?

A

Planning, execution and feedback.

37
Q

What is the planning element of the investment management process?

A

Establishing inputs necessary for decision making: data about client and the capital market.

38
Q

What is the execution element of the investment management process?

A

Details of optimal asset allocation and security selection.

39
Q

What is the feedback element of the investment management process?

A

Process of adapting to changes in expectations and objectives, and to changes in portfolio composition that result from changes in market prices.

40
Q

Explain in detail the planning stage of the CFA Investment Management Process.

A

A. Identifying and specifying the investors objectives and constraints.
B. Creating the investment policy statement (IPS).
C. Forming capital market expectations.
D. Creating the strategic asset allocation (target, minimum and baseline asset class weights). A long term target considering investors objectives and constraints.

41
Q

Explain in detail the execution: portfolio construction and revision stage of the CFA Investment Management Process.

A

A. Asset allocation (including tactical - short term deviation from long term target asset allocation) and portfolio optimisation (combining assets to meet risk and return objectives).
B. Security selection.
C. Implementation and execution.

42
Q

Explain in detail the feedback stage of the CFA Investment Management Process.

A

A. Monitoring (investor, economic and market input factors).
B. Rebalancing.
C. Performance evaluation.

43
Q

How can risk objectives be measured?

A
  • In an absolute way (standard deviation or variance) or relative way (tracking error/risk).
44
Q

What does risk tolerance depend on?

A

Investors willingness and ability.

45
Q

How can return objectives be measured?

A
  • In an absolute way or relative way.

- For example, 10% (absolute) or 2% above FTSE100 index (relative).

46
Q

Return objectives should be consistent with…

A

Risk objectives. The higher the return the higher the risk. It should be consistent with risk tolerance. It is not consistent to target a high return without a high risk.

47
Q

Explain the different constraints investors are subject to.

A

Liquidity - cash spending needs at a specified time point. For example, a family might have a high liquidity need if their child is going to college in one years time.
Time horizon - the time between making an investment and needing the funds. For example, if an investor invests money at age 20 for retirement, then there might be a 40 year time horizon.
Tax concerns - after tax returns matter. Taxes reduce total return. Important to consider different investor’s tax bracket.
Legal and regulatory factors - external factors imposed by governmental, regulatory, or oversight authorities to constraint investment decision making. For example, pension funds.
Unique circumstances - internal factor related to personal preferences or other factors. For example, religions, ethical behaviour, environmental care or social health etc. Investors might also prefer to invest in a company with high corporate responsibility or in local firms.

48
Q

What is an investment policy statement (IPS)?

A
  • A strategic guide to the planning and implementation of an investment program.
  • We can use it to understand and articulate realistic investor goals, needs and risk tolerance.
  • Ensure that goals are realistic.
  • Provide an objective measure of portfolio performance.
49
Q

What are the two implications of markets being competitive?

A
  • Risk return trade off.

- Efficient market hypothesis.

50
Q

What does risk return trade off mean?

A
  • Higher risk assets are priced to offer higher expected returns than lower risk assets.
  • Diversification and modern portfolio theory.
  • If you hold a number of assets and assets with lower correlation then you may have diversification effects. There may be a reduction in risk at the same level of return. These are the basics of modern portfolio theory.
51
Q

What is efficient market hypothesis?

A
  • If the market is efficient then the prices of securities fully reflect available information. They will be correctly priced and there will be no mispriced securities.
  • Three forms - weak, semi strong and strong types of efficiency.
  • Different types of information reflected in each form.
  • If the market is efficient then there is no need to conduct active management. Passive asset management should be used, you would just hold a diversified portfolio and you earn the market return.
  • If the market is not efficient then active management is better.
  • Security selection and timing.

3rd Year - Investment Management (10 decks)

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