Investment and Portfolio Management

Course 1: Global Financial Markets and Instruments

WEEK 1
What is the investment management process?
 The investment management process starts with setting investment objectives.
 The first step is identifying investment goals. We can express these as either
for example, a desired nominal or real rate of return, or alternatively these
objectives may be liable to driven. In that case, the investment must produce a
certain cash flow to meet the contractual obligations. And these investment
objectives of course should reflect risk return trade-off between the expected
return the investor wants to achieve, and how much he is willing to assume
risk.
 The second step in the investment management process is developing an
investment policy. Investment policy is a kind of document that guides all
investment decisions. Essentially this amounts to deciding on the investor’s
actual portfolio.
 Typically an investor may start with all her money in a cash bank account. And
then maybe consider how much to invest in something riskier or with the
higher expected return. So we can think of this as more broadly the asset
allocation decision.
 The next step is the security selection decision which basically deals with the
choice of the particular securities to hold within each different asset class.
 The last step is of course, measurement and evaluation of investment
performance. This involves monitoring the portfolio, rebalancing the portfolio
as necessary and measuring the performance and evaluating that performance
relative to some benchmark
 So in summary, the investment process consists, one setting the investment
objectives, two, coming up with a policy. Document that guy’s old investment
and portfolio decisions. Three, finally reviewing and evaluating the performance
of the portfolio.

Review of Elementary Finance Tools (part1)

What is time value of money?
The time value of money is the concept that money you have now is worth more than
the identical sum in the future due to its potential earning capacity.
What is Future Value?
The Future Value (FV) is the value of a current asset at a future date based on an
assumed rate of growth. The future value is important to investors and financial
planners as they use it to estimate how much an investment made today will be
worth in the future.
Future Value of a cash flow today is the value of the funds invested at your
opportunity cost which we can call ‘r’.
Finding a future value is compounding;
Formula for finding Future Value (FV) = Present Value (PV)*(1+r/100)^n
Compound interest = Future Value – Present Value

What is Present Value?

Present Value is the current value of a future sum of money or stream of cash flows
given a specified rate of return
Present Value of a future cash flow is the amount of cash you would take today
instead of the promised future cash flow.
Finding present value is discounting.
PV = FV *{1/(1+r)^n}

 In Present Value, Future Value calculations the ‘r’ that we use represents the
discount rate, interest rate, opportunity costs of capital.

Review of Elementary Finance Tools (part 2)

What will you learn?
 What is the future value of a stream of cash flows?
 What is the present value of a stream of cash flows?
 What is an annuity?
 How do you find the present or future value of an annuity?

ANNUITIES
 An annuity is a series of equal fixed payments for a specified number of
periods.
 Annuity Compound Factor, ACF(r, n), sums up the compounding factors for n
payments at a constant interest rate r.
Some of the examples of annuities are bond payments, car loan payments, mortgage
payments where we have fixed cash flows i.e. fixed payments over a period. Annuity
Compounding Factor basically sum up these compounding factors for individual
payments at a constant interest rate. In general the compounding is (1+r) to the n – 1
divided by r. what is the future value of an annuity where the cash flows are C
dollars? The future value is going to be C dollars (the equal cash flows), the fixed
payment, times the ACF.
Ex. Suppose we are getting even cash flow streams of $3000 every year across 4 years
at a rate of 5%.
Annuity Compounding Factor = {(1+r)^n} – 1/r
Therefore, future value will be = Annuity Compounding Factor * Present Value
ACF = {(1+ 0.05)^4} – 1/0.05
= 4.310125
Future Value = 4.310125 * 3000
= 12930

Annuities example: Retirement problem

Suppose you want to make sure that you have $1 million, when you retire in 35 years.
So that gives me the future value at T = 35 and we have rate of 6% year
 We are making an assumption that interest rate is constant at 6% for the next
35 years.
FV = PV * {(1+r)^n} – 1 / r
1,000,000 = PV * {(1+.06)^35} – 1/0.06
1,000,000 = PV * 111.434779872
Therefore, PV = 1,000,000 / 111.434779872
= 8973.859

We found the future value of the stream of cash flows by Annuity Compounding
Factor (ACF). Now we will find present value by Annuity Discounting Factor (ADF).

Ex. Suppose we are getting even cash flow streams of $2000 every year across 4
years. So how much would you be willing to pay to receive these annuity if the
opportunity cost of capital or interest rate is 5% per year?
The answer is going to be 2000 times the annuity discounting factor, where r = 5%, n=
4%
Annuity Discounting Factor (ADF) = {1 – [1/(1+r)^n]} / r
Present Value = Future Value * ADF
Therefore, ADF = {1 – [1/(1+0.06)^4]} / 0.06
= 3.4651
Present Value = 2000 * 3.4651
= 6930.2112

 Compounding Periods – The phrase “the interest rate is 4% per year,

compounded monthly” tells us what the interest rate per compounding period
is.

Example of Loan problem

Suppose the purchase price of the car that we would like to buy today is $37150. The
present value of the car we want to buy today is $37150. We want to take a loan with
a maturity of 60 months and the interest rate is 4% per year compounded monthly.
What are our monthly car payments?
Therefore, we have r = 4%/12 = 0.33%, n= 60, present value = 37150
ADF = {1 – [1/(1+0.33)^60]} / 0.33
= 3.0303
37150 = FV * 3.0303
Therefore, FV = 37150 / 3.0303
= 12259.5004

Summary - We learnt how to compute the present value and future value of a stream
of cash flows such as annuities.

Review of Elementary Finance Tools (Part 3)

What will you learn?
 How do you find effective interest rates?
 How do you adjust for compounding periods?
 What is continuous compounding?

Ex. The interest rate was given as 4% per year, compounded monthly. This is not the
effective interest rate. This is the stated interest rate or sometimes called the APR on
our bank account statement. Interest rates are expressed as Annual Percentage Rate
(APR).

Example of effective interest rate:

Suppose the stated interest rate is 4% per year, compounded monthly. Let’s find the
effective annual rate.
Effective Annual Rate compounded monthly (ra) = [1+(APR/m)]^m – 1
M = months, APR = 4% /12 months
Therefore, ra1 = [1+(4%/12 )]^12-1
= [1+ 0.0033]^12 – 1
= [1.0033]^12 – 1
= 0.04032
= 4.032%

Effective 2 months rate = [1+0.0033]^2 – 1

= 0.6611%
Effective 3 months rate = [1 + 0.0033]^3 – 1
= 0.9933%
Effective 6 Months rate = [1+0.0033]^6 – 1
 = 1.9964%
Effective 18 months rate or 1.5 year rate = [1+0.0033]^18 – 1
= 6.1096%

Example: What if r=6% per year, compounded semi-annually?

APR = 6%/2 = 3%
Ra = [1+APR]^m/6 - 1

Effective 6 month rate = [1+0.03]^6/6 – 1

= 3%
Effective 3 months rate = [1+0.03]^3/6 – 1
= 1.4889%
Effective 2 year rate i.e. 24 months rate compounded semi-annually. Which means it
will be compounded 4 times every 6 months
= [1+0.03]^24/6 – 1
= 12.551%
Effective 15 months rate = [1+0.03]^15/6 – 1
= 7.67%

What if instead of every month, interest rate is compounded every instant, say
continuously?
r = e^m – 1
Example: 6% interest rate is compounded every instant
r = e^0.06 – 1 = 6.184%

Summary
 Difference between stated interest rate and effective rate
 Compute effective rate
 Compute continuously compounded rate

Review of Elementary Finance Tools (Part 4)

What will you learn?
 How to value perpetuities?
 Growing annuities and perpetuities

Perpetuity is a series of equal payments of a fixed amount for an infinite number of

periods.
When fixed cash flows go into the future forever then, Perpetuity = C/r
When cash flow is growing at a constant growth rate g then,
Perpetuity = C/(r-g)
Valuing growing annuities
ADF (r,n,g) = [1- {(1+g)^n/(1+r)^n}]/(r-g)

ACF (r,n,g) = [(1+r)^n – (1+g)^n]/(r-g)

WEEK 2
Goal in this module is to familiarize with the institutional features of financial
markets. Look at the wide range of financial instruments available and also
understand the roles played by various participants in these markets.
Why do we need financial markets? What role do they really serve?
- Peter Bernstein, a famous American financial historian and economist once
said, financial markets are a kind of time machine that allows selling investors
to compress the future into the present and buying investors to stretch the
present into the future.

What do financial markets do?

- Financial markets help direct the flow of savings and investment in the
economy from the suppliers of capital to the users of capital.
- This facilitates the allocation and deployment of scarce resources across time
and space in the economy.
- On one hand they enables individuals like us to save for retirement, afford to
buy homes or finance our education.
- They help entrepreneurs fund their businesses, grow their businesses and
develop new products and technologies.

Capital markets enable State and Local Governments to use the proceeds from
issuing municipal bonds to construct roads, schools and other public facilities.

What is a financial asset? And how is it different from a real asset?

- Financial Assets are essentially claims. They may be sometimes a piece of paper
or sometimes a computer entry but they are basically, claims to future cash
flows, usually generated by real assets.
- Real Assets are what produces the goods and services in the economy. They are
for example buildings, equipment, machines, land etc.
- For example if we can own an auto plant, which is a real asset, we can own
shares in Ford and share the income generated by the production of cars by
Ford.
- So in other words, while real assets generate the income in the economy,
financial assets determine the allocation of this income among investors.

Examples of financial assets:-

  A bond issued by the US Department of Treasury – In this case the US
Government is the issuer and it agrees to pay the investor, the owner of the
bond, interest until the bond matures and at maturity the principal amount, in
other words the amount borrowed.
 A bond issued by Apple or a bond issued by the state of California – These are
all fixed income securities with known fixed cash flows.
 A bond issued by the government of Greece – the cash payments are also fixed
and known if the Greece government doesn’t default, but the cash payment
may be denominated in euros, So from the US investors point of view the dollar
cash amount may not be certain, as it will depend on the exchange rate at the
time of the payment.
 A home mortgage loan – is an example of fixed income security. This time the
bank is the investor and has lent funds to an individual and the loan agreement
specifies a schedule of payments to the bank.
 Common stock issued by Microsoft – is an example of an equity security and it
entitles the investor to dividend payments if Microsoft pays any dividends. It
also entitles the investor to a claim on the pro rata share of the residual value
of the company if it is ever liquidated.
 The same applies to the cash payments on the common stock issued by Honda
Motor Company – however again the dividend payments are denominated in
Japanese Yen, and therefore from a US investor’s point of view, it is subject to
uncertainty depending on the exchange rate.
Diagram on classification of financial markets and instruments is in the handouts.

1. There are several ways of classifying financial markets and instruments. One
way is the type of the financial claim. The claims of the financial instrument can
either be fixed, a fixed amount or it could be residual claim.
2. Those that have fixed cash flow payments are called debt instruments and they
are traded in the debt market or the fixed income market.
3. Financial assets with a residual claim are called equity instruments and are
traded in the equity or stock market.
4. Preferred stock is a kind of hybrid instrument because it is an equity instrument
with equity claims, but it entitles the investors to receive a fixed cash flow so it
has also debt features.
5. Alternatively, we can classify financial marketing instruments by the maturity of
the claims.
6. For example, financial assets with short-term maturity are called money market
instruments and the traditional cut-off between short-term and long-term is
one year. So all instruments less than one year maturity, belong to the money
market. A financial asset with a maturity of more than one year is part of the
capital market. Since equity is perpetual, they belong to the capital market.
 7. So to summarize, fixed income securities are financial claims that have a
predetermined stream of cash flows in the future.
8. Those that have maturities less than one year are traded in the money market
and long term fixed income securities are traded in the debt market.
9. Equity securities on the other hand, are residual cash flow claims and they
represent ownership in a corporation.
 Derivative securities are contracts that derive their value from the price of the
underlying financial assets.

Quiz on a primer of financial assets

1. Real assets such as buildings, machines, land and knowledge are
- The means of production of goods and services of an economy.

2. Financial assets are securities in which individuals can invest their wealth with
the expectation to obtain a return in the future.
- True
Financial assets are claims to future cash flows, examples are bonds, stocks,
derivatives etc.

Basics of Bond Valuation

What will you learn?
 Learn key features of a bond issue
 Find the value of a zero-coupon bond
 Find the value of coupon bond
 Compute the yield to maturity of a bond

To value any financial asset we need 2 ingredients

1. We need the promised or the expected cash flows
2. We need an appropriately risk adjusted discounted rate, r.
To find the value of any financial asset, all we have to do is basically discount the cash
flows, the promised or the expected cash flows, at the appropriately risk-adjusted
discount rate.

What is a bond?
- A bond is a fixed income instrument, basically it’s an IOU (I owe you), a note
that promises to make specified future cash flows.
Bonds have typically two cash flows
- First they have the principle, or the face value at maturity. The face value is also
called the par value and is typically a $1000 for corporate bonds in the US.
- Second, a bond may also make periodic payments that are called coupons.
Coupons
- Periodic cash flows (called coupons = C)
- The coupons are specified by the coupon rate. Which is expressed as the
percentage of the face value.
- Coupon rate is not rate of the return or interest rate of the bond.
- Coupons payments have to be discounted in order to calculate the bond value.
- Coupons are usually paid semi-annually.
- For example, let’s say the face value of a bond is 1000 and the coupon rate is
5%. So we will get $50 periodically, annually in coupon payment. Typically the
coupon payments will be made semi-annually, so that each coupon will in fact
be $25.
Question: The value of a coupon bond is the discounted value of the face value of the
bond at maturity at time T.
- False

Zero Coupon Bonds

 Zero coupon bonds are the simplest financial assets, or bonds, to value because
they have only one single cash flow which is equal to the face value of the bond
at maturity.
 As the name suggests, they don’t have any coupons.
 Zero-coupon bonds have only one cash flow which is equal to the face value at
maturity.
 The value of a zero-coupon is simply the discounted value of the single cash
flow at maturity at time T.
Example: Suppose there is a one year zero-coupon bond with a face value of $10000,
and the one year discount rate is 5.35%. What should be the value of the bond
today? What should be the market value?
- In other words we have to find the discounted value of $10000
= 10000/ (1+0.0535) ^ 1 = $9492.17

What if we know the discounted rate i.e. the market price and the promised cash
flow i.e. the future value of a bond, we can ask what rate of return is being offered by
the bond. In other words we can solve for the discount rate that makes the price of
the bond equal to the present value of the promised cash flows?
So this is called the internal rate of return, or the yield to maturity of the bond.

Example: Suppose we have a 20 year bond, with a face value of $ 1 million (promised
cash flow) and the present value of the bond today is $455,500. What is the rate of
return or what is the internal rate of return on this bond or what is the yield to
maturity of this bond?
- 1,000,000 = 455,000 (1+r) ^ 20
 - 1,000,000 / 455,000 = (1+r) ^20
- 2.1978021978 ^ (1/20) = 1+r
- r = 0.040158 = 4.0158%
This is annually if we were using semi-annual compounding, then it would
compound twice every year, so n will become 40
Therefore, r will be 1.985%. So the annual yield would be twice that i.e. 1.985*2

Yield to Maturity
 Conversely we can ask what rate of return the bond promises, given the bond’s
promised cash flows and the current bond price.
 Yield to Maturity (YTM) = single interest rate that sets the price equal to the
present value (IRR).
 There is an inverse relationship between bond prices and yields.
 The yield to maturity is the discount rate that makes the present value of the
bond’s promised cash flows equal to its current price. When the bond is selling
at par, the yield to maturity is equal to its coupon rate.
 If the bond is selling at premium, which is at a price greater than its par value,
its yield to maturity should be less than the coupon rate.

Coupon Bond Valuation Example:

A 2 year bond with a face value of $1000, a coupon rate of 12% and semi-annual
coupon payments is sold in a market where the 12 month discount rate is 5.35%,
compounded semi-annually. What is the market value of the bond?
- 1000*12% = 120 Therefore semi-annually $60 will be the coupon amount
- $60 is paid 4 times in 2 years, so we have to find the present value of annuity
with the annuity discounting factor.
- And we also have to find the present value of $1000 today
- 60 * ADF (r=5.35%/2, n=4) + 1000/(1+0.0535/2)^4
- 60 * [1-1/(1+0.0535/2)^4] / 0.0535/2 + 1000/1.02675^4
- 224.770132 + 899.78998
- $ 1124.56

Summary
 Learn key features of a bond issue
 Find the value of a zero coupon bond
 Find the value of coupon bond
 Compute the yield to maturity of a bond

1. You expect the Federal reserve will begin to loosen credit and force yields down
by 50 basis points across all maturities in the very near future. (A basis point is
 equal to 1/100th of 1% so 50 basis points are equal to ½ of 1%) How do you
expect the Fed’s policy effect will show up in the bond market?
- Bond prices will increase (there is an inverse relationship between bond prices
and yields)

Fixed Income Securities: Money Market Instruments

What will you learn?
1. What is the money market?
2. What are the different types of money market instruments?
 Federal funds market, LIBOR market
 Treasury bills
 Repurchase (REPO) agreements
 Commercial Paper
 Certificates of Deposit
3. We look at longer term US treasury and corporate debt instruments in the next
chapter.

The Money Market

Money market consist of very short term fixed income securities. It is a very
important segment of financial markets, as it serves three important purposes.
 First, it provides investors, who would like to invest in very liquid assets, a
market where they can do so.
 Second, it provides those in need of short term liquidity a market where they
can borrow from.
 And finally, very importantly, it provides the Federal Reserve Bank, the US
Central bank, a channel to conduct its monetary policy by influencing the
availability and cost of liquidity in the money market.

Federal Funds Market

 Federal Funds are the funds that banks are required to maintain as reserves at
their local Federal Reserve Bank.
 Institutions with excess reserves can lend to other institutions in need of
federal funds.
 These unsecured interbank loans – typically overnight transactions – are
arranged at the federal funds rate.
 Key barometer of monetary policy.

London Interbank Offered Rate (LIBOR)

 The interbank funding rate at which banks can borrow on an unsecured basis in
the London money market is called the London Interbank Offer Rate, or LIBOR.
 LIBOR is calculated based on responses to a daily survey of large banks.
  Key interest rate as it is used as a reference interest rate in many derivative
contracts, commercial, consumer and mortgage loans.

LIBOR Rigging Scandal

 Does this survey-based borrowing cost truly reflect interbank funding cost?
 It emerged that participating banks were colluding to improve profits on their
derivative trades.
 Several banks have settled with large fines following lawsuits.

U.S Treasury Bills

 Debt securities that are issued by the U.S Treasury are backed by the full faith
and credit of the U.S government.
 Typically viewed as having no default risk
 Treasury securities are used to develop benchmark rates.
 Treasury bills are zero-coupon securities with maturities of one year or less.
 Issued at initial maturities of 4, 13, 26, and 52 weeks.
 Highly liquid, easily converted to cash, traded at low transaction cost.

Certificate of Deposit
 A certificate of deposit is a time deposit with a bank.
 The bank pays interest and principal to the depositor at the end of the fixed
term of the CD.

Commercial Paper
 Short-term unsecured debt notes issued by corporations typically for working
capital or short term financing needs.
 CP has maturities ranging from 1 day to 270 days
 An alternative to bank borrowing available to issuers with high credit ratings.
From the Wall Street Journal on June 17, 2015.
 “Mail and document services and software company Pitney Bowles Inc. used
the commercial paper market to help finance its acquisition last month of
Borderfree Inc. More companies have been turning to the commercial market
to complete deals.”
 “Verizon Communications, Inc., for example, announced in May it is financing
its $4.4 billion acquisition of AOL Inc. by selling commercial paper.

REPO Market
 Increasingly important role in the fixed income market as it is used by traders to
borrow and lend cash on a collateralized basis.
 A repurchase (REPO) agreement is the sale of a security with a commitment by
the seller to buy the security back from the purchaser at a specified price at a
designated date.
 A reverse repo is the opposite transaction: it is the purchase of a security for
cash with the agreement to sell it back to the original owner at predetermined
price.
 Collateralized