Investment Analysis and Portfolio Management

3

First Canadian Edition By Reilly, Brown, Hedges, Chang

Chapter 3
Selecting Investments in a Global Market
• The Case for Global Investments • Global Investment Choices • Historical Risk-Returns on Alternative Investments

Copyright © 2010 by Nelson Education Ltd.

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Global Investment Opportunities
• More investment instruments available in the financial markets as a results of technological advances and new regulations • Ability to invest from a global perspective thanks to the globalization or integration of domestic and foreign financial markets
Copyright © 2010 by Nelson Education Ltd.

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Global Investment Opportunities
• Investment vehicles with a variety of maturities, risk-return characteristics, and cash flow patterns being spawned due to competition and deregulations in the financial sector

Copyright © 2010 by Nelson Education Ltd.

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The Case for Global Investment
• Three reasons Canadian investors should think of constructing global investment portfolios 1. Ignoring foreign markets can substantially reduce the investment choices for all investors 2. Rates of return on foreign securities often substantially exceed those on Canadian investments 3. Low correlation between Canadian securities markets and many foreign markets can help to substantially reduce portfolio risk

Copyright © 2010 by Nelson Education Ltd.

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in world stock and bond markets has dropped from about 65% of the total in 1969 to about 46% in 2006 • Growing importance of foreign securities in world capital markets is likely to continue • Overall value of securities available in world capital market has increased from $2.The Case for Global Investment • Relative Size of Financial Markets • Share of U.S.3 trillion in 1969 to $103 trillion in 2006 • U.S. 3-6 . portion has declined to less than half Copyright © 2010 by Nelson Education Ltd.

3-7 .The Case for Global Investments Copyright © 2010 by Nelson Education Ltd.

The Case for Global Investments: Bond Markets The performance of the Canadian bond market ranked higher than the U. bond market due to the weaker Canadian dollar during the period. Copyright © 2010 by Nelson Education Ltd.S. 3-8 .

The Case for Global Investments: Equity Markets Investors that limit themselves to domestic markets may experience below average ROI. Copyright © 2010 by Nelson Education Ltd. Notice that Canadian and Mexican equity markets produced comparatively high returns in the 2003-06 period. 3-9 .

3-10 . Copyright © 2010 by Nelson Education Ltd.The Case for Global Investments: Diversification • Diversification with foreign securities can help reduce portfolio risk because foreign markets have low correlation with Canadian capital markets. • The correlation of returns between a single pair of countries changes over time because the factors influencing the correlation change over time.

00 • Combining investments with perfect positive correlation will NOT help diversification.The Case for Global Investments: Diversification • Diversified portfolios reduce variability of returns over time. • Correlations range from -1. • Correlation coefficients measure diversification contribution.00 to +1. 3-11 . • Combining two assets with negative correlation is ideal for diversification Copyright © 2010 by Nelson Education Ltd.

3-12 . economic growth & fiscal & monetary policies differ between countries • Copyright © 2010 by Nelson Education Ltd.The Case for Global Investment: Global Bond Portfolio Low Positive Correlation • Low positive correlations among returns indicates substantial opportunities for risk reduction Why? International trade patterns.

3-13 .The Case for Global Investment: Global Bond Portfolio Low Positive Correlation • Opportunities for investors to reduce risk • Correlation changes over time • Adding non-correlated foreign bonds to a portfolio of Canadian bonds increases rate of return & reduces portfolio risk Copyright © 2010 by Nelson Education Ltd.

S.537 to . correlation is relatively low ranging from .635 but is a very low .389 when comparing Canada & Japan Copyright © 2010 by Nelson Education Ltd. 3-14 .The Case for Global Investment: Global Equity Portfolio Low Positive Correlation • Correlation of world equity markets resembles that for bonds • Canada–U.

The Case for Global Investment: Global Equity Portfolio & Risk Reduction • Opportunities to reduce risk of a stock portfolio by including foreign stocks Copyright © 2010 by Nelson Education Ltd. 3-15 .

3-16 . Maple bonds.Global Investment Choices • Fixed-Income Investments • Bonds and preferred stocks • International Bond Investing • Eurobond. international domestic bonds • Equity Instruments • Special Equity Instruments • Warrants and options • Futures Contracts • Investment Companies • Real Estate • Low-Liquidity Investments Copyright © 2010 by Nelson Education Ltd.

Fixed-Income Investments • Basic concepts of fixed-income investments • Contractual payment schedule • Recourse varies by instrument • Bonds • Investors are lenders • Expect interest payment and return of principal • Preferred stocks • Dividends require board of directors approval Copyright © 2010 by Nelson Education Ltd. 3-17 .

Fixed-Income Investments • Savings Accounts • Fixed earnings • Convenient • Liquid and low risk • Low rates • Certificates of Deposit (CDs) • Usually less than 1 year in maturity • Usually insured by CDIC • Guaranteed Investment Certificates (GICs) • Usually issued with terms greater than 1 year • Usually insured by CDIC Copyright © 2010 by Nelson Education Ltd. 3-18 .

