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Contents
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Preface 1
Contents 16
Chapter 1: Investment Environment 17
Meaning of investment
Investing versus financing
Investment management process
Direct versus indirect investing
Investment environment
Summary
Chapter 2: Investment in Stocks 60
Stock as specific investment
Stock analysis for investment decision making
E-I-C analysis
Fundamental analysis
Decision making of investment in stocks
Stock valuation
Market Efficiency
Formation of stock portfolios
categories of stocks
Strategies for investing in stocks
Summary
Chapter 3: Investment in bonds 101
Identification and classification of bonds
Bond analysis: structure and contents
Quantitative analysis
Qualitative analysis
Market interest rates analysis
Decision making of investment in bonds
Bond valuation
Strategies for investing in bonds
Summary
Chapter 4: Technical Analysis and Behavioral Finance 140

3
 The efficient market
The Behavioral Critique
Evaluating the Behavioral Critique
Technical Analysis and Behavioral Finance
Trends and Corrections
Dow Theory
Point and figure charts
Moving averages
Summary
Chapter 5: Quantitative methods of investment analysis 177
Investment income and risk
Return on investment and expected rate of return
Investment risk. Variance and standard deviation
Relationship between risk and return
Covariance
Correlation and Coefficient of determination
Relationship between the returns on asset and
market portfolio
The characteristic line and the Beta factor
Residual variance
Summary
Chapter 6: Theory for investment portfolio formation 221
Markowitz portfolio theory
Indifference Curves for a Risk-Averse Investor
Capital Market Line (CML)
Efficient Frontier
Expected Rate of Return and Risk of Portfolio
Capital Asset Pricing Model (CAPM)
Beta Coefficient

Chapter 7: Capital Budgeting Techniques 266

Active versus passive portfolio management
Strategic versus tactical asset allocation
Monitoring and revision of the portfolio
Portfolio performance measures
Manager Continuation Policy

4
15
Preface

History

The beginnings of a separate industry

The process of managing money has been around for approximately
140 years. At its outset, investment management was relationship-
based. Assignments to manage assets grew out of relationships that
banks and insurance companies already had with institutions—
primarily companies or municipal organizations with employee
pension funds—that had funds to invest. These asset managers were
chosen in an unstructured way, with assignments growing out of
preexisting relationships rather than through a formal request for
proposal and bidding process. The actual practice of investment
management was also unstructured. Asset managers might simply
pick 50 stocks they thought were good investments as there was
nowhere near as much analysis on managing risk or organizing a fund
around a specific category or style. Historically, managed assets were
primarily pension funds. Traditional and alternative asset classes such
as retail funds, hedge funds and private equity had yet to mature.
The rise of the retail fund
Historians cite the closed-end investment companies launched in the Netherlands
by King William I during 1822 as the first retail funds, while others point to a
Dutch merchant named Adriaan van Ketwich whose investment trust, created in
1774, may have inspired the idea. The Boston Personal Property Trust, formed
in 1893, was the first closed-end fund in the US. The first modern mutual fund
was created in 1924, when three Boston securities executives pooled their
money for investment. Retail funds were normally used by financially
sophisticated investors who paid a lot of attention to their investments. They
really came to prominence in the early- to mid-1980s, when mutual fund

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Preface

investment hit new highs and investors reaped impressive returns. During this
time, investor sophistication increased with the advent of modern portfolio
theory and asset management firms began heavily marketing retail funds as a
safe and smart investment tool, pitching to individual investors the virtues of
diversification and other benefits of investing in retail funds.
Modern Portfolio Theory
Modern Portfolio Theory (MPT) was born in 1952, when University of Chicago
economics student Harry Markowitz published his doctoral thesis, ―Portfolio
Selection,‖ in the Journal of Finance. Markowitz, who won the Nobel Prize for
economics in 1990 for his research and its far-reaching effects, provided the
framework for what is now known as Modern Portfolio Theory. MPT quantifies
the benefits of diversification, looking at how investors create portfolios in order
to optimize market risk against expected returns. Assuming all investors are risk
averse, Markowitz proposed that when choosing a security to add to their
portfolio, investors should not base their decision on the amount of risk an
individual security has, but rather on how that security contributes to the overall
risk of the portfolio. To do this, Markowitz considered how securities move in
relation to one another under similar circumstances. This is called ―correlation,‖
which measures how much two securities fluctuate in price relative to each
other. Taking this into account investors can create ―efficient portfolios,‖ ones
with the highest expected returns for a given level of risk.
Traditional vs. alternative asset managers
By the early 1970s, the investment management industry had begun to mature as
retail funds and other asset classes gained prominence. The dominant theme over
the past decade has been the proliferation of alternative asset managers. It is
necessary to make the distinction between traditional asset managers and
alternative asset managers. Traditional asset managers, such as retail funds, are

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Preface

highly regulated entities that are governed by strict laws. In the UK, the
Financial Services Authority (FSA) is the principal governing body, and its rules
are designed to protect investors and limit unnecessary risk-taking. Traditional
asset managers have defined investment mandates that determine what types of
securities and strategies they can pursue in a given portfolio. These strategies are
discussed in detail in further chapters.

Alternative asset managers include assets classes such as hedge funds, private
equity and venture capital. For much of their existence, the hallmark of these
investment vehicles was light (or nonexistent) regulatory constraints and their
freedom to operate without defined investment strategies or transparent risk
tolerances. As a result, these asset classes evolved almost without correlation to
the broad stock and bond markets, and sought to provide ―alpha‖ returns in a
variety of economic situations. Hedge funds, for example, are high-risk money
managers that borrow money to invest in a multitude of stocks, bonds and
derivatives. They use a large equity base to borrow more capital and therefore
multiply returns through leveraging. Alternative investments can be extremely
lucrative, but they are also extremely risky, so individual investors who wish to
join this high-flying world must be ―accredited‖—in other words, they need to
have sufficient net worth, typically six figures and up, to invest. Recently
pension funds have become major investors in hedge funds, hoping to reap the
same outsized returns as other high-net-worth investors.

Europe holds its own

The United States is the world’s leading country when it comes to assets under
management with about 50 per cent of the world’s assets under management.

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But the UK has recently grown to join the US as a major market for fund
management. At the close of 2007, before the worst of the credit crisis struck,
UK fund managers were responsible for a record £4.1 trillion. For all of Europe,
assets under management totaled €13.6 trillion at the end of 2007. This figure
dropped to around €10.7 trillion by the end of 2008, but rose to €14 trillion by
the end of 2011.
Unsettled times
How did the credit crunch hurt the asset management industry? First and
foremost, the lack of credit meant a lack of leverage for fund managers, which
reduced the size of the best they could make and thereby lowered returns.
Spinoffs, sales and downsizing at major investment banks made an additional
impact on those banks’ asset management divisions. Ironically, the fact that
some asset management divisions performed well despite the crisis made them
more likely to be sold, because banks knew they’d be attractive on the market.
As an example, Citigroup sold its own asset management division in 2005. But
as one of the hardest-hit banks in the credit crisis, Citi was forced to continue
divesting units that weren’t part of its traditional banking businesses, so in 2009
it sold its entire stake in Japanese asset manager Nikko Asset Management. The
trend continued in Europe: Barclays put its successful asset management
division, Barclays Global Investors, up for sale in order to streamline itself and
boost capital ratios, and the beleaguered Commerzbank sold its Swiss asset
management unit to Liechtenstein-based asset manager LGT Group. ―Focusing
on core banking activity‖ was the name of the game for battered banks around
the world.
Different kinds of deals
Consolidation in the asset management industry is hardly a recent development.
In the last two decades, over 150 firms have merged or combined forces;

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American investment management giant Black Rock owes much of its clout to
acquisitions, including its purchases of State Street Research Management,
Merrill Lynch Investment Managers, Quellos Capital and R3 Capital
Management, all deals that closed between 2005 and early 2009. And in June
2009, Black Rock announced that it would pay $13.5 billion for Barclays Global
Investors, a transaction that made Black Rock the biggest money manager in the
world (as of July 2013, Black Rock had $3.8 trillion in assets under
management). One month later Crédit Agricole and Société Générale unveiled a
deal to combine their asset management operations into a single entity, which
controlled €591 billion of assets at closing and became Europe’s fourth-largest
asset manager. Mergers and acquisitions in the asset management industry were
hot during 2007, with plenty of takeovers by private equity firms and lucrative
sales of hedge fund assets. In fact, over a dozen transactions in 2007 were valued
at $1 billion or more. However, in 2008 just three deals fetched such high prices,
and disclosed deal value was just $16.1 billion, compared to $52.1 billion in
2007. And no wonder: almost two-thirds of the transactions in the second half of
2008 were related to divestitures, evidence of sellers’ distress and the need to
offer units at fire sale prices. In another shift, investment banks and insurance
companies—major buyers of asset management firms in the late 1990s and early
2000s—became sellers, unloading their purchases to private equity buyers or
entering into strategic partnerships to form pure-play asset managers.

In 2009, the deals kept coming and, overall, for the year, $4 billion in assets
under management changed hands, either as part of acquisitions or divestitures.
In 2010, global deals in the asset management industry saw a slight increase
versus 2009, but M&A deals slowed significantly in 2011. In fact, according to a
report published in February 2012 by PricewaterhouseCoopers, which closely

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Preface

analyzes the asset management industry, ―Volatile markets, increased regulatory

and economic uncertainty, decreasing availability of debt funding, and
differences in valuations between buyers concerned with overpaying and sellers
reluctant to accept lower prices made 2011 the least active and lucrative year for
mergers and acquisitions in the global asset management industry since 2006.‖
However, 2011 did see a few large deals, including Henderson Group’s $584
million acquisition of British firm Gartmore Investment Management, and
Invesmentaktiebolaget Latour’s $576 million acquisition of Swedish firm Saekl
AB. PwC also noted in its report that ―potential divestiture of asset management
divisions by European banks, continuing improvement in valuations and
stronger interest from buyers are likely to make 2012 a better year.‖
Bigger, not necessarily better
Big firms in the index tracking business have limited costs. However, being too
big and trying to beat the market can be a disadvantage. The bigger a portfolio
is, the more likely it is to resemble the market. That is why there has been a rise
in the number of ―boutique managers,‖ smaller firms that concentrate on niche
markets and try not to get too big in order to keep returns high. This proved to be
the case. According to Sandler O’Neill’s Asset Manager Transaction Review,
investment management M&A deals rose 6.8 per cent in 2012; the total assets
under management that changed hands equaled $1.5 trillion. The reasons for the
rise included improving stock markets, the fear of rising taxes and finance firms
selling off non-core units. Three of the largest deals of the year in the investment
management sector were Janus Capital Group’s $153 billion sale of a minority
stake to Dai-ichi Life Insurance, Société Générale’s $127 billion sale of TCW
Group to the Carlyle Group and TCW management, and Bridgewater
Associates’ $112.4 billion sale of a minority stake to the Texas Teacher
Retirement System.

Investment Management
Preface

The world is watching

The second half of 2008 saw unprecedented government intervention in the
financial sector. The US Federal Reserve bailed out investment bank Bear
Stearns and engineered a hasty sale to JPMorgan Chase; amidst controversy that
has yet to settle, American authorities later allowed Lehman Brothers to
collapse, and the remains of Lehman’s businesses were snapped up by several
international buyers. In the UK, more than €47 billion was poured into a bank
bailout plan. Among the largest recipients of funds were Lloyds TSB, HBO S
plc and the Royal Bank of Scotland; Lloyds and HBO S were subsequently
combined to form the Lloyds Banking Group. Similar stories played out in
France, Germany and Italy. These capital infusions came with strings attached,
like increased lending requirements, new leverage rules and limits on executive
compensation and bonuses.

Indeed, the lasting legacy of the world financial crisis may be tougher
regulations and heightened scrutiny of executive compensation. Hedge fund
owners, alternative asset managers and investment bankers have been criticized
for taking home millions, if not billions, while others scrape by on
unemployment benefits and food stamps. (Those financiers who made their
windfalls by shorting the subprime junk that created the crisis have drawn extra
ire.) In 2009, the UK’s Financial Services Authority drafted new codes designed
to minimize what it calls ―excessive‖ risk-taking by tying compensation to risk
management. The codes touched on everything from makeup of remuneration
committees to mandatory annual reports on pay and performance measurement.
In 2010 it was announced that the UK’s Financial Services Authority would be
replaced by two new regulatory agencies—the Financial Conduct Authority and
the Prudential Regulation Authority. The Bank of England would also take over

Investment Management
Preface

some of the regulatory duties of the FSA. And in the third quarter 2012, new
regulation went into effect in Europe that altered the manner in which trades are
executed in the world’s $700 trillion over-the-counter (OTC) derivatives market.
In the past, the OTC derivatives market was largely self-regulated; the aim of
new regulation is to increase transparency and liquidity and decrease risk, thus
mitigating the likelihood that trading in OTC derivatives will quickly strain the
health of financial firms like it did during the financial crisis of 2008. To that
end, new regulation mandates that trades be cleared through central clearing
counterparties, thus making OTC derivatives more like exchange-traded
financial instruments.

Perhaps underscoring the need for such regulation, in the second quarter of 2012
it was revealed that a London-based trader with JPMorgan Chase (the trader was
nicknamed ―The London Whale‖ by the media) had placed a massive bet in the
credit derivatives market, leading to the loss of more than $5 billion. In the
aftermath of the revelation of the loss, JPMorgan Chase’s market capitalization
fell by $14 billion. Jamie Dimon, the CEO of JPMorgan Chase, had previously
been an outspoken opponent of much of the new securities regulation in the US,
fervently lobbying against the Dodd-Frank Act’s so-called Volcker Rule, which
limits banks’ ability to trade their own capital. But after the London Whale
controversy, Dimon lessened his criticism of new securities regulation, even
going as far as saying, in one public speech, ―I don’t disagree with the intent of
the Volcker Rule.‖
Pension reform, controversy and opportunities
Throughout Europe, pension reform has become a politically explosive topic—
one that’s being watched closely by banks in London, Frankfurt and New York,
not to mention millions of workers across the continent. The problem, quite

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Preface

simply, is that Europe’s population is getting older. Projections suggest that in

2030 there will be 24 million more people aged 55 to 64 than there was in 2005.
Meanwhile, the number of people aged 15 to 64, the so-called working age
population, is expected to decrease by 20.8 million over the same period of time.
Finland’s ratio of pensioners to workers is the highest in Europe: it will reach 41
per cent by 2025. Pension schemes in Europe follow a ―pay-as-you-go‖
arrangement, which means that money paid into the retirement system by
today’s workers is immediately transferred to today’s retirees. As the ratio of
pensioners to workers increases, there will be greater burden on workers to pay
for their retirements. Governments in Western and Eastern Europe are taking
two key steps to address this problem: first, they’re gradually rising the
minimum retirement age. Second—and more importantly, from an investment
manager’s point of view—they are shifting responsibility to private investment
plans, instead of state-run pension schemes. At the same time, many nations are
increasing the requirements for defined benefit contributions. While these
changes have prompted union strikes and street protests in some countries, they
present opportunities for investment managers in Europe, who are now
marketing a variety of investment options to younger workers.

There’s always tomorrow

As long as there are assets and investors who desire yields, whether from risky
short-term ventures or more secure long-term investments, there will be an asset
management industry. And though the global economy may be edging its way
toward a recovery, the effects of the economic crisis will be felt for some time.
Credit is neither as cheap nor as plentiful as it was before the crunch, and many
investors have sharply reduced tolerance for risk and exposure to volatile
equities. In a way, however, the grim headlines of 2008 and early 2009 helped

Investment Management
Preface

prove the value of reputable, skilled investment management professionals. As

European pension funds reported record deficits, more and more workers turned
to private investment plans to secure their futures. Disgraced American financier
Bernie Madoff brought the phrase ―Ponzi scheme‖ to breakfast tables around the
world, as details of his $50 billion swindle were uncovered by US authorities.
Tragically, many of Madoff’s victims lost their life savings—and pulling hedge
funds under regulatory control is now a priority for the United States and
Europe. Given the amount of suspicion in the media and in public opinion,
investment management firms that can establish themselves as trustworthy
financial guides will be able to distinguish themselves. As part of Europe’s
financial services industry, asset management has become increasingly
important. London is now one of the world’s top centers for international fund
management, and Europe holds approximately one-third of the world’s
investment fund assets.
Convergence
Managers are competing increasingly closely as the lines between the asset
classes become blurred. Investors increasingly understand how to invest and
which investments could generate higher returns in a regulated environment.
Regulators have realized this and are now offering traditional asset managers
new flexibility as long as investors remain protected. The search for the alpha
has aided the process. Traditional asset managers have been buying hedge fund
boutiques for some time. But now the difference between these businesses and
their core investment strategies are disappearing. Long-only managers are also
using regulatory devices such as UC ITS III (and soon, UC ITS IV) to offer
hedge fund products for retail investors and other products to widen the choice
for their institutional investors. Meanwhile, alternative asset managers are
reaching a wider audience among investors through regulated fund vehicles and

Investment Management
Preface

eschewing offshore domiciles of the Caribbean and the British Isles for EU
member states, such as Luxembourg. Even the staid European pension fund
industry holds approximately 20 per cent of its assets in alternatives, including
hedge funds, private equity and real estate funds, according to the Alternative
Investment Management Association (AIMA), the global hedge fund
association. There is convergence among alternative assets, too. Private equity
houses and hedge funds are frequently adopting similar investment strategies.
Cheap credit, low volatility and rising equity markets encouraged.
UCITS
UCITS, Undertakings for Collective Investment. In Transferable Securities, is a
European Directive first enacted in 1985 by the European Commission. The
main point of UCITS is to enable funds to be ―passported‖ to other EU countries
and sold with minimum interventions by national governments and regulators.
Indeed, international regulatory barriers have been eroded by UCITS,
accelerating the development of the cross-border funds market. UCITS III,
enabled in 2002, provides increased investment flexibility by expanding the
investments in which a fund can take positions. Next up: UCITS IV, which has
been approved by the European Parliament and took effect in 2011. UCITS IV
will simplify administrative requirements for cross-border distributed funds, and
will give management companies a passport to manage funds across borders
without having to go through a service provider in the fund’s domicile. Because
of these and other enhancements, the new directive is expected to increase the
number of small funds that merge into mega-funds capable of cross-border
distribution. At the same time, UCITS IV aims to strengthen existing regulations
with provisions for greater transparency to investors and required disclosures by
funds.
Back and forth between bonds and equities

Investment Management
Preface

Bonds are safe and equities are risky, or so the theory goes. Experienced fund
managers know the real trick is to maintain diversified portfolios, spreading risk
between stocks and bonds. If the recent economic crisis taught us anything, it’s
that even safe bets aren’t necessarily safe. Still, in times of uncertainty
investment assets tend to flow into bonds. That’s precisely what happened in the
UK during the 1970s, when stagflation ran rampant and equities were
performing poorly. These conditions sent investors flocking to secure bonds like
government debt. The advent of high-performing tech stocks in the early- and
mid-1990s made equities more attractive, but then the dot-com bubble burst and
ruined the party. According to some estimates, pension funds moved £40 billion
out of equities and into bonds in 2004 alone. A brief shift back to equities was
spurred by weakening bond yields and economic growth until the credit crisis set
investors running back to high-quality debt, like investment grade corporate and
government bonds.
Eye on exchange traded funds
As the name implies, exchange traded funds are bought and sold on stock
exchanges, and some say they are undermining the traditional business model of
asset management. One thing’s for certain, ETFs have grown exponentially in
recent years: from September 2008 to May 2009, almost 49 billion ETF shares
changed hands each month. For the same period in 2007 to 2008, ETF volume
averaged just 20.5 billion shares per month. According to industry estimates,
ETF assets will reach $3.8 trillion by 2016. As of June 2013, global assets under
management in ETFs totaled $2.1 trillion, up more than 10 per cent since the
beginning of 2013. In Europe, ETF assets grew by 14.4 per cent to €309.5
billion during the 12-month period ending May 31, 2013. Remarkably, the
burgeoning ETF market is less than two decades old. These instruments were
invented as open-end index funds that are like mutual funds in many ways;

Investment Management
Preface

underlying the ETF is a bundle of assets and securities in which investors hold
an interest. The difference is that stakes in an ETF are easy to buy and sell
through a retail broker—buy now, sell tomorrow, repeat. Lately more complex
ETFs have made their way to the market. These include hedge fund ETFs and
leveraged ETFs, which seek higher-than-standard returns by relying on futures
options, swaps and other exotic derivatives. In spring and summer 2009,
leveraged ETFs were the subject of regulatory scrutiny, as the US Financial
Industry Regulatory Authority issued warnings that leveraged ETFs might be too
risky for retail customers.
More than just investment
More than ever asset management companies are focusing on more than just
investing. Business decisions such as marketing and distribution, global growth
and technology integration are becoming increasingly important factors in the
success of investment management firms. While this guide will focus mainly on
developing a career on the investment side of the investment management
industry, we will also spend some time discussing the growing alternative career
opportunities relating to these ―non-investment‖ business issues.
Course Objectives
Investment analysis and portfolio management course objective is to help
entrepreneurs and practitioners to understand the investments field as it is
currently understood and practiced for sound investment decisions making.
Following this objective, key concepts are presented to provide an appreciation
of the theory and practice of investments, focusing on investment portfolio
formation and management issues. This course is designed to emphasize both
theoretical and analytical aspects of investment decisions and deals with modern
investment theoretical concepts and instruments. Both descriptive and
quantitative materials on investing are presented.

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Upon completion of this course the entrepreneurs shall be able:

• To describe and to analyze the investment environment, different types of
investment vehicles.
• To understand and to explain the logic of investment process and the contents
of its’ each stage;
• To use the quantitative methods for investment decision making – to calculate
risk and expected return of various investment tools and the investment
portfolio;
• To distinguish concepts of portfolio theory and apply its’ principals in the
process of investment portfolio formation;
• To analyze and to evaluate relevance of stocks, bonds, options for the
investments;
• To understand the psychological issues in investment decision making;
• To know active and passive investment strategies and to apply them in
practice.
The structure of the course
The Course is structured in 7 chapters, covering both theoretical and analytical
aspects of investment decisions:
1. Investment environment and investment process;
2. Investment in stocks;
3. Investment in bonds;
4. Behavioral Finance and Technical Analysis.
5. Quantitative methods of investment analysis;
6. Theory of investment portfolio formation;
7. Portfolio management and evaluation.
Evaluation Methods

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As has been mentioned before, every chapter of the course contains

opportunities to test the knowledge of the audience, which are in the form of
questions and more involved problems. The types of question include open
ended questions as well as multiple choice questions. The problems usually
involve calculations using quantitative tools of investment analysis, analysis of
various types of securities, finding and discussing the alternatives for investment
decision making.
Summary for the Course
The course provides the target audience with a broad knowledge on the key
topics of investment analysis and management. Course emphasizes both
theoretical and analytical aspects of investment decision making, analysis and
evaluation of different corporate securities as investments, portfolio
diversification and management.
Special attention is given to the formulation of investment policy and strategy.
The course can be combined with other further professional education courses
developed in the project.

Investment Management
‫‪Chapter One‬‬
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‫‪Investment Environment‬‬
‫ـــــــــــــ ـــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــ ــــــــــــــــــــــــــــــــــــــــــــــــــــــ‬

‫‪17‬‬
Investment Environment Chapter one

1. Meaning of investment
The income that a person receives may be used for purchasing goods
and services that he currently requires or it may be saved for purchasing
goods and services that he may require in the future .In other words,
income can be what is spent for current consumption. savings are
generated when a person or organization abstain from present
consumption for a future use .The person saving a part of his income
tries to find a temporary repository for his savings until they are required
to finance his future expenditure .this result in investment.

