Lecture 3

Question 1

Principal asset classes

Answer 1

Money markets:
- short term, <1 year
- highly marketable
- liquid
- low risk

Capital markets:
- 1 yr +
- assets such as equities and bonds
- riskier

Question 2

Asset Classes

Answer 2

Cash (no risk to capital)
Bonds ( government and corporate)
Equities ( and equity related derivatives)
Property (residential and commercial)

Exposure to any asset class can be either:
Direct
Indirect

Question 3

Main Asset Classes

Answer 3

• Cash ( deposits, t-bills, money market funds, floating rate notes etc.)
• Fixed Income ( gov bonds, inflation-linked, investment grade corporates, high yield, emerging markets, convertible bonds)
• Equities ( emerging markets, global, small cap, lathe cap etc.)
• Real Estate ( residential, commercial etc. )
• Alternatives ( commodities, hedge funds, private equity)

Question 4

Cash and Money Markets

Answer 4

Main reasons for holding cash:
- liquidity
- accessibility
- security

Money market instruments:
- Securities and investment products up to 1 year

Question 5

Cash and money markets
- Discount Instruments

Answer 5

Bankers Acceptance
- Short term credit investments issued by firms. If firm defaults, borrower has legal recourse to the bank where the first acceptance is made.
- Safe
- Return slightly higher than T bills
- Tradable in security markets

Certificates of deposits
- time deposits with a bank
- majority up to 6 months
- highly liquid

Commercial Paper
- unsecured promissory note issued by large corporations
- US CP market much developed then European one
- Mainly aiming at institutional investors
- Higher credit risk
- Less liquid than T-bills

Question 6

Money Market Funds

Answer 6

Money market funds: pooled diversification and full time professional management

Question 7

Risks of Cash Deposit and Money Market Instrument

Answer 7

Default risk
Rollover risk
Inflation risk (real return = nominal return - inflation rate)

Question 8

Fixed Income Securities

Answer 8

They offer fixed stream of payments with general features:
- term to maturity
- coupon
- par value

Types based on coupon they pay
- fixed
- floating
- zero coupon
- index linked

Types based on issuers
- governments
- corporates
- supranational bodies
- local authorities

All bonds trade at dirty price which is clean price - accrued interest (portion of the coupon from last settlement date)

Credit analysis:
Credit ratings like (investment grade ends with BBB, High yield begins with BB)

Question 9

Characteristics of Fixed Income Securities

Answer 9

Negotiable instruments with a nominal value and a specified maturity that pay a periodic coupon (except zero coupon)

Theres an inverse relationship between bonds price and interest rates

Question 10

Measures of bond yields

Answer 10

• Ytm (expected return from bond if held to maturity) and all coupons re-invested at promised yield
• Nominal yield (coupon)
• Current yield (coupon / price)
• Yield to call (call date assumed to be end date)
• Realized (Horizon) yield

Question 11

Interest rate determinants

Answer 11

Real risk free rate
Expected inflation rate
Liquidity premium
Term premium
Credit risk

Question 12

Bond volatility

Answer 12

Duration: average life of the cashflows generated by a bond

Convexity: measures of how duration changes with yield

Question 13

Risks

Answer 13

Credit risk or default risk
Inflation risk
Liquidity risk
Issue specific risk
Fiscal and currency risks

Question 14

Role of bonds within a multi asset portfolio

Answer 14

• lower risk than equity and property
• important diversifier
• more difficult to implement passive strategies than equities
• stratified sampling (duration matched)

The Active management strategies:
- interest rate anticipation
- yield curve positioning
- relative value and spread bets - based on credit and yield curve analysis
-structured bets - matched funding, portfolio dedication, portfolio immunization, contingent immunizations

Diversification into other bonds: high yield bonds , international bonds

Bond funds: investment grade, high yield, multi sector/multi strategy

Question 15

Equities

Answer 15

• ordinary shares
• preference shares
• private vs public listed companies
• IPOS
• American Depositary Receipts - ownership of shares in non US company but trading in US and denominated in USD
• equity dealing services:
  
  • execution only
  • dealing with advice
  • advisory portfolio managemenr
  • discretionary

Question 16

Roles of equities in portfolio

Answer 16

• inflation hedge
• outperformance in the long term
• high volatility

Influence on share prices:
- Buy/sell views and recommendations
- new info on management, dividends, economic outlook, global markets, interest rates, speculative activity, market sentiment; behavioral biases

Question 17

Share Valuation Models

Answer 17

• DDM
• GGM
• P/E multiples
• ROE = Net Income / BV of common equity

Question 18

Factors affecting share prices

Answer 18

• Expectations about companys earnings
• Cost of capital

Question 19

Equity portfolio investing

Answer 19

Passive equity investing
- assumes markets are efficient, benchmarking, strategies:full replication, sampling, tracking error

Structured active strategy
- still benchmarked against index but the manager has room to take a small active portfolio

Active equity investing
- mandate to beat benchmark by decisions with regards to both portfolio composition and timing

Question 20

Factors affecting share prices

Answer 20

Different styles (value investing -low P/E stocks, growth investing -High EPS stocks)

Empirical evidence:
- Flat or inverted yield curve: growth strategies outperform
- Flat to steeper yield curve: value stocks outperform

Also distinction between large cap (more liquid) and small cap stocks (higher liquidity premium and more volatile)

Importance of collective investments: mutual funds, unit trusts, OEICS, investment trusts etc) and ETFS

Question 21

Commodities

Answer 21

Tangible assets - relatively homogeneous in nature

3 categories of commodities
Hard - metals and diamonds
Energy - crude oil, natural gas, biofuels
Soft - agricultural products, food stuffs

Question 22

Direct and Indirect investments

Answer 22

Direct investments:
Cash market
- hard to access for investors- mainly for users of the actual commodities
- requires storage and insurance
- most common investment: non deteriorating commodities such as metals

Futures market
- exchange traded standardized contracts
- homogeneous and specified asset
- fixed future date
- price agreed today

Indirect investments
Shares in commodity companies
- (e.g miners and oil producers)
- correlation with performance of commodity may fluctuate
- main reason for discrepancy: corporate hedging

Commodity funds
Other vehicles: ETFs

Question 23

Advantages of Indirect investments

Answer 23

• Low holding and storage costs
• more flexible and suitable minimum dealing size
• possibility for dividend
• quite liquid esp etfs
• allow investments in a sector which has a low correlation with major asset classes

Question 24

Main merits of commodities

Answer 24

Effective risk diversifiers and sound inflation hedges

Question 25

Property

Answer 25

Inflation protection & low correlation to traditional asset classes

Direct (buy to let) or Indirect exposure ( property funds such as REITS or shares in property companies)

Unique features of property:
- Heterogeneous nature
- difficulties in ascertaining market value
- absence of liquidity
- difficult to diversify due to high value of investment.

Residential vs commercial property
Commercial property ownership more institutional

Rental yield= gross rent - expenses/cost of property

Main determinants on price of property:
- economic cycle (position at purchase)
- GDP growth
- inflation

• Extensive use of leverage (lending)
• Positive performance during periods of unexpected inflation

Historical evidence:
- positive real long term returns, low volatility and a reliable income stream
- significant diversification benefits
- direct investments however suffer from low liquidity and high transaction costs
- also downturns can be more prolonged than on other asset classes

Question 26

Risk free asset

Answer 26

Requirement for the investment to be:
- default free
- carry no reinvestment risk
- no callability

Example short term government t bills

Risk free rate can be used by investors to evaluate opportunity cost

Actual measure will depend on NATURE and TIMING of CASH FLOW REQUIRED