InstrumentsLecture1notes.docx
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InstrumentsLecture1notes.docx
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InstrumentsLecture1notes
FINANCIALINSTRUMENTS
Lecture1
IntroductionandOverview
Aims
Afterthislectureyoushould:
•Understandtheoverallprocessofinvestmentmanagement
•Knowthemainelementsofclientobjectives
•Knowtheprincipalconstraintsaffectingclientinvestments
•Befamiliarwithtypicalinstitutionalpolicyagreementsandoperatingguidelines
•Knowtheprincipalinstrumentsavailableforfinancialinvestment
•Knowthemainpropertiesofthesefinancialinstruments
•Knowthemainformsofinvestmentmanagementinstitutions
Reading:
–AnalysisofInvestmentsandManagementofPortfolios,9thedition,KeithC.BrownandFrankK.Reillyand(SouthWestern,2009)Chapters1,2,16
–CaseStudy:
EdnamProductsCompany
–USS“InvestmentPolicyStatement”
NOTE:
Inthesubsequentsections,▀denotesthatitisnotinyourlecturenotesbuthavebeenincludedheretogiveyousomeadditionalinformationonly.
Investments,What?
Why?
•DefiningInvestment:
Acurrentcommitmentof£sforaperiodoftimeinordertoderivefuturepaymentsthatwillcompensatefor:
–Thetimethefundsarecommitted
–Theexpectedrateofinflation
–Uncertaintyoffutureflowoffunds
•ReasonforInvesting:
Byinvesting(savingmoneynowinsteadofspendingit),individualscantradeoffpresentconsumptionforalargerfutureconsumption.Enablessmoothingofincomes.
•PureRateofInterest(PRI)
–Itistheexchangeratebetweenacertainfutureconsumption(future£s)andacertainpresentconsumption(current£s).Establishedbydemandandsupply.
Ifanyuncertainty/inflation:
PRI+e
Usefulnessoffinancialmarkets
Note:
theslopeofthelineis–(1+r),ristheinterestrateatwhichinvestorsarewillingtotradeoffcurrentconsumptionforfutureconsumption.Itisdecidedbyinvestorstime-preferenceforconsumptionandthedemandandsupplyoffundsforrealinvestments.Theproductionopportunitycurvefromrealinvestmentsarenotshown.
Theslopeisdeterminesasfollows
Weknowthatgivenri0=i1/(1+r)andthati1=i0(1+r)andthattheslopeofthelineismeasureasrise/run
Withcompleteinvestmentofi0theriseisi1andtherunis-i0asyouarenowdecreasingyouri0.Therefore,i1/-i0=i0(1+r)/-i0=-(1+r).
▀Forthosewhoareinterested,pleaseseehttp:
//www.jstor.org/stable/1827424?
seq=1foranarticlebyJackHirshleiferforamoreelaboratediscussionofthistopic.Thisarticleisalsorelevantfromacorporatefinancepointofviewasitsetsouthowfirmsshouldmaketheoptimalinvestmentdecisionwheninvestorshavedifferenttimepreferences.
Whoaretheinvestors?
•Individuals,Trusts
•Charities/Endowments
•Companies
•MutualFunds
•InsuranceCompanies
•PensionFunds
•DefinedBenefit
•DefinedContribution
Note:
youshouldbeabletobrieflydescribethesevariousinvestortypes.
Investorsbysize
•Smallinvestors
•Pooledinvestmentvehiclerunbyafinancialinstitution.
–i.e.unittrusts(Openendfunds),
–Investmenttrusts(Closed-endfunds),
•Smallinsurancefunds
•Largeinvestors
•Fundmanagerhiredtomanagethefund,or
•Clientmayemployafundmanagerin-house
–i.e.largepensionfunds,
•Largeinsurancecompanies,
•Largecharities
TypesofAssetClasses
Assetclass:
Comprisedofsecuritiesthathavesimilarcharacteristics,attributesandrisk/returnprofiles.
•FixedIncomeInstruments
–SavingsAccounts,Certificatesofdeposits,Tbills,Govtbonds/Gilts,corporatebonds(pref.stock?
)
•EquityInstruments–Domestic/ForeignEquities
•DerivativeInstruments
–Options,Futures,Swaps
•InvestmentCompanies
–Moneymarketfunds,Bondfunds,EquityFunds,Indexfunds,ETF
•AlternativeInvestmentsInstruments
–Antiques,Art,Coinsandstamps,GemsandMinerals,hedgefunds,privateequityetc.
–
Note:
youshouldbeabletobrieflydescribethesevariousassetclasses.
Investmentstylebox
Youcanfindaverygooddescriptionhereand
Inadditiontothedomesticequitystylebox,Morningstarofferstwootherstyleboxes:
an internationalequitystyleboxandafixed-incomestylebox.
▀AcategorisationofFinancialAssets(inorderofRiskinesss).Note:
Thistableisnotonyourlectureslidesbutisincludedherejusttogiveyousomeadditionalinfo.
Category
Type
Characteristics
Non-Marketable
SavingsAccounts
CertificatesofDeposit
GovernmentSavingsCertificates
shorttermandsafereturn
MoneyMarket
TreasuryBills
NegotiableCDs
CommercialPaper
RepurchaseAgreement(Repo)
BankersAcceptances
Currencies
Short-term
BondMarket
CorporateBonds
Eurobonds
SupranationalBonds
GovernmentBonds
-fixedinterestpayments(&floating)
-facevalueatmaturity
-Returns(slightly)random
-sovereign:
safe(?