Investment is an activity that is engaged in by people who have savings, i.e.

investments are made from savings, or in other words, people invest their savings.
But all savers are not investor’s .investment is an activity which is different from
saving. Let us see what is meant by investment. It may mean many things to many
persons. If one person has advanced some money to another, he may consider his
loan as an investment. He expect to get back the money along with interest at a
future date .another person may have purchased on kilogram of gold for the
purpose of price appreciation and may consider it as an investment. In all these
cases it can be seen that investment involves employment of funds with the main
aim of achieving additional income or growth in the values. The essential quality
of an investment is that it involves something for reward. Investment involves the
commitment of resources which have been saved in the hope that some benefits
will accrue in future. Thus investment may be defined as “a commitment of funds
made in the expectation of some positive rate of return “since the return is
expected to realize in future, there is a possibility that the return actually realized is
lower than the return expected to be realized. This possibility of variation in the
actual return is known as investment risk. Thus every investment involves return
and risk.
F. Amling defines investment as “purchase of financial assets that produces a yield
that is proportionate to the risk assumed over some future investment period”.
According to sharpe, ”investment is sacrifice of certain present value for some

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uncertain future values, formulas and finance in this book are only the necessary
tools to convert your reasoned, informed, and intuitive estimates of the future into
the information that you need today to make good decisions.
2. Investing versus financing
The term ‘investing” could be associated with the different activities, but the
common target in these activities is to “employ” the money (funds) during the
time period seeking to enhance the investor’s wealth. Funds to be invested come
from assets already owned, borrowed money and savings. By foregoing
consumption today and investing their savings, investors expect to enhance their
future consumption possibilities by increasing their wealth. But it is useful to make
a distinction between real and financial investments. Real investments generally
involve some kind of tangible asset, such as land, machinery, factories, etc.
Financial investments involve contracts in paper or electronic form such as stocks,
bonds, etc.
Following the objective as it presented in the introduction this course deals only
with the financial investments because the key theoretical investment concepts and
portfolio theory are based on these investments and allow to analyze investment
process and investment management decision making in the substantially broader
context Some information presented in some chapters of this material developed
for the investments course could be familiar for those who have studied other
courses in finance, particularly corporate finance. Corporate finance typically
covers such issues as capital structure, short-term and long-term financing, project
analysis, current asset management. Capital structure addresses the question of
what type of long-term financing is the best for the company under current and
forecasted market conditions; project analysis is concerned with the determining
whether a project should be undertaken.
Current assets and current liabilities management addresses how to manage the
day-by-day cash flows of the firm. Corporate finance is also concerned with how
to allocate the profit of the firm among shareholders (through the dividend
payments), the government (through tax payments) and the firm itself (through
retained earnings). But one of the most important questions for the company is

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Investment Environment Chapter one

financing. Modern firms raise money by issuing stocks and bonds. These securities
are traded in the financial markets and the investors have possibility to buy or to
sell securities issued by the companies. Thus, the investors and companies,
searching for financing, realize their interest in the same place – in financial
markets. Corporate finance area of studies and practice involves the interaction
between firms and financial markets and Investments area of studies and practice
involves the interaction between investors and financial markets. Investments field
also differ from the corporate finance in using the relevant methods for research
and decision making.
Investment problems in many cases allow for a quantitative analysis and modeling
approach and the qualitative methods together with quantitative methods are
more often used analyzing corporate finance problems. The other very important
difference is, that investment analysis for decision making can be based on the
large data sets available from the financial markets, such as stock returns, thus, the
mathematical statistics methods can be used. But at the same time both Corporate
Finance and Investments are built upon a common set of financial principles, such
as the present value, the future value, the cost of capital). And very often
investment and financing analysis for decision making use the same tools, but the
interpretation of the results from this analysis for the investor and for the financier
would be different. For example, when issuing the securities and selling them in
the market the company perform valuation looking for the higher price and for
the lower cost of capital, but the investor using valuation search for attractive
securities with the lower price and the higher possible required rate of return on
his/her investments.
Together with the investment the term speculation is frequently used. Speculation
can be described as investment too, but it is related with the short-term
investment horizons and usually involves purchasing the salable securities with the
hope that its price will increase rapidly, providing a quick profit. Speculators try to
buy low and to sell high, their primary concern is with anticipating and profiting
from market fluctuations. But as the fluctuations in the financial markets are and
become more and more unpredictable speculations are treated as the investments

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Investment Environment Chapter one

of highest risk. In contrast, an investment is based upon the analysis and its main
goal is to promise safety of principle sum invested and to earn the satisfactory risk.
However, There are two types of investors:
- Individual investors;
- Institutional investors.
Individual investors are individuals who are investing on their own. Sometimes
individual investors are called retail investors. Institutional investors are entities
such as investment companies, commercial banks, insurance companies, pension
funds and other financial institutions. In recent years the process of
institutionalization of investors can be observed. As the main reasons for this can
be mentioned the fact, that institutional investors can achieve economies of scale,
demographic pressure on social security, the changing role of banks. One of
important preconditions for successful investing both for individual and
institutional investors is the favorable investment environment. Our focus in
developing this course is on the management of individual investors’ portfolios.
But the basic principles of investment management are applicable both for
individual and institutional investors.
3. Investment management process
Investment management process is the process of managing money or funds. The
investment management process describes how an investor should go about
making decisions. Investment management process can be disclosed by five-step
procedure, which includes following stages:
1. Setting of investment policy.
2. Analyzing and evaluating the investment vehicles.
3. Formatting of diversifying the investment portfolio.
4. Portfolio revision.
5. Measuring and evaluating the portfolio performance.
3.1 Setting of investment policy is the first and very important step in
investment management process. Investment policy includes setting of
investment objectives. The investment policy should have the specific
objectives regarding the investment return requirement and risk tolerance of

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the investor. For example, the investment policy may define that the target of
the investment average return should be 15 % and should avoid more than
10% losses. Identifying investor’s tolerance for risk is the most important
objective, because it is obvious that every investor would like to earn the
highest return possible.
But because there is a positive relationship between risk and return, it is not
appropriate for an investor to set his/ her investment objectives as just “to make a
lot of money”. Investment objectives should be stated in terms of both risk and
return. The investment policy should also state other important constrains which
could influence the investment management. Constrains can include any liquidity
needs for the investor, projected investment horizon, as well as other unique needs
and preferences of investor. The investment horizon is the period of time for
investments.
Projected time horizon may be short, long or even indefinite. Setting of
investment objectives for individual investors is based on the assessment of their
current and future financial objectives. The required rate of return for investment
depends on what sum today can be invested and how much investor needs to have
at the end of the investment horizon. Wishing to earn higher income on his / her
investments investor must assess the level of risk he /she should take and to decide
if it is relevant for him or not. The investment policy can include the tax status of
the investor. This stage of investment management concludes with the
identification of the potential categories of financial assets for inclusion in the
investment portfolio. The identification of the potential categories is based on the
investment objectives, amount of investable funds, investment horizon and tax
status of the investor. From the section 1.3.1 we could see that various financial
assets by nature may be more or less risky and in general their ability to earn
returns differs from one type to the other. As an example, for the investor with
low tolerance of risk common stock will be not appropriate type of investment.
3.2 Analyzing and evaluating the investment vehicles. When the investment
policy is set up, investor’s objectives defined and the potential categories of
financial assets for inclusion in the investment portfolio identified, the

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Investment Environment Chapter one

available investment types can be analyzed. This step involves examining

several relevant types of investment vehicles and the individual vehicles inside
these groups. For example, if the common stock was identified as investment
vehicle relevant for investor, the analysis will be concentrated to the common
stock as an investment. The one purpose of such analysis and evaluation is to
identify those investment vehicles that currently appear to be mispriced.
There are many different approaches how to make such analysis. Most
frequently two forms of analysis are used: technical analysis and fundamental
analysis.
Technical analysis involves the analysis of market prices in an attempt to predict
future price movements for the particular financial asset traded on the market. This
analysis examines the trends of historical prices and is based on the assumption that
these trends or patterns repeat themselves in the future.
Fundamental analysis in its simplest form is focused on the evaluation of
intrinsic value of the financial asset. This valuation is based on the assumption that
intrinsic value is the present value of future flows from particular investment. By
comparison of the intrinsic value and market value of the financial assets those
which are underpriced or overpriced can be identified. Fundamental analysis will
be examined in other Chapter. This step involves identifying those specific
financial assets in which to invest and determining the proportions of these
financial assets in the investment portfolio.
3.3 Formation of diversified investment portfolio is the next step in
investment management process. Investment portfolio is the set of investment
vehicles, formed by the investor seeking to realize its’ defined investment
objectives. In the stage of portfolio formation the issues of selectivity, timing
and diversification need to be addressed by the investor.
Selectivity refers to micro forecasting and focuses on forecasting price
movements of individual assets.
Timing involves macro forecasting of price movements of particular type of
financial asset relative to fixed-income securities in general.

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Investment Environment Chapter one

Diversification involves forming the investor’s portfolio for decreasing or

limiting risk of investment. 2 techniques of diversification:
• Random diversification, when several available financial assets are put to the
portfolio at random.
• Objective diversification when financial assets are selected to the portfolio
following investment objectives and using appropriate techniques for analysis and
evaluation of each financial asset.
Investment management theory is focused on issues of objective portfolio
diversification and professional investors follow settled investment objectives then
constructing and managing their portfolios.
3.4 Portfolio revision, this step of the investment management process concerns
the periodic revision of the three previous stages. This is necessary, because
over time investor with long-term investment horizon may change his / her
investment objectives and this, in turn means that currently held investor’s
portfolio may no longer be optimal and even contradict with the new settled
investment objectives. Investor should form the new portfolio by selling some
assets in his portfolio and buying the others that are not currently held. It
could be the other reasons for revising a given portfolio: over time the prices
of the assets change, meaning that some assets that were attractive at one time
may be no longer be so. Thus investor should sell one asset ant buy the other
more attractive in this time according to his/ her evaluation. The decisions to
perform changes in revising portfolio depend, upon other things, in the
transaction costs incurred in making these changes. For institutional investors
portfolio revision is continuing and very important part of their activity. But
individual investor managing portfolio must perform portfolio revision
periodically as well.
Periodic reevaluation of the investment objectives and portfolios based on them
is necessary, because financial markets change, tax laws and security regulations
change, and other events alter stated investment goals.
3.5 Measuring and evaluating the portfolio performance.

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Investment Environment Chapter one

This is the last step in investment management process involves determining

periodically how the portfolio performed, in terms of not only the return
earned, but also the risk of the portfolio. For evaluation of portfolio
performance appropriate measures of return and risk and benchmarks are
needed. A benchmark is the performance of predetermined set of assets,
obtained for comparison purposes. The benchmark may be a popular index of
appropriate assets – stock index, bond index. The benchmarks are widely used
by institutional investors evaluating the performance of their portfolios.
It is important to point out that investment management process is continuing
process influenced by changes in investment environment and changes in
investor’s attitudes as well. Market globalization offers investors new possibilities,
but at the same time investment management become more and more
complicated with growing uncertainty.

4. Direct versus indirect investing

Investors can use direct or indirect type of investing. Direct investing is realized
using financial markets and indirect investing involves financial intermediaries.
The primary difference between these two types of investing is that applying direct
investing investors buy and sell financial assets and manage individual investment
portfolio themselves. Consequently, investing directly through financial markets
investors take all the risk and their successful investing depends on their
understanding of financial markets, its fluctuations and on their abilities to analyze
and to evaluate the investments and to manage their investment portfolio.
Contrary, using indirect type of investing investors are buying or selling financial
instruments of financial intermediaries (financial institutions) which invest large
pools of funds in the financial markets and hold portfolios. Indirect investing
relieves investors from making decisions about their portfolio. As shareholders
with the ownership interest in the portfolios managed by financial institutions
(investment companies, pension funds, insurance companies, commercial banks)
the investors are entitled to their share of dividends, interest and capital gains
generated and pay their share of the institution’s expenses and portfolio

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Investment Environment Chapter one

management fee. The risk for investor using indirect investing is related more with
the credibility of chosen institution and the professionalism of portfolio managers.
In general, indirect investing is more related with the financial institutions which
are primarily in the business of investing in and managing a portfolio of securities
(various types of investment funds or investment companies, private pension
funds). By pooling the funds of thousands of investors, those companies can offer
them a variety of services, in addition to diversification, including professional
management of their financial assets and liquidity.
Investors can “employ” their funds by performing direct transactions, bypassing
both financial institutions and financial markets (for example, direct lending). But
such transactions are very risky, if a large amount of money is transferred only to
one’s hands, following the well-known American proverb “don't put all your eggs
in one basket” (Cambridge Idioms Dictionary, 2nd ed. Cambridge University
Press 2006). That turns to the necessity to diversify your investments. From the
other side, direct transactions in the businesses are strictly limited by laws avoiding
possibility of money laundering. All types of investing discussed above and their
relationship with the alternatives of financing are presented in Table 1.1.

Table 1.1 Types of investing and alternatives for financing

Types of investing in the economy Alternatives for financing in the
economy
Direct investing Raising equity capital or borrowing
(through financial markets) in financial markets
Indirect investing (through financial Borrowing from financial institutions
institutions)
Direct transactions Direct borrowing, partnership contracts

Companies can obtain necessary funds directly from the general public (those who
have excess money to invest) by the use of the financial market, issuing and selling
their securities. Alternatively, they can obtain funds indirectly from the general
public by using financial intermediaries. And the intermediaries acquire funds by

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Investment Environment Chapter one

allowing the general public to maintain such investments as savings accounts,

Certificates of deposit accounts and other similar vehicles.
5. Investment environment
Investment environment can be defined as the existing investment vehicles in the
market available for investor and the places for transactions with these investment
vehicles. Thus further in this subchapter the main types of investment vehicles and
the types of financial markets will be presented and described.
5.1 Investment vehicles
In this course we are focused to the financial investments that mean the object will
be financial assets and the marketable securities in particular. But even if further in
this course only the investments in financial assets are discussed, for deeper
understanding the specifics of financial assets comparison of some important
characteristics of investment in this type of assets with the investment in physical
assets is presented. Investment in financial assets differs from investment in physical
assets in those important aspects:
• Financial assets are divisible, whereas most physical assets are not. An asset is
divisible if investor can buy or sell small portion of it. In case of financial assets it
means, that investor, for example, can buy or sell a small fraction of the whole
company as investment object buying or selling a number of common stocks.
• Marketability (or Liquidity) is a characteristic of financial assets that is not shared
by physical assets, which usually have low liquidity. Marketability (or liquidity)
reflects the feasibility of converting of the asset into cash quickly and without
affecting its price significantly. Most of financial assets are easy to buy or to sell in
the financial markets.
• The planned holding period of financial assets can be much shorter than the
holding period of most physical assets. The holding period for investments is
defined as the time between signing a purchasing order for asset and selling the
asset. Investors acquiring physical asset usually plan to hold it for a long period,
but investing in financial assets, such as securities, even for some months or a year
can be reasonable. Holding period for investing in financial assets vary in very
wide interval and depends on the investor’s goals and investment strategy.

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Investment Environment Chapter one

• Information about financial assets is often more abundant and less costly to
obtain, than information about physical assets. Information availability shows the
real possibility of the investors to receive the necessary information which could
influence their investment decisions and investment results. Since a big portion
of information important for investors in such financial assets as stocks, bonds is
publicly available, the impact of many disclosed factors having influence on value
of these securities can be included in the analysis and the decisions made by
investors.
Even if we analyze only financial investment there is a big variety of financial
investment vehicles. The ongoing processes of globalization and integration open
wider possibilities for the investors to invest into new investment vehicles which
were unavailable for them some time ago because of the weak domestic financial
systems and limited technologies for investment in global investment
environment.
Financial innovations suggest for the investors the new choices of investment but
at the same time make the investment process and investment decisions more
complicated, because even if the investors have a wide range of alternatives to
invest they can’t forgot the key rule in investments: invest only in what you really
understand. Thus the investor must understand how investment vehicles differ
from each other and only then to pick those which best match his/her
expectations. The most important characteristics of investment vehicles on which
bases the overall variety of investment vehicles can be assorted are the return on
investment and the risk which is defined as the uncertainty about the actual return
that will be earned on an investment (determination and measurement of returns
on investments and risks will be examined in other Chapter).
Each type of investment vehicles could be characterized by certain level of
profitability and risk because of the specifics of these financial instruments.
Though all different types of investment vehicles can be compared using
characteristics of risk and return and the most risky as well as less risky investment
vehicles can be defined. However the risk and return on investment are close

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related and only using both important characteristics we can really understand the
differences in investment vehicles.
The main types of financial investment vehicles are:
• Short term investment vehicles;
• Fixed-income securities;
• Common stock;
• Speculative investment vehicles;
• Other investment tools.
5.1.1 Short - term investment vehicles
Are all those which have a maturity of one year or less. Short term investment
vehicles often are defined as money-market instruments, because they are traded
in the money market which presents the financial market for short term (up to one
year of maturity) marketable financial assets. The risk as well as the return on
investments of short-term investment vehicles usually is lower than for other types
of investments. The main short term investment vehicles are:
• Certificates of deposit;
• Treasury bills;
• Commercial paper;
• Bankers’ acceptances;
• Repurchase agreements.
A) Certificate of deposit is debt instrument issued by bank that indicates a
specified sum of money has been deposited at the issuing depository
institution. Certificate of deposit bears a maturity date and specified
interest rate and can be issued in any denomination. Most certificates of
deposit cannot be traded and they incur penalties for early withdrawal. For
large money-market investors financial institutions allow their large-
denomination certificates of deposits to be traded as negotiable certificates
of deposits. But deposits as a whole can be classified into the following
categories:

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Investment Environment Chapter one

1) Bank deposits
It is the simplest investment avenue open for the investors. He has to open an
account and deposit the money. Traditionally the banks offered current account,
Saving account and fixed deposits account. Current account does not offer any
interest rate. The drawback of having large amount in saving accounts is that the
return is just 4 percent. The saving account is more liquid and convenient to
handle. The fixed account carries high interest rate and the money is locked up for
a fixed period. With increasing competition among the banks, the banks have
handled the plain saving account with the fixed account to cater to the needs of
the small savers.
2) Post office deposits
Post office also offers fixed deposit facility and monthly income scheme. Monthly
income scheme is a popular scheme for the retired. an interest rate of 9 percent is
paid monthly .the term of the scheme is 6 years, at the end of which a bonus of 10
percent is paid. The annualized yield to maturity works out to be 15.01 per
annum after three years, premature closure is allowed without any penalty .if the
closure is one year, a penalty of 5 percent is charged.
3) NBFC deposits
In recent years there has been a significant increase in the importance of non-
banking financial companies in the process of financial intermediation. The NBFC
come under the purview of the RBI. The Act in January 1997, made registration
compulsory for the NBFCs.
1) Period the period ranges from few months to five years.
2) Maximum limit the limit for acceptance of deposit has been on the credit rating
of the company.
3) Interest NBFCs have been debarred from offering an interest rate exceeding
16% per annum and a brokerage fee over 2% on public deposit. The interest
rate differs according to maturity period.
B) Treasury bills (also called T-bills) are securities representing financial
obligations of the government. Treasury bills have maturities of less than
one year. They have the unique feature of being issued at a discount from

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Investment Environment Chapter one

their nominal value and the difference between nominal value and
discount price is the only sum which is paid at the maturity for these short
term securities because the interest is not paid in cash, only accrued. The
other important feature of T-bills is that they are treated as risk-free
securities ignoring inflation and default of a government, which was rare in
developed countries, the T-bill will pay the fixed stated yield with
certainty. But, of course, the yield on T-bills changes over time influenced
by changes in overall macroeconomic situation. T-bills are issued on an
auction basis. The issuer accepts competitive bids and allocates bills to
those offering the highest prices.
Noncompetitive bid is an offer to purchase the bills at a price that equals the
average of the competitive bids. Bills can be traded before the maturity, while
their market price is subject to change with changes in the rate of interest. But
because of the early maturity dates of T-bills large interest changes are needed to
move T-bills prices very far. Bills are thus regarded as high liquid assets.
C) Commercial paper is a name for short-term unsecured promissory notes
issued by corporation. Commercial paper is a means of short-term
borrowing by large corporations. Large, well-established corporations
have found that borrowing directly from investors through commercial
paper is cheaper than relying solely on bank loans. Commercial paper is
issued either directly from the firm to the investor or through an
intermediary. Commercial paper, like T-bills is issued at a discount. The
most common maturity range of commercial paper is 30 to 60 days or less.
Commercial paper is riskier than T-bills, because there is a larger risk that a
corporation will default. Also, commercial paper is not easily bought and
sold after it is issued, because the issues are relatively small compared with
T-bills and hence their market is not liquid.
Banker‘s acceptances are the vehicles created to facilitate commercial trade
transactions. These vehicles are called bankers acceptances because a bank accepts
the responsibility to repay a loan to the holder of the vehicle in case the debtor
fails to perform. Banker‘s acceptances are short-term fixed-income securities that

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Investment Environment Chapter one

are created by non-financial firm whose payment is guaranteed by a bank. This

short-term loan contract typically has a higher interest rate than similar short –
term securities to compensate for the default risk. Since bankers’ acceptances are
not standardized, there is no active trading of these securities.
D) Repurchase agreement (often referred to as a repo) is the sale of security
with a commitment by the seller to buy the security back from the
purchaser at a specified price at a designated future date. Basically, a repo is
a collectivized short-term loan, where collateral is a security. The collateral
in a repo may be a Treasury security, other money-market security. The
difference between the purchase price and the sale price is the interest cost
of the loan, from which repo rate can be calculated. Because of concern
about default risk, the length of maturity of repo is usually very short. If
the agreement is for a loan of funds for one day, it is called overnight repo;
if the term of the agreement is for more than one day, it is called a term
repo. A reverse repo is the opposite of a repo. In this transaction a
corporation buys the securities with an agreement to sell them at a
specified price and time. Using repos helps to increase the liquidity in the
money market. Our focus in this course further will be not investment in
short-term vehicles but it is useful for investor to know that short term
investment vehicles provide the possibility for temporary investing of
money/ funds and investors use these instruments managing their
investment portfolio.
5.1.2 Fixed-income securities
Fixed-income securities are those which return is fixed, up to some redemption
date or indefinitely. The fixed amounts may be stated in money terms or indexed
to some measure of the price level. This type of financial investments is presented
by two different groups of securities:
• Long-term debt securities
• Preferred stocks.
A) Long-term debt securities can be described as long-term debt
instruments representing the issuer’s contractual obligation. Long term

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securities have maturity longer than 1 year. The buyer (investor) of these
securities is landing money to the issuer, who undertake obligation
periodically to pay interest on this loan and repay the principal at a stated
maturity date. Long-term debt securities are traded in the capital markets.
From the investor’s point of view these securities can be treated as a “safe”
asset. But in reality the safety of investment in fixed –income securities is
strongly related with the default risk of an issuer. The major representatives
of long-term debt securities are bonds, but today there are a big variety of
different kinds of bonds, which differ not only by the different issuers
(governments, municipals, companies, agencies, etc.), but by different
schemes of interest payments which is a result of bringing financial
innovations to the long-term debt securities market. As demand for
borrowing the funds from the capital markets is growing the long-term
debt securities today are prevailing in the global markets. And it is really
become the challenge for investor to pick long-term debt securities
relevant to his/her investment expectations, including the safety of
investment. We examine the different kinds of long-term debt securities
and their features important to understand for the investor in other
Chapter, together with the other aspects in decision making investing in
bonds.
B) Preferred stocks are equity security, which has infinitive life and pay
dividends. But preferred stock is attributed to the type of fixed-income
securities, because the dividend for preferred stock is fixed in amount and
known in advance. Though, this security provides for the investor the
flow of income very similar to that of the bond. The main difference
between preferred stocks and bonds is that for preferred stock the flows are
forever, if the stock is not callable. The preferred stockholders are paid
after the debt securities holders but before the common stock holders in
terms of priorities in payments of income and in case of liquidation of the
company. If the issuer fails to pay the dividend in any year, the unpaid
dividends will have to be paid if the issue is cumulative. If preferred stock

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Investment Environment Chapter one

is issued as noncumulative, dividends for the years with losses do not have
to be paid. Usually same rights to vote in general meetings for preferred
stockholders are suspended. Because of having the features attributed for
both equity and fixed-income securities preferred stocks is known as
hybrid security. A most preferred stock is issued as noncumulative and
callable. In recent years the preferred stocks with option of convertibility
to common stock are proliferating.
5.1.3 The common stock is the other type of investment vehicles which is one
of most popular among investors with long-term horizon of their investments.
Common stock represents the ownership interest of corporations or the equity of
the stock holders. Holders of common stock are entitled to attend and vote at a
general meeting of shareholders, to receive declared dividends and to receive their
share of the residual assets, if any, if the corporation is bankrupt. The issuers of the
common stock are the companies which seek to receive funds in the market and
though are “going public”. The issuing common stocks and selling them in the
market enables the company to raise additional equity capital more easily when
using other alternative sources. Thus many companies are issuing their common
stocks which are traded in financial markets and investors have wide possibilities
for choosing this type of securities for the investment. The questions important for
investors for investment in common stock decision making will be also discussed
in other Chapter.
5.1.4 Speculative investment vehicles following the term “speculation” could
be defined as investments with a high risk and high investment return. Using these
investment vehicles speculators try to buy low and to sell high, their primary
concern is with anticipating and profiting from the expected market fluctuations.
The only gain from such investments is the positive difference between selling and
purchasing prices. Of course, using short-term investment strategies investors can
use for speculations other investment vehicles, such as common stock, but here we
try to accentuate the specific types of investments which are more risky than other
investment vehicles because of their nature related with more uncertainty about

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the changes influencing the their price in the future. Speculative investment
vehicles could be presented by these different vehicles:
• Options;
• Futures;
•Commodities traded on the exchange (coffee, grain metals, and other
commodities).
A) Options are the derivative financial instruments. An options contract gives
the owner of the contract the right, but not the obligation, to buy or to sell
a financial asset at a specified price from or to another party. The buyer of
the contract must pay a fee (option price) for the seller. There is a big
uncertainty about if the buyer of the option will take the advantage of it
and what option price would be relevant, as it depends not only on
demand and supply in the options market, but on the changes in the other
market where the financial asset included in the option contract are traded.
Though, the option is a risky financial instrument for those investors who
use it for speculations instead of hedging.
B) Futures are the other type of derivatives. A future contract is an
agreement between two parties than they agree tom transact with the
respect to some financial asset at a predetermined price at a specified future
date. One party agree to buy the financial asset, the other agrees to sell the
financial asset. It is very important, that in futures contract case both parties
are obligated to perform and neither party charges the fee. There are two
types of people who deal with options (and futures) contracts:
Speculators and hedgers.

Speculators buy and sell futures for the sole purpose of making a profit by closing
out their positions at a price that is better than the initial price. Such people
neither produce nor use the asset in the ordinary course of business.
In contrary, hedgers buy and sell futures to offset an otherwise risky position in
the market. Transactions using derivatives instruments are not limited to financial
assets. There are derivatives, involving different commodities (coffee, grain,

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Investment Environment Chapter one

precious metals, and other commodities). But in this course the target is on
derivatives where underlying asset is a financial asset.
C) Commodities
Commodities have emerged as an alternative investment option now a days
and investors make use of this option to hedge against spiraling inflation
commodities may be broadly divided into three. Metals, petroleum products
and agricultural commodities .Metals can be divided in to precious metals and
other metals. Gold and silver are the most preferred once for beating inflation.
C.1 Gold
Off all the precious metals gold is the most popular as an investment. Investors
generally buy gold as a hedge against economic, political, social fiat currency
crisis. Gold prices are soaring to the new highs in recent years comparing to
the previous decades because whenever the signs of an economic crisis arises
in the world markets may find shelter in gold as safest asset class for investors
all around the world.
C.2 Silver
Yellow metal is treated as safe haven .but silver is used abundantly for
industrial applications. Investment in silver has given investor, super returns
than what gold has given.
Other investment tools:
• Various types of investment funds;
• Investment life insurance;
• Pension funds;
• Hedge funds.
• Real estate
• Others
A) Investment companies / investment funds. They receive money from
investors with the common objective of pooling the funds and then
investing them in securities according to a stated set of investment
objectives. Two types of funds:
• Open-end funds (mutual funds).

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Investment Environment Chapter one

• Closed-end funds (trusts).

