Lecture 8 Flashcards
Diversification:
Please list the formulas for return and variance and describe the role of correlation
Rp = w1r1 + w2r2
ππ^2 = (w1)^2π1 + (w2)^2π2 + 2w1w2π1π2π1,2
Correlation can range from -1 to 1. The lower the correlation, the greater the benefits of diversification
International diversification
-Impact of foreign exchange on total risk
-Reasons for international diversification
The total risk of investing in foreign assets is often higher because of the added risk of foreign exchange rates
Investors may choose to pursue international diversification for:
-Risk reduction: Risk can be lower as long as assets are not perfectly correlated
-Return enhancement: Returns are sometimes higher abroad
Please describe what cross listing is and what the benefits associated with it may be
Cross listing refers to having shares listed on one or more exchanges in addition to the home exchange.
-Provides a mean for expanding the investor base
-Cross listing establishes name recognition of the company in a new capital market
-Brings the firmβs name in front of more investor and consumer groups
-Cross listing into developed market exchanges signals strong corporate governance policies
-Cross listing may mitigate the risk of hostile takeover
Depository receipts:
Please provide a brief description of what they are and provide the pricing formula
Foreign stocks can be traded on a national stock exchange in the form of a Depository Receipt (DR), which is equivalent to a specified number of shares of a security
-The use of DRs circumvent some disclosure requirements imposed on share offerings in the destination stock market, enabling foreign companies to tap into the destination stock market
-The price of a DR should reflect the value of the underlying security in its home market and the exchange rate
P(dr) = Conv * P(fs) * S
Where P(dr) is the price of the dep. receipts in the destination currency
Conv is how many shares make up one DR.
P(fs) is the price per foreign share in its domestic currency
S is spot exchange rate
EXAMPLE:
A Chinese company wants to list depository receipts on the US stock market. List American Depository Receipts (ADRs).
One of their shares is 100 CNY and the spot is 0.14USD/CNY.
Conv = 2
Calculate the price on NYSE in USD
P(dr) = Conv * P(fs) * S
P(dr) 2 * 100 * 0.14 = 28 USD
Please provide characteristics of a closed-end fund
Closed-end funds (CEFs) issue a fixed a number of shares to the public only once
-Like other publicly-traded securities, the market price of CEF shares fluctuates and is determined by supply and demand in the marketplace.
-CEFs do not issue or redeem shares to meet investor demand
-Investors may need to buy and sell the shares in the secondary market at substantial premium or discount relative to the fundβs net asset value (NAV).
-Almost all CEFs are actively managed
Unit investment trust
-Unit investment trust (UIT) makes one-time public offering of a specific, fixed number of shares/units.
-UIT maintains an active secondary market where investors can buy and sell shares of UIT
-Unlike CEFs, UITs are redeemable at its NAV
-UIT has a predetermined termination date that is determined at its inception
-The composition of the portfolio held by UIT does not change over time
Open-end/mutual funds
Mutual funds pool money from investors to invest in securities according to a specified investment policy
-Can be actively or passively managed
-Mutual funds are not publicly traded and can only be bought through an advisor, brokerage account or directly from the fundβs customer service
-Mutual funds are willing to buy back their shares at the end of every business day at the NAV.
Exchange traded funds and their advantages
ETFs are a type of investment fund that holds a collection of assets (stocks, bonds, commodities etc)
They can be bought and sold on the stock exchange like any other security - therefore can be bought on margin and shorted.
Advantages:
-Combine positive attributes of both CEFs and Mutual funds
-They have better pricing efficiency than CEFs because of the creation and redemption policy
-Offer marketability OEFs cannot
-Usually less expensive due to less administration and customer service
-They are more tax-efficient than mutual funds because they do not need to sell securities to meet redemption
Please describe the price efficency of ETFs
-The pricing efficiency of an ETF is maintained by the creation and redemption mechanism
-This is that Authorized Participants (APs) typically large institutional investors are authorized by the ETF sponsor to create and redeem ETF shares.
-This, in turn, ensures the value of the ETF is always close to its NAV.
If ETF trading at a premium. APs will buy underlying securities at market rate and exchange them for ETF shares that they will then in turn sell at a higher rate. This creates greater supply of ETFs pushing down the price
If ETF trading at a discount, APs will buy ETFs and exchange them for the underlying securities and sell those securities at the NAV. This creates greater demand for ETFs pushing up the price closer to its NAV