)/inflation
-corporate:
risky
EquityMarket
PreferredStock(PreferenceShares)
CommonStock(OrdinaryShares)
-Randomdividendpayments
-Stockpricefluctuates
-Returnsrandom
-Smallcapstocksmorevolatile
-ForeignStocksmorevolatile
MutualFunds
OpenEnd(UK=UnitTrust)
ClosedEnd(UK=InvestmentTrust)
-Diversifiedportfolio
Derivatives
Options
Futures
Swaps
-Dependsonotherassetspay-offs
-Levered–hencerisky
AlternativeInvestments
Realestate,
VentureCapital
HedgeFunds
Commodities,works-of-art
-Illiquid
-Long-term?
▀AreallysimpleandgoodguidetoinvestingwhichdoescontainsdiscussionofsometheseassetclassescanbefoundontheInvestmentmanagementAssociation(IMA)websiteathttp:
//www.investmentfunds.org.uk/consumer-centre.TheIMArepresentstheUKinvestmentmanagementindustry.Itsmembersmanageover£3.4trillionofassetsonbehalfofUKandoverseasclients.
AverageAssetAllocationacrossUKPensionFunds1962-2007
Thiswasanexampleofaparticularinvestortype’sallocationacrossassetclassesovertime.Youshouldbeablemakesomecommentsonhowtheassetallocationhaschangedovertimeandwhatthatmeansintermsofaggressivenessoftheallocationstrategy.
OwnershipofUKEquityMarket1963-2006.
Thisisanexampleofhowparticularinvestortypesareinvestinginaparticularassetclass.Youshouldbeabletomakesomecommentsonthetimetrendsandpossiblereasonsforthis.
IndividualInvestorLifeCycle
ThemainpointhereisthatInvestmentneedschangeoveraperson’slifecycle.Thatimpliesthattheobjectivesfrominvestment,theriskthatoneiswillingtotaketoachievethosereturnsetcwillchangeasonemoveforwardsintime.Buttherearesomebasicconditionsthatneedtobesatisfiedbeforeyoucanembarkonasuccessfulinvestmentmanagementprogramthesearediscussedhere
–Potentialinvestorsneedstohaveadequateincometocoverlivingexpensesandinsurancetocoverfortheunexpected.
–Insurance–life,healthetc.
•DeathBenefit
•Surrenderthevalueofyourlifeinsurancepolicyandusetheproceedstosupplementyourretirementincome.
–Cashreserve–recommended6monthsoflivingexpenses.Inveryliquidassets.Bankaccounts,Short-termbondmutualfundsetc.
–Oncebasicinsuranceandcashreserveneedsaremetthencanstartasaving/investmentprogram.
Thisisadiagrammaticrepresentationofahypotheticalindividualinvestorslifecycleandhowtheneedschangeovertime.Youshouldbeabletomakesomecommentsonhowtheseneedswouldimpactonriskaversion,timehorizonforinvestmentetc.
Theideaisthattheearlieryoustartonaninvestmentprogramthebetteritisandthefollowingtableshowsyouhowinvestingearlyonbenefits.
•Growthfrominitial10,000investmentover20,30and40yearsat7%and8%
•Example:
investing50,000over20yearsyields120,000whileinvesting90,000over40yearsyieldsoverhalfamillion@7%
PortfolioManagementProcess
Giventhatmostinvestorsholdportfoliosnotsingleassetsonemightthingabouthowthisactuallyworks.Aswithanyprocessthereisaplanning,executingandafeedbackphase.Thefirsttwostepsaretheplanningphases,step2isexecutionandstep3isthefeedbackandmonitoringphase.
So
1.PolicyStatement
a.Identifyinvestors’needs
2.Contextofcurrentandprojectedeconomic,politicalandsocialconditions
a.Isrelationshipbetweenkeyfactorsandexpectedreturnsonassetsreviewed?
3.Portfolioconstruction
a.Investinarangeofassets
4.Assessment:
Monitoring/feedback
a.Arekeyfactorsaffectingreturnsinthecapitalmarketsmonitored?
b.Processforconstructing&revisingportfolio
c.Howisportfolioperformancemonitored?
d.WhatistheBENCHMARK,bywhichperformancewillbejudged?
InputtoPS-ClientObjectives
Thepolicystatementisanimportantdocumentthatsetsoutaparticularinvestors’returnobjectivesandrisktolerances.Thisshouldenableonetoarrivetheappropriateassetallocationstrategiesforaparticularinvestor.
•Thesearetheinvestmentgoalsdefinedintermsofbothriskandreturn.
•Returnobjectives:
–Specificasinacertain%returnorrelativetoabenchmarkorageneralgoalasin
•CapitalPreservation–minimiseriskoflossofcapital.(riskaverse+shortterminvestors).Thishastodowithmaintainingthepurchasingpowerandthereforethereturnsontheinvestmentneedstobenolessthantherateofinflation.
•Capitalappreciation–portfoliotogrowinrealterms.Focusoncapitalgains.(longterm+lessriskaverse).Inthisstrategygrowthoccursthroughcapitalappreciationandtherateofreturnmustbegreaterthantherateofinflation.
•Currentincome–portfoliotogenerateincome.Thismightsuitinvestorswhowantsanadditionalsourceofinco
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