1) Open-end funds have no pre-determined amount of stocks outstanding
and they can buy back or issue new shares at any point. Price of the share is
not determined by demand, but by an estimate of the current market value
of the fund’s net assets per share (NAV) and a commission.
2) Closed-end funds are publicly traded investment companies that have
issued a specified number of shares and can only issue additional shares
through a new public issue. Pricing of closed-end funds is different from
the pricing of open-end funds: the market price can differ from the NAV.
Other classifications of mutual funds are:
Growth scheme:
Aims to provide capital appreciation over medium to long term. Generally these
funds invest their money in equities.
Income scheme:
Aims to provide a regular return to its unit holders. Mostly these funds deploy
their funds in fixed income securities.
Balanced scheme:
A combination of steady return as well as reasonable growth. The fund of this
scheme is invested in equities and debt instruments
Money market scheme:
This type of fund invests its money to money market instruments.
Tax saving scheme:
This type of scheme offers tax rebates to investors.
Index scheme:
Here investment is made on the equities of the Stock index.
B) Insurance Companies are in the business of assuming the risks of adverse
events (such as fires, accidents, etc.) in exchange for a flow of insurance
premiums. Insurance companies are investing the accumulated funds in
securities (treasury bonds, corporate stocks and bonds), real estate. Three
types of Insurance Companies: life insurance; non-life insurance (also
known as property-casualty insurance) and reinsurance.

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During recent years investment life insurance became very popular investment
alternative for individual investors, because this hybrid investment product allows
to buy the life insurance policy together with possibility to invest accumulated life
insurance payments or lump sum for a long time selecting investment program
relevant to investor‘s future expectations. Usually the contract provides for the
payment of an amount on the date of maturity or at a specified date or if
unfortunate death occurs. The major advantage of life insurance is given below;
1) Protection saving through life insurance guarantees full protection against risk
of death of the saver. The full assured sum is paid, whereas in other schemes
only the amount saved is paid.
2) Easy payments for the salaried people the salary saving schemes are introduced.
Further there is an installment facility method of payment through monthly,
quarterly, half yearly or yearly mode.
3) Liquidity loans can be raised on the security of the policy.
4) Tax relief tax relief in income tax and wealth tax is available for amounts paid
by way of premium for life insurance subject to the tax rates in force.
Types of life insurance policy
1) Endowment policy;
The objective of this policy is to provide an assured sum, both in the event of
the policy holders’ death or at the expiry of the policy.
2) Term policy:
In a term policy investor pays a small premium to insure his life for a
comparatively higher value. The objective behind the scheme is not to get any
amount on the expiry of the policy, but simply to ensure the financial future of
the investors dependents.
3) Whole life policy
It is a low cost insurance plan where the sum assured is payable on the death of
the life insured and premium are payable throughout life.
4) Money back policy

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Investment Environment Chapter one

The insurance company pays the sum assured at periodical intervals to the
policy holder plus the entire sum assured to the beneficiaries in case of the
policy holders demise before maturity.
5) ULIPs:
Unit Linked Insurance Policies are a combination of mutual fund and life
insurance. Investments in ULIPs have two component-one part is used as a
premium for life insurance while the other part acts s the investment fund. The
investment component works exactly like mutual fund money is invested in
stocks, bonds; government securities etc., an investor receive money in return.
C) Pension Funds are an asset pools that accumulates over an employee’s
working years and pays retirement benefits during the employee’s
nonworking years. Pension funds are investing the funds according to a
stated set of investment objectives in securities (treasury bonds, corporate
stocks and bonds), real estate.
D) Hedge funds are unregulated private investment partnerships, limited to
institutions and high-net-worth individuals, which seek to exploit various
market opportunities and thereby to earn larger returns than are ordinarily
available. They require a substantial initial investment from investors and
usually have some restrictions on how quickly investor can withdraw their
funds. Hedge funds take concentrated speculative positions and can be
very risky. It could be noted that originally, the term “hedge” made some
sense when applied to these funds. They would by combining different
types of investments, including derivatives, try to hedge risk while seeking
higher return. But today the word “hedge’ is misapplied to these funds
because they generally take an aggressive strategies investing in stock, bond
and other financial markets around the world and their level of risk is high.

E) Real estate The real estate market offers a high return to the investors.
The word real estate means land and buildings. There is a normal notion
that the price of the real estate has increased by more than 12% over the
past ten years. Real estate investments cannot be enchased quickly.

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Investment Environment Chapter one

Liquidity is a problem. Real estate investment involves high transaction

cost. The asset must be managed, i.e. painting, repair, maintenance etc.
F) Tax sheltered saving scheme
The important tax sheltered saving scheme is:
a) Public provident fund scheme (PPF)
PPF earn an interest rate of 8.5% per annum compounded annually. Which is
exempted from the income tax under sec80 C.The individuals and Hindu
undivided families can participate in this scheme. There is a lock in period of
15years.PPF is not indented for those who are liquidity and short term returns. At
the time of maturity no tax is to be given.
b) National saving scheme (NSS)
This scheme helps in deferring the tax payment. Individuals and HUF are eligible
to open NSS account in the designated post office.
c) National saving certificate
This scheme is offered by the post office. These certificate come in the
denomination of Rs.500,1000,5000 and 10000.the contribution and the interest
for the first five years are covered by sec 88.the interest is cumulative at the rate of
8.5%per annum and payable biannually is covered by sec 80 L.
6. Financial markets
Financial markets are the other important component of investment environment.
Financial markets are designed to allow corporations and governments to raise
new funds and to allow investors to execute their buying and selling orders. In
financial markets funds are channeled from those with the surplus, who buy
securities, to those, with shortage, who issue new securities or sell existing
securities. A financial market can be seen as a set of arrangements that allows
trading among its participants. Financial market provides three important
economic functions (Frank J. Fabozzi, 1999):
1. Financial market determines the prices of assets traded through the interactions
between buyers and sellers.
2. Financial market provides a liquidity of the financial assets.

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Investment Environment Chapter one

3. Financial market reduces the cost of transactions by reducing explicit costs, such
as money spent to advertise the desire to buy or to sell a financial asset.
Financial markets could be classified on the bases of those characteristics:
• Sequence of transactions for selling and buying securities.
• Term of circulation of financial assets traded in the market.
• Economic nature of securities traded in the market.
• From the perspective of a given country.
A) By sequence of transactions for selling and buying securities:
- Primary market
- Secondary market
All securities are first traded in the primary market, and the secondary market
provides liquidity for these securities.
Primary market is where corporate and government entities can raise capital and
where the first transactions with the new issued securities are performed. If a
company’s share is traded in the primary market for the first time this is referred to
as an initial public offering (IPO).
Investment banks play an important role in the primary market:
• Usually handle issues in the primary market.
• Among other things, act as underwriter of a new issue, guaranteeing the
proceeds to the issuer.
Secondary market is the place under which, the previously issued securities are
traded among investors. Generally, individual investors do not have access to
secondary markets. They use security brokers to act as intermediaries for them.
The broker delivers an orders received form investors in securities to a market
place, where these orders are executed. Finally, clearing and settlement processes
ensure that both sides to these transactions honor their commitment.
Types of brokers:
• Discount broker: who executes only trades in the secondary market.
• Full service broker: who provides a wide range of additional services to clients
(ex., advice to buy or sell);

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Investment Environment Chapter one

• Online broker is a brokerage firm that allows investors to execute trades

electronically using Internet.
Types of secondary market places:
• Organized security exchanges;
• Over-the-counter markets;
• Alternative trading system.
An organized security exchange provides the facility for the members to trade
securities, and only exchange members may trade there. The members include
brokerage firms, which offer their services to individual investors, charging
commissions for executing trades on their behalf. Other exchange members buy
or sell for their own account, functioning as dealers or market makers who set
prices at which they are willing to buy and sell for their own account. Exchanges
play very important role in the modern economies by performing the following
tasks:
• Supervision of trading to ensure fairness and efficiency.
• The authorization and regulation of market participants such as brokers and
market makers;
• Creation of an environment in which securities’ prices are formed efficiently and
without distortion. This requires not only regulation of an orders and
transaction costs but also a liquid market in which there are many buyers and
sellers, allowing investors to buy or to sell their securities quickly;
• Organization of the clearing and settlement of transactions.
• The regulation of the admission of companies to be listed on the exchange and
the regulation of companies who are listed on the exchange;
• The dissemination of information (trading data, prices and announcements of
companies listed on the exchange). Investors are more willing to trade if
prompt and complete information about trades and prices in the market is
available.
The over-the-counter (OTC) market is not a formal exchange. It is organized
network of brokers and dealers who negotiate sales of securities. There are no
membership requirements and many brokers register as dealers on the OTC. At

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the same time there are no listing requirements and thousands of securities are
traded in the OTC market. OTC stocks are usually considered as very risky
because they are the stocks that are not considered large or stable enough to trade
on the major exchange.
An alternative trading system (ATS) is an electronic trading mechanism
developed independently from the established market places – security exchanges
– and designed to match buyers and sellers of securities on an agency basis. The
brokers who use ATS are acting on behalf of their clients and do not trade on their
own account. The distinct advantages of ATS in comparison with traditional
markets are cost savings of transactions, the short time of execution of transactions
for liquid securities, extended hours for trading and anonymity, often important
for investors, trading large amounts.
B) By term of circulation of financial assets traded in the market:
- Money market;
- Capital market
Money market, in which only short-term financial instruments are traded.
Capital market, in which only long-term financial instruments are traded.
The capital markets allow firms, governments to finance spending in excess of
their current incomes.

Features Money market Capital market

Term of circulation of Short-term, Long-term,
securities traded less than 1 year more than 1 year
Level of risk Low, because of trading Long-term securities,
short-term securities traded in this market, is
which more risky
have lower level of risk
and high liquidity
Fund suppliers Commercial banks, Banks, insurance
nonfinancial companies, pension
business funds, lending the large
institutions with the amounts of funds for a
excess long-term period;
funds investment funds with
big pools of funds for
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Investment Environment Chapter one

investing
Financial instruments Certificates of deposit; Common stocks,
Treasury bills; Preferred stocks,
Commercial paper; Treasury bonds,
Bankers’ acceptances; Municipal bonds,
Repurchase agreements, Corporate bonds,
other short-term other long-term
investment vehicles investment
vehicles
Aims for raising For financing of working For financing of further
money capital and current needs business development
and
investment projects

C) By economic nature of securities, traded in the market:

- Equity market or stock market;
- Common stock market;
- Fixed-income market;
- Debt market;
- Derivatives market.

D) From the perspective of a given country financial markets are:

- Internal or national market;
- External or international market.

The internal market can be split into two fractions: domestic market and foreign
market. Domestic market is where the securities issued by domestic issuers
(companies, Government) are traded. A country’s foreign market is where the
securities issued by foreign entities are traded.

The external market also is called the international market includes the securities
which are issued at the same time to the investors in several countries and they are
issued outside the jurisdiction of any single country (for example, offshore
market).

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Investment Environment Chapter one

Globalization and integration processes include the integration of financial

markets into an international financial market. Because of the globalization of
financial markets, potential issuers and investors in any country become not
limited to their domestic financial market.
7. Concept of risk and return
Any rational investor, before investing his or her investable wealth in the
stock, analysis the risk associated with the particular stock. The actual return
he receives from a stock may vary from his expected return and is expressed in
the variability of return.
A) Risk
The dictionary meaning of risk is the possibility of loss or injury; risk the
possibility of not getting the expected return. The difference between
expected return and actual return is called the risk in investment. Investment
situation may be high risk, medium and low risk investment.
EX:

Types of risk
Systematic risk:
The systematic risk is caused by factors external to the particular company and
uncontrollable by the company. The systematic risk affects the market as a
whole.
Unsystematic risk:
In case of unsystematic risk the factors are specific, unique and related to the
particular industry or company.
Sources of risk
Interest rate risk:

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Investment Environment Chapter one

Interest rate risk is the variation in the single period rates of return caused by the
fluctuations in the market interest rate. Most commonly the interest rate risk
affects the debt securities like bond, debentures.
Market risk:
Jack Clarkfrancis has defined market risk as that portion of total variability of
return caused by the alternating forces of bull and bear market. This is a type of
systematic risk that affects share .market price of shares move up and down
consistently for some period of time.
Purchasing power risk
Another type of systematic risk is the purchasing power risk .it refers to the
variation in investor return caused by inflation.
Business risk:
Every company operates with in a particular operating environment; operating
environment comprises both internal environment within the firm and external
environment outside the firm. Business risk is thus a function of the operating
conditions faced by a company and is the variability in operating income caused
by the operating conditions of the company.
Financial risk
It refers to the variability of the income to the equity capital due to the debt
capital. Financial risk in a company is associated with the capital structure of the
company. The debt in the capital structure creates fixed payments in the form of
interest this creates more variability in the earning per share available to equity
share holders .this variability of return is called financial risk and it is a type of
unsystematic risk.
B): Return
The major objective of an investment is to earn and maximize the return.
Return on investment may be because of income, capital appreciation or a
positive hedge against inflation .income is either interest on bonds or debenture,
dividend on equity, etc
Rate of return:
The rate of return on an investment for a period is calculated as follows:

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Investment Environment Chapter one

Rate of return = annual income + (ending price – beginning price) /

Beginning price
Ex: Ajay brought a share of a co. for Rs.140 from the market on 1/6/2012. The
co. paid dividend of Rs.8 per share. Later Ajay sold the share at Rs.160 on
1/6/2013.
The rate of return= 8+ {(160-140) / 140} x100 = 20 percent.
8. Security Market Indices
Stock market indices are the barometers of the stock market. They mirror the
stock market behavior. With some 7,000 companies listed on the Bombay stock
exchange, it is not possible to look at the prices of every stock to find out whether
the market movement is upward or downward. The indices give a broad outline
of the market movement and represent the market. Some of the stock market
indices are BSE Sensex, BSE-200, Dollex, NSE-50, CRISIL-500, MCX-SX 40,
Business Line 250 and RBI Indices of Ordinary Shares.
Usefulness of Indices
1. Indices help to recognize the broad trends in the market.
2. Index can be used as a bench mark for evaluating the investor’s portfolio.
3. Indices function as a status report on the general economy. Impacts of the
various economic policies are reflecting on the stock market.
4. The investor can use the indices to allocate funds rationally among stocks. To
earn returns on par with the market returns, he can choose the stocks that
reflect the market movement.
5. Index funds and futures are formulated with the help of the indices. Usually
fund managers construct portfolios to emulate any one of the major stock
market index. ICICI has floated ICICI index bonds. The return of the bond
is linked with the index movement.
6. Technical analysts studying the historical performance of the indices predict
the future movement of the stock market. The relationship between the
individual stock and index predicts the individual share price movement.
Computation of Stock Index

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A stock market index may either be a price index or a wealth index. The un-
weighted price index is a simple arithmetical average of share prices with a base
date. This index gives an idea about the general price movement of the
constituents that reflects the entire market. In a wealth index the prices are
weighted by market capitalization. In such an index, the base period values are
adjusted for subsequent rights and bonus offers. This gives an idea about the real
wealth created for shareholders over a period of time.
The Composition of the Stocks
The composition of the stocks in the index should reflect the market movement
as well as the macroeconomic changes. The Centre for Monitoring Indian
Economy maintains an index. If often changes the composition of the index so as
to reflect the market movements in a better manner. Some of the scrip’s traded
volume may fall down and at the same time some other stock may attract the
market interest should be dropped and others must be added. Only then, the
index would become more representative. In 1993, Sensex dropped one
company and added another. In August 1996 Sensex was thoroughly revamped.
Half of the scrips were changed. The composition of the Nifty was changed in
April 1996 and 1998. Crisils 500 was changed in November 1996. In October
1998 the Nifty Junior Index composition has been changed. Recognizing the
importance of the information technology scrips, they are included in the index.
NSE - 50 Index – (NIFTY)
NIFTY index is the security market indice of National Stock Exchange[NSE].it
composes 50 leading stocks from different sectors of the listed companies in
NSE.This index is built by India Index Services Product Ltd (IISL and Credit
Rating Information Services of India Ltd. (CRISIL).The CRISIL has a strategic
alliance with Standard and Poor rating Services. Hence, the index is named as S &
P CNX Nifty. NSE - 50 index was introduced on April 22,1996 with the
objectives given below :
* Reflecting market movement more accurately
* Providing fund managers a tool for measuring portfolio returns vis-market
return.

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Investment Environment Chapter one

* Serving as a basis for introducing index based derivatives. Nifty replaced the
earlier NSE - 100 index, which was established as an interim measure till the
time the automated trading system established. To make the process of
building an index as interactive and user driven as possible an index
committee is appointed. The composition of the committee is structured to
represent stock exchanges, mutual fund managers and academicians. To
reflect the dynamic changes in the capital market, the index set is reduced and
modified by the index committee based on certain predetermined entry and
exit criteria.
The current composition of Nifty stocks with sector given below [December
2013].

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Investment Environment Chapter one

Bse Sensex
The S&P BSE SENSEX (S&P Bombay Stock Exchange Sensitive Index), also-
called the BSE 30 or simply the SENSEX, is a free float market weighted index of

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30 well-established and financially sound companies listed on Bombay Stock

Exchange. The 30 component companies which are some of the largest and most
actively traded stocks are representative of various industrial of the Indian
economy. Published since 1 January 1986, the S&P BSE SENSEX is regarded as
the pulse of the domestic stock markets in India. The base value of the S&P BSE
SENSEX is taken as100 on 1 April 1979, and its base year as 1978–79. On 25 July
2001 BSE launched DOLLEX-30, a dollar-linked version of S&P BSE SENSEX.
MCX SX 40
MCX Stock Exchange Limited (MCX-SXAT) is an Indian stock exchange.
SX40
Is the flagship Index of MCX-SXAT. A free float based index of 40 large cap -
liquid stocks representing diversified sectors of the economy. It is designed to be a
performance benchmark and to provide for efficient investment and risk
management instrument. It would also help in structuring passive investment
vehicles.
9. Information sources
Learning about investing means learning how money makes money. No one will
watch over your investments more closely or carefully as you yourself, and this is
as good a reason as any to learn as much as you can and become as knowledgeable
and savvy about investing as possible. This holds true even if you determine to
have a financial planner or advisor manage your investment funds.
10.Becoming "Investment Literate"
It is important to be an informed investor. Financial websites, periodicals,
investment books and publications will keep you up to date and educated about
investing, about what is going on in the economy, what influences your money,
your invested funds, and where your money can be placed so that it will work
hardest for you. These sources contain valuable information about business in
general, as well as current economic and financial trends, news of the stock market
and related news stories, all those things that affect the investment community in
general, and most importantly, that affect your investments and investment
decisions.

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Investment Environment Chapter one

There is a wealth of financial and investment information available to the

individual investor, and one of your tasks if you wish to be an informed investor is
to distil this volume of information in order to find those sources that you can
understand, that you are comfortable using, that provide information that is clear,
reliable, and, as much as possible, independent of bias.
11.Sources of Investment Information
The following sources of investment information are intended as a starting point.
They are stepping stones. As you proceed to research, investigate, educate yourself
and learn, you will find that one place of information will lead you to the next,
and you will find yourself gaining the knowledge that you need in order to
become a most successful investor. Becoming investment literate is an on-going
process.
A) Books
“The Intelligent Investor”, written by Benjamin Graham - recognized as one of
the classic texts on investing, value investing specifically. A comprehensive
essential text for any serious student of investing.
B) Financial websites
MSN Money (moneycentral.msn.com) - up to date financial news, an
educational/investing center, stock, bond, and mutual fund research and
evaluation resources, help with personal finance and more. CNN Money.com
(money.cnn.com) - as with MSN Money, a comprehensive financial site
including current news affecting the economy and the investment community.
The site also provides a very helpful, step-by-step, personal finance money
guide, Money 101. Morningstar (www.morningstar.com) - a comprehensive
research and evaluation site for stocks, bonds, ETF's (exchange traded funds), and
mutual funds, utilizing the Morningstar rating system for investment screening.

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Investment Environment Chapter one

Summary
1. The common target of investment activities is to “employ” the money (funds)
during the time period seeking to enhance the investor’s wealth. By foregoing
consumption today and investing their savings, investors expect to enhance
their future consumption possibilities by increasing their wealth.
2. Corporate finance area of studies and practice involves the interaction between
firms and financial markets and Investments area of studies and practice involves
the interaction between investors and financial markets. Both Corporate
Finance and Investments are built upon a common set of financial principles,
such as the present value, the future value, the cost of capital). And very often
investment and financing analysis for decision making use the same tools, but
the interpretation of the results from this analysis for the investor and for the
financier would be different.
3. Direct investing is realized using financial markets and indirect investing
involves financial intermediaries. The primary difference between these two
types of investing is that applying direct investing investors buy and sell
financial assets and manage individual investment portfolio themselves;
contrary, using indirect type of investing investors are buying or selling
financial instruments of financial intermediaries (financial institutions) which
invest large pools of funds in the financial markets and hold portfolios. Indirect
investing relieves investors from making decisions about their portfolio.
4. Investment environment can be defined as the existing investment vehicles in
the market available for investor and the places for transactions with these
investment vehicles.
5. The most important characteristics of investment vehicles on which bases the
overall variety of investment vehicles can be assorted are the return on
investment and the risk which is defined as the uncertainty about the actual
return that will be earned on an investment. Each type of investment vehicles
could be characterized by certain level of profitability and risk because of the
specifics of these financial instruments. The main types of financial investment

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vehicles are: short- term investment vehicles; fixed-income securities; common

stock; speculative investment vehicles; other investment tools.
6. Financial markets are designed to allow corporations and governments to raise
new funds and to allow investors to execute their buying and selling orders. In
financial markets funds are channeled from those with the surplus, who buy
securities, to those, with shortage, who issue new securities or sell existing
securities.
7. All securities are first traded in the primary market, and the secondary market
provides liquidity for these securities. Primary market is where corporate and
government entities can raise capital and where the first transactions with the
new issued securities are performed. Secondary market, under which
previously issued securities are traded among investors. Generally, individual
investors do not have access to secondary markets. They use security brokers to
act as intermediaries for them.
8. Financial market, in which only short-term financial instruments are traded, is
Money market and financial market in which only long-term financial instruments
are traded is Capital market.
9. The investment management process describes how an investor should go about
making decisions. Investment management process can be disclosed by five-
step procedure, which includes following stages: (1) setting of investment
policy; (2) analysis and evaluation of investment vehicles; (3) formation of
diversified investment portfolio; (4) portfolio revision; (5) measurement and
evaluation of portfolio performance.
10. Investment policy includes setting of investment objectives regarding the
investment return requirement and risk tolerance of the investor. The other
constrains which investment policy should include and which could influence
the investment management are any liquidity needs, projected investment
horizon and preferences of the investor.
11. Investment portfolio is the set of investment vehicles, formed by the investor
seeking to realize its’ defined investment objectives. Selectivity, timing and
diversification are the most important issues in the investment portfolio

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formation. Selectivity refers to micro forecasting and focuses on forecasting

price movements of individual assets. Timing involves macro forecasting of
price movements of particular type of financial asset relative to fixed-income
securities in general. Diversification involves forming the investor’s portfolio
for decreasing or limiting risk of investment.
Key-terms
• Alternative trading system (ATS)
• Broker
• Capital market
• Closed-end funds
• Common stock
• Debt securities
• Derivatives
• Direct investing
• Diversification
• Financial institutions
• Financial intermediaries
• Financial investments
• Financial markets
• Indirect investing
• Institutional investors
• Investment
• Investment environment
• Investment vehicles
• Investment management process
• Investment policy
• Investment horizon
• Investment management
• Investment funds
• Investment portfolio
• Investment life insurance

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Investment Environment Chapter one

• Hedge funds
• Investment portfolio
• Long-term investments
• Money market
• Open-end funds
• Organized security exchange
• Over-the-counter (OTC) market
• Pension funds
• Primary market
• Preferred stock
• Real investments
• Secondary market
• Short-term investments
• Speculation
• Speculative investment
Questions and problems
1. Distinguish investment and speculation.
2. Explain the difference between direct and indirect investing.
3. How could you describe the investment environment?
4. Classify the following types of financial assets as long-term and short term:
a) Repurchase agreements
b) Treasury Bond
c) Common stock
d) Commercial paper
e) Preferred Stock
f) Certificate of Deposit
5. Comment the differences between investment in financial and physical assets
using following characteristics:
a) Divisibility
b) Liquidity
c) Holding period

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d) Information ability
6. Why preferred stock is called hybrid financial security?
7. Why Treasury bills considered being a risk free investment?
8. Describe how investment funds, pension funds and life insurance companies
each act as financial intermediaries.
9. Distinguish closed-end funds and open-end funds.
10. How do you understand why word “hedge’ currently is misapplied to hedge
funds?
11. Explain the differences between
a) Money market and capital market;
b) Primary market and secondary market.
12. Why the role of the organized stock exchanges is important in the modern
economies?
13. What factors might an individual investor take into account in determining
his/her investment policy?
14. Define the objective and the content of a five-step procedure.
15. What are the differences between technical and fundamental analysis?
16. Explain why the issues of selectivity, timing and diversification are important
when forming the investment portfolio.
17. Think about your investment possibilities for 3 years holding period in real
investment environment.
a) What could be your investment objectives?
b) What amount of funds you could invest for 3 years period?
c) What investment vehicles could you use for investment? (What types of
investment vehicles are available in your investment environment?)
d) What types of investment vehicles would be relevant to you? Why?
e) What factors would be critical for your investment decision making in this
particular investment environment?
References and further readings
1. Black, John, Nigar Hachimzade, Gareth Myles (2009). Oxford Dictionary of
Economics. 3rd ed. Oxford University Press Inc., New York.