3-19 .Fixed-Income Investments • Fixed income obligations that trade in secondary market • Corporate bonds – issued by corporations to fund long-term commitments • Bankers Acceptances – issued by banks to fund short term (less than 1 year) obligations • Government of Canada bonds & T-bills • Provincial government bonds • Agency bonds are issued by Crown corporations • Example: Canada Mortgage and Housing Corporation (CMHC) Copyright © 2010 by Nelson Education Ltd.

3-20 .Corporate Bonds • • • • • Issued by a corporation Fixed income Credit quality measured by ratings Maturity Features: • Indenture – legal agreement stating obligations of issue • Call provision – specify when bonds can be called away from investors before maturity • Sinking fund – provision for payments to pay down bond debt Copyright © 2010 by Nelson Education Ltd.

Preferred Stock (Equity) • Hybrid security • Fixed dividends • Dividend obligations are not legally binding. 3-21 . but must be voted on by the board of directors to be paid • Most preferred stock is cumulative • Credit implications of missing dividends Copyright © 2010 by Nelson Education Ltd.

to non-U. investors Copyright © 2010 by Nelson Education Ltd.S. 3-22 .International Bond Investing • Eurobonds • An international bond denominated in a currency other than the country where it is issued • Example: Eurodollar bond is issued in USD but sold outside of the U.S.

International Bond Investing • Maple bonds • A Canadian dollar denominated bond sold in Canada by a foreign corporation or government • Interest payments are made in CAD$ • Example: Maple bond issued by British Airways in Canada to Canadian investors Copyright © 2010 by Nelson Education Ltd. 3-23 .

3-24 . investors Copyright © 2010 by Nelson Education Ltd.S.International Bond Investing • Yankee bonds • Sold in the United States and denominated is US$. but issued by foreign corporations or governments • Eliminates exchange risk to U.

3-25 . A Canadian investor could purchase this bond by exchanging Canadian dollars for yen and then purchase the bond.International Bond Investing • International domestic bonds • Sold by issuer within its own country in that country’s currency • Example: bond sold by Nippon Steel. Copyright © 2010 by Nelson Education Ltd. However. denominated in yen. the Canadian investor would be exposed to foreign exchange rate risk.

3-26 .Equity Instruments • Common Stock • Represents ownership of a firm • Investor’s return tied to the performance of the company and may result in loss or gain Copyright © 2010 by Nelson Education Ltd.

machinery. 3-27 . truck lines. railroads • Financial: banks. gas suppliers. beverages • Utilities: electrical power companies.Equity Instruments • Common Stock Classifications • Industrial: manufacturers of automobiles. credit unions Copyright © 2010 by Nelson Education Ltd. chemicals. savings and loans. water industry • Transportation: airlines.

S. 3-28 .S. bank that represents indirect ownership of a certain number of shares of a specific foreign firm on deposit in a U.Buying Foreign Equities • American Depository Receipts (ADRs) • Easiest way to directly acquire foreign shares • Certificates of ownership issued by a U. bank in the firm’s home country Copyright © 2010 by Nelson Education Ltd.

S. exchanges Copyright © 2010 by Nelson Education Ltd.S. dollars • May represent multiple shares • Listed on U.Buying Foreign Equities • Buy and sell in U.S. dollars • Dividends in U. 3-29 .

Copyright © 2010 by Nelson Education Ltd. 3-30 .Buying Foreign Equities • Global Mutual Funds or ETFs • Global funds: Invest in both U.S.S. and foreign stocks • International funds: Invest mostly outside the U.

3-31 .Buying Foreign Equities • Funds can specialize • • • • Diversification across many countries Concentrate in a segment of the world Concentrate in a specific country Concentrate in types of markets • Exchange-traded funds (ETFs) are a recent innovation in the world of index products Copyright © 2010 by Nelson Education Ltd.

Equity Derivatives: Warrants • Warrants • An options issued by a company giving the holders the right to buy its common stock • Normally issued with bonds Copyright © 2010 by Nelson Education Ltd. 3-32 .

3-33 .Equity Derivatives: Options • Equity-derivative securities which have a claim on the common stock of a firm • Rights to buy or sell common stock or other underlying assets at a stated price for a period of time • Puts are options to sell • Calls are options to buy Copyright © 2010 by Nelson Education Ltd.

Futures Contracts • Exchange of a particular asset at a specified delivery date for a stated price paid at the time of delivery • Deposit (10% margin) is made by buyer at contract to protect the seller • Commodities trading is largely in futures contracts • Current price depends on expectations • Example: Corn. oil Copyright © 2010 by Nelson Education Ltd. 3-34 . soybeans.

and Eurobonds • Traded mostly on Chicago Mercantile Exchange (CME) and Chicago Board of Trade (CBOT) • Allow investors and portfolio managers to protect against volatile interest rates • Currency futures allow protection against changes in exchange rates • Various stock futures on market indexes such as the S&P 500 and Value Line Index Copyright © 2010 by Nelson Education Ltd.Financial Futures • Recent development of contracts on financial instruments such as T-bills. 3-35 . Treasury bonds.

