Department of Banking and Finance SPRING Investment, its background, Investors and the Investment Process Investment, its background, Investors and the Investment Process by Asst. Prof. Sami Fethi

Investment Management © 2005, Sami Fethi, EMU, All Right Reserved. ch: 1-21 Investment and Background 2 Define an investment An investment is the current commitment of money or other resources in the expectation of reaping future benefits. For example, the time you spend for your education is a kind of investment. Sometimes, you can give up either current leisure or the income for the sake of your future career. This means that you sacrifice something of value now and expecting to benefit from that sacrifice later.

Investment Management © 2005, Sami Fethi, EMU, All Right Reserved. ch: 1-21 Investment and Background 3 Essential nature of Investments & Assets Essential nature of investment – Reduced current consumption – Planned later consumption Real Assets – Assets used to produce goods and services Financial Assets – Claims on real assets

Investment Management © 2005, Sami Fethi, EMU, All Right Reserved. ch: 1-21 Investment and Background 4 Financial Assets Financial Assets: claim on real assets or income generated by them or financial assets are claims to the income generated by real assets.  Financial assets such as stocks and bonds do not contribute directly to the productive capacity of the economy (i.e. if we do not have our own auto plan (real asset), we can buy shares in General motors or Toyota (financial asset) and thereby, share in the income derived from the production of automobiles).

Investment Management © 2005, Sami Fethi, EMU, All Right Reserved. ch: 1-21 Investment and Background 5 Real Assets Real Assets: Assets used to produce goods and services. Real Assets refers the productive capacity of an economy. (i.e. land, buildings, machines and knowledge). These can be used to produce goods and services. While real assets generate net income to the economy, financial assets simply define the allocation of income or wealth among investors so individuals can choose between consuming their wealth or investing future.

Investment Management © 2005, Sami Fethi, EMU, All Right Reserved. ch: 1-21 Investment and Background 6 Are the following assets real or financial? a) Patents (R) b) Lease obligation (F) c) Customer goodwill (R) d) A college education (R) e) A $ 5 bill (F)

Investment Management © 2005, Sami Fethi, EMU, All Right Reserved. ch: 1-21 Investment and Background 7 Describe a derivative security and understand how they are used in a market. Derivative securities such as option and futures providing pay-offs that are determined by the prices of other assets such as bond or stock prices. One use of derivatives (i.e. primary use) is to hedge risks or transfer them to the other parties. The use of these securities for risk management is so commonplace that the multitrilion-dollar market in derivative assets is routinely taken for granted. Derivatives also can be used to take highly speculative positions in a market.

Investment Management © 2005, Sami Fethi, EMU, All Right Reserved. ch: 1-21 Investment and Background 8 The Investment Process Asset allocation Security selection Risk-return trade-off Market efficiency Active vs. passive management

Investment Management © 2005, Sami Fethi, EMU, All Right Reserved. ch: 1-21 Investment and Background 9 Investors make two major steps or decisions in constructing their own portfolios Portfolio is simply collection of investment assets The asset allocation decision is the choice among broad asset classes such as stocks, bonds, real estate, commodities, and so on. Top-down portfolio construction starts with asset allocation. The security selection decision is the choice of which particular securities to hold within each asset class. This is related with bottom-up strategy. i.e., the most attractive investment opportunities.

Investment Management © 2005, Sami Fethi, EMU, All Right Reserved. ch: 1-21 Investment and Background 10 An understanding of the risk/return trade-off An understanding of the risk/return trade-off Assets with higher expected returns have greater risk. A risk-return trade-off in the securities markets, with higher risk assets priced to offer higher expected returns than lower-risk assets. Risk tolerance: The investor’s willingness to accept higher risk to attain higher expected returns. Risk aversion: The investor is also reluctant to accept risk An investor’s objectives can be classified as return requirement and risk tolerance

Investment Management © 2005, Sami Fethi, EMU, All Right Reserved. ch: 1-21 Investment and Background 11 Active vs. Passive Management Active Management Finding undervalued securities Timing the market Passive Management No attempt to find undervalued securities No attempt to time Holding an efficient portfolio

Investment Management © 2005, Sami Fethi, EMU, All Right Reserved. ch: 1-21 Investment and Background 12 Active vs. Passive Management AM: Buying and holding a diversified portfolio without attempting to identify mispriced securities. PM: Attempting to identify mispriced securities or to forecast broad market trends. For example: Individuals can follow passive strategy if markets are efficient and prices reflect all relevant information.

Investment Management © 2005, Sami Fethi, EMU, All Right Reserved. ch: 1-21 Investment and Background 13 Financial Intermediaries Financial Intermediaries Institutions that connect borrowers and lenders by accepting funds from lenders and loaning funds to borrowers. – Such as banks, investment companies, insurance companies and credit unions. – FI’s issue their own securities to raise funds to purchase the securities of other corporation. – Why? An individuals lender can able to reduce risk, and monitor the credit risk of borrowers.

Investment Management © 2005, Sami Fethi, EMU, All Right Reserved. ch: 1-21 Investment and Background 14 Investments and Innovation Technology and Delivery of Service Computer advancements More complete and timely information Globalization Domestic firms compete in global markets Performance in regions depends on other regions Causes additional elements of risk

Investment Management © 2005, Sami Fethi, EMU, All Right Reserved. ch: 1-21 Investment and Background 15 Key Trends - Globalization International and Global Markets Continue Developing Managing foreign exchange Diversification to improve performance Instruments and vehicles continue to develop.World equity benchmark shares (WEBs) Information and analysis improves

Investment Management © 2005, Sami Fethi, EMU, All Right Reserved. ch: 1-21 Investment and Background 16 Key Trends - Securitization Securitization & Credit Enhancement Securitization: Pooling loans into standardized securities back by those loans which can be traded like other security Offers opportunities for investors and originators Changes in financial institutions and regulation Improvement in information capabilities Credit enhancement and its role

Investment Management © 2005, Sami Fethi, EMU, All Right Reserved. ch: 1-21 Investment and Background 17 Key Trends - Financial Engineering Repackaging Services of Financial Intermediaries FE is the process of bundling and unbundling of cash flows which refers to the creation and design of securities with custom tailor characteristics. UB: breaking up and allocating the cash flows from one security to create several new securities. B: combining more than one security into a composite security.