57
Investment Environment Chapter one

2. Bode, Zvi, Alex Kane, Alan J. Marcus (2005). Investments. 6th ed. McGraw
Hill.
3. Fabozzi, Frank J. (1999). Investment Management. 2nd. ed. Prentice Hall Inc.
4. Francis, Jack C., Roger Ibbotson (2002). Investments: A Global Perspective.
Prentice Hall Inc.
5. Haan, Jakob, Sander Oosterloo, Dirk Schoenmaker (2009). European Financial
Markets and Institutions. Cambridge University Press.
6. Jones, Charles P. (2010). Investments Principles and Concepts. John Wiley &
Sons, Inc.
7. LeBarron, Dean, Romesh Vaitlingam (1999). Ultimate Investor. Capstone.
8. Levy, Haim, Thierry Post (2005). Investments. FT / Prentice Hall.
9. Rosenberg, Jerry M. (1993). Dictionary of Investing. John Wiley &Sons Inc.
10. Sharpe, William F. Gordon J.Alexander, Jeffery V.Bailey. (1999). Investments.
International edition. Prentice –Hall International.

Relevant websites
• www.cmcmarkets.co.uk CMC Markets
• www.dcxworld.com Development Capital Exchange
• www.euronext.com Euronext
• www.nasdaqomx.com NASDAQ OMX
• www.world-exchanges.org World Federation of Exchange
• www.hedgefund.net Hedge Fund
• www.liffeinvestor.com Information and learning tools from LIFFE to help the
private investor
• www.amfi.com Association of Mutual Funds Investors
• www.standardpoors.com Standard &Poors Funds
• www.bloomberg.com/markets Bloomberg

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 Investment in Stocks

2. Investment in Stocks

2.1 Stock as specific investment

Stock represents part ownership in a firm.

2 main types of stock (see Chapter 1)
• Common stock
• Preferred stock
In this chapter we focus only on the investment in common stocks.
Common stock = Common share = Equity
The main features of the common stock:
• Typically each common stock owned entitles an investor to one vote in
corporate shareholders‘ meeting.
• Investor receives benefits in the form of dividends, capital gains or both.
But:
dividends are paid to shareholders only after other liabilities such
as interest payments have been settled;
typically the firm does not pay all its earnings in cash dividends;
special form of dividend is stock dividend, in which the
corporation pays in stocks rather than cash.
• Common stock has no stated maturity. Common stock does not have a date
on which the corporation must buy it back. But: some corporations pay
cash to their shareholders by purchasing their own shares. These are known
as share buybacks.

• Common stocks on the whole historically have provided a higher return,

but they also have higher risk. An investor earns capital gains (the
difference between the purchase price and selling price) when he / she sell
at a higher price than the purchase price.
Main advantages of common stock as investment:
• the investment income is usually higher;
• the investor can receive operating income in cash dividends;
• common stock has a very high liquidity and can easily be moved from one
investor to the other;
• the costs of transaction with common stocks involved are relatively low;
• the nominal price of common stock is lower in comparison with the other
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 Investment in Stocks

securities.
Main disadvantages of common stock as investment:
• common stock is more risky in comparison with many other types of
securities;
• the selection of these securities is complicated: high supply and difficult to
evaluate;
• the operating income is relatively low (the main income is received from
the capital gain – change in stock price).

2.2 Stock analysis for investment decision making

In this section the focus is on the fundamental analysis of common stocks.
Although technical analysis is used by many investors, fundamental analysis is far
more prevalent. By performing fundamental analysis investor forecasts among other
things, the future changes in GDP, changes in sales, other performance indicators for
a number of industries and, in particular, future sales, earnings for a number of the
firms. The main objective of this analysis for investor is to identify the attractive
potential investments in stocks.
Analysts and investors use two alternative approaches for fundamental analysis:
• ―Top-down‖ forecasting approach;
• ―Bottom-up‖ forecasting approach.
Using “top-down” forecasting approach the investors are first involved in
making the analysis and forecast of the economy, then for industries, and finally for
companies. The industry forecasts are based on the forecasts for the economy and a
company’s forecasts are based on the forecasts for both its industry and the economy.
Using “bottom-up”forecasting approach, the investors start with the analysis
and forecast for companies, then made analysis and forecasts for industries and for the
economy.
In practice ―top down‖ approach prevail in analysis and forecasting because
logically for forecasting of the companies' performance the changes in macroeconomic
environment must be analyzed first otherwise the inconsistent assumptions could be
drawn. The combination of two approaches is used by analysts too. For example,
analysis and forecasts are made for the economy using ―top-down‖ approach and then
using ―bottom-up‖ approach continuing with the forecasts for individual companies.
But despite of the different approaches to the sequence of the analysis the content of it
is based on the E-I-C analysis.

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 Investment in Stocks

2.2.1 E-I-C analysis

E-I-C analysis includes:

 E - Economic (macroeconomic) analysis (describes the
macroeconomic situation in the particular country and its potential
influence on the profitability of stocks).
 I - Industry analysis (evaluates the situation in the particular industry/
economic sector and its potential influence on the profitability of
stocks).
 C - Company analysis (the financial analysis of the individual
companies from the shareholder approach)
The contents of Macroeconomic analysis:
• The behavior of economics in the context of economic cycle (at what
point of this cycle is the economy now: growth stage? peak? decline
stage? recession stage?);
• Fiscal policy of the government (financial stability, budget deficit,
public debt, etc.)
• Monetary policy (the stability of national currency against other foreign
currencies; the ability of authorities (Central Bank) to use the money
market instruments on time, etc.);

• the other economic factors:

 inflation/deflation;
 the level of unemployment;
 the level of consumption;
 investments into businesses;
 the possibilities to use different types of energy, their prices;
 foreign trade and the exchange rate of the foreign currency
against national currency (devaluation? revaluation?)

The contents of Industry analysis could be disclosed answering following

questions:

• What is the nature of the industry? Is it monopolistic or competitive?

• What is the level of regulation and administration inside this industry?
• What is the situation with the self-organization of the human resources
in this industry? Is where any unions other organized structures?
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 Investment in Stocks

• How important and how complex is the technology for this industry?
• What are the key factors which influence this industry?
• What conditions in production and financial activity are important in
this industry?
• (production resources, the perspectives for raising capital, competition
form the other countries, etc.)
• What is the stage of the industry‘s development cycle? (Introductory?
Growth? Maturity? Decline?)
The other way for the development of Industry’s analysis by focusing it
into four important areas:
I. Demand:
• Could this sector/ industry be described as growing, mature or
cyclical?
• How are this sector/ industry influenced by changes in GDP or
interest rates?
• If the industry is cyclical, what is the key driver of it demand/ profit:
business (capital expenditures) or consumption cycle?
• How precisely the demand for capital expenditures is defined?
• Are the goods in this industry expensive? luxury goods? cheap? For
day-to-day consumption?
II. Pricing:
• How consolidated (concentrated) is this industry?
• What are the barriers for entrance to this industry? Are they high?
• How powerful and demanding are the consumers in this industry?
• Is where in the market of industry‘s goods the surplus, how strong is
the fight for market share?
• Is where in this industry a high competition in the international
environment?
III. Costs:
• How is the industry supplied with the implements of production?
• Are the tendencies of the prices for raw materials used in this
industry substantially influencing the profit?
• Are the labor costs the main component?
• Is the question of qualification for the human resources in this
industry?

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IV. The influence of the whole economics and financial market to the
industry:
• Is this industry defensive or growing? How it could function in
period of economic recession?
• How is this industry influenced by interest rates?
• Are severe stocks dominated in this industry?
• Is this sector global?
• How the fluctuations in currency exchange rate are influencing the
sector? Are these fluctuations of currency exchange rate influencing
the amount of profit received from abroad or the competitiveness of
the sector?
• Is it possibility that political and/ or regulation risk could influence
the sector?
2.2.2. Fundamental analysis
The base for the company analysis is fundamental analyses are the publicly
disclosed and audited financial statements of the company:

2.2.1.1 Balance Sheet

2.2.1.2 Profit/ loss Statement
2.2.1.3 Cash Flow Statement
2.2.1.4 Statement of Profit Distribution Analysis could use the period not
less than 3 years.
Ratio analysis is useful when converting raw financial statement information into
a form that makes easy to compare firms of different sizes. The analysis includes the
examination of the main financial ratios:
1. Profitability ratios, which measure the earning power of the firm.
2. Liquidity ratios, which measure the ability of the firm to pay its immediate
liabilities.
3. Debt ratios, which measure the firm‘s ability to pay the debt obligations over
the time.
4. Asset – utilization ratios, which measure the firm‘s ability to use its assets
efficiently.
5. Market value ratios are an additional group of ratios which reflect the market
value of the stock and the firm.

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 Investment in Stocks

Table 2.1 Financial ratios by category

Ratio Equation
Profitability ratios
Gross profit margin Gross profit/ Sales
Operating profit margin Operating profit / Sales
Net profit margin Net income/ Sales
Return on assets (ROA) Net income / Total assets
Return on equity (ROE) Net income / Stockholders‘ equity
Liquidity ratios
Current ratio Current assets / Current liabilities
Quick ratio (Current assets – Inventory) / Current liabilities
Net working capital Current assets - Current liabilities
Debt ratios
Debt to assets Total liabilities / Total assets
Debt to equity Total Debt / Equity
Times interest earned Income before interest and taxes / Interest
Asset utilization ratios
Inventory turnover Cost of goods sold / Inventory
Receivables turnover Sales (credit) / Receivables
Fixed asset turnover Sales/ Fixed assets
Total assets turnover Sales/ Total assets
Market Value Ratios
Capitalization Number of common stock *
Market price of the common stock
Earnings per share (EPS) (Net Income – Cash Dividends of Preferred stock) /
Number of Common Stocks
Price/Earnings ratio (PER) Market price of the stock/ Earnings per share
Book value of the stock (Equity–Preferred stock- Preferred stock dividends) /
Number of Common Stock
Market price to Book value Market price of the stock /
Book value of the stock
Dividends per share (Dividends - Preferred stock dividends)/
Number of Common Stock
Payout Ratio Dividends per share / Earnings per share

Market value ratios provide an investor with a shortest way to understand how
attractive the stock in the market is. But looking for long-term investment decisions
investor must analyze not only the current market results but to assess the potential of
the firm to generate earnings in the future. Thus, only using the other groups of
financial ratios investor can receive ―a full picture‖ of the financial condition of the
firm and when continue with stock valuation.

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 Investment in Stocks

After calculating the ratios, the investor must compare the ratios of the firm
with the ratios of a relevant benchmark. The selection of the appropriate benchmark is
a difficult decision. For this reason firms are frequently benchmarked against other
firms with similar size and in the same home country and industry. However, such
comparisons do not always reveal whether the company is buy-worthy, because the
whole size category, country or industry may under perform. When using these ratios
for analysis of the firm investors compare them also with industry average.

Fundamental analysis in a practical sequence:

Fundamental analysis is the study of the various factors that affect a company's
earnings and dividends. Fundamental analysis studies the relationship between a
company's share price and the various elements of its financial position and
performance. Fundamental analysis also involves a detailed examination of the
company's competitors, the industry or sector it is a member of and the broader
economy.
If the shares are
trading at less than the
intrinsic value then the shares
may be seen as good value.
Many people use
fundamental analysis to select
a company to invest in, and
technical analysis to help
make their buy and sell
decisions.
Factors that affect a company's earnings and dividends

Analyzing individual companies

The analysis of an individual
company has two components:
- what the
company does, what its
outlook is
- the
financials of the company,
balance sheet and income
statement and ratio
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 Investment in Stocks

analysis.
Unfortunately, balance sheet and ratio analysis is probably the most daunting part of
fundamental analysis for non- professional investors. A large number of numerical
techniques appear to be used.
However, you can make it less painful by adopting a methodical approach and by always
remembering that behind all the numbers is a real business run by real people producing
real goods and services, this is the part we call 'the story'.
It is unlikely that you will need
to do the number crunching for
every company; your time will
be more profitably spent
developing the company story.
Balance sheets and ratio
analysis, both historical and
forecast, can be obtained from
either a full service or discount
stockbroker.

What are you trying to learn about a company?

Before trying to leap into the calculations behind fundamental analysis there are some
basic questions that are worth
considering as a starting point:

company coming from?

achieved organically or
through acquisition?

with the sector and with

competitors?

margin - is it growing? Is it
too high compared to
competitors?
If it is too high then new competitors could enter on price reducing margins. Low earnings

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 Investment in Stocks

could suggest control of the cost base has been lost or factors outside the company's
control are squeezing margins.
-off events?

multidimensional. For example debt funding may have increased - this

may be a positive move if the funds produce new productive assets.
However we will introduce you to the financial statements, (the place where the numbers
come from) and introduce the concept of ratio analysis. We will look at some of the most
commonly quoted financial ratios; dividend yield, Price Earnings Ratio (PE) and earnings
per share (EPS).

Annual Report
Sourcing information
The key source of information for all
analysts when constructing the ratios
used in fundamental analysis is a
company's annual report. The annual
report is a comprehensive document
that provides details on the
company's activities over the
previous year and what its plans for
the future are.
Some key elements to the annual
report are:

Annual reports are sent to

shareholders of the company. If you
are not a shareholder and would like
an annual report they are made
available in the company
announcements section of the ASX
website.

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 Investment in Stocks

Annual reports are generally released at the same time each year during what is known as
'reporting season'. It is in the annual report that you can find a company's balance sheet.
The aim of the balance sheet is to provide information about the financial position,
financial performance and cash flows of an entity. Financial reports also show the results
of management performance. This information has a wide number of users so a standard
method is set out by the Australian Accounting Standards Board for how to display
financial reports.

Financial reports provide information about an entity's:

- what the company owns
- what the company owes

nd losses

This information, along with other information in the notes, assists users of financial
reports in predicting the entity's future cash flows and, in particular, their timing and
certainty.

The main components of a financial report

A financial report comprises:
1. A balance sheet (showing
assets and liabilities)
2. An income statement
(showing revenue and
expenses)
3. A statement of changes in
equity showing either:

those arising from

transactions with equity
holders acting in their
capacity as equity holders
4. A cash flow statement
5. Notes, comprising a summary of significant accounting policies and other explanatory
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 Investment in Stocks

notes.
Now what do all these various forms and tables in the financial reports really mean?
It can appear a little confusing at first, but the more time you spend reading annual reports
and studying the basic accounting principles that are used in constructing financial reports
the easier it becomes to make sense of them.
Easy things you can do are check the headline figures such as net profit also check cash
flow, and level of debt.
If you like checking the fine print, the notes to the figures can provide very interesting
reading as some key information can get buried in there.
You will also find the salaries
of the most senior
management and a list of the
largest shareholders in the
company. If you do find the
figures a little daunting, try
reading the director's report,
usually at the beginning of the
annual report. It is a good
review of the key
achievements of the previous
year, and will usually give an
indication as to what lies
ahead.
Dividend per share & dividend
yield: Introducing financial
ratios
When you are researching
shares to buy and sell you may
make use of analyst reports.
These reports are put together
by professionals that specialize
in reading and interpreting
annual reports. Analysts use
the raw data from annual
reports to create forecasts and

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 Investment in Stocks

calculate financial ratios.

Analysts use financial ratios to compare the performance of a company to its previous
results, to its competitors, and to industry averages. There are limitations on the
effectiveness of ratio analysis, you may experience too much data, the data may be
imperfect, or it may have already
been factored into a company's share
price reducing its use as a timely
signal to act. These limitations
aside, reviewing the balance sheet
and analyst reports contribute to
building an objective case for your
share investment decisions.
Objectivity means removing the
emotion from your decisions.
Objectivity is one of the key
advantages attached to having an
investment strategy.
A basic step towards successful investing is to relate a company's performance to the price
of its shares. By calculating 'per share' data we can compare earnings, debt and corporate
health to a company's share price. There are a multitude of ratios used by analysts to make
valuations about a company's shares. In this topic we will look at two important ratios
used by investors, dividend per share and dividend yield.
Dividend per share (DPS)
This is the amount that the
company chooses to pay out of
net profit to its shareholders,
expressed as a number of cents
per share. The company has the
choice of paying out all of the net
profit as a dividend, part of, or
none of the net profit. It depends
on whether or not the company
needs the money to fund growth
or repay debt.

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 Investment in Stocks

A thorough analyst does not merely observe consistent dividend payment over many years
and then determine the investment to be 'safe' and the company a 'Blue chip'.
It is essential to check if the dividends were paid from the current year's earnings or from
retained earnings from previous years. To do that you can check the payout ratio or
dividends/earnings which show what percentage of earnings was paid out as a dividend.
The reciprocal is earnings/dividends which is the dividend cover ratio. If the dividend
cover ratio is less than one then the dividends must have been paid out of retained
earnings. Sometimes paying out all the earnings as dividends is not a good thing, for
example, in the case of a company being able to obtain an above average rate of return
funding expansion or acquisition instead of paying a dividend. At other times, if the
company has surplus cash it may pay out a special dividend or announce a return of
capital.
Dividend yield

The dividend yield is the dividend

expressed as a percentage of the
share price. This is the rate that can
be used to compare the income
generated from one investment to
that from other investments.
High dividend yields are attractive
but they are a representation of past
payouts. They are not a guarantee
of future dividend amounts. The dividend yield figure may also be affected by fluctuating
share prices. It is important to check to see the level of franking attached to the dividend
and what the forecasts are for next year. (Franking: the amount of tax the company has
paid which attaches to the share.)
Earnings per share & PE ratio
Earnings per share (EPS)
The earnings per share are the portion of the profit earned for every ordinary share on
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 Investment in Stocks

issue. It shows at a glance the growth in earnings from one year to the next and the
relative size of earnings to dividends. It is also essential for calculating the Price
Earnings ratio. EPS is calculated by taking the net profit, if any, and dividing by the
number of ordinary shares.

An EPS figure on its own means

very little. The company may not
pay this amount out as a dividend or
it could include non-recurring items.
It is important that the analyst looks
at net profit after tax before any of
these non-recurring items referred
to as 'abnormal items'.
After determining the current EPS,
look for trends. Has EPS been
growing or falling, and how much is
from normal operations rather than
one off events? If EPS is the same
as last year, has there been an
increase in the shares on issue?
Remember EPS does not lend itself to the determination of 'quality'. In bear markets
analysts look much more closely at the quality of earnings and quickly dismiss one-off
items. (Bear market: a term used to describe a market that is falling; this is the opposite
of a bull market.)
Price earnings ratio - PE ratio
The PE ratio is simply the share
price divided by the earning per
share (EPS).

The PE ratio shows how many

times, in years, it will take for your
purchase to be covered by
earnings.
The PE ratio reflects the market's
view of the earnings potential of the
company.
A low PE ratio suggests that the
market expects no growth or lower
profits, while a high PE ratio

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 Investment in Stocks

suggests that the market expects

high growth and a higher profit.
Compare the PE ratio of a company
you are looking at to that of other companies in the same sector and the market as a
whole.

4.3. Decision making of investment in stocks.

Stock valuation
Valuation theory is grounded on the assumption that investors are rational,
wealth maximizing individuals and that stock market prices reflect the fundamental
value. The distinction between fundamental and speculative value of stock is very
important one. Fundamental value here we understand the value of an equity
investment that is held over the long term, as opposed to the value that can be realized
by short term, speculative trading.

Stock valuation process:

1. Forecasting of future cash flows for the stock.
2. Forecasting of the stock price.
3. Calculation of Present value of these cash flows. This result is intrinsic
(investment) value of stock.
4. Comparison of intrinsic value of stock and current market price of the stock
and decision making: to buy or to sell the stock.

Valuation methods:
Common stockholders expect to be rewarded through periodic cash dividends and an
increasing share value. Some of these investors decide which stocks to buy and sell based
on a plan to maintain a broadly diversified portfolio. Other investors have a more
speculative motive for trading. They try to spot companies whose shares are
undervalued—meaning that the true value of the shares is greater than the current market
price. These investors buy shares that they believe to be undervalued and sell shares that
they think are overvalued (that is, the market price is greater than the true value).
Regardless of one‘s motive for trading, understanding how to value common stocks is an
important part of the investment process. Stock valuation is also an important tool for
financial managers—how can they work to maximize the stock price without
understanding the factors that determine the value of the stock? In this section, we will
describe specific stock valuation techniques. First, we will consider the relationship
between market efficiency and stock valuation.

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 Investment in Stocks

Market Efficiency

Economically rational buyers and sellers use their assessment of an asset‘s risk and return
to determine its value. To a buyer, the asset‘s value represents the maximum purchase
price, and to a seller it represents the minimum sale price. In competitive markets with
many active participants, such as the New York Stock Exchange, the interactions of many
buyers and sellers result in an equilibrium price—the market value—for each security.
This price reflects the collective actions that buyers and sellers take on the basis of all
available information.

Buyers and sellers digest new information quickly as it becomes available and, through
their purchase and sale activities, create a new market equilibrium price. Because the flow
of new information is almost constant, stock prices fluctuate, continuously moving toward
a new equilibrium that reflects the most recent information available. This general concept
is known as market efficiency.

The Efficient Market Hypothesis

As noted in Chapter 2, active broker and dealer markets, such as the New York Stock
Exchange and the Nasdaq market, are efficient—they are made up of many rational
investors who react quickly and objectively to new information. The efficient-market
hypothesis (EMH), which is the basic theory describing the behavior of such a ―perfect‖
market, specifically states that:

1. Securities are typically in equilibrium, which means that they are fairly priced and that
their expected returns equal their required returns.

2. At any point in time, security prices fully reflect all information available about the firm
and its securities, and these prices react swiftly to new information.

3. Because stocks are fully and fairly priced, investors need not waste their time trying to
find mispriced (undervalued or overvalued) securities.

Not all market participants are believers in the efficient-market hypothesis. Some feel that
it is worthwhile to search for undervalued or overvalued securities and to trade them to
profit from market inefficiencies. Others argue that it is mere luck that would allow market
participants to anticipate new information correctly and as a result earn abnormal
returns—that is, actual returns greater than average market returns. They believe it is
unlikely that market participants can over the long run earn abnormal returns. Contrary to
this belief, some well-known investors such as Warren Buffett and Bill Gross have over
the long run consistently earned abnormal returns on their portfolios. It is unclear whether

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 Investment in Stocks

their success is the result of their superior ability to anticipate new information or of some
form of market inefficiency.

The Behavioral Finance Challenge

Although considerable evidence supports the concept of market efficiency, a growing

body of academic evidence has begun to cast doubt on the validity of this notion. The
research documents various anomalies—outcomes that are inconsistent with efficient
markets—in stock returns. A number of academics and practitioners have also recognized
that emotions and other subjective factors play a role in investment decisions.

This focus on investor behavior has resulted in a significant body of research, collectively
referred to as behavioral finance. Advocates of behavioral finance are commonly referred
to as ―behaviorists.‖ Daniel Kahneman was awarded the 2002 Nobel Prize in economics
for his work in behavioral finance, specifically for integrating insights from psychology
and economics. Ongoing research into the psychological factors that can affect investor
behavior and the resulting effects on stock prices will likely result in growing acceptance
of behavioral finance. The Focus on Practice box further explains some of the findings of
behavioral finance.

While challenges to the efficient market hypothesis, such as those presented by advocates
of behavioral finance, are interesting and worthy of study, in this text we generally take
the position that markets are efficient. This means that the terms expected return and
required return will be used interchangeably because they should be equal in an efficient
market. In other words, we will operate under the assumption that a stock‘s market price at
any point in time is the best estimate of its value. We‘re now ready to look closely at the
mechanics of common stock valuation.

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 Investment in Stocks

Basic Common Stock Valuation Models

Like the value of a bond, which we discussed in Chapter 6, the value of a share of
common stock is equal to the present value of all future cash flows (dividends) that it is
expected to provide. Although a stockholder can earn capital gains by selling stock at a
price above that originally paid what the buyer really pays for is the right to all future
dividends. What about stocks that do not currently pay dividends? Such stocks have a
value attributable to a future dividend stream or to the proceeds from the sale of the
company. Therefore, from a valuation viewpoint, future dividends are relevant.

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 Investment in Stocks

The basic valuation model for common stock is given in Equation 7.1:

The equation can be simplified somewhat by redefining each year‘s dividend, Dt, in terms
of anticipated growth. We will consider three models here: zero growth, constant growth,
and variable growth.

Zero-Growth Model

The simplest approach to dividend valuation, the zero-growth model, assumes a constant,
no growing dividend stream. In terms of the notation already introduced, When we let D1
represent the amount of the annual dividend, Equation 7.1 under zero growth reduces to

The equation shows that with zero growth, the value of a share of stock would equal the
present value of a perpetuity of D1 dollars discounted at a rate rs.

Example:

Chuck Swimmer estimates that the dividend of Denham Company, an established textile
producer, is expected to remain constant at $3 per share indefinitely. If his required return
on its stock is 15%, the stock‘s value is $20 ($3÷ 0.13) per share.

Preferred Stock Valuation:

Because preferred stock typically provides its holders with a fixed annual dividend over its
assumed infinite life, Equation 7.2 can be used to find the value of preferred stock. The
value of preferred stock can be estimated by substituting the stated dividend on the
preferred stock for D1 and the required return for rs in Equation 7.2. For example, a
preferred stock paying a $5 stated annual dividend and having a required return of 13
percent would have a value of $38.46 ($5÷ 0.13) per share.
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 Investment in Stocks

Constant-Growth Model

The most widely cited dividend valuation approach, the constant-growth model, assumes
that dividends will grow at a constant rate, but a rate that is less than the required return.
(The assumption that the constant rate of growth, g, is less than the required return, rs, is a
necessary mathematical condition for deriving this model.1) By letting D0 represent the
most recent dividend, we can rewrite Equation 7.1 as follows:

The constant-growth model in Equation 7.4 is commonly called the Gordon growth model.
An example will show how it works.

Example: Lamar Company, a small cosmetics company, from 2007 through 2012 paid
the following per-share dividends:

We assume that the historical annual growth rate of dividends is an accurate estimate of
the future constant annual rate of dividend growth, g. To find the historical annual growth
rate of dividends, we must solve the following for g:

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 Investment in Stocks

Using a financial calculator or a spreadsheet, we find that

the historical annual growth rate of Lamar Company
dividends equals 7%.2 The company estimates that its
dividend in 2013, D1, will equal $1.50 (about 7% more than
the last dividend). The required return, rs, is 15%. By
substituting these values into Equation 7.4, we find the
value of the stock to be:

Assuming that the values of D1, rs, and g are accurately estimated, Lamar Company‘s
stock value is $18.75 per share.

