Investment Analysis and Portfolio

Management
First Canadian Edition

3 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

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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

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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

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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

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 The Case for Global Investment

Relative Size of Financial Markets

Share of U.S. 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 $2.3 trillion in
1969 to $103 trillion in 2006
U.S. portion has declined to less than half

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The Case for Global Investments

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The Case for Global Investments:
Bond Markets

The performance of the Canadian bond market ranked higher

than the U.S. bond market due to the weaker Canadian dollar
during the period.

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The Case for Global Investments:
Equity Markets

Investors that limit themselves to domestic markets may

experience below average ROI.
Notice that Canadian and Mexican equity markets produced
comparatively high returns in the 2003-06 period.
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 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.

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 The Case for Global Investments:
Diversification
Diversified portfolios reduce variability of returns
over time.
Correlation coefficients measure diversification
contribution.
Correlations range from -1.00 to +1.00
Combining investments with perfect positive
correlation will NOT help diversification.
Combining two assets with negative correlation is
ideal for diversification

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 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,
economic growth &
fiscal & monetary
policies differ between
countries

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 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

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 The Case for Global Investment:
Global Equity Portfolio
Low Positive
Correlation
Correlation of world
equity markets
resembles that for
bonds
CanadaU.S.
correlation is relatively
low ranging from .537
to .635 but is a very low
.389 when comparing
Canada & Japan

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 The Case for Global Investment:
Global Equity Portfolio & Risk Reduction

Opportunities to
reduce risk of a
stock portfolio by
including foreign
stocks

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 Global Investment Choices

Fixed-Income Investments
Bonds and preferred stocks
International Bond Investing
Eurobond, Maple bonds, international domestic bonds
Equity Instruments
Special Equity Instruments
Warrants and options
Futures Contracts
Investment Companies
Real Estate
Low-Liquidity Investments
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 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

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 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

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 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)

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 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

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 Preferred Stock (Equity)

Hybrid security
Fixed dividends
Dividend obligations are not legally binding, but
must be voted on by the board of directors to be
paid
Most preferred stock is cumulative
Credit implications of missing dividends

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 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. to non-U.S. investors

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 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

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 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.S. investors

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 International Bond Investing

International domestic bonds

Sold by issuer within its own country in that
countrys currency
Example: bond sold by Nippon Steel, denominated in
yen. A Canadian investor could purchase this bond by
exchanging Canadian dollars for yen and then purchase
the bond. However, the Canadian investor would be
exposed to foreign exchange rate risk.

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 Equity Instruments

Common Stock
Represents ownership of a firm
Investors return tied to the performance
of the company and may result in loss or
gain

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 Equity Instruments

Common Stock Classifications

Industrial: manufacturers of automobiles,
machinery, chemicals, beverages
Utilities: electrical power companies, gas
suppliers, water industry
Transportation: airlines, truck lines, railroads
Financial: banks, savings and loans, credit unions

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 Buying Foreign Equities

American Depository Receipts (ADRs)

Easiest way to directly acquire foreign
shares
Certificates of ownership issued by a U.S.
bank that represents indirect ownership of
a certain number of shares of a specific
foreign firm on deposit in a U.S. bank in
the firms home country

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 Buying Foreign Equities

Buy and sell in U.S. dollars

Dividends in U.S. dollars
May represent multiple shares
Listed on U.S. exchanges

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 Buying Foreign Equities

Global Mutual Funds or ETFs

Global funds: Invest in both U.S. and
foreign stocks
International funds: Invest mostly outside
the U.S.

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 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

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 Equity Derivatives: Warrants

Warrants
An options issued by a company giving the
holders the right to buy its common stock
Normally issued with bonds

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 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

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 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, soybeans, oil

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 Financial Futures

Recent development of contracts on financial

instruments such as T-bills, Treasury bonds, 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
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 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

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 Investment Companies

Money-Market Funds
Acquire high-quality, short-term investments
Yields are higher than normal bank CDs or GICs
Typical minimum investment is $1,000
No sales commission charges
Withdrawal is by cheque with no penalty
Investments usually are not insured
Total value reached more than $2.5 trillion in
2007

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 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
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 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

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 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

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 Real Estate

Real Estate Investment Trusts (REITs)

Investment fund that invests in variety of real
estate properties, 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

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 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,
taxes, and property maintenance

Land Development
Divide the land into individual lots
Build houses or a shopping mall on it
Requires capital, time, and expertise

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 Low Liquidity Investments

Some investments dont 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

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 Low Liquidity Investments

Antiques
Dealers buy at estate sales, refurbish, 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

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 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

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 Low Liquidity Investments
Coins and Stamps
Enjoyed by many as hobby and as an investment
Market is more fragmented than stock market, 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

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 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, storage, and appraisal

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 Historical Risk Returns
on Investments
Reilly and Wright
(2004) examined
the performance
of various
investment
alternatives from
the Canada, the
U.S, Europe,
Japan, and the
emerging markets
for the period
1993-2009 (CAD)
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 Historical Risk Returns
on Investments

The expected
relationship
between annual
rates of return
and total risk
(standard
deviation) of
these securities
was confirmed

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 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

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 Correlations Between
Various Capital Markets

A good hedge
should have a
strong positive
correlation with
inflation

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