Investment Management © 2005, Sami Fethi, EMU, All Right Reserved. ch: 1-21 Investment and Background 18 The Future Globalization continues and offers more opportunities Securitization continues to develop Continued development of derivatives and exotics Strong fundamental foundation is critical Integration of investments & corporate finance

Investment Management © 2005, Sami Fethi, EMU, All Right Reserved. ch: 1-21 Investment and Background 19 Overview of the Investment Process Specify objectives Identify constraints Formulate an investment policy Monitor performance Reevaluate and modify portfolio as determined from monitoring

Investment Management © 2005, Sami Fethi, EMU, All Right Reserved. ch: 1-21 Investment and Background 20 The basic factors affecting an individual investor usually arise from that investor’s stage in the life cycle Major asset: Education or investment in human capital: earning power derived from their skill; at this point financial risk due to illness or injury is greater than that associated with the rate of return on their portfolios of financial assets-insurance. Major economic asset: is to buy their own house; first risk is the risk of increases rental rates; second risk is availability. Age concern: in the middle age most investor will be willingly to take on a meaningful amount of portfolio risk in order to increase their expected rate of return.

Investment Management © 2005, Sami Fethi, EMU, All Right Reserved. ch: 1-21 Investment and Background 21 Individual Investors Professional investors provide investment management services for a fee. Most of them are either pool many individual investor funds and manage them or serve institutional investors.

Investment Management © 2005, Sami Fethi, EMU, All Right Reserved. ch: 1-21 Investment and Background 22 Specifying Objectives: Individual Investors Balance risk and return Life Cycle is critical to the process of determining the risk/return trade-off Younger investors - willing to bear more risk for higher returns Older investors - willing to accept lower returns for lower risk

Investment Management © 2005, Sami Fethi, EMU, All Right Reserved. ch: 1-21 Investment and Background 23 Specifying Objectives: Personal Trusts and Mutual Funds Personal Trusts – Determined by the individual for whom the funds are being managed Mutual Funds – Varies with type of fund – More detailed in the next chapter

Investment Management © 2005, Sami Fethi, EMU, All Right Reserved. ch: 1-21 Investment and Background 24 Personal trust and Mutual funds Personal trust: the objectives of personal trusts normally are more limited in scope than those of the individual investor. They are usually risk avers person. Mutual funds: the objectives of mutual funds is to invest such shares that the income generated by the funds.

Investment Management © 2005, Sami Fethi, EMU, All Right Reserved. ch: 1-21 Investment and Background 25 Specifying Objectives: Pension Funds and Endowments Pension Funds – Defined contribution - shifted to the individual – Defined benefit - depends on average time to retirement of individuals Endowment Funds – Gifts to nonprofits are invested – Funds from the endowment used by the nonprofit

Investment Management © 2005, Sami Fethi, EMU, All Right Reserved. ch: 1-21 Investment and Background 26 Specifying Objectives: Insurance Companies Life Companies – Investments are hedged against potential claims of policy holders Non-Life Companies – Invest premiums not paid back to policyholders for loss – Hedge against potential claims

Investment Management © 2005, Sami Fethi, EMU, All Right Reserved. ch: 1-21 Investment and Background 27 Specify Objectives: Banks Sources of funds: deposits and borrowed funds Investment of funds: predominately in loans and fixed income securities Active in the securitized loan and asset markets Not active in equity except in the Trust Function

Investment Management © 2005, Sami Fethi, EMU, All Right Reserved. ch: 1-21 Investment and Background 28 Investors Constraints Constraints are the kind of financial circumstances impose on investor’s choice. Five common types of constraints are: Liquidity: refers an asset can be converted to cash Investment horizon: is the planned liquidation date of investment. Regulations: Only professional and institutional investors are constrained by regulations- prudent investor rule-professional investors who manage other people’s money have fiduciary responsibility to restrict investment to assets that would have been approved by a prudent investor.

Investment Management © 2005, Sami Fethi, EMU, All Right Reserved. ch: 1-21 Investment and Background 29 Investors Constraints Tax considerations: special considerations related to tax position of the investor. The performance of any investment strategy are always measured by its ror after tax. Unique needs; are often centre around their stage in the life cycle such as retirement, housing and children’s education.

Investment Management © 2005, Sami Fethi, EMU, All Right Reserved. ch: 1-21 Investment and Background 30 Investment Policy: Asset Allocation Decision Individual - depends on life cycle Younger Higher equity 75% Lower safe assets 25% Older Lower equity 40% Higher safe assets 60% Institutional - depends on objectives Example -all stock mutual fund would want nearly 100% in stock Sector or Region allocations

Investment Management © 2005, Sami Fethi, EMU, All Right Reserved. ch: 1-21 Investment and Background 31 Investment Policy: Active or Passive Active Trying to secure better than average performance Must balance returns and costs Passive Trying to get average returns rather than do better than the market Mix of Passive and Active

Investment Management © 2005, Sami Fethi, EMU, All Right Reserved. ch: 1-21 Investment and Background 32 The End Thanks