Variable-Growth Model
The zero- and constant-growth common stock models do not allow for any shift in
expected growth rates. Because future growth rates might shift up or down because of
changing business conditions, it is useful to consider a variable-growth model that allows
for a change in the dividend growth rate.3 We will assume that a single shift in growth
rates occurs at the end of year N, and we will use g 1 to represent the initial growth rate

and g2 for the growth rate after the shift. To determine the value of a share of stock in the
case of variable growth, we use a four-step procedure:
Step 1 Find the value of the cash dividends at the end of each year, Dt, during the initial
growth period, years 1 through N. This step may require adjusting the most recent
dividend, D0, using the initial growth rate, g1, to calculate the dividend amount
for each year. Therefore, for the first N years,

Step 2 Find the present value of the dividends expected during the initial growth period.
Using the notation presented earlier, we can give this value as:

Step 3 Find the value of the stock at the end of the initial growth period,
PN = (DN + 1)/(rs – g2) which is the present value of all dividends expected from
year N + 1 to infinity, assuming a constant dividend growth rate, g2. This value is

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 Investment in Stocks

found by applying the constant-growth model (Equation 7.4) to the dividends

expected from year N + 1 to infinity.
The present value of PN would represent the value today of all dividends that are
expected to be received from year N + 1 to infinity. This value can be represented by

Step 4 Add the present value components found in Steps 2 and 3 to find the value of the
stock, P0, given in Equation 7.5:

The following example illustrates the application of these steps to a variable growth
situation with only one change in growth rate.

Example:
Victoria Robb is considering purchasing the common stock of Warren Industries, a
rapidly growing boat manufacturer. She finds that the firm‘s most recent (2012) annual
dividend payment was $1.50 per share. Victoria estimates that these dividends will
increase at a 10% annual rate, g1, over the next 3 years (2013, 2014, and 2015) because
of the introduction of a hot new boat. At the end of the 3 years (the end of 2015), she
expects the firm‘s mature product line to result in a slowing of the dividend growth rate
to 5% per year, g2, for the foreseeable future. Victoria‘s required return, rs, is 15%. To
estimate the current (end-of-2012) value of Warren‘s common stock, P0 = P2012 , she
applies the four-step procedure to these data.

Step1 The value of the cash dividends in each of the next 3 years is calculated in columns
1, 2, and 3 of Table 7.3. The 2013, 2014, and 2015 dividends are $1.65, $1.82,
and $2.00, respectively.

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 Investment in Stocks

Step 2 The present value of the three dividends expected during the 2013–2015 initial
growth period is calculated in columns 3, 4, and 5 of Table 7.3. The sum of the
present values of the three dividends is $4.12.
Step 3 The value of the stock at the end of the initial growth period (N = 2015) can be
found by first calculating DN+1 = D2016:
D2016 = D2015 × (1 + 0.05) = $2.00 × (1.05) = $2.10

By using D2016 = $2.10, a 15% required return, and a 5% dividend growth rate,
the value of the stock at the end of 2015 is calculated as follows:

Finally, in Step 3, the share value of $21 at the end of 2015 must be converted
into a present (end-of-2012) value. Using the 15% required return, we get:

Step 4 Adding the present value of the initial dividend stream (found in Step 2) to the
present value of the stock at the end of the initial growth period (found in Step 3)
as specified in Equation 7.5, the current (end-of-2012) value of Warren Industries
stock is:

P2012 = $4.12 + $13.81 = $17.93 per share

Victoria‘s calculations indicate that the stock is currently worth $17.93 per
share.

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 Investment in Stocks

Decisions for the investor in stocks:

Valuation equations measure the stock value at a point in time based on expected return
and risk. Any decisions of the financial manager that affect these variables can cause the
value of the firm to change. Figure 7.3 depicts the relationship among financial decisions,
return, risk, and stock value.

Changes in Expected Dividends

Assuming that economic conditions remain stable, any management action that would
cause current and prospective stockholders to raise their dividend expectations should
increase the firm‘s value. In Equation 7.4, we can see that P0 will increase for any
increase in D1 or g. Any action of the financial manager that will increase the level of
expected dividends without changing risk (the required return) should be undertaken,
because it will positively affect owners‘ wealth.

 If Pm < V - decision to buy the stock, because it is under valuated;

 If Pm > V - decision to sell the stock, because it is over valuated;
 If Pm = V - stock is valuated at the same range as in the market and
its current market price shows the intrinsic value.

Changes in Risk
Although the required return, rs, is the focus of Chapters 8 and 9, at this point we can
consider its fundamental components. Any measure of required return consists of two
components, a risk-free rate and a risk premium. We expressed this relationship as
Equation 6.1 in the previous chapter, which we repeat here in terms of rs:

In the next chapter you will learn that the real challenge in finding the required return is
determining the appropriate risk premium. In Chapters 8 and 9 we will discuss how

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investors and managers can estimate the risk premium for any particular asset. For now,
recognize that rs represents the minimum return that the firm‘s stock must provide to
shareholders to compensate them for bearing the risk of holding the firm‘s equity.

Any action taken by the financial manager that increases the risk shareholders must bear
will also increase the risk premium required by shareholders, and hence the required
return. Additionally, the required return can be affected by changes in the risk free rate—
even if the risk premium remains constant. For example, if the risk-free rate increases due
to a shift in government policy, then the required return goes up too. In Equation 7.1, we
can see that an increase in the required return, rs, will reduce share value, P0, and a
decrease in the required return will increase share value. Thus, any action of the financial
manager that increases risk contributes to a reduction in value, and any action that
decreases risk contributes to an increase in value.

Example:
Assume that Lamar Company‘s 15% required return resulted from a risk-free rate of 9%
and a risk premium of 6%. With this return, the firm‘s share value was calculated in an
earlier example (on pages 280 and 281) to be $18.75. Now imagine that the financial
manager makes a decision that, without changing expected dividends, causes the firm‘s
risk premium to increase to 7%. Assuming that the risk-free rate remains at 9%, the new
required return on Lamar stock will be 16% (9% + 7%), substituting D1 = $1.50, rs =
0.16, and g = 0.07 into the valuation equation (Equation 7.3), results in a new share value
of $16.67 {$1.50 , (0.16 - 0.07)}. As expected, raising the required return, without any
corresponding increase in expected dividends, causes the firm‘s stock value to decline.
Clearly, the financial manager‘s action was not in the owners‘ best interest.

Combined Effect
A financial decision rarely affects dividends and risk independently; most decisions affect
both factors often in the same direction. As firms take on more risk, their shareholders
expect to see higher dividends. The net effect on value depends on the relative size of the
changes in these two variables.
Example:
If we assume that the two changes illustrated for Lamar Company in the preceding
examples occur simultaneously, the key variable values would be D1 = $1.50, rs = 0.16,
and g = 0.09. Substituting into the valuation model, we obtain a share price of $21.43
{$1.50 ÷ (0.16 - 0.09)}. The net result of the decision, which increased dividend growth
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 Investment in Stocks

(g, from 7% to 9%) as well as required return (r s, from 15% to 16%), is positive. The
share price increased from $18.75 to $21.43. Even with the combined effects, the
decision appears to be in the best interest of the firm‘s owners because it increases their
wealth.

2.3 Formation of stock portfolios

In this section we review the important principles behind the stock selection
process that are relevant in the formation and management of the stock portfolios. We
focus on the explanation of the principal categories of common stock, especially the
investment characteristics that make a category of stock suitable for one portfolio but
not for another.
The most widely used categories of stocks are:
2.3.1 blue chip stocks;
2.3.2 income stocks;
2.3.3 cyclical stocks;
2.3.4 defensive stocks;
2.3.5 growth stocks;
2.3.6 speculative stocks;
2.3.7 Penny stocks.
Blue chip stock is the best known of all the categories of stocks presented
above. These stocks represent the best-known firms among the investment community.
But it is difficult to define exactly this category of stock, because in most cases blue
chip stocks are presented using the examples of the firms. One common definition of
Blue Chip Company is that this company has long continuous history of divided
payments. For example, Coca Cola has a history of dividend payments more than for
100 years. But it doesn‘t mean that the younger successful companies running business
for some decades and paying dividends can‘t be categorized as ―blue chips‖ in the
specific investment environment. From the other side, many high quality stocks do not
meet the criterion of uninterrupted dividend history. It is a practice that brokerage
firms recommend for their clients – individual investors the list of blue chip stock as
high quality ones in their understanding, based on the analysis of information about
the firm.

Income stocks are the stocks, the earnings of which are mainly in the form of
dividend income, as opposed to capital gains. It is considered a conservative,
dependable investment, suitable to supplement other income. Well-established
corporations with a consistent record of paying dividends are usually considered
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income stock. In addition, income stocks usually are those that historically have paid a
larger-than-average percentage of their net income after taxes as dividends to their
shareholders and the payout ratio for these companies are high. The common examples
of income stocks are the stocks of public utilities, such as telecommunication
companies, electric companies, etc.
Cyclical stocks are the securities that go up and down in value with the trend
of business and economy, rising faster in the periods of rapidly improving business
conditions and sliding very noticeably when business conditions deteriorate. During a
recession they do poorly. The term cyclical does not imply that these stocks are more
predictable than other categories. They are cyclical because they follow business cycle.
The examples of cyclical stocks can be industrial chemicals, construction industry,
automobile producers, etc.
Defensive stocks (synonymous – protective stocks) are those which are
opposite to cyclical stocks. These stocks shift little in price movements and are very
rarely of interest to speculators. The defensive stocks have low Betas and thus are
assigned to the stocks with lower risk. Held by long-term investors seeking stability,
these stocks frequently withstand selling pressure in a falling market. The best
examples of defensive stocks are food companies, tobacco and alcohol companies and
utilities. Other defensive products include cosmetics, drugs, and health care products.
They continue to sell their products regardless of changes in macroeconomic
indicators.
Growth stocks (synonymous – performance stocks) are stocks of
corporations whose existing and projected earnings are sufficiently positive to indicate
an appreciable and constant increase in the stock‘s market value over the extended
time period. The rate of increase in market value for these stocks is larger than those of
most corporate stock. Income stocks pay out a relatively high percentage of their
earnings as dividends, but growth stocks do not. Instead, the company reinvests its
earnings into profitable investment opportunities that are expected to increase the
value of the firm, and therefore, the value of the firm‘s stock. Many firms have never
paid a dividend and publicly state they have no plans to do so. By default it seems
these should be a growth stocks, because a stock that pays no dividend and does not
increase in value would not be a very attractive investment. Though the analysts and
the experienced investors themselves spend the time trying to discover little-known
growth stocks.
Speculative stocks are the stocks issued by relatively new firms of unproven
financial status and by firms with less than average financial strength. Speculation, by
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definition, involves a short time horizon, and the speculative stocks are those that have
a potential to make their owners a lot of money quickly. At the same time, though,
they carry an unusually high degree of risk. Some analysts consider speculative stocks
to be a most risky growth stocks. However, some new established technological
companies that paid no dividends and had short history would probably be considered
a speculative rather than a growth stock.
Penny stocks are low-priced issues, often highly speculative, selling at very
small price a share. Thus, such stocks could be affordable even for the investors with
small amounts of money.
The categories of the stocks presented above are not really mutually exclusive.
As an examples show, some blue chip stocks at the same time can be an income stock.
Similarly, both cyclical and defensive stocks can be income stocks.

2.5 Strategies for investing in stocks

In this section we focus on the three main types of strategies than investing in
stocks:
• Sector rotation and business cycle strategy;
• Market timing strategy;
• Value screening strategy.

Sector rotation and business cycle strategy. The essentiality of this strategy:
each economic sector as potential investment object has the specific patterns of market
prices which depend upon the phase of the economic (business) cycle.
Sector rotation and business cycle strategy intends the movement of invested
funds from one sector to the other depending on the changes in the economic
(business) conditions.
This strategy use the classification of all stocks traded in the market on the
bases of their behavior in regard to business cycle. The following groups are identified:

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 Defensive stocks
 Interest-sensitive stocks
 Consumer durables
 Capital goods
Defensive stocks were defined in the previous section (4.4). These stocks are
usually related with food industry, retail, tobacco, beverages industries,
pharmaceuticals and other suppliers of the necessity goods and services. The prices of
these stocks reach their highest levels in the later phases of business cycle.
Interest-sensitive stocks are related with the sectors of communications,
utilities, housing industry, also with the insurance and other financial institutions. The
behavior of these stocks is most unfavorable for the investor in the phase of economic
crises/ recession. These stocks are considered as a good investment in the early phases
of business cycle, i.e. in the optimistic phase.
Consumer durables are related with automobile, domestic electric appliances,
furniture industries, and luxury goods and also with the wholesale. These stocks are a
good investment in the middle of business cycle.
Capital goods are related with industries producing machinery, plant, office
equipment, computers and other electronic instruments. Because of the remarkable
time gap between the orders of this production and the terms of their realization, these
stocks demonstrate their high and stabile prices in the latest phases of business cycle.
Thus by knowing and identifying the different patterns of prices relating to
the industries in the real investment environment the investor can diversify his / her
stock portfolio which will reflect to the changes in the economic (business) cycle.

Market timing strategy. The essentiality of this strategy: the investors

endeavor to be „in-the-market― when market is in a „bullish― phase, i.e., when prices
are growing, and to withdraw from the market in the „bearish― phase, i.e., when prices
are slumping.
Investors use several different techniques for forecasting the major ups and
downs in the market. The most often applied techniques using market timi9ng
strategies:
• Technical analysis;
• Stock valuation analysis
• Analysis of economic forecasting

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Technical analysis is based on the diagrams of price fluctuations in the market, the
investors continuously watch the stocks which prices are growing and which falling
as they signalize about the presumable changes in the stock market.
The purpose of the stock valuation analysis is to examine whether the stock market is a
supply market, or is it a demand market. If the under valuated stocks prevail in the
market it reflects to supply market and vice versa – if the over valuated stocks prevail,
it reflects to demand market. The concept and key methods of stock valuation was
discussed in section 4.2. The valuation tools frequently used when applying for market
timing strategy are:
• Price/Earnings ratio (PER);
• The average market price/ book value ratio;
• The average dividend income.
Analysis of economic forecasting. Investors by forecasting changes in the macro
economy and in interest rates endeavor to decrease the investment in stocks in the
phases of economic downturn and to return to these investments during upturn phases
of the economy.

Valuation screening strategy. The essentiality of this strategy: by choosing

and applying one or combining several stock valuation methods and using available
information about the stocks from the data accumulated in the computer database, the
valuation screens are set by investor. All stocks on these screens are allocated on the
basis of their ratings in such an order: on the top of the screen – under valuated stocks,
at the bottom – over valuated stocks. Using these screens investors can form their
diversified stock portfolio and exercise the changes in the existent portfolio.
Various financial indicators and ratios can be used for the rating of stocks
when applying valuation screening strategy. The most often used are following
indicators:
• Price/Earnings ratio (PER);
• Dividend income
• Return on Equity (ROE)
• Return on Investments (ROI).
Valuation screening is very popular strategy; it is frequently used together
with the other investment strategies, because the investors in the market have
possibility to choose from the variety of stocks even in the same market segment.

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What could be the best choose? – rating of the stocks as alternatives using the screen
can be the answer. Usually investors setting the screens combine more than one
indicator for rating of stocks searching for the better results in picking the stocks to
their portfolios. The examples of the other financial indicators used applying valuation
screening strategy:
• Return on assets (ROA)
• Net profit margin
• Debt to assets
• Debt to equity
• Earnings per share (EPS)
• Market price to Book value

Summary

1. Higher investment income, possibility to receive an operating income in cash

dividends, high liquidity and low costs of transactions are the main advantages of
investment in common stock.
2. The relatively higher risk in comparison with many other types securities, the
complicated selection of the stocks because of their high supply in the financial
market, the relatively low the operating income are the main disadvantages of
investment in common stock.
3. E-I-C analysis includes: Economic (macroeconomic) analysis, Industry analysis
and Company analysis. Two alternative approaches used for analysis: (1) ―Top-
down‖ forecasting approach; (2) ―Bottom-up‖ forecasting approach. Using ―top-
down‖ forecasting approach the investors are first involved in making the analysis
and forecast of the economy, then for industries, and finally for companies. Using
―bottom-up‖ forecasting approach, the investors start with the analysis and forecast
for companies, then made analysis and forecasts for industries and for the
economy. The combination of two approaches is used by analysts too.
4. The Macroeconomic analysis includes the examining of economic cycle, fiscal
policy of the government, monetary policy, the other economic factors: inflation,
the level of unemployment; the level of consumption; investments into businesses;
the possibilities to use different types of energy, their prices; foreign trade and the
exchange rate, etc.

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5. The Industry analysis includes the examining of the nature of the industry, the level
of regulation inside this industry, the situation with the self-organization of the
human resources the key factors which influence this industry (production
resources, the perspectives for raising capital, competition form the other countries,
etc), the stage of the industry‘s development cycle. The alternative approach to the
industry analysis suggests the examining of four key areas: demand, pricing, costs
and the influence of the whole economics and financial markets.
6. The base for the company analysis is fundamental analysis is the publicly disclosed
and audited financial statements of the company: (Balance Sheet; Profit/ Loss
Statement; Cash Flow Statement; Statement of Profit Distribution). Analysis use
the period not less than 3 years.
7. Ratio analysis is useful when converting raw financial statement information into a
form that makes easy to compare firms of different sizes. This analysis includes the
examination of the main financial ratios: profitability ratios, which measure the
earning power of the firm; liquidity ratios, which measure the ability of the firm to
pay its immediate liabilities; debt ratios, which measure the firm‘s ability to pay
the debt obligations over the time; asset – utilization ratios, which measure the
firm‘s ability to use its assets efficiently and market value ratios are an additional
group of ratios which reflect the market value of the stock and the firm.
8. The investor must compare the ratios of the firm with the ratios of a relevant
benchmark. For this reason firms are frequently benchmarked against other firms
with similar size and in the same home country and industry.
9. Stock valuation process includes four stages: (1) forecasting of future cash flows
for the stock; (2) forecasting of the stock price; (3) calculation of Present value of
these cash flows. This result is intrinsic (investment) value of stock; (4)
comparison of and current and decision making: to buy or to sell the stock. If
market price of the stock is lower than intrinsic value of the stock decision would
be to buy the stock, because it is under valuated; if market price of the stock is
higher than intrinsic value of the stock decision would be to sell the stock, because
it is over valuated; if market price of the stock is equal to the intrinsic value of
stock is valuated at the same range as in the market and its current market price
shows the intrinsic value.

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10. Most frequently used methods for valuation of common stocks are: the method of
income capitalization; discounted dividend models and valuation using multiples.
11. The discounted dividends models (DDM) are based on the method of income
capitalization and considers the stock price as the discounted value of future
dividends, at the risk adjusted required return of equity, for dividend paying firms.
Various types of DDM, depending upon the assumptions about the expected
growth rate in dividends (g):―Zero‖ growth DDM; Constant growth DDM;
Multistage growth DDM.
12. The most common used multiply is the Price Earning Ratio (PER). Decision
making for investment in stocks, using PER: if the normative PER is higher than
observed decision would be to buy or to keep the stock, because it is under
valuated; if the normative PER is lower than observed decision would be to sell the
stock, because it is over valuated; If normative and PER is equal to observed PER,
stock is valuated at the same range as in the market. In this case the decision
depends on the additional observations of investor.
13. The other alternative multiples used for stock valuation by investors include Sales /
Market capitalization of the firm; Sales / Equity value; Market capitalization /Book
Value of the Equity Ratio etc. These alternative multiples are used when earnings
are not representative.
14. The categories of stocks most widely used in the selection process and relevant in
the formation and management of the stock portfolios. are: blue chip stocks;
income stocks; cyclical stocks; defensive stocks; growth stocks; speculative stocks;
penny stocks.
15. Sector rotation and business cycle strategy intends the movement of invested funds
from one sector to the other depending on the changes in the economic (business)
conditions. This strategy use the classification of all stocks traded in the market on
the bases of their behavior in regard to business cycle.
16. The essentiality of market timing strategy is that the investors endeavor to be „in-
the-market―when market is in a „bullish―phase, i.e., when prices are growing, and
to withdraw from the market in the „bearish―phase, i.e., when prices are slumping.
17. Valuation screening strategy use the valuation screens set by investor. All stocks
on these screens are allocated on the basis of their ratings in such an order: on the
top of the screen – under valuated stocks, at the bottom – over valuated stocks.

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Using these screens investors can form their diversified stock portfolio and
exercise the changes in the existent portfolio.

Key-terms
• Asset – utilization ratios • Industry analysis
• Blue chip stocks • Interest-sensitive stocks
• ―Bottom-up‖ forecasting • Intrinsic (investment) value
approach
• Liquidity ratios
• Capital goods • Market timing strategy
• Cyclical stocks • Market value ratios
• Company analysis • Multiples method
• Constant growth DDM • Multistage growth DDM
• Consumer durables • Penny stocks
• Debt ratios • Profitability ratios
• Defensive stocks • Sector rotation and business
• Discounted dividend models cycle strategy
(DDM)
• Speculative stocks
• Economic analysis • Stock valuation process
• E-I-C analysis • Technical analysis
• Fundamental analysis • ―Top-down‖ forecasting
• Growth stocks approach
• Income stocks • Value screening strategy
• Income capitalization • ―Zero‖ growth DDM

Questions and problems

1. The investor wants to identify if the stock of firm A is cyclical. How he/ she would
proceed?
2. Common stock hasn‗t term to maturity. How then can a stock that does not pay
dividends have any value? Give an examples of such firms listed in the domestic
market of your country.
3. What is the difference between blue chip and income stocks?
4. Give examples of defensive stocks in the domestic market of your country.
5. Present the examples of blue chip stocks in the domestic market Explain, why did
you categorize them as blue chips.
 Investment in Stocks

6. What is meant by the intrinsic (investment) value of a stock?

7. How can investors obtain EPS forecasts? Which sources could be used?
8. What are the variables that affect the price/ earnings ratio? Is the effect direct or
inverse for each component?
9. What is meant by normalized price/earnings ratio?
10. If the intrinsic value for the stock is 8 Euro and the market price for this stock is 9
Euro, than:
a) Stock is over valuated and could be good investment;
b) Stock is over valuated and isn‗t good investment;
c) Stock is under valuated and could be good investment;
d) Stock is under valuated and isn‗t good investment.
11. Firm currently pays a dividend of 4 EURO per share. That dividend is expected to
grow at a 5 % rate indefinitely. Stocks with similar risk provide a 10 % expected
return. Estimate the intrinsic value of the firm‘s stock based on the assumption that
the stock will be sold after 2 years from now at its expected intrinsic value.
12. Using the given historical data of the company for 5 previous years analyze and
comment on the company‗s performance. Upon the analysis based on this
historical data do you find this company attractive for investment in stocks?
Explain.

FINANCIAL
RATIOS
2010-01-01 2009-01-01 2008-01-01 2007-01-01 2006-01-01
LIQUIDITY
RATIOS
Current ratio 0.81 0.99 1.24 2.60 4.43
Quick ratio 0.39 0.45 1.02 0.89 1.61
PROFITABILITY
RATIOS
Gross profit margin 38.8% 57.9% 57.6% 52.0% 47.4%
Profit from
10.0% 26.9% 27.3% 26.9% 22.3%
operations margin
Net profit margin 7.9% 23.8% 33.1% 18.0% 14.5%
ROA 10.6% 18.5% 24.8% 12.4% 6.8%
ROE 15.0% 25.5% 38.2% 19.6% 9.4%
DEBT RATIOS
Debt to assets 29.2% 27.5% 34.9% 36.9% 27.6%
Debt to equity 41.2% 38.0% 53.7% 58.4% 38.0%
ASSET-
UTILIZATION
RATIOS
 Investment in Stocks

Inventory turnover 88 91 133 166 240

Receivables turnover 31 49 50 34 51
Long term assets
0.37 0.95 1.05 0.96 0.63
turnover
Asset turnover 0.31 0.78 0.75 0.69 0.47
MARKET VALUE
RATIOS
Capitalization, mln.
118,221,72 116,442,06 240,002,85 71,950,00 42,373,38
EURO
P/E ratio 7.72 4.60 8.08 6.90 10.03
Earnings per share,
0.60 0.99 1.17 1.23 0.50
EURO
Market price to book
1.16 1.18 3.08 1.35 0.94
value
Book value of share,
4.01 3.90 3.06 6.28 5.33
EURO
Cash dividend per
0.06 0.16 0.16 0.25 0.12
share, EURO
Payout ratio 10.2% 16.1% 13.7% 20.3% 24.2%

13. The new little known firm is analyzed from the prospect of investments in
its shares by two friends. The firm paid dividends last year 3 EURO per share.
Tomas and Arnas examined the prices of similar stocks in the market and
found that they provide 12 % expected return. The forecast of Tomas is as
follows: 4 % of growth in dividends indefinitely. The forecast of Arnas is as
follows: 10% of growth in dividends for the next two years, after which the
growth rate is expected to decline to 3 % for the indefinite period.
a) What is the intrinsic value of the stock of the firm according to
Tomas forecast?
b) What is the intrinsic value of the stock of the firm according to
Arnas forecast?
c) If the stocks of this firm currently are selling in the market for 40
EURO per share, what would be the decisions of Tomas and Arnas,
based on their forecasting: is this stock attractive investment? Explain.
14. Look through the listed companies on the domestic stock exchange. What
industries they represent? Would you be able to construct the stock
portfolio applying sector rotation strategy in the domestic stock exchange?
15. Explain the linkages among financial decisions, return, risk, and stock value?
 Investment in Stocks

16. Assuming that all other variables remain unchanged, what impact would each of
the following have on stock price? (a) The firm‘s risk premium increases. (b) The
firm‘s required return decreases. (c) The dividend expected next year decreases.
(d) The rate of growth in dividends is expected to increase.
17. Common stock valuation—Zero growth
Scotto Manufacturing is a mature firm in the machine tool component industry.
The firm‘s most recent common stock dividend was $2.40 per share. Because of
its maturity as well as its stable sales and earnings, the firm‘s management feels
that dividends will remain at the current level for the foreseeable future.
a. If the required return is 12%, what will be the value of Scotto‘s common
stock?
b. If the firm‘s risk as perceived by market participants suddenly increases,
causing the required return to rise to 20%, what will be the common stock value?
c. Judging on the basis of your findings in parts a and b, what impact does risk
have on value? Explain.
18. Common stock value—Zero growth
Kelsey Drums, Inc., is a well-established supplier of fine percussion instruments
to orchestras all over the United States. The company‘s class A common stock
has paid a dividend of $5.00 per share per year for the last 15 years. Management
expects to continue to pay at that amount for the foreseeable future. Sally Talbot
purchased 100 shares of Kelsey class A common 10 years ago at a time when the
required rate of return for the stock was 16%. She wants to sell her shares today.
The current required rate of return for the stock is 12%. How much capital gain
or loss will Sally have on her shares?
19. Preferred stock valuation
Jones Design wishes to estimate the value of its outstanding preferred stock. The
preferred issue has an $80 par value and pays an annual dividend of $6.40 per
share. Similar-risk preferred stocks are currently earning a 9.3% annual rate of
return.
a. What is the market value of the outstanding preferred stock?
b. If an investor purchases the preferred stock at the value calculated in part a,
how much does she gain or lose per share if she sells the stock when the
required return on similar-risk preferred stocks has risen to 10.5%? Explain.
20. Common stock value—Constant growth
 Investment in Stocks

Use the constant-growth model (Gordon growth model) to find the value of each
firm shown in the following table.

21. Common stock value—Constant growth

McCracken Roofing, Inc., common stock paid a dividend of $1.20 per share last
year. The company expects earnings and dividends to grow at a rate of 5% per
year for the foreseeable future.
a. What required rate of return for this stock would result in a price per share of
$28?
b. If McCracken expects both earnings and dividends to grow at an annual rate of
10%, what required rate of return would result in a price per share of $28?
22. Common stock value—Constant growth
Elk County Telephone has paid the dividends shown in the following table over
the past 6 years. The firm‘s dividend per share next year is expected to be $3.02.

a. If you can earn 13% on similar-risk investments, what is the most you would
be willing to pay per share?
b. If you can earn only 10% on similar-risk investments, what is the most you
would be willing to pay per share?
 Investment in Stocks

c. Compare and contrast your findings in parts a and b, and discuss the impact of
changing risk on share value.
23. Common stock value—Variable growth
Newman Manufacturing is considering a cash purchase of the stock of Grips
Tool. During the year just completed, Grips earned $4.25 per share and paid cash
dividends of $2.55 per share. Grips‘ earnings and dividends are expected to grow
at 25% per year for the next 3 years, after which they are expected to grow at
10% per year to infinity. What is the maximum price per share that Newman
should pay for Grips if it has a required return of 15% on investments with risk
characteristics similar to those of Grips?
24. Common stock value—Variable growth
Home Place Hotels, Inc., is entering into a 3-year remodeling and expansion
project. The construction will have a limiting effect on earnings during that time,
but when it is complete, it should allow the company to enjoy much improved
growth in earnings and dividends. Last year, the company paid a dividend of
$3.40. It expects zero growth in the next year. In years 2 and 3, 5% growth is
expected, and in year 4, 15% growth. In year 5 and thereafter, growth should be a
constant 10% per year. What is the maximum price per share that an investor
who requires a return of 14% should pay for Home Place Hotels common stock?
25. Common stock value—Variable growth
Lawrence Industries‘ most recent annual dividend was $1.80 per share (D0 =
$1.80), and the firm‘s required return is 11%. Find the market value of
Lawrence‘s shares when:
a. Dividends are expected to grow at 8% annually for 3 years, followed by a 5%
constant annual growth rate in years 4 to infinity.
b. Dividends are expected to grow at 8% annually for 3 years, followed by a 0%
constant annual growth rate in years 4 to infinity.
c. Dividends are expected to grow at 8% annually for 3 years, followed by a 10%
constant annual growth rate in years 4 to infinity.
 Investment in Stocks

References and further readings

1. Arnold, Glen (2010). Investing: the definitive companion to investment and
the financial markets. 2nd ed. Financial Times/ Prentice Hall.
2. Barker, Richard (2001). Determining Value: Valuation Models and
Financial Statements. Financial Times / Prentice Hall.
3. Brammertz, Willi at al. (2009). Unified financial analysis. John Wiley & Sons,
Ltd.
4. Fabozzi, Frank J. (1999). Investment Management. 2nd. ed. Prentice Hall Inc.
5. Francis, Jack C., Roger Ibbotson (2002). Investments: A Global
Perspective. Prentice Hall Inc.
6. Jones, Charles P. (2010). Investments Principles and Concepts. John Wiley
& Sons, Inc.
7. Rosenberg, Jerry M. (1993).Dictionary of Investing. John Wiley &Sons Inc.
8. Sharpe, William F., Gordon J.Alexander, Jeffery V.Bailey. (1999).
Investments. International edition. Prentice –Hall International.
9. Strong, Robert A. (1993). Portfolio Construction, Management and Protection.
10. Vause, B. (2009). Guide to Analyzing Companies. 5th ed. The Economist
Books/ Profile Books.

Relevant websites
http://www.marketwatch.com Market Watch
http://www.bloomberg.com Bloomberg
http://www.advfn.com ADVFN
http://www.zacks.com/screening Zaks Investment
Research http://www.reuters.com/ Reuters
www.nasdaqomx.com NASDAQ OMX
 Investment in bonds

3. Investment in bonds

3.1 Identification and classification of bonds

Bonds are securities with following basic characteristics:

• They are typically securities issued by a corporation or governmental body
for specified term: bonds become due for payment at maturity, when the
par value/ face value of bond are returned to the investors.
• Bonds usually pay fixed periodic interest installments, called coupon
payments. Some bonds pay variable income.
• When investor buys bond, he or she becomes a creditor of the issuer. Buyer
does not gain any kind of owner ship rights to the issuer, unlike in the case
with equity securities.
The main advantages of bonds to the investor:
• They are good source of current income;
• Investment to bonds is relatively safe from large losses;
• In case of default bondholders receive their payments before shareholders
can be compensated.
A major disadvantage of bonds is that potential profit from investment in bonds
is limited.
Currently in the financial markets there are a lot of various types of bonds and
investor must understand their differences and features before deciding what bonds
would be suitable for his/ her investment portfolio.

Bonds classification by their key features:

 By form of payment:
• Noninteresting bearing bonds - bonds issued at a discount. Throughout the
bond‟s life its interest is not earned, however the bond is redeemed at
maturity for face value.
• Regular serial bonds - serial bonds in which all periodic installments of
principal repayment are equal in amount.
• Deferred –interest bonds –bonds paying interest at a later date;
• Income bonds – bonds on which interest is paid when and only when
earned by the issuing firm;
• Indexed bonds - bonds where the values of principal and the payout rise
with inflation or the value of the underlying commodity;
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 Investment in bonds

• Optional payment bonds – bonds that give the holder the choice to receive
payment on interest or principal or both in the currency of one or more
foreign countries, as well as in domestic currency.

 Coupon payment:
• Coupon bonds – bonds with interest coupons attached;
• Zero-coupon bonds – bonds sold at a deep discount from its face value and
redeemed at maturity for full face value. The difference between the cost of
the bond and its value when redeemed is the investor‟s return. These
securities provide no interest payments to holders;
• Full coupon bonds – bonds with a coupon rate near or above current market
interest rate;

• Floating-rate bonds – debt instruments issued by large corporations and

financial organizations on which the interest rate is pegged to another rate,
often the Treasury-bill rate, and adjusted periodically at a specified amount
over that rate.

 Collateral:
• Secured bonds – bonds secured by the pledge of assets (plant or
equipment), the title to which is transferred to bondholders in case of
foreclosure;

• Unsecured bonds – bonds backed up by the faith and credit of the issuer
instead of the pledge of assets.
• Debenture bonds – bonds for which there is no any specific security set
aside or allocated for repayment of principal;
• Mortgage bonds (or mortgage-backed securities) – bonds that have as an
underlying security a mortgage on all properties of the issuing corporation;
• Sinking fund bonds – bonds secured by the deposit of specified amounts.
The issuing corporation makes these deposits to secure the principal of the
bonds, and it is sometimes required that the funds be invested in other
securities;
• Asset-Backed Securities (ABS) – similar to mortgage bonds, but they are
backed by a pool of bank loans, leases and other assets. The ABS are
related with the new market terminology – securitization which understood
as the process of transforming lending vehicles such as mortgages into
marketable securities. The main features of ABS for investor: relatively
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 Investment in bonds

high yield, shorter maturities (3-5 years) and monthly, rather than
semiannual principal/ interest payments. From their introducing to the
market they were ranked as high credit quality instruments. But the recent
financial crises showed that these debt instruments could be extremely risky
investment when banks loans portfolios as a guarantee of ABS become
worthless causing banks‟ insolvency problems.
• General obligation bonds – bonds, secured by the pledge of the issuer‟s full
faith and credit, usually including unlimited tax-power;
• Guaranteed bonds – bonds which principal or income or both are
guaranteed by another corporation or parent company in case of default by
the issuing corporation;
• Participating bonds – bonds which, following the receipt of a fixed rate of
periodic interest, also receive some of the profit generated by issuing
business;
• Revenue bonds – bonds whose principal and interest are to be paid solely
from earnings.

 Type of circulation:
• Convertible bonds – bonds that give to its owner the privilege of
exchanging them for other securities of the issuing corporation on a
preferred basis at some future date or under certain conditions;
• Interchangeable bonds – bonds in coupon form that can be converted to the
other form or its original form at the request of the holder paying the
service charge for this conversion.

 Type of issuers:
• Treasury (government) bonds – an obligation of the government. These
bonds are of the highest quality in each domestic market because of their
issuer – Government. This guarantee together with their liquidity makes
them popular with both individual and institutional investors. The
government bonds are dominant in the fixed-income market.
• Municipal bonds - bonds issued by political subdivisions in the country
(county, city, etc.);
• Corporate bonds – a long-term obligation of the corporation;
• Industrial bonds – bonds issued by corporations other than utilities, banks
and railroads. This debt is used for expansion, working capital and retiring
other debts;
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• Public utility bonds – high quality debt instruments issued by public utility
firms.

 Recall possibility:
• Callable (redeemable) bonds – bonds issue, all or part of which may be
redeemed by the issuing corporation under definite conditions, before the
issue reaches maturity;
• Noncallable (irredeemable) bonds – bonds issued which contains no
provision for being “called” or redeemed prior to maturity date.

 Place of circulation:
• Internal bonds - bonds issued by a country payable in its own currency;
• External bonds - bonds issued by government or firm for purchase
outside the nation, usually denominated in the currency of the purchaser.
The term Eurobond is often applied to these bonds that are offered outside
the country of the borrower and outside the country in whose currency
the securities are denominated. As the Eurobond market is neither
regulated nor taxed, it offers substantial advantages for many issuers and
investors in bonds.

 Quality:
• Gilt-edged bonds – high-grade bonds issued by a company that has
demonstrated its ability to earn a comfortable profit over a period of years
and to pay its bondholders their interest without interruption;
• Junk bonds - bonds with low rating, also regarded as high yield bonds.
These bonds are primarily issued y corporations and also by municipalities.
They have a high risk of default because they are issued as unsecured and
have a low claim on assets.

 Other types of bonds:

• Voting bonds - unlike regular bonds, these bonds give the holder some
voice in corporation management;
• Senior bonds - bonds which having prior claim to the assets of the debtor
upon liquidation;
• Junior bonds – bonds which is subordinated or secondary to senior bonds.

3.2 Bond analysis: structure and contents

Similar to analysis when investing in stocks investor before buying bonds must

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evaluate a wide range of the factors which could influence his/ her investment results.
The key factors are related with the results of the performance and the financial
situation of the firm which is issuer of the bonds. Various indicators are used for the
evaluation of these factors.
Bond analysis includes:
 Quantitative analysis.
 Qualitative analysis.

3.2.1 Quantitative analysis.

Quantitative indicators – the financial ratios which allows assessing the
financial situation, debt capacity and credibility of the company –issuer of the bonds.
Since the bonds are debt instruments and the investor in bonds really becomes
the creditor the most important during analysis is the assessment of the credibility of
the firm – issuer of the bonds. Basically this analysis can be defined as the process of
assessment the issuer‟s ability to undertake the liabilities in time. Similar to the
performing of fundamental analysis for common stock, bond analysis (or credit
analysis) uses financial ratios. However the analysis of bonds differs from the analysis
of stock, because the holder of the regular bonds has not any benefit of the fact that the
income of the firm is growing in the future and thus the dividends are growing – these
things are important to the shareh older. Instead of this investor in bonds is more
interested in the credibility of the firm, its financial stability. Estimation of financial
ratios based on the main financial statements of the firm (Balance sheet; Profit/ loss
statement; Cash flow statement, etc.) is one of the key instruments of quantitative
analysis. Some ratios used in bond analysis are the same as in the stock analysis. But
most important financial ratios for the bond analysis are:
3.2.1.1 Debt / Equity ratio;
3.2.1.2 Debt / Cash flow ratio;
3.2.1.3 Debt coverage ratio;
3.2.1.4 Cash flow / Debt service ratio.

Debt / Equity ratio = long-term debt / total stockholders' equity (5.1)

Debt / Equity ratio = DL / SET ,

here: DL - long-term debt;

SET - total stockholders „equity.

Debt/ Equity ratio shows the financial leverage of the firm. Equity represents
the conservative approach of the firm financing, because in the case of financial crises
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 Investment in bonds

of the firm dividends are not paid to the shareholders. While repayment of debt and
interest payments must be undertaken despite of what is the level of firm‟s
profitability. The higher level of this ratio is the indicator of increasing credit risk.
Estimation of this ratio is based on the data from the Balance sheet of the firm.

Debt / Cash flow ratio

= (long-term debt + lease payments) / (net income + depreciation), (5.2)

Debt / Cash flow ratio = (DL+ LP) / (NI + DC), (5.2)

here: LP - lease payments;

NI – net income;
DC – depreciation.

Debt/ cash flow ratio shows the number of years needed to the firm to undertake
all its long-term liabilities and leasing contracts using current generated funds (cash
flow) by firm. Of course this is practically unbelievable that the firm could use such
an aggressive debt repayment plan; however this ratio is an effective measure of the
firm‟s financial soundness and financial flexibility. Firms with the low Debt /Cash
flow ratio can borrow funds needed easily at any time. From the other side, firms with
the high Debt /Cash flow ratio could meet substantial problems if they would like to
increase the capital for their business activity by borrowing. Estimation of this ratio is
based on the data from the balance sheet (long term debt), profit/loss statement (net
income, depreciation) or cash flow statement (if the depreciation is not showed a
profit/loss statement of the firm. Information about future leasing payments of the firm
often is presented in the of-balance sheet statements.

Debt coverage ratio = EBIT / I, (5.3)

here: EBIT - earnings before interest and taxes;

I - interest expense.
Debt coverage ratio sometimes is presented as “Interest turnover” ratio. This is
very important analytical indicator. The firm with the higher ratio is assessed as
financially stronger. When analyzing this ratio it is not enough to take only a one year
result of the firm, but it is necessary to examine the tendencies of changes in this ratio
during longer period. It is especially important to analyze how the firm has managed to
pay the interest on the debt when it generated low income, i.e. in the period of
economic crises and other unfavorable conditions for the firm. Besides this ratio shows
what the reserve the firm has for the coverage of the interest, if the income of the firm
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would decrease. The higher the reserve, the lower is the risk of the bonds issued by the
firm.

Cash flow/Debt service ratio = (EBIT+ DC)/ [I + DR (1-Tr)-1 +LP (1-Tr)-1], (5.4)

here: DR – debt retirement;

Tr – corporation tax rate.
Note that the estimation of the Cash flow/Debt service ratio includes the
adjustment of the debt and interest payments by the corporation tax. This is necessary
because the sum of the debt repayment must be increased by the sum of corporation
tax. Thus, the debt is redeemed using net income, and the interest expenses and often
leasing payments are the part of financial expenses of the firm. Although Debt
coverage ratio is a good measure for the evaluation of the credit level of the firm
however many credit analysts consider Cash flow/Debt service ratio as the best
measure for evaluation of the firm‟s credibility. Their main arguments are: generated
income of the firm shows not only net income but the non-cash expenses –
depreciation expenses - as well; for creditor not only ability of the firm to pay interest
is important, but the ability to repay the debt and to cover leasing payments in time
too.

3.2.2 Qualitative analysis

Qualitative indicators are those which measure the factors influencing the
credibility of the company and most of which are subjective in their nature and
valuation, are not quantifiable.
Although the financial ratios discussed above allows evaluating the credit
situation of the firm, but this evaluation is not complete. For the assessment of the
credibility of the firm necessary to analyze the factors which are not quantifiable
Unfortunately the nature of the majority of these factors and their assessment are
subjective wherefore it is more difficult to manage these factors. However, this part of
analysis in bonds based on the qualitative indicators is important and very often is the
dividing line between effective and ineffective investment in bonds.
Groups of qualitative indicators/ dimensions:
 Economic fundamentals (the current economic climate – overall
economic and industry-wide factors);
 Market position (market dominance and overall firm size: the larger
firm – the stronger is its credit rating);
 Management capability (quality of the firm‟s management team);

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 Bond market factors (term of maturity, financial sector, bond

quality, supply and demand for credit);
 Bond ratings (relationship between bond yields and bond quality).
Analysis of Economic fundamentals is focused on the examining of business
cycle, the macroeconomic situation and the situation of particular sectors / industries in
the country‟s economy. The main aim of the economic analysis is to examine how the
firm would be able to perform under the favorable and unfavorable conditions, because
this is extremely important for the investor, when he/ she is attempting to evaluate his/
her risk buying the bonds of the firm.
Market position is described by the firm‟s share in the market and by the size
of the firm. The other conditions being equal, the firm which share in the market is
lager and which is larger itself generally has credit rating higher. The predominance of
the firm in the market shows the power of the firm to set the prices for its goods and
services. Besides, the large firms are more effective because of the effect of the
production scale, their costs are lower and it is easier for such firms overcome the
periods of falls in prices. For the smaller firms when the prices are increasing they are
performing well but when the markets are slumping – they have the problems. Thus it
is important for the creditor to take it in mind.
Management capability reflects the performance of the management team of
the firm. It is often very difficult to assess the quality of the management team, but the
result of this part of analysis is important for the investor attempting to evaluate the
quality of the debt instruments of the firm. The investors seeking to buy only high
quality (that means – low risk) bonds most often are choosing only those firms
managers of which follow the conservative policy of the borrowing. Contrary, the risk-
taking investors will search for the firms which management uses the aggressive policy
of borrowing and are running with the high financial leverage. In general the majority
of the holders of the bonds first of all are want to know how the firm‟s managers
control the costs and what they are doing to control and to strengthen the balance sheet
of the firm (for this purpose the investor must analyze the balance sheet for the period
of 3-5 years and to examine the tendencies in changes of the balance sheet main
elements.
Bond market factors (term of maturity, financial sector, bond quality, supply
and demand for credit); The investor must understand which factors and conditions
have the influence on the yield and the prices of the bonds. The main factors to be
mentioned are:

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 Investment in bonds

• Term to maturity. Generally term to maturity and the interest rate (the
yield) of the bond are directly related; thus, the bonds with the longer term
to maturity have the higher yield than the bonds with shorter terms to
maturity.
• The sector in the economy which the issuer of the bonds represents. The
yields of the bonds vary in various sectors of the economy; for example,
generally the bonds issued by the utility sector firms generate higher yields
to the investor than bonds in any other sector or government bonds.
• The quality of the bonds. The higher the quality of the bond, the lower the
yield. For the bonds with lower quality the yield is higher.

• The level of inflation; the inflation decreases the purchasing power of the
future income. Since the investors do not want to decrease their real yield
generated from the bonds cash flows, they require the premium to the
interest rate to compensate for their exposure related with the growing
inflation. Thus the yield of the bond increases (or decreases) with the
changes in the level of inflation.
• The supply and the demand for the credit; The interest rate o the price of
borrowing money in the market depend on the supply and demand in the
credit market; When the economy is growing the demand for the funds is
increasing too and the interest rates generally are growing. Contrary, when
the demand for the credits is low, in the period of economic crises, the
interest rates are relatively low also.

Bond ratings. The ratings of the bonds sum up the majority of the factors
which were examined before. A bond rating is the grade given to bonds that indicates
their credit quality. Private independent rating services such as Standard & Poor's,
Moody's and Fitch provide these evaluations of a bond issuer's financial strength, or
it‟s the ability to pay a bond's principal and interest in a timely fashion. Thus, the role
of the ratings of the bonds as the integrated indicator for the investor is important in
the evaluation of yield and prices for the bonds. The rating of the bond and the yield of
the bond are inversely related: the higher the rating, the lower the yield of the bond.
Bond ratings are expressed as letters ranging from 'AAA', which is the highest grade,
to 'C' ("junk"), which is the lowest grade. Different rating services use the same letter
grades, but use various combinations of upper- and lower-case letters to differentiate
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 Investment in bonds

themselves (see more information about the bond ratings in Annex 1 and the relevant
websites of credit ratings agencies).

3.2.3 Market interest rates analysis

It's very important for the investor to the bonds to understand what causes the
changes in the interest rates in the market in the different periods of time. We could
observe frequent changes in the interest rates and the wide amplitude of it fluctuations
during last decade, thus the interest rates became the crucial factor in managing fixed
income securities portfolios as well as stock portfolios. The understanding of the
macroeconomic processes and the causality of the various economic factors with the
interest rates helps the investors to forecast the direction of the changes in interest
rates. At the macroeconomic level the relationship between the interest rate and the
level of savings and investments, changes in government spending, taxes, foreign trade
balance is identified.
Macroeconomic factors with positive influence to the interest rates (from the
investors in bonds position - increase in interest rates):
• Increase in investments;
• Decrease in savings level;
• Increase in export;
• Decrease in import;
• Increase in government spending;
• Decrease in Taxes.
Macroeconomic factors with negative influence to the interest rates (from the
investors in bonds position - decrease in interest rates):
• Decrease in investments;
• Increase in savings level;
• Decrease in export;
• Increase in import;
• Decrease in government spending;
• Increase in Taxes.
By observing and examining macroeconomic indicators presented above the
investors can assess the situation in the credit securities market and to revise his/ her
portfolio (the investment strategies in bonds will be discussed later in this chapter).
For interest rates forecasting purpose such tool as the term structure of interest
rates is used. Term structure of interest rates is a yield curve displaying the
relationship between spot rates of zero-coupon securities and their term to maturity.
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 Investment in bonds

The resulting curve allows an interest rate pattern to be determined, which can then be
used to explain the movements and to forecast interest rates. Unfortunately, most
bonds carry coupons, so the term structure must be determined using the prices of
these securities. Term structures are continuously changing, and though the resulting
yield curve is usually normal, it can also be flat or inverted. Usually, longer term
interest rates are higher than shorter term interest rates. This is called a "normal yield
curve". A small or negligible difference between short and long term interest rates is
called a "flat" yield curve. When the difference between long and short term interest
rates is large, the yield curve is said to be "steep".
The 3 main factors influencing the yield curve are identified:
• market forecasts and expectations about the direction of changes in interest
rates;
• presumable liquidity premium in the yield of the bond.
• market inefficiency or the turn from the long-term (or short-term) cash
flows to the short-term (or long term cash flows.
On the bases of these key factors three interest rates term structure theories
are developed to explain the shape of the yield curve.
3.2.3.1 The Market expectations theory, which states that since short
term bonds can be combined for the same time period as a longer term
bond, the total interest earned should be equivalent, given the efficiency of the
market and the chance for arbitrage (speculators using opportunities to
make money). According to this theory, yield to maturity for the 5 year
bond is simply the average of 1 year yield to maturity during next 5 years.
Mathematically, the yield curve can then be used to predict interest rates at
future dates.
3.2.3.2 The Liquidity preference theory, which states that the profile of
yield curve depends upon the liquidity premiums. If the investor does not
consider short- term and long-term bonds as the good substitutes for the
investments he / she may require the different yields to the maturity, similar
to the stocks with high and low Beta. Thus, Liquidity preference theory states
that the yield curve of interest term structure depends not only upon the
market expectations, but upon the spread of liquidity premiums between
shorter-term and longer-term bonds.

3.2.3.3 The Market segmentation theory is based on the understanding

of market inefficiency in defining the prices of the bonds. This theory states
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 Investment in bonds

that each segment in the bonds 'market, identified on the basis of the yield to
maturity of the bonds could be treated as independent segment from the
others. These segments are represented by different groups of investors
which are resolute about the necessity to invest in the bonds with this
particular yield to maturity. These different groups of investors (for example –
banks, insurance companies, non-financial firms, individuals, etc.) need to
„employ“ their funds for specific periods of time, hence a preference for
long or short term bonds which is reflected in the shape of the yield curve.
An inverted curve can then be seen to reflect a definite investor preference
for longer term bonds. The profile of terms structure will depend not on the
market expectations or risk Premium but most often because of the changes
in the direction of cash flows (similar to swing effect).
Investors in bonds often use yield curves in making investment decisions.
Analyzing the changes in yield curves over the time provides the investors with
information about future interest rate movements and how they an affect price
behavior and comparative returns. For example, if the yield curve begins to rise
sharply, it usually means that inflation is growing or is expected to grow in the nearest
future. In this case investors can expect that interest rates will rise also. Under these
conditions, the active investors will turn to short or intermediate maturities, which
provide reasonable returns and minimize exposure to capital loss hen prices fall.
Another example could be steep yield curves. They are generally viewed as a sign of
bullish market. For aggressive investors in bonds this profile of the yield curve can be
a signal to start moving into long-term bonds segment. Flatter yield curves, contrary,
reduce the incentive for investing in long-term debt securities.

3.3 Decision making of investment in bonds.

Bond valuation.
Selection of bond types relevant for investor and bond analysis are the
important components of overall investment in bonds decision making process.
Investment in bonds decision making process:
3.3.1 Selection of bond‟s type according to the investor‟s goals
(expected income and risk).
3.3.2 Bond analysis (quantitative and qualitative).
3.3.3 Bond valuation.
3.3.4 Investment decision making.

In this section the third and the fourth components of the decision making
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process are examined.

In the bond market investment decisions are made more on the bond‟s yield
than its price basis.

Basic Valuation Model:

Simply stated, the value of any asset is the present value of all future cash flows it is
expected to provide over the relevant time period. The time period can be any length,
even infinity. The value of an asset is therefore determined by discounting the expected
cash flows back to their present value, using the required return commensurate with the
asset‟s risk as the appropriate discount rate. Using the present value techniques
explained in Chapter 5, we can express the value of any asset at time zero, V0, as

We can use the previous equation to determine the value of any asset.
Example 1):
Celia Sargent uses Equation 6.4 to calculate the value of each asset. She
values Michaels Enterprises stock using Equation 5.14 on page 178, which
says that the present value of a perpetuity equals the annual payment
divided by the required return. In the case of Michaels stock, the annual
cash flow is $300, and Celia decides that a 12% discount rate is
appropriate for this investment. Therefore, her estimate of the value of
Michaels Enterprises stock is
$300 ÷ 0.12 = $2,500
Next, Celia values the oil well investment, which she believes is the most
risky of the three investments. Using a 20% required return, Celia
estimates the oil well‟s value to be

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 Investment in bonds

Finally, Celia estimates the value of the painting by discounting the expected
$85,000 lump sum payment in 5 years at 15%:

Bond Valuation:
The basic valuation equation can be customized for use in valuing specific securities:
Bonds, common stock, and preferred stock. We describe bond valuation in this chapter,
and valuation of common stock and preferred stock in Chapter 2.

Bond Fundamentals
As noted earlier in this chapter, bonds are long-term debt instruments used by business
and government to raise large sums of money, typically from a diverse group of lenders.
Most corporate bonds pay interest semiannually (every 6 months) at a stated coupon
interest rate, have an initial maturity of 10 to 30 years, and have a par value, or face
value, of $1,000 that must be repaid at maturity. Mills Company, a large defense
contractor, on January 1, 2013, issued a 10% coupon interest rate, 10-year bond with a
$1,000 par value that pays interest annually. Investors who buy this bond receive the
contractual right to two cash flows: (1) $100 annual interest (10% coupon interest rate ×
$1,000 par value) distributed at the end of each year and (2) the $1,000 par value at the
end of the tenth year.
We will use data for Mills‟s bond issue to look at basic bond valuation.
Basic Bond Valuation
The value of a bond is the present value of the payments its issuer is contractually
obligated to make, from the current time until it matures. The basic model for the value,
B0, of a bond is given by Equation 3.2:

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 Investment in bonds

We can calculate bond value by using Equation 6.5 and a financial calculator or by
using a spreadsheet.
Example 2):
Tim Sanchez wishes to determine the current value of the Mills Company bond.
Assuming that interest on the Mills Company bond issue is paid annually and that the
required return is equal to the bond‟s coupon interest rate I = $100, rd = 10%, M =
$1,000, and n = 10 years. The computations involved in finding the bond value are
depicted graphically on the following time line.

Calculator Use
Using the Mills Company‟s inputs shown at the left, you
should find the bond value to be exactly $1,000. Note that
the calculated bond value is equal to its par value; this will
always be the case when the required return is equal to the
coupon interest rate.3

Spreadsheet Use
The value of the Mills Company bond also can be
calculated as shown in the following Excel spreadsheet.

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 Investment in bonds

Bond Value Behavior

In practice, the value of a bond in the marketplace is rarely equal to its par value. In the
bond data (see Table 6.2 on page 235), you can see that the prices of bonds often differ
from their par values of 100 (100 percent of par, or $1,000). Some bonds are valued
below par (current price below 100), and others are valued above par (current price above
100). A variety of forces in the economy, as well as the passage of time, tend to affect
value. Although these external forces are in no way controlled by bond issuers or
investors, it is useful to understand the impact that required return and time to maturity
have on bond value.
Required Returns and Bond Values
Whenever the required return on a bond differs from the bond‟s coupon interest rate, the
bond‟s value will differ from its par value. The required return is likely to differ from the
coupon interest rate because either (1) economic conditions have changed, causing a shift
in the basic cost of long-term funds; or (2) the firm‟s risk has changed. Increases in the
basic cost of long-term funds or in risk will raise the required return; decreases in the cost
of funds or in risk will lower the required return.

Regardless of the exact cause, what is important is the relationship between the required
return and the coupon interest rate: When the required return is greater than the coupon
interest rate, the bond value, B0, will be less than its par value, M. In this case, the bond
is said to sell at a discount, which will equal M - B0 When the required return falls below
the coupon interest rate, the bond value will be greater than par. In this situation, the bond
is said to sell at a premium, which will equal M - B0

Example 3):
The preceding example showed that when the required
return equaled the coupon interest rate, the bond‟s value

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 Investment in bonds

equaled its $1,000 par value. If for the same bond the
required return were to rise to 12% or fall to 8%, its value
in each case could be found using Equation 6.5 or as
follows.
Calculator Use
Using the inputs shown at the left for the two different
required returns, you will find the value of the bond to be
below or above par. At a 12% required return, the bond
would sell at a discount of $113.00 ($1,000 par value -
$887.00 value). At the 8% required return, the bond would
sell for a premium of $134.20 ($1,134.20 value - $1,000
par value). The results of these calculations for Mills
Company‟s bond values are summarized in Table 6.6 and
graphically depicted in Figure 6.4. The inverse
relationship between bond value and required return is
clearly shown in the figure.
Spreadsheet Use
The values for the Mills
Company bond at
required returns of 12%
and 8% also can be
calculated as shown in the
following Excel
spreadsheet. Once this
spreadsheet has been
configured you can
compare bond values for
any two required returns
by simply changing the
input values.

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 Investment in bonds

Yield to Maturity (YTM)

When investors evaluate bonds, they commonly consider yield to maturity (YTM). This
is the compound annual rate of return earned on a debt security purchased on a given day
and held to maturity. (The measure assumes, of course, that the issuer makes all
scheduled interest and principal payments as promised.) The yield to maturity on a bond
with a current price equal to its par value (that Is B0 = M) will always equal the coupon
interest rate. When the bond value differs from par, the yield to maturity will differ from
the coupon interest rate. Assuming that interest is paid annually, the yield to maturity on a
bond can be found by solving Equation 6.5 for rd. In other words, the current value, the
annual interest, the par value, and the number of years to maturity are known, and the
required return must be found. The required return is the bond‟s yield to maturity. The
YTM can be found by using a financial calculator, by using an Excel spreadsheet, or by
trial and error. The calculator provides accurate YTM values with minimum effort.
Example 4):
Earl Washington wishes to find the YTM on Mills Company‟s bond. The bond currently
sells for $1,080, has a 10% coupon interest rate and $1,000 par value, pays interest
annually, and has 10 years to maturity.
Calculator Use
Most calculators require either the present value (B0
in this case) or the future values (I and M in this
case) to be input as negative numbers to calculate
yield to maturity. That approach is employed here.
Using the inputs shown at the left, you should find
the YTM to be 8.766%.
Spreadsheet Use
The yield to maturity of Mills
Company‟s bond also can be
calculated as shown in the

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 Investment in bonds

following Excel spreadsheet.

First, enter all the bond‟s cash
flows. Notice that you begin with
the bond‟s price as an outflow (a
negative number). In other
words, an investor has to pay the
price up front to receive the cash
flows over the next 10 years.
Next, use Excel‟s internal rate of
return function.

This function calculates the discount rate that makes the present value of a series of cash
flows equal to zero. In this case, when the present value of all cash flows is zero, the
present value of the inflows (interest and principal) equals the present value of the
outflows (the bond‟s initial price). In other words, the internal rate of return function is
giving us the bond‟s YTM, the discount rate that equates the bond‟s price to the present
value of its cash flows.

Semi-Annual Interest and Bond Values

The procedure used to value bonds paying interest semiannually is similar to that shown
in Chapter 5 for compounding interest more frequently than annually, except that here
we need to find present value instead of future value. It involves
1. Converting annual interest, I, to semiannual interest by dividing I by 2.
2. Converting the number of years to maturity, n, to the number of 6-month periods to
maturity by multiplying n by 2.
3. Converting the required stated (rather than effective)6 annual return for similar-risk
bonds that also pay semiannual interest from an annual rate, rd, to a semiannual rate
by dividing rd by 2.
Substituting these three changes into Equation 6.5 yields

Example 5):
Assuming that the Mills Company bond pays interest semiannually and that the required

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 Investment in bonds

stated annual return, rd, is 12% for similar-risk bonds that also pay semiannual interest,
substituting these values into Equation 6.6 yields

Calculator Use
In using a calculator to find bond value when interest
is paid semiannually, we must double the number of
periods and divide both the required stated annual
return and the annual interest by 2. For the Mills
Company bond, we would use 20 periods (2 × 10
years), a required return of 6% (12% ÷ 2), and an
interest payment of $50 ($100 ÷ 2). Using these inputs,
you should find the bond value with semiannual interest
to be $885.30, as shown at the left.

Spreadsheet Use
The value of the Mills
Company bond paying
semiannual interest at a
required return of 12% also
can be calculated as shown
in the following Excel
spreadsheet.

Comparing this result with the $887.00 value found earlier for annual compounding, we
can see that the bond‟s value is lower when semiannual interest is paid. This will always
occur when the bond sells at a discount. For bonds selling at a premium, the opposite
will occur: The value with semiannual interest will be greater than with annual interest.

The decision for investment in bond can be made on the bases of two
alternative approaches: (1) using the comparison of yield-to-maturity and appropriate
yield-to-maturity or (2) using the comparison of current market price and intrinsic
value of the bond (similar to decisions when investing in stocks). Both approaches are
based on the capitalization of income method of valuation.

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 Investment in bonds

(1) approach:
 If YTM > YTM* - decision to buy or to keep the bond as it is under
valuated;
 If YTM < YTM * - decision to sell the bond as it is over valuated;

 If YTM = YTM * - bond is valuated at the same range as in the market

and its current market price shows the intrinsic value.

(2) approach:
 If P > V - decision to buy or to keep the bond as it is under valuated;
 If P < V - decision to sell the bond as it is over valuated;
 If P = V - bond is valuated at the same range as in the market and its
current market price shows the intrinsic value.

3.4 Strategies for investing in bonds.

Immunization
Two types of strategies investing in bonds:
 Passive management strategies;
 Active management strategies.
Passive bond management strategies are based on the proposition that bond
prices are determined rationally, leaving risk as the portfolio variable to control. The
main features of the passive management strategies:
• They are the expression of the little volatile in the investor‟s forecasts
regarding interest rate and/ or bond price;
• Have a lower expected return and risk than do active strategies;
• The small transaction costs.
The passive bond management strategies include following two broad classes of
strategies:
Buy and hold strategies;
Indexing strategies.
Buy and hold strategy is the most passive from all passive strategies. This is
strategy for any investor interested in nonactive investing and trading in the market.
An important part of this strategy is to choose the most promising bonds that meet the
investor‟s requirements. Simply because an investor is following a buy-and-hold
strategy does not mean that the initial selection is unimportant. An investor forms the
diversified portfolio of bonds and does not attempt to trade them in search for the
higher return. Following this strategy, the investor has to make the investment
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decisions only in these cases:

• The bonds held by investor lost their rating, it decreases remarkably;
• The term to maturity ended;
• The bonds were recalled by issuer before term to maturity.

Using Indexing strategy the investor forms such a bond portfolio which is
identical to the well diversified bond market index. While indexing is a passive
strategy, assuming that bonds are priced fairly, it is by no means a simply strategy.
Each of the broad bond indexes contains thousands of individual bonds. The market
indices are continually rebalanced as newly issued bonds are added to the index and
existing bonds are dropped from the index as their maturity falls below the year.
Information and transaction costs make it practically impossible to purchase each bond
in proportion to the index. Rather than replicating the bond index exactly, indexing
typically uses a stratified sampling approach. The bond market is stratified into
several subcategories based on maturity, industry or credit quality. For every
subcategory the percentage of bonds included in the market index that fall in that
subcategory is computed. The investor then constructs a bond portfolio with the
similar distribution across the subcategories.
There are various indexing methodologies developed to realize this passive
strategy. But for all indexing strategies the specific feature is that the return on bond
portfolio formed following this strategy is close to the average bond market return.
Active bond management strategies are based on the assumption that the
bonds market is not efficient and, hence, the excess returns can be achieved by
forecasting future interest rates and identifying over valuate bonds and under valuated
bonds.
There are many different active bond management (speculative) strategies. The
main classes of active bond management strategies are:
 The active reaction to the forecasted changes of interest rate;
 Bonds swaps;
 Immunization.
The essentiality of the active reaction to the anticipated changes of interest rate
strategy: if the investor anticipates the decreasing in interest rates, he / she is
attempting to prolong the maturity of the bond portfolio or duration, because long-term
bonds‟ prices influenced by decrease in interest rates will increase more than short-
term bonds‟ prices; if the increase in interest rates is anticipated, investor attempts to

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shorten the maturity of the bond portfolio or duration, by including more bonds with
the shorter maturity of the portfolio.

The essentiality of bond swaps strategies is the replacement of the bond which
is in the portfolio by the other bond which was not in the portfolio for the meantime.
The aim of such replacement - to increase the return on the bond portfolio based on the
assumptions about the tendencies of changes in interest rates. There are various types
of swaps, but all are designed to improve the investor‟s portfolio position. The bond
swaps can be:
• Substitution swap;
• Interest rate anticipation swap;
• Swaps when various bond market segments are used.
The essentiality of substitution swap: one bond in the portfolio is replaced by
the other bond which fully suits the changing bond by coupon rate, term to maturity,
credit rating, but suggests the higher return for the investor. The risk of substitution
swap can be determined by the incorrect rating of the bonds and the exchange of the
unequal bonds causing the loss of the investor.

Interest rate anticipation swap is based on one of the key features of the bond
– the inverse relationship between the market price and the interest rate (this means
that when the interest rates are growing, the bonds prices are decreasing and vice
versa. The investor using this strategy bases on his steady belief about the anticipated
changes of interest rates and attempts to change frequently the structure of his/ her
bond portfolio seeking to receive the abnormal return from the changes in bonds‟
prices. This type of swaps is very risky because of the inexact and unsubstantiated
forecasts about the changes in the interest rates.
Swaps when various bond market segments are used are based on the
assessment of differences of yield for the bonds in the segregated bond market
segments.
The differences of the yields in the bond market are called yield spreads and
their existence can be explained by differences between
• Quality of bonds credit (ratings);
• Types of issuers of the bonds (government, company, etc.);
• The terms to maturity of the bonds (2 years, 5 years, etc.).
This strategy is less risky than the other swaps‟ strategies; however the return

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for such a portfolio is lower also.

The immunization is the strategy of immunizing (protecting) a bond portfolio

against interest rate risk (i.e., changes in the general level of interest rates).Applying
this strategy the investor attempts to keep the same duration of his portfolio.
Duration is the present value weighted average of the number of years over
which investors receive cash flow from the bond. It measures the economic life or the
effective maturity of a bond (or bond portfolio) rather than simply its time to maturity.
Such concept, called duration (or Macaulay's duration) was developed by Frederick
Macaulay. Duration (Macaulay duration) can be calculated using formula:

n
{[Ct/ (1 + YTM)t] t} + [Pn / (1 + YTM)ⁿ] n
t =1
DR = ----------------------------------------------------------------, (5.9)
P

here: DR - duration (or Macaulay‟s duration);

n - term to maturity, years;
Ct - interest rate of the bond during period t;
Pn - face value of the bond;
YTM - yield-to-maturity of the bond;
P - current market price of the bond.

The duration is expressed in years, because using formula (5.5) a weighted

average of the number of years is calculated. Duration will always be less than time to
maturity for bonds that pays coupon interest. For the zero coupon bonds the duration
will be equal to the term to maturity.
The duration concept is the basis for the immunization theory. A portfolio is
said to be immunized if the duration of the portfolio is made equal to a selected
investment horizon for the portfolio. The immunization strategy will usually require
holding bonds with the maturities in excess of the investment horizon in order to make
the duration match the investment horizon. The duration of the portfolio consisting of
several bonds can be calculated using the technique of weighted average, similar to
calculation of portfolio expected rate of return:
n
DRp = Σ wi DRi = w1 DR1 + w2 DR2 +…+ wn DRn, (5.10)
i=1

here wi - the proportion of the portfolio‟s initial value invested in bond i;

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 Investment in bonds

DRi - the duration of bond i;

n - the number of bonds in the portfolio.

Summary
1. The main advantages of bonds to the investor: they are good source of current
income; investment to bonds is relatively safe from large losses; in case of default
bondholders receive their payments before shareholders can be compensated. A
major disadvantage of bonds is that potential profit from investment in bonds is
limited.
2. Currently in the financial markets there are a lot of various types of bonds and
investor must understand their differences and features before deciding what bonds
would be suitable for his/ her investment portfolio. Bonds can be classified by such
features as form of payment, coupon payment, collateral, type of circulation, recall
possibility, issuers.
3. Investment in bonds decision making process: (1) selection of bond‟s type
according to the investor‟s goals (expected income and risk); (2) bond analysis
(quantitative and qualitative); (3) bond valuation; (4) Investment decision making.
4. Quantitative analysis of bonds is based on the financial ratios which allow
assessing the financial situation, debt capacity and credibility of the company –
issuer of the bonds. Since the bonds are debt instruments and the investor in bonds
really becomes the creditor the most important during analysis is the assessment of
the credibility of the firm – issuer of the bonds. The most important financial ratios
for the bond analysis are: Debt / Equity ratio; Debt / Cash flow ratio; Debt
coverage ratio; Cash flow / Debt service ratio.
5. Quantitative analysis of bonds is based on the qualitative indicators which measure
the factors influencing the credibility of the company and most of which are
subjective in their nature and valuation, are not quantifiable. The main groups of
qualitative indicators/ dimensions are: economic fundamentals (the current
economic climate – overall economic and industry-wide factors); market position
(market dominance and overall firm size: the larger firm – the stronger is its credit
rating); management capability (quality of the firm‟s management team); bond
market factors (term of maturity, financial sector, bond quality, supply and demand
for credit); bond ratings (relationship between bond yields and bond quality).

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6. The role of the bond ratings as the integrated indicator for the investor is important
in the evaluation of yield and prices for the bonds. The bond rating and the yield of
the bond are inversely related: the higher the rating, the lower the yield of the
bond.
7. Macroeconomic factors, changes of which have an influence to the interest rates
(increase or decrease), are: level of investment; savings level; export/ import;
government spending; taxes.
8. Term structure of interest rates is a yield curve displaying the relationship between
spot rates of zero-coupon securities and their term to maturity. The resulting curve
allows an interest rate pattern to be determined, which can then be used to explain
the movements and to forecast interest rates. The 3 main factors influencing the
yield curve are identified: market forecasts and expectations about the direction of
changes in interest rates; presumable liquidity premium in the yield of the bond;
market inefficiency or the turn from the long-term (or short-term) cash flows to the
short-term (or long term cash flows.
9. In the bond market investment decisions are made more on the bond‟s yield than
its price basis. There are three widely used measures of the yield: Current Yield;
Yield-to-Maturity; Yield- to- Call. Current Yield indicates the amount of current
income a bond provides relative to its market price. Yield- to- Maturity is the fully
compounded rate of return earned by an investor in bond over the life of the
security, including interest income and price appreciation. Yield- to- Maturity is
the most important and widely used measure of the bonds returns and key measure
in bond valuation process. Yield-to-Call measures the yield on the bond if the issue
remains outstanding not to maturity, but rather until its specified call date.
10. The decision for investment in bond can be made on the bases of two alternative
approaches: (1) using the comparison of yield-to-maturity and appropriate yield-to-
maturity or (2) using the comparison of current market price and intrinsic value of
the bond (similar to decisions when investing in stocks). Both approaches are
based on the capitalization of income method of valuation.
11. Using yield-to-maturity approach, if yield-to-maturity is higher than appropriate
yield-to-maturity, bond is under valuated and investor‟s decision should be to buy
or to keep bond in the portfolio; if yield-to-maturity is lower than appropriate
yield-to-maturity, bond is over valuated and investor‟s decision should be not to

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buy or to sell the bond; if yield-to-maturity is lower than appropriate yield-to-

maturity, bond is valuated at the same range as in the market and its current market
price shows the intrinsic value.
12. Two types of strategies investing in bonds: (1) passive management strategies; (2)
active management strategies. Passive bond management strategies are based on
the proposition that bond prices are determined rationally, leaving risk as the
portfolio variable to control. Active bond management strategies are based on the
assumption that the bonds market is not efficient and, hence, the excess returns can
be achieved by forecasting future interest rates and identifying over valuate bonds
and under valuated bonds.
13. The passive bond management strategies include two broad classes of strategies:
“buy and hold” and indexing. “Buy and hold” is strategy for any investor interested
in non active investing and trading in the market. An important part of this strategy
is to choose and to buy the most promising bonds that meet the investor‟s
requirements. Using Indexing strategy the investor forms such a bond portfolio
which is identical to the well diversified bond market index.
14. The active reaction to the anticipated changes of interest rate is based on the
investor‟s decision making in his/ her portfolio as reaction to the anticipated
changes in interest rates.
15. The essentiality of bond swaps strategies is the replacement of the bond which is in
the portfolio by the other bond which was not in the portfolio for the meantime.
The aim of such replacement - based on the assumptions about the tendencies of
changes in interest rates to increase the return on the bond portfolio. The bond
swaps can be: Substitution swaps; Interest rate anticipation swap; Swaps when
various bond market segments are used.
16. The immunization is the strategy of immunizing (protecting) a bond portfolio
against interest rate risk (i.e., changes in the general level of interest rates).
Applying this strategy the investor attempts to keep the same duration of his/her
portfolio.

17. Duration is the present value weighted average of the number of years over which
investors receive cash flow from the bond and it measures the economic life or the
effective maturity of a bond (or bond portfolio) rather than simply its time to
maturity.

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 Investment in bonds

Key-terms
• Active management strategies • Internal bonds
• Asset-Backed Securities (ABS) • Intrinsic value of the bond
• Bond ratings • Junior bonds
• Bonds swaps • Junk bonds
• Buy and hold strategy • Liquidity preference theory
• Callable (redeemable) bonds • Market expectations theory
• Cash flow / Debt service ratio • Market segmentation theory
• Convertible bonds • Mortgage bonds
• Corporate bonds • Municipal bonds
• Coupon bonds • Noncallable (irredeemable)
• Current Yield bonds
• Debenture bonds • Noninteresting bearing bonds
• Debt / Equity ratio
• Optional payment bonds
• Debt / Cash flow ratio
• Passive management strategies
• Debt coverage ratio
• Participating bonds
• Deferred –interest bonds
• Public utility bonds
• Duration (Macaulay duration )
• Regular serial bonds
• Full coupon bonds
• Revenue bonds
• Floating-rate bonds
• Quantitative indicators
• External bonds
• Qualitative indicators
• Eurobonds
• Secured bonds
• General obligation bonds
• Senior bonds
• Gilt-edged bonds
• Sinking fund bonds
• Guaranteed bonds
• Term structure of interest rates
• Immunization
• Treasury (government) bonds
• Income bonds
• Unsecured bonds
• Industrial bonds
• Voting bonds
• Indexing strategy
• Yield-to-Call
• Indexed bonds
• Yield-to-Maturity
• Interchangeable bonds
• Zero-coupon bonds

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 Investment in bonds

Questions and problems

1. How the zero coupon bond provide returns to investors?
2. Is any mortgage bond or asset backed security necessarily a more secure
investment than any debenture? Comment.
3. What features of the Eurobond market make Eurobonds attractive both for issuers
and investors?
4. What is the purpose of bond ratings? If the bonds ratings are so important to the
investors why don„t common stock investors focus on quality ratings of the
companies in making their investment decisions?
5. How would you expect interest rates to respond to the following economic events
(what would be the direction of the interest rates changes)? Explain why.
a) Increase in investments;
b) Increase in savings level;
c) Decrease in export;
d) Decrease in import;
e) Increase in government spending;
f) Increase in Taxes.
6. Distinguish between an interest rate anticipation swap and a substitution swap.
7. What is a key factor in analyzing bonds? Why?
8. Distinquish between yield-to-call and yield-to-maturity.
9. What is the difference between the market expectation theory and the liquidity
preference theory?
10. Bond with face value of 1000 EURO, 2 years time to maturity and 10 % coupon
rate, makes semiannual coupon payments and provides 8% yield-to-maturity.
a) Calculate the price of the bond.
b) If the yield-to-maturity would increase to 9%, what will be the price of the
bond? How this change in the yield-to-maturity would influence bond price?
11. The callable bond has a par value of 100 LT, 8% coupon rate and five years to
maturity. The bond makes annual interest payment. Investor purchased this bond
for 90 LT when it was issued in May 2008.
a) What is the yield-to-maturity of this bond?
b) What is the duration of this bond if currently its market price is 95 LT?

