The investment setting Flashcards
Goal of investment management
To find investments that satisfy the investor’s required rate of return
Wealth
- Can be seen as an individual’s total assets minus their liabilities (Net Worth)
- Or as the present value of their future income minus the present value of their expenses
Investments
- Defined as the current commitment of an individual’s money, based on fundamental research, to real and/or financial assets for a given period in order to accumulate wealth over the long term
- Can be seen as an individual’s actual portfolio
Speculation
- Investments that involve high risks and high returns
- Usually associated with a certain view taken on the market in order to make a profit
Gambling
- Taking an almost certain small loss for the probability of making a large profit
Most important decision in creating wealth
Asset allocation
Most important decision in creating wealth
Asset allocation
Required rate of return
The minimum return an investor should accept from an investment to compensate him for deferring consumption
Three components/categories of required rate of return
- The time value of money during the period of the investment (excluding inflation)
- The expected rate of inflation during the period
- The risks involved
Real Risk Free Rate
- Price charged for the exchange between current consumption and future consumption
- Starting point in determining the investor’s required rate of return
Risk Free Investment
An investment which provides the investor with certainty regarding the amount and timing of the expected returns
Capital markets
Bring together investors (who want to invest their savings) and demanders of funds
Monetary and fiscal policy determine the conditions in the capital market
Monetary policy
Refers to the policy of the central bank (SARB in SA) on the control of interest rates based on its expectations about growth in the economy, the inflation rate and the exchange rate of the local currency
If the economy grows / inflation increases, the the interest rates increase (FACT CHECK!!!)
Fiscal Policy
- Fiscal policy is determined by the extent to which a government finances its expenditure by mean of taxes and debt
- The greater the deficit (the part of the budget that cannot be financed by taxes), the more money the government has to borrow in the capital market
Different types of risk premiums
- Political Risks
- Business Risks
- Financial Risks
- Liquidity Risks
- Currency Risk
- Market Risk
- Callability Risk
- Convertibility Risk
Political Risks
Broadly refers to the risks associated with a certain country’s political system
Business Risk
Refers to the extent of certainty about a firm’s cash flows as a result of the nature of its business
Eg monopolies and products with an inelastic demand have greater certainty about their income and cashflows
Financial Risk
Relates to the financial leverage (gearing) employed by a firm
Credit Rating and how firms is financed
Liquidity Risk
Relates to obtaining the right price in the right time for a certain investment
Liquidity Risk thus refers to the effort and certainty of trading a specific investment instrument in the secondary financial markets
Currency Risk
Relates to the fluctuation of the exchange rate
Market Risk
Refers to adverse movements in the value of equities, currencies, interest rates and commodities
Callability Risk
Refers to the variability of return that derives from the possibility that bonds or preference shares may be called by the issuing firm
Convertibility Risk
Refers to the possibility that the investment may be converted into the issuer’s ordinary shares at times or under terms which prevent the investor from achieving his required rate of return
Total Risk
Non-Systematic Risk + Systematic Risk
Non-Systematic Risk
- Risk that can be diversified away
- Relates to events that affect individual companies
Systematic Risk
- Risk that cannot be diversifies away
- Relates to general economic conditions and monetary and fiscal policy that affect all firms
Time value of money
Refers to the phenomenon that an amount of money can increase in value because of interest earned from an investment over time
Risk
- The uncertainty about whether an investment will earn its expected rate of return
- Uncertainty about future outcomes or the probability of an adverse outcome
Non-financial / Pure Risk
- Exposure to uncertainty that has a non-monetary outcome or implication
- No financial benefit from an increases exposure to the risk
- Best outcome is no loss
Financial Risk
-Associated with a distribution of possible outcomes, including both positive and negative scenarios
Return
Refers to the sum of cash dividends, interest and any capital appreciation or loss resulting from an investment
Standard deviation assumptions
- The scale of measurement for standard deviation is the same as for the original data and expected value. Probability distributions are assumed relatively normal
- Can be used for a non-diversified portfolio, but not the most-appropriate measure for a diversified portfolio
Doen nog normality vs skewness vs kurtosis
Diversification
Refers to a method of reducing the unsystematic risk of a portfolio by investing in various classes
Asset classes
Real Assets Financial Assets - Money market - Bonds - Preference shares - Equity - Ordinary shares - Warrants - Unit trusts - Investment trusts - Hedge funds - Participation bond schemes
Real Assets
Involve some kind of tangible asset, such as real estate, commodities, art and collectable items
Financial Assets
Represent legal claims to some future benefit and are also called financial instruments or securities
Fixed Income Securities
- Debt-like instruments
- An investor would place an upfront investment and receive periodic payments, called coupons
- The nominal amount is returned after a set term
Such as:
- Certificate of deposit
- Money market funds
- Eurodollar deposit
- Treasury bill
- Banker’s acceptance
Bonds
Different bonds based on:
- Collateralisation
- seniority
- Covenants
- Interest type (zero, fixed, floating, CPI-linked, etc.)
- Convertibility
- Callability
Different types p 12:
- Secured
- Mortgage
- Collateral
- Equipment trust certificates
- Debentures
- Senior/Subordinate
- Income
- Convertible
- Treasury
- Zero-coupon
Preference shares
- Regarded as fixed income securities because most preference share dividends are fixed
- Receive dividends before ordinary shareholders and are usually cumulative
- Can be callable and/or redeemable
Equity
- Ordinary shares
- Warrants
Ordinary shares
- Gives the investor all the privileges and rights of ownership in the firm, but with a limited extent of liability, which is measured by the amount invested in the firm
- Shareholder has the right to vote, and the right to refuse new share offerings
- The ordinary shareholder would also be entitled to any dividends declared to ordinary shareholders
NOG???????
Warrants
Derivative securities that give the holder the right, but not the obligation, to buy a stated number of the ordinary shares of the issuing company at a specified price, called the exercise price, during the life of the warrant
Warrants are issued by the same company of the underlying equity
Unit trusts
Unit trust companies receive investor’s money, issue sub-shares(units) to investors, pool the money and invest it on behalf of unit holders in diversified portfolios consisting of various securities
Investment trusts
Investment trusts receive investors’ money after selling ordinary shares of the company to them. The investors’ money is pooled and invested on their behalf in various securities. The investors are called participants
Exchange Traded Funds (ETFs)
Listed investment products that track the performance of a group or basket of shares, bonds or commodities
Hedge funds
May be describes as a pool of private capital structured as a limited partnership with the objective of consistently achieving returns under all market conditions by investing in any asset class and by using any investment strategy
Participation bond schemes
Pools funds received from investors and lends them out by means of first mortgage bonds over commercial or industrial properties
Benefits of international diversification
- Risk is reduced
- The risk-adjusted return of the portfolio is improved
Constraints of international diversification
- Unfamiliarity with foreign markets
- Regulations
- Market Efficiency (Liquidity risks)
- Risk Perception (Currency risks)
Costs of international diversification
- Transaction costs
- Custodian costs
- Taxes
- Management fees
Investment management process
- Establish investment objectives and constraints
- Create investment policy statement (a written statement which guides and controls investment decision making because it represents the long term objectives and constraints of the investor)
- Select a portfolio strategy (active [uses information and forecasting techniques to seek a better performance than with a diversified portfolio] or passive [minimum expectational input and relies on diversification to match performance of some market index])
- Select the assets
- Measure and evaluate portfolio performance
- Repeat from step 1
