1 Capital Markets and Portfolio Analysis

2 Introduction u Capital market theory springs from the notion that: People like return People do not like risk Dispersion around expected return is a reasonable measure of risk

3 Role of the Capital Markets u Definition u Economic function u Continuous pricing function u Fair price function

4 Definition u Capital markets trade securities with lives of more than one year u Examples of capital markets New York Stock Exchange (NYSE) American Stock Exchange (AMEX) BSE NSE

5 Economic Function u The economic function of capital markets facilitates the transfer of money from savers to borrowers E.g., mortgages, Treasury bonds, corporate stocks and bonds

6 Continuous Pricing Function u The continuous pricing function of capital markets means prices are available moment by moment Continuous prices are an advantage to investors Investors are less confident in their ability to get a quick quotation for securities that do not trade often

7 Fair Price Function u The fair price function of capital markets means that an investor can trust the financial system The function removes the fear of buying or selling at an unreasonable price The more participants and the more formal the marketplace, the greater the likelihood that the buyer is getting a fair price

8 The Life of every man is a diary in which he means to write one story, and writes another; and his humblest hour is when he compares the volume as it is with what he vowed to make it. - J.M. Barrie

9 Investments u Traditional investments covers: Security analysis –Involves estimating the merits of individual investments Portfolio management –Deals with the construction and maintenance of a collection of investments

10 Security Analysis u A three-step process 1)The analyst considers prospects for the economy, given the state of the business cycle 2)The analyst determines which industries are likely to fare well in the forecasted economic conditions 3)The analyst chooses particular companies within the favored industries EIC analysis

11 The Portfolio Manager’s Job u Begins with a statement of investment policy, which outlines: Return requirements Investor’s risk tolerance Constraints under which the portfolio must operate

12 The Six Steps of Portfolio Management 1)Learn the basic principles of finance 2)Set portfolio objectives 3)Formulate an investment strategy 4)Have a game plan for portfolio revision 5)Evaluate performance 6)Protect the portfolio when appropriate

13 Low Risk vs. High Risk Investments (cont’d) 1)Earns 10% per year for each of ten years (low risk) Terminal value is $25,937 2)Earns 9%, -11%, 10%, 8%, 12%, 46%, 8%, 20%, -12%, and 10% in the ten years, respectively (high risk) Terminal value is $23,642 u The lower the dispersion of returns, the greater the terminal value of equal investments

14 Background, Basic Principles, and Investment Policy (cont’d) u There is a distinction between “good companies” and “good investments” The stock of a well-managed company may be too expensive The stock of a poorly-run company can be a great investment if it is cheap enough

15 Background, Basic Principles, and Investment Policy (cont’d) u The two key concepts in finance are: 1)A dollar today is worth more than a dollar tomorrow 2)A safe dollar is worth more than a risky dollar u These two ideas form the basis for all aspects of financial management

16 Background, Basic Principles, and Investment Policy (cont’d) u Setting objectives It is difficult to accomplish your objectives until you know what they are Terms like growth or income may mean different things to different people

17 Portfolio Management u Passive management has the following characteristics: Follow a predetermined investment strategy that is invariant to market conditions or Do nothing Let the chips fall where they may

18 PART THREE Portfolio Management u Active management: Requires the periodic changing of the portfolio components as the manager’s outlook for the market changes

Measuring Returns Dollar Returns u Investors in market-traded securities (bonds or stock) receive investment returns in two different form: –Income yield –Capital gain (or loss) yield u The investor will receive dollar returns, for example: –$1.00 of dividends –Share price rise of $2.00 To be useful, dollar returns must be converted to percentage returns as a function of the original investment. (Because a $3.00 return on a $30 investment might be good, but a $3.00 return on a $300 investment would be unsatisfactory!)

Measuring Returns Dollar Returns u Investors in market-traded securities (bonds or stock) receive investment returns in two different form: –Income yield –Capital gain (or loss) yield u The investor will receive dollar returns, for example: –$1.00 of dividends –Share price rise of $2.00 To be useful, dollar returns must be converted to percentage returns as a function of the original investment. (Because a $3.00 return on a $30 investment might be good, but a $3.00 return on a $300 investment would be unsatisfactory!)

Measuring Returns Converting Dollar Returns to Percentage Returns An investor receives the following dollar returns a stock investment of $25: –$1.00 of dividends –Share price rise of $2.00 The capital gain (or loss) return component of total return is calculated: ending price – minus beginning price, divided by beginning price [8-2]

22 Return on a Single Asset u Total return = Dividend + Capital gain u Year-to- Year Total Returns on HLL Share

23 Average Rate of Return u The average rate of return is the sum of the various one-period rates of return divided by the number of period. u Formula for the average rate of return is as follows:

Measuring Average Returns Geometric Mean u Measures the average or compound growth rate over multiple periods. [8-5]

CHAPTER 8 – Risk, Return and Portfolio Theory Estimating Expected Returns u The general formula Where: ER = the expected return on an investment R i = the estimated return in scenario i Prob i = the probability of state i occurring [8-6]

Estimating Expected Returns Example: This is type of forecast data that are required to make an ex ante estimate of expected return.

Estimating Expected Returns Example Solution: Sum the products of the probabilities and possible returns in each state of the economy.

Estimating Expected Returns Example Solution: Sum the products of the probabilities and possible returns in each state of the economy.

CHAPTER 8 – Risk, Return and Portfolio Theory Risk u Probability of incurring harm u For investors, risk is the probability of earning an inadequate return. If investors require a 10% rate of return on a given investment, then any return less than 10% is considered harmful.

30 Risk of Rates of Return: Variance and Standard Deviation

Measuring Risk Example Using the Ex post Standard Deviation Problem Estimate the standard deviation of the historical returns on investment A that were: 10%, 24%, -12%, 8% and 10%. Step 1 – Calculate the Historical Average Return Step 2 – Calculate the Standard Deviation

32 Portfolio Return: Two-Asset Case u The return of a portfolio is equal to the weighted average of the returns of individual assets (or securities) in the portfolio with weights being equal to the proportion of investment value in each asset.

33 Portfolio Risk: Two-Asset Case u The portfolio variance or standard deviation depends on the co-movement of returns on two assets. Covariance of returns on two assets measures their co-movement. u The formula for calculating covariance of returns of the two securities X and Y is as follows: Covariance XY = Standard deviation X ´ Standard deviation Y ´ Correlation XY u The variance of two-security portfolio is given by the following equation: