BINDURA UNIVERSITY OF SCIENCE EDUCATION

FACULTY OF COMMERCE

DEPARTMENT OF BANKING AND FINANCE

NAME NHOVA NICOLE

REG NO B1542563
PROGRAMME BANKING AND FINANCE
COURSE INVESTMENT ANALYSIS AND
PORTFOLIO MANAGEMENT
COURSE CODE BS419
LECTURER MR NJANIKE
ASSIGNMENT 2 INDIVIDUAL
a) What information is necessary before a financial planner can assist a person in
constructing an investment policy statement? (12)
b) Describe the alternatives to direct investment in foreign stocks available. (13)
c) Discuss briefly factors that are used to evaluate the creditworthiness of a potential
customer of a microfinance firm. (12)
d) Many investors called technical analysts claim to observe patterns in stock market
prices. Explain whether technical analysis is consistent with the Efficient Market
Hypothesis. [50 marks] (8)
a) What information is necessary before a financial planner can assist a person in
constructing an investment policy statement?
An investment policy statement (IPS) according to CFA (2010) serves as a strategic guide to
the planning and implementation of an investment program and if properly implemented, the
statement anticipates issues related to planning for appropriate asset allocation, governance of
the investment program, implementing an investment program with internal and/or external
managers, monitoring the results, risk management, and appropriate reporting. It acts as a
directive from the client to the investment manager about how the money is to be managed as
well as provide the guidelines for all investment decisions and responsibilities of each party.

Griswold (2011) added that the IPS must be flexible enough to guide the investment
managers through environments that may be different from those prevailing at the time of its
adoption.
Since the IPS is a highly customized document uniquely tailored to meet the preferences,
attitudes, and situation of each investor, financial planners are required to have a thorough
understanding of the investor’s objectives, restrictions, tolerance of risk, and preferences to
be able to develop a truly useful policy guide.
Investor’s objectives
Investors has unique investment objectives that are affected by short- and long-term needs
and requirements. Investor’s long-term objectives ranges from the need for supplemental
retirement income, large future expenditures such as the purchase of a house, educational
funding, or other long-term financial needs. The client’s investment goals must be clearly
stated in terms of both risk and return. Brown and Reilly (2009) added that investors’
objectives can also be the need for capital preservation or appreciation. A financial planner
needs to understand why his or her client wants to invest. Answering this question will assist
the planner in formulating an IPS that will meet the expectations of the investor. For instance,
if an investor’s objective is defined in terms of the need to preserve capital, then it makes
investment sense to invest such funds in money market instruments like treasury bills issued
by governments in stable economies rather that equities that are highly volatile.
Risk tolerance
In order to fulfill investment objectives, financial advisors and their clients need to evaluate
the risk appetite of the investor. Damodaran (2012) asserted that a client’s risk tolerance is
one most important factor in choosing an asset allocation mix in a portfolio and it also
determines the risk premium as well as the rate of return required by an investor.
Understanding one’s tolerance for risk is key to choosing an investment program. A financial
planner, before constructing an IPS, must look for ways to assess the risk appetite of his/her
client as this assessment will assist the planner to effectively pick assets that will meet the
investor’s objectives given his/her risk tolerance. Risk tolerance questionnaire can be utilized
to determine a client’s level of risk aversion and to make sure that the advisor has an accurate
measure of quantifying the risk. Lastly, risk tolerance can be influenced by various factors
like age, past experience and net worth implying that risk tolerance changes over time
demanding regular update of the investment policy statement.
Time horizon
In most cases, investors tend to have multiple investment objectives, each with a different
investment period. These time horizons of each client’s goal are important because they
affect an investor’s asset allocation, risk profile and how the investments might change over
time as the investor requires money to meet various goals like buying a house. In general, the
longer the time horizon, the better the investor can handle volatility and fluctuations in value
and take more risks in order to reap more returns. Bodie et al (2009) asserted that time
preferences vary among individuals but long term commitment of funds allows an investment
plenty of time to recover from market declines, industry shake-ups as well company setbacks.
Having noted the above, a financial planner needs to know the timeframe of the investment as
this will guide decisions on the type and nature of the investment.
Investor’s liquidity needs
One question a financial planner should ask a client to determine his or her liquidity needs is
whether the investor requires a portfolio that can be liquidated easily, or he or she can afford
to wait?”. Understanding the liquidity needs of an investor is important as this guides on the
classes of assets to include in the portfolio having the appropriate mix to meet the investment
objectives of the client given his/her risk appetite. Examples of liquid assets are money
market instruments and stocks issued by public listed companies. Liquidity considerations are
also important because of the inherent trade-off that exist between liquidity of an asset and its
returns. In most cases, greater liquidity generally results in lower return. For instance, a
money market fund is highly liquid with low risk but the price of this safety is a relatively
low yield compared to other alternative assets.
Investment Restrictions
Having established the investment objectives, tolerance of risk and time horizon of the
investments, a financial planner needs to know the various investment restrictions that are
imposed by the regulatory authorities in a given economy. This information is important
because investment restrictions determine the type of assets that can be used to meet an
investor’s goals by limiting investment in certain assets to a group of people or investors.
Take for example the Sharia investments, payment or receipt of interests is considered unjust
and debt issuance is also disapproved. Given such a case, a client whose objective is capital
preservation have to look for other types of assets other than debt securities. In our case in
Zimbabwe, foreigners are not allowed to hold more than 49% of a company’s outstanding
shares which acts as an investment restriction to foreign investors.
Investment methodology and the investor’s preferences
Bodie et al (2009) highlight that there are a variety of investment strategies portfolio
managers can follow in implementing an investment program. Financial planners need to
carefully evaluate the pros and cons of different approaches and check if the strategy to be
adopted will suit the investor’s preferences. This implies that before constructing an
investment policy statement, a financial planner must understand his/her client’s preferences
as that information will help guide various individuals responsible as market conditions
change and as the investor considers new investment vehicles and strategies in the future. For
instance, the investor’s time preference for current consumption affects the risk premium
implying that the return investors require increases as their preferences for current over future
consumption increases.

b) Describe the alternatives to direct investment in foreign stocks available.

International investing as an alternative to investing funds in one’s country can provide
investors with vast opportunities. Despite the fact that investing internationally enables
investors to avoid risks associated with their home countries such as country risk, there are
three barriers that are associated with committing funds in foreign financial instruments:
these are transaction costs, information costs and exchange rate risks. Mason (2007) indicated
that the effects of barriers were significantly reduced in recent years by the introduction of
automated trading systems, use of internet to access information about companies and the use
of derivatives like forward contracts to hedge against changing market rates.

Past researches indicate that investors can greatly benefit by diversifying internationally and
one method to do so is through direct investment in foreign stocks. Mason (2007) highlighted
two alternative method of investing directly in foreign stocks: investors can buy foreign
stocks from foreign stock exchange through a stock broking firm or alternatively investors
can purchase shares of foreign companies that are listed on the local bourse. Due to market
imperfections and limited number of foreign stock on any local stock exchange, this method
alone may not be adequate for an investor to enjoy the full benefits of international
diversification. This paper serves to discuss some of the alternatives to direct investment in
foreign stocks.
International Mutual Funds
One alternative method is to consider purchasing units in an international mutual fund (IMF).
These funds can be accessed from investment firms like Fidelity in the US and just like
domestic mutual funds, these funds are popular because of the low minimum investment to
participate in the fund, the presumed expertise of the portfolio managers, and the high level
of diversification achieved by the inclusion of different securities to the portfolio. Through
these funds, investors are able to purchase shares in a much diversified portfolio of foreign
investments as these IMFs resembles a prepackaged portfolio and investors who utilize them
do not need to create their own portfolios. Investors feel more comfortable when their
international investments are under the management of experts.

There are various types of funds that investors can use if they choose to go the “mutual
funds” way. The first type is a global fund which covers the entire when looking for
investments. This implies that with this type of fund, there are no restrictions to which
countries or regions to select securities that will constitute the fund portfolio. This fund also
enables investors to significantly lower the overall risk of investment because of negatively
correlated assets in the fund. An international fund is another fund that is offered by
investment firms and this fund concentrates on a particular region of the globe such as the
Eurozone or SADC.

There is also a country fund that selects one individual foreign country to invest in. portfolio
managers, in this case analyse different companies in that country and come up with a
portfolio consisting of the best performers. Lastly a sector fund invests in particular sectors
across multiple countries, like the energy sector.

One of the advantages of IMFs is enhance return portfolio by participating in foreign

exchanges with counters that may be growing at a faster rate that local companies. On the
other hand, political unrest and economic instability in these foreign countries could
negatively impact on the performance of the funds. Moreover, volatile foreign exchange rates
can increase or decrease the value of an investment even if the price is more or less the same.
Exchange Traded Funds
ETFs are sometimes referred to as world equity benchmark shares (WEBS) and these
represent market indexes that track the performance of stocks for particular countries.
According to Investopedia, investors can buy ETFs that track most of the major foreign
market indexes, thus allowing investors to obtain a return based on a foreign market without
having too much exposure from that market. Though ETFs, investors are able to invest
directly in a stock index representing any one of several countries.

ETFs are similar to IMFs but there exist a few differences between the two. As their name
suggests, ETFs are traded on the exchange implying that investors can trade in shares of
nearly any ETF as long as the exchange is open. Unlike in the case of ETFs, to buy or
liquidate a unit in a mutual fund, an investor will put an order for a share and it will be
processed at the end of the trading day at the net asset value of the fund. ETFs, on the other
hand enables investors to take advantage of price movements and do a trade if the price is in
their favor. Moreover, ETFs are accessed from various EFT providers but investors should
seek out low-cost, high-return funds that meet their investment objectives and risk appetite.
Brown and Reilly (2009)

It is important to highlight the downside of ETFs as a way of investing internationally. Since

ETFs are designed to track the performance of certain indices, investor is exposed to risk of
loss or volatility associated with the underlying index. There is also a possibility of tracking
rise, that is, disparities in performance between an ETF and its underlying index or asset.
These errors can be due to changes in the composition of the underlying index or asset and
the ETF provider’s replication strategy. Lastly, ETFs for assets denominated in foreign
currency expose investor to exchange rate risk and currency fluctuations affects the value of
an asset as well as the price of the ETF.
Depository Receipts
DRs are viewed as adequate substitutes for direct investing in foreign stocks. DRs are
negotiable financial instruments issued by a financial institution to represent a foreign
company’s traded securities. In the United States, American Depository Receipts are traded
on US stock exchanges but represents a number of stocks in a global corporation. With
ADRs, American financial institution purchases a specified number of shares of foreign
companies and then create a share that can be bought or sold on any American stock
exchange. Mason (2007) advanced that this share created will represent a certain number of
shares in the foreign company and these alternative is an excellent way for domestic investors
participate in international investing as it eliminates problems associated with investors
acquiring shares directly from the foreign company. Depository receipts make it easier to buy
foreign stocks because the shares do not have to leave the home country. Moreover, these
foreign stocks that are listed as ADRs on the US stock exchanges must comply with US SEC
regulations governing other local blue chip counters listed.

Worth mentioning is that even though ADRs are traded in US dollars on any US securities
exchange, any dividends declared and paid will be denominated in the foreign currency and
then converted into U.S. dollars upon distribution, thus introducing exposure to currency
exchange rate risk. Investment experts view ADRs as lacking in diversification because only
a portion of foreign companies offer ADRs. Lastly, in the event of liquidation, holders of
ADRs are not guaranteed to exercise their right of claim and may lose their entire investment.
Invest in stocks of Multi-National Corporations
MNC are companies with operations in several countries but managed from one country
(usually the home country). Brown and Reilly (2009) asserted that because MNCs derive
some of their revenues from other countries, MNCs represent international diversification and
by simply buying shares or bonds issued by such a company has more or less the same
benefits as direct purchase of foreign stocks. This implies that a MNC as a single firm can
achieve the same stability to an internationally diversified stock portfolio. However, research
studies have shown that diversification benefits from investing in a multinational company
are limited due to the fact that these firms are not affected by the operations of foreign stock
exchanges in countries where other operations are done.

Over and above allocating assets amongst different securities and industries, international
investing is a good alternative for diversification. It reduces the effect of a downturn of a
certain economy to an investor and also to increase returns on portfolios concentrated in
domestic markets that are no longer growing. Due to a lot of work involved in invest directly
in foreign stocks, alternatives covered in this paper are easy ways of participating in
international markets.

c) Discuss briefly factors that are used to evaluate the creditworthiness of a potential
customer of a microfinance firm.
Creditworthiness is a valuation performed by lenders that determines the possibility a
borrower may default on his debt obligations. It considers factors such as character, capacity,
capital, collateral, conditions and some look at inventory and receivables. Starting with
character,
Character.
This refers to the borrower's integrity and willingness to repay the financial obligation. In this
the microfinance will be assessing whether the borrower have a bad credit history, has the
borrower declared bankruptcy in the past, has he or she ever had a failed enterprise in the
past? And has the borrower failed to meet family obligations. A "yes" answer to any of these
questions could place the borrower's character in doubt. This is a highly subjective evaluation
of the business owner’s personal history. If it’s a company borrowing, then the Lenders have
to believe that a business owner is a reliable individual who can be depended on to repay the
loan. Background characteristics such as personal credit history, education, and work
experience are all factors in this business credit analysis. Griswold et al (2011). Lenders
want to deal with honest, ethical and fair borrowers. (The difference between the ability to
repay a loan and the willingness to repay a loan is an example of a person’s character.) The
knowledge, skills, and abilities of the owner and management team are vital components of
this credit factor.
Capacity.
This addresses the borrower's cash flow and ability to repay the debt from ongoing business
operations. Unforeseen business difficulties will always arise and the microfinance needs to
know how you will repay the funds before it will approve your loan. Accordingly, the use of
the borrowed funds must generate sufficient funds during the period of the loan to cover these
contingencies, and still have a generous amount left over in order to service any remaining
debts. Capacity is evaluated by several components, including the following: Cash Flow
which refers to the income an individual generates versus the expenses, Payment
history which refers to the timeliness of the payments that have been made on previous loans
and Contingent sources for repayment which are additional sources of income that can be
used to repay a loan. These could include personal assets, savings or checking accounts, and
other resources that might be used. Brown and Reilly (2009)
Capital.
This is the borrower's financial net worth. A significantly positive net worth has the potential
to offset insufficient cash flows, because financiers perceive the borrower still has more than
adequate means to repay the loan. In terms of small businesses borrowing a Capital is the
owner’s personal investment in his/her business which could be lost if the business fails.

Collateral.
This refers to any property owned by the borrower that can be pledged for security. If the
property has been previously pledged against another loan, financiers would probably not
consider it available to be pledged again until the previous loan has been paid off. Collateral
might consist of financial instruments, houses, cash, or even objects such as art, jewelry,
Conditions.
These refer to economic, industrial and company-specific prospects and events that may
occur during the period of the loan that could have a significant effect on your company. This
is an overall evaluation of the general economic climate and the purpose of the loan. These
might include rising raw material prices, an employee strike, increasing interest rates, etc.
Economic conditions specific to the purpose of the loan as well as the overall state of the
country’s economy factor heavily into a decision to approve a loan. For example, if it’s a
small firm borrowing during a time of economic growth, there is more of a chance that the
loan will be granted than if the industry is declining and the economy is uncertain. Typical
factors included in this evaluation step include: the strength and number of competitors, size
and attractiveness of the market, dependence on changes in consumer tastes and preferences,
customer or supplier concentration, length of time in business, and any relevant social,
economic, or political forces that could impact the business. Griswold et al (2011).
d) Many investors called technical analysts claim to observe patterns in stock market
prices. Explain whether technical analysis is consistent with the Efficient Market
Hypothesis.

In finance, technical analysis is an analysis methodology for forecasting the direction of

prices through the study of past market data, primarily price and volume. Behavioral
economics and quantitative analysis use many of the same tools of technical analysis, which,
being an aspect of active management, stands in contradiction to much of modern portfolio
theory. The efficacy of technical analysis is disputed by the efficient-market hypothesis
which states that stock market prices are essentially unpredictable.

Technical analysts use market indicators of many sorts, some of which are mathematical
transformations of price, often including up and down volume, advance/decline data and
other inputs. These indicators are used to help assess whether an asset is trending, and if it is,
the probability of its direction and of continuation. Technicians also look for relationships
between price/volume indices and market indicators. Examples include the moving average,
relative strength index, and MACD. Other avenues of study include correlations between
changes in Options (implied volatility) and put/call ratios with price. Also important are
sentiment indicators such as Put/Call ratios, bull/bear ratios, short interest, Implied Volatility,
etc. There are many techniques in technical analysis. Adherents of different techniques (for
example, Candlestick analysis -the oldest form of technical analysis developed by a Japanese
grain trader, Harmonics, Dow theory, and Elliott wave theory) may ignore the other
approaches, yet many traders combine elements from more than one technique. Some
technical analysts use subjective judgment to decide which pattern(s) a particular instrument
reflects at a given time and what the interpretation of that pattern should be. Others employ a
strictly mechanical or systematic approach to pattern identification and interpretation.
Lawrence (1977).

A core principle of technical analysis is that a market's price reflects all relevant information
impacting that market. A technical analyst therefore looks at the history of a security or
commodity's trading pattern rather than external drivers such as economic, fundamental and
news events. It is believed that price action tends to repeat itself due to the collective,
patterned behavior of investors. Hence technical analysis focuses on identifiable price trends
and conditions.

Based on the premise that all relevant information is already reflected by prices, technical
analysts believe it is important to understand what investors think of that information, known
and perceived. Technical analysts believe that prices trend directionally, i.e., up, down, or
sideways (flat) or some combination. The basic definition of a price trend was originally put
forward by Dow theory. Technical analysts believe that investors collectively repeat the
behavior of the investors that preceded them. To a technician, the emotions in the market may
be irrational, but they exist. Because investor behavior repeats itself so often, technicians
believe that recognizable (and predictable) price patterns will develop on a chart. Recognition
of these patterns can allow the technician to select trades that have a higher probability of
success. Technical analysis is not limited to charting, but it always considers price trends. For
example, many technicians monitor surveys of investor sentiment. Jarrett (2010).
These surveys gauge the attitude of market participants, specifically whether they are bearish
or bullish. Technicians use these surveys to help determine whether a trend will continue or if
a reversal could develop; they are most likely to anticipate a change when the surveys report
extreme investor sentiment. Surveys that show overwhelming bullishness, for example, are
evidence that an uptrend may reverse; the premise being that if most investors are bullish
they have already bought the market (anticipating higher prices).

And because most investors are bullish and invested, one assumes that few buyers remain.
This leaves more potential sellers than buyers, despite the bullish sentiment. This suggests
that prices will trend down, and is an example of contrarian trading.
The efficient-market hypothesis (EMH) contradicts the basic tenets of technical analysis by
stating that past prices cannot be used to profitably predict future prices. Thus it holds that
technical analysis cannot be effective. EMH advocates reply that while individual market
participants do not always act rationally (or have complete information), their aggregate
decisions balance each other, resulting in a rational outcome (optimists who buy stock and
bid the price higher are countered by pessimists who sell their stock, which keeps the price in
equilibrium). Coffey (2011)

The crux of the argument between the EMH and technical analysis is the role of historical
data. Technical analysts argue that prices and investors tend to follow predictable patterns.
Once identified, those patterns can be used to anticipate future trading opportunities for above
market-average returns. According to the EMH, security prices already reflect all available
information. This includes investor sentiment about possible price trends and all recurring
phenomena that might produce those trends again. Moreover, the EMH challenges the notion
that past price and volume data have any relationship with future movements

Technicians say that EMH ignores the way markets work, in that many investors base their
expectations on past earnings or track record, for example. Because future stock prices can be
strongly influenced by investor expectations, technicians claim it only follows that past prices
influence future prices. Malkiel (2003). They also point to research in the field of behavioural
finance, specifically that people are not the rational participants EMH makes them out to be.
Technicians have long said that irrational human behaviour influences stock prices, and that
this behaviour leads to predictable outcomes.
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Bodie, K., Kane, A. and Marcus, A. J. (2004). Investments. McGraw-Hill International. 4th
Edition.

Damodaran, A. (2012). Equity Risk Premiums (ERP): Determinants, Estimation and

Implications. Stern School of Business

Greg Coffey, CFA, Client Service Manager. Russel Research Investments, June 2011.
Griswold, J. S. and Jarvis, W. F. (2011). The Investment Policy Statement. Common fund
Institute.

Griswold, J. S. and Jarvis, W. F. (2011). The Investment Policy Statement. Common fund
Institute.

Jarrett, E.J., (2010). Efficient markets hypothesis and daily variation in small Pacific-basin
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Lawrence J Gitman (1977), Principles of Managerial Finance, 11 th edition, United States, San
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Mason, O. H. (2007). Investing in International Financial Markets. Thomson-South Western

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www.moneymatters360.com: 20/10/2014

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