Investment Companies • Mutual Funds • Rather than buy individual securities directly from the issuer they can be acquired indirectly through shares in an investment company • Investment companies sell shares in itself and uses proceeds to buy securities • Investors own part of the portfolio of investments Copyright © 2010 by Nelson Education Ltd. 3-36 .

5 trillion in 2007 Copyright © 2010 by Nelson Education Ltd. 3-37 . short-term investments • Yields are higher than normal bank CDs or GICs • Typical minimum investment is $1.Investment Companies • Money-Market Funds • Acquire high-quality.000 • No sales commission charges • Withdrawal is by cheque with no penalty • Investments usually are not insured • Total value reached more than $2.

Investment Companies • Bond Funds • Invest in long-term government or corporate bonds • Vary in bond quality from risk-free government bonds to high-yield or junk bonds • Expected returns also differ reflecting the risk level of bonds in the fund Copyright © 2010 by Nelson Education Ltd. 3-38 .

3-39 .Investment Companies • Bond Funds • Invest in a combination of stocks and bonds depending on their stated objectives • Numerous non-stock indexes including various bond indexes have been created Copyright © 2010 by Nelson Education Ltd.

3-40 .Investment Companies • Index Funds • These are mutual funds created to track the performance of a market index like the S&P/TSX Composite • Appeal to passive investors who want to simply experience returns equal to some market index • Lower costs to investors as management expense fees are lower than actively managed mutual funds Copyright © 2010 by Nelson Education Ltd.

3-41 . similar to stock or bond mutual fund • Construction and development trusts provide builders with construction financing • Mortgage trusts provide long-term financing for properties • Equity trusts own various income-producing properties Copyright © 2010 by Nelson Education Ltd.Real Estate • Real Estate Investment Trusts (REITs) • Investment fund that invests in variety of real estate properties.

Real Estate • Direct Real Estate Investment • Purchase of a home • Purchase of raw land • Intention of selling in future for a profit • Ownership provides a negative cash flow due to mortgage payments. and expertise Copyright © 2010 by Nelson Education Ltd. 3-42 . time. taxes. and property maintenance • Land Development • Divide the land into individual lots • Build houses or a shopping mall on it • Requires capital.

3-43 .Low Liquidity Investments • Some investments don’t trade on securities markets • Lack of liquidity keeps many investors away • Auction sales create wide fluctuations in prices • Without notional markets. dealers incur high transaction costs • Some may consider them more as hobbies than investments Copyright © 2010 by Nelson Education Ltd.

and sell at a profit • Serious collectors may enjoy good returns • Individuals buying a few pieces to decorate a home may have difficulty overcoming transaction costs to ever enjoy a profit them more as hobbies than investments Copyright © 2010 by Nelson Education Ltd.Low Liquidity Investments • Antiques • Dealers buy at estate sales. 3-44 . refurbish.

3-45 .Low Liquidity Investments • Art • Investment requires substantial knowledge of art and the art world • Acquisition of work from a well-known artist requires large capital commitments and patience • High transaction costs • Uncertainty and illiquidity Copyright © 2010 by Nelson Education Ltd.

but more liquid than art and antiques markets • Price lists are published weekly and monthly • Grading specifications aid sales • Widespread between bid and ask prices Copyright © 2010 by Nelson Education Ltd. 3-46 .Low Liquidity Investments • Coins and Stamps • Enjoyed by many as hobby and as an investment • Market is more fragmented than stock market.

storage.Low Liquidity Investments • Diamonds • Can be illiquid • Grading determines value. but is subjective • Investment-grade gems require substantial investments • No positive cash flow until sold • Costs of insurance. 3-47 . and appraisal Copyright © 2010 by Nelson Education Ltd.

Historical Risk Returns on Investments • Reilly and Wright (2004) examined the performance of various investment alternatives from the Canada. and the emerging markets for the period 1993-2009 (CAD) Copyright © 2010 by Nelson Education Ltd. Japan. the U. 3-48 .S. Europe.

3-49 .Historical Risk Returns on Investments • The expected relationship between annual rates of return and total risk (standard deviation) of these securities was confirmed Copyright © 2010 by Nelson Education Ltd.

Comparing the TSX & Other Stock Markets • The systematic risk measure (beta) did a better job of explaining the returns during the period than did the total risk measure Copyright © 2010 by Nelson Education Ltd. 3-50 .

3-51 .Correlations Between Various Capital Markets • A good hedge should have a strong positive correlation with inflation Copyright © 2010 by Nelson Education Ltd.

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