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 Investment in bonds

c) If this bond would be called in May 2010 for 98 LT, what would be the
yield- to-call of this bond?
12. Investor plans his investments for the period of four years and selects for
his portfolio two different bonds with the same face values:
• Bond A has 4 years time to maturity, 8% coupon rate, and 960 LT current
market price.
• Bond B has 8 years time to maturity, 12% coupon rate, and 1085 LT
current market price.
How should be bonds A and B allocated in the portfolio if the investor is
using the immunization strategy?
13. Anna is considering investing in a bond currently selling in the market for
875 EURO. The bond has four years to maturity, a 1000 EURO face value
and a 7% coupon rate. The next annual interest payment is due one year
from today. The appropriate discount rate for the securities of similar risk
is10%.
a) Estimate the intrinsic value of the bond. Based on the result of
this estimation, should Ann purchase the bond? Explain.
b) Estimate the yield-to-maturity of the bond. Based on the result of
this estimation, should Ann purchase the bond? Explain.
14. Using the resources available in your domestic investment environment select
any 4 bonds issued by Government and corporations relevant to you.
a) Determine the current yield and yield-to maturity for each bond.
b) Assuming that you put an equal amount of money into each
of 4 bonds selected, estimate the duration for the 4 bonds
portfolio.
15. What would happen to this bond portfolio if (1) market interest rates increase
by 1%; (2) market interest rates decrease by 1%.
16. What basic procedure is used to value a bond that pays annual interest?
Semiannual interest?
17. What relationship between the required return and the coupon interest rate will
cause a bond to sell at a discount? At a premium? At its par value?
18. If the required return on a bond differs from its coupon interest rate, describe
the behavior of the bond value over time as the bond moves toward maturity.

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 Investment in bonds

19. As a risk-averse investor, would you prefer bonds with short or long periods
until maturity? Why?
20. What is a bond‟s yield to maturity (YTM)? Briefly describe the use of a
financial calculator and the use of an Excel spreadsheet for finding YTM.
21. Bond valuation
Lahey Industries has outstanding a $1,000 par-value bond with an 8% coupon
interest rate. The bond has 12 years remaining to its maturity date.
a. If interest is paid annually, find the value of the bond when the required return is
(1) 7%, (2) 8%, and (3) 10%.
b. Indicate for each case in part a whether the bond is selling at a discount, at a
premium, or at its par value.
c. Using the 10% required return, find the bond‟s value when interest is paid
semiannually.
22. Bond yields
Elliot Enterprises‟ bonds currently sell for $1,150, have an 11% coupon interest rate
and a $1,000 par value, pay interest annually, and have 18 years to maturity.
a. Calculate the bonds‟ current yield.
b. Calculate the bonds‟ yield to maturity (YTM).
c. Compare the YTM calculated in part b to the bonds‟ coupon interest rate and
current yield (calculated in part a). Use a comparison of the bonds‟ current price
and par value to explain these differences.
23. The risk-free rate on T-bills recently was 1.23%. If the real rate of interest is
estimated to be 0.80%, what was the expected level of inflation?
24. The yields for Treasuries with differing maturities on a recent day were as shown
in the table on page 253.
a. Use the information to plot a yield curve for this date.
b. If the expectations hypothesis is true, approximately what rate of return do
investors expect a 5-year Treasury note to pay 5 years from now?

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 Investment in bonds

c. If the expectations hypothesis is true, approximately (ignoring compounding) what

rate of return do investors expect a 1-year Treasury security to pay starting 2 years
from now?
d. Is it possible that even though the yield curve slopes up in this problem, investors
do not expect rising interest rates? Explain.

25. The yields for Treasuries with differing maturities, including an estimate of the
real rate of interest, on a recent day were as shown in the following table:

Use the information in the preceding table to calculate the inflation expectation for
each maturity.
26. Recently, the annual inflation rate measured by the Consumer Price Index (CPI)
was forecast to be 3.3%. How could a T-bill have had a negative real rate of
return over the same period? How could it have had a zero real rate of return?
What minimum rate of return must the T-bill have earned to meet your
requirement of a 2% real rate of return?
27. Calculate the risk premium for each of the following rating classes of long-term
securities, assuming that the yield to maturity (YTM) for comparable Treasuries
is 4.51%.

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 Investment in bonds

28. You have two assets and must calculate their values today based on their different
payment streams and appropriate required returns. Asset 1 has a required return
of 15% and will produce a stream of $500 at the end of each year indefinitely.
Asset 2 has a required return of 10% and will produce an end-of-year cash flow
of $1,200 in the first year, $1,500 in the second year, and $850 in its third and
final year.
29. A bond with 5 years to maturity and a coupon rate of 6% has a par, or face, value
of $20,000. Interest is paid annually. If you required a return of 8% on this
bond, what is the value of this bond to you?
30. Assume a 5-year Treasury bond has a coupon rate of 4.5%.
a. Give examples of required rates of return that would make the bond sell at a
discount, at a premium, and at par.
b. If this bond‟s par value is $10,000, calculate the differing values for this bond
given the required rates you chose in part a.
31. Basic bond valuation
Complex Systems has an outstanding issue of $1,000-parvalue bonds with a 12%
coupon interest rate. The issue pays interest annually and has 16 years remaining to its
maturity date.
a. If bonds of similar risk are currently earning a 10% rate of return, how much
should the Complex Systems bond sell for today?
b. Describe the two possible reasons why the rate on similar-risk bonds is below
the coupon interest rate on the Complex Systems bond.
c. If the required return were at 12% instead of 10%, what would the current
value of Complex Systems‟ bond be? Contrast this finding with your
findings in part a and discuss.
32. Bond valuation—Annual interest
Calculate the value of each of the bonds shown in the following table, all of which
pay interest annually.

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 Investment in bonds

33. Bond value and changing required returns Midland Utilities has outstanding a
bond issue that will mature to its $1,000 par value in 12 years. The bond has a coupon
interest rate of 11% and pays interest annually.
a. Find the value of the bond if the required return is (1) 11%, (2) 15%, and
(3) 8%.
b. Plot your findings in part a on a set of “required return (x axis)–market value
of bond (y axis)” axes.
c. Use your findings in parts a and b to discuss the relationship between the
coupon interest rate on a bond and the required return and the market value
of the bond relative to its par value.
d. What two possible reasons could cause the required return to differ from the
coupon interest rate?
34. Bond value and time—Constant required returns
Pecos Manufacturing has just issued a 15-year, 12% coupon interest rate, $1,000-par
bond that pays interest annually. The required return is currently 14%, and the
company is certain it will remain at 14% until the bond matures in 15 years.
a. Assuming that the required return does remain at 14% until maturity, find the
value of the bond with (1) 15 years, (2) 12 years, (3) 9 years, (4) 6 years, (5)
3 years, and (6) 1 year to maturity.
b. Plot your findings on a set of “time to maturity (x axis)–market value of bond
(y axis)” axes constructed similarly to Figure 6.5 on page 246.
c. All else remaining the same, when the required return differs from the coupon
interest rate and is assumed to be constant to maturity, what happens to the
bond value as time moves toward maturity? Explain in light of the graph in
part b.
35. Bond value and time—Changing required returns
Lynn Parsons is considering investing in either of two outstanding bonds. The bonds

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 Investment in bonds

both have $1,000 par values and 11% coupon interest rates and pay annual interest.
Bond A has exactly 5 years to maturity, and bond B has 15 years to maturity.
a. Calculate the value of bond A if the required return is (1) 8%, (2) 11%, and
(3) 14%.
b. Calculate the value of bond B if the required return is (1) 8%, (2) 11%, and
(3) 14%.
c. From your findings in parts a and b, complete the following table, and discuss
the relationship between time to maturity and changing required returns.

d. If Lynn wanted to minimize interest rate risk, which bond should she
purchase? Why?
36. Yield to maturity
The relationship between a bond‟s yield to maturity and coupon interest rate can be
used to predict its pricing level. For each of the bonds listed, state whether the price of
the bond will be at a premium to par, at par, or at a discount to par.

37. Yield to maturity

The Salem Company bond currently sells for $955 has a 12% coupon interest rate and
a $1,000 par value, pays interest annually, and has 15 years to maturity.
a. Calculate the yield to maturity (YTM) on this bond.
b. Explain the relationship that exists between the coupon interest rate and yield

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 Investment in bonds

to maturity and the par value and market value of a bond.

38. Yield to maturity
Each of the bonds shown in the following table pays interest annually.

a. Calculate the yield to maturity (YTM) for each bond.

b. What relationship exists between the coupon interest rate and yield to
maturity and the par value and market value of a bond? Explain.

39. Bond valuation and yield to maturity

Mark Goldsmith‟s broker has shown him two bonds. Each has a maturity of 5 years, a
par value of $1,000, and a yield to maturity of 12%. Bond A has a coupon interest rate
of 6% paid annually. Bond B has a coupon interest rate of 14% paid annually.
a. Calculate the selling price for each of the bonds.
b. Mark has $20,000 to invest. Judging on the basis of the price of the bonds,
how many of either one could Mark purchase if he were to choose it over the
other? (Mark cannot really purchase a fraction of a bond, but for purposes of
this question, pretend that he can.)
c. Calculate the yearly interest income of each bond on the basis of its coupon
rate and the number of bonds that Mark could buy with his $20,000.
d. Assume that Mark will reinvest the interest payments as they are paid (at the
end of each year) and that his rate of return on the reinvestment is only 10%.
For each bond, calculate the value of the principal payment plus the value of
Mark‟s reinvestment account at the end of the 5 years.
e. Why are the two values calculated in part d different? If Mark were worried
that he would earn less than the 12% yield to maturity on the reinvested
interest payments, which of these two bonds would be a better choice?
40. Bond valuation—Semiannual interest
Find the value of a bond maturing in 6 years, with a $1,000 par value and a coupon

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 Investment in bonds

interest rate of 10% (5% paid semiannually) if the required return on similar-risk
bonds is 14% annual interest (7% paid semiannually).
41. Bond valuation—Semiannual interest
Calculate the value of each of the bonds shown in the following table, all of which
pay interest semiannually.

42. Bond valuation—Quarterly interest

Calculate the value of a $5,000-par-value bond paying quarterly interest at an annual
coupon interest rate of 10% and having 10 years until maturity if the required return
on similar-risk bonds is currently a 12% annual rate paid quarterly.

References and further readings

1. Arnold, Glen (2010). Investing: the definitive companion to investment and
the financial markets. 2nd ed. Financial Times/ Prentice Hall.
2. Bode, Zvi, Alex Kane, Alan J. Marcus (2005). Investments. 6th ed. McGraw
Hill.
3. Encyclopedia of Alternative Investments/ ed. by Greg N. Gregoriou. CRC
Press, 2009.

4. Fabozzi, Frank J. (1999). Investment management. 2nd ed. Prentice Hall Inc.
Francis, Jack C., Roger Ibbotson (2002). Investments: A Global
Perspective. Prentice Hall Inc.
5. Gitman, Lawrence J., Michael D. Joehnk (2008). Fundamentals of
Investing. Pearson / Addison Wesley.
6. Haugen, Robert A. (2001). Modern Investment Theory. 5th ed. Prentice Hall.
7. Jones, Charles P. (2010).Investments Principles and Concepts. John Wiley &
Sons Inc.
8. LeBarron, Dean, Romeesh Vaitilingam. (1999). Ultimate Investor. Capstone.

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 Investment in bonds

9. Nicolaou, Michael A. (2000). The Theory and Practice of Security

Analysis. Macmillan Business.
10. Rosenberg, Jerry M. (1993).Dictionary of Investing. John Wiley &Sons Inc.
11. Sharpe, William, F. Gordon J. Alexander, Jeffery V.Bailey. (1999)
Investments. International edition. Prentice –Hall International.

Relevant websites
• www.fitchratings.com Fitch (bond credit ratings)
• www.bondmarketprices.com ICMA
• www.standardpoors.com Standard&Poors (bond
credit ratings)
• www.ft.com/bonds&rates The Financial Times (bonds)
• www.riskgrades.com Risk Grades
• www.moodys.com Moody„s
• http://www.bloomberg.com/markets/rates-bonds Bloomberg
• http://www.investopedia.com/calculator/ Investopedia

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Technical Analysis and Behavioral Finance

The efficient market

The efficient market hypothesis makes two important predictions. First,

it implies that security prices properly reflect whatever information is
available to investors. A second implication follows immediately: Active
traders will find it difficult to outperform passive strategies such as
holding market indexes. To do so would require differential insight; this
in a highly competitive market is very hard to come by. Unfortunately, it
is hard to devise measures of the ―true‖ or intrinsic value of a security,
and correspondingly difficult to test directly whether prices match those
values. Therefore, most tests of market efficiency have focused on the
performance of active trading strategies. These tests have been of two
kinds. The anomalies literature has examined strategies that apparently
would have provided superior risk-adjusted returns (e.g., investing in
stocks with momentum or in value rather than glamour stocks). Other
tests have looked at the results of actual investments by asking whether
professional managers have been able to beat the market.

Neither class of tests has proven fully conclusive. The anomalies literature suggests that
several strategies would have provided superior returns. But there are questions as to
whether some of these apparent anomalies reflect risk premiums not captured by simple
models of risk and return, or even if they merely reflect data mining. Moreover, the
apparent inability of the typical money manager to turn these anomalies into superior
returns on actual portfolios casts additional doubt on their ―reality.‖ A relatively new
school of thought dubbed behavioral finance argues that the sprawling literature on
trading strategies has missed a larger and more important point by overlooking the first
implication of efficient markets—the correctness of security prices. This may be the
more important implication, since market economies rely on prices to allocate resources
efficiently. The behavioral school argues that even if security prices are wrong, it still can
be difficult to exploit them, and, therefore, that the failure to uncover obviously
successful trading rules or traders cannot be taken as proof of market efficiency. Whereas
conventional theories presume that investors are rational, behavioral finance starts with
the assumption that they might not be. We will examine some of the information-
processing and behavioral irrationalities uncovered by psychologists in other contexts
and show how these tendencies applied to financial markets might result in some of the
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anomalies discussed in the previous chapter. We then examine the limitations of
strategies designed to take advantage of behaviorally induced mispricing. If the limits to
such arbitrage activity are severe, mispricing can survive even if some rational investors
attempt to exploit it. We turn next to technical analysis and show how behavioral models
give some support to techniques that clearly would be useless in efficient markets. We
close the chapter with a brief survey of some of these technical strategies.

4.1 The Behavioral Critique

The premise of behavioral finance is that conventional financial theory ignores how real
people make decisions and that people make a difference. 1 A growing number of
economists have come to interpret the anomalies literature as consistent with several
―irrationalities‖ that seem to characterize individuals making complicated decisions.
These irrationalities fall into two broad categories: first, that investors do not always
process information correctly and therefore infer incorrect probability distributions about
future rates of return; and second, that even given a probability distribution of returns,
they often make inconsistent or systematically suboptimal decisions.

Of course, the existence of irrational investors would not by itself be sufficient to render
capital markets inefficient. If such irrationalities did affect prices, then sharp-eyed
arbitrageurs taking advantage of profit opportunities might be expected to push prices
back to their proper values. Thus, the second leg of the behavioral critique is that in
practice the actions of such arbitrageurs are limited and therefore insufficient to force
prices to match intrinsic value. This leg of the argument is important. Virtually everyone
agrees that if prices are right (i.e., price _ intrinsic value), then there are no easy profit
opportunities. But the converse is not necessarily true. If behaviorists are correct about
limits to arbitrage activity, then the absence of profit opportunities does not necessarily
imply that markets are efficient. We‘ve noted that most tests of the efficient market
hypothesis have focused on the existence of profit opportunities, often as reflected in the
performance of money managers. But their failure to systematically outperform passive
investment strategies need not imply that markets are in fact efficient. We will start our
summary of the behavioral critique with the first leg of the argument, surveying a sample
of the informational processing errors uncovered by psychologists in other areas.
‫ـــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــ‬
1. The discussion in this section is based on two excellent survey articles: Nicholas Barberis and
Richard Thaler, ―A Survey of Behavioral Finance,‖ in the Handbook of the Economics of
Finance, eds. G. M. Constantinides, M. Harris, and R. Stulz (Amsterdam: Elsevier, 2003); and
W. F. M. De Bondt and R. H. Thaler, ―Financial Decision Making in Markets and Firms,‖ in
Handbooks in Operations Research and Management Science, Volume 9: Finance, eds. R. A
Jarrow, V. Maksimovic, and W. T. Ziemba (Amsterdam: Elsevier, 1995).

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We next examine a few of the behavioral irrationalities that seem to characterize decision
makers. Finally, we look at limits to arbitrage activity, and conclude with a tentative
assessment of the import of the behavioral debate.

Information Processing
Errors in information processing can lead investors to misestimate the true probabilities
of possible events or associated rates of return. Several such biases have been uncovered.
Here are four of the more important ones. Forecasting errors A series of experiments by
Kahneman and Tversky (1972, 1973) indicate that people give too much weight to recent
experience compared to prior beliefs when making forecasts (sometimes dubbed a
memory bias ) and tend to make forecasts that are too extreme given the uncertainty
inherent in their information. De Bondt and Thaler (1990) argue that the P/E effect can be
explained by earnings expectations that are too extreme. In this view, when forecasts of a
firm‘s future earnings are high, perhaps due to favorable recent performance, they tend to
be too high relative to the objective prospects of the firm. This results in a high initial P/E
(due to the optimism built into the stock price) and poor subsequent performance when
investors recognize their error. Thus, high P/E firms tend to be poor investments.

Overconfidence. People tend to overestimate the precision of their beliefs or forecasts,

and they tend to overestimate their abilities. In one famous survey, 90% of drivers in
Sweden ranked themselves as better-than-average drivers. Such overconfidence may be
responsible for the prevalence of active versus passive investment management—itself an
anomaly to adherents of the efficient market hypothesis. Despite the growing popularity
of indexing, only about 10% of the equity in the mutual fund industry is held in indexed
accounts. The dominance of active management in the face of the typical
underperformance of such strategies (consider the disappointing performance of actively
managed mutual funds reviewed in Chapter another as well as in the previous chapter) is
consistent with a tendency to overestimate ability.

An interesting example of overconfidence in financial markets is provided by Barber and

Odean (2001), who compare trading activity and average returns in brokerage accounts of
men and women. They find that men (in particular single men) trade far more actively
than women, consistent with the greater overconfidence among men well-documented in
the psychology literature. They also find that trading activity is highly predictive of poor
investment performance. The top 20% of accounts ranked by portfolio turnover had
average returns 7 percentage points lower than the 20% of the accounts with the lowest

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turnover rates. As they conclude, ―trading [and by implication, overconfidence] is
hazardous to your wealth.‖

Conservatism. A conservatism bias means that investors are too slow (too conservative)
in updating their beliefs in response to new evidence. This means that they might initially
underreact to news about a firm, so that prices will fully reflect new information only
gradually. Such a bias would give rise to momentum in stock market returns.

Sample size neglect and representativeness. The notion of representativeness holds that
people commonly do not take into account the size of a sample, apparently reasoning that
a small sample is just as representative of a population as a large one. They may therefore
infer a pattern too quickly based on a small sample and extrapolate apparent trends too
far into the future. It is easy to see how such a pattern would be consistent with
overreaction and correction anomalies. A short-lived run of good earnings reports or high
stock returns would lead such investors to revise their assessments of likely future
performance, and thus generate buying pressure that exaggerates the price run-up.
Eventually, the gap between price and intrinsic value becomes glaring and the market
corrects its initial error. Interestingly, stocks with the best recent performance suffer
reversals precisely in the few days surrounding earnings announcements, suggesting that
the correction occurs just as investors learn that their initial beliefs were too extreme
(Chopra, Lakonishok, and Ritter, 1992).

Behavioral Biases
Even if information processing were perfect, many studies conclude that individuals
would tend to make less-than-fully rational decisions using that information. These
behavioral biases largely affect how investors frame questions of risk versus return, and
therefore make risk return trade-offs. Framing Decisions seem to be affected by how
choices are framed. For example, an individual may reject a bet when it is posed in terms
of the risk surrounding possible gains but may accept that same bet when described in
terms of the risk surrounding potential losses. In other words, individuals may act risk
averse in terms of gains but risk seeking in terms of losses. But in many cases, the choice
of how to frame a risky venture—as involving gains or losses—can be arbitrary.
Consider a coin toss with a payoff of $50 for tails. Now consider a gift of $50 that is
bundled with a bet that imposes a loss of $50 if that coin toss comes up heads. In both
cases, you end up with zero for heads and $50 for tails. But the former description frames
the coin toss as posing a risky gain while the latter frames the coin toss in terms of risky
losses. The difference in framing can lead to different attitudes toward the bet.
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Example 4.1
Framing Mental accounting. Mental accounting is a specific form of framing in which
people segregate certain decisions. For example, an investor may take a lot of risk with
one investment account, but establish a very conservative position with another account
that is dedicated to her child‘s education. Rationally, it might be better to view both
accounts as part of the investor‘s overall portfolio with the risk-return profiles of each
integrated into a unified framework. Statman (1997) argues that mental accounting is
consistent with some investors‘ irrational preference for stocks with high cash dividends
(they feel free to spend dividend income, but would not ―dip into capital‖ by selling a
few shares of another stock with the same total rate of return) and with a tendency to ride
losing stock positions for too long (since ―behavioral investors‖ are reluctant to realize
losses). In fact, investors are more likely to sell stocks with gains than those with losses,
precisely contrary to a tax-minimization strategy (Shefrin and Statman, 1985; Odean,
1998).
Mental accounting effects also can help explain momentum in stock prices. The house
money effect refers to gamblers‘ greater willingness to accept new bets if they currently
are ahead. They think of (i.e., frame) the bet as being made with their ―winnings
account,‖ that is, with the casino‘s and not with their own money, and thus are more
willing to accept risk. Analogously, after a stock market run-up, individuals may view
investments as largely funded out of a ―capital gains account,‖ become more tolerant of
risk, discount future cash flows at a lower rate, and thus further push up prices.

Regret avoidance Psychologists have found that individuals who make decisions that turn
out badly have more regret (blame themselves more) when that decision was more
unconventional. For example, buying a blue-chip portfolio that turns down is not as
painful as experiencing the same losses on an unknown start-up firm. Any losses on the
blue-chip stocks can be more easily attributed to bad luck rather than bad decision
making and cause less regret. De Bondt and Thaler (1987) argue that such regret
avoidance is consistent with both the size and book-to-market effect. Higher book-to-
market firms tend to have depressed stock prices. These firms are ―out of favor‖ and
more likely to be in a financially precarious position. Similarly, smaller, less-well-known
firms are also less conventional investments. Such firms require more ―courage‖ on the
part of the investor, which increases the required rate of return. Mental accounting can
add to this effect. If investors focus on the gains or losses of individual stocks, rather than
on broad portfolios, they can become more risk averse concerning stocks with recent

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poor performance, discount their cash flows at a higher rate, and thereby create a value-
stock risk premium.

Prospect theory
Prospect theory modifies the analytic description of rational risk averse investors found
in standard financial theory. Figure 4.1, panel A, illustrates the conventional description
of a risk-averse investor. Higher wealth provides higher satisfaction or ―utility,‖ but at a
diminishing rate (the curve flattens as the individual becomes wealthier). This gives rise
to risk aversion: A gain of $1,000 increases utility by less than a loss of $1,000 reduces
it; therefore, investors will reject risky prospects that don‘t offer a risk premium. Figure
4.1, panel B, shows a competing description of preferences characterized by ―loss
aversion.‖ Utility depends not on the level of wealth as in panel A, but on changes in
wealth from current levels. Moreover, to the left of zero (zero denotes no change from
current wealth), the curve is convex rather than concave. This has several implications.
Whereas many conventional utility functions imply that investors may become less risk
averse as wealth increases, the function in panel B always recenters on current wealth,
thereby ruling out such decreases in risk aversion and possibly helping to explain high
average historical equity risk premiums.

Moreover, the convex curvature to the left of the origin in panel B will induce investors
to be risk seeking rather than risk averse when it comes to losses. Consistent with loss
aversion, traders in the T-bond futures contract have been observed to assume
significantly greater risk in afternoon sessions following morning sessions in which they
have lost money (Coval and Shumway, 2005). These are only a sample of many
behavioral biases uncovered in the literature. Many have implications for investor
behavior. The nearby box offers some good examples.

Limits to Arbitrage
Behavioral biases would not matter for stock pricing if rational arbitrageurs could fully
exploit the mistakes of behavioral investors. Trades of profit-seeking investors would
correct any misalignment of prices. However, behavioral advocates argue that in practice,
several factors limit the ability to profit from mispricing. Fundamental risk Suppose that
a share of IBM is underpriced. Buying it may present a profit opportunity, but it is hardly
risk-free, since the presumed market underpricing can get worse. While price eventually
should converge to intrinsic value, this may not happen until after the trader‘s investment
horizon. For example, the investor may be a mutual fund manager who may lose clients
(not to mention a job!) if short-term performance is poor, or a trader who may run
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through her capital if the market turns against her, even temporarily. The fundamental
risk incurred in exploiting the apparent profit opportunity presumably will limit the
activity of the traders.

Figure 4.1
Prospect theory.
Panel A:
A conventional
utility function is
defined in terms of
wealth and is
concave, resulting
in risk aversion.

Panel B:
Under loss
aversion, the utility
function is defined
in terms of changes
from current
wealth. It is also
convex to the left
of the origin,
giving rise to risk-
seeking behavior in
terms of losses.

On the Market Front

Why it's so tough to fix your portfolio? Blame it on the old ―get even, then get out‖
If your portfolio is out of whack, you could syndrome. With stocks treading water, many
ask an investment adviser for help. But you investors are reluctant to sell, because they
might have better luck with your therapist. are a long way from recovering their bear-
It‘s a common dilemma: You know you market losses. To be sure, investors who
have the wrong mix of investments, but you bought near the peak are underwater,
cannot bring yourself to fix the mess. Why whether they sell or not. But selling losers is
is it so difficult to change? At issue are three still agonizing, because it means admitting
mental mistakes. you made a mistake.

Chasing Winners
Looking to lighten up on bonds and get back ―If you‘re rational and you have a loss, you
into stocks? Sure, you know stocks are a sell, take the tax loss and move on,‖ Prof.
long-term investment and, sure, you know Statman says. ―But if you‘re a normal
they are best bought when cheap. Yet it‘s a person, selling at a loss tears your heart out.‖
lot easier to pull the trigger and buy stocks if Mustering Courage
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Technical Analysis and Behavioral Finance
the market has lately been scoring gains. Whether you need to buy stocks or buy
―People are influenced by what has bonds, it takes confidence to act. And right
happened most recently, and then they now, investors just aren‘t confident.
extrapolate from that,‖ says Meir Statman, a ―There‘s this status-quo bias,‖ says John
finance professor at Santa Clara University Nofsinger, a finance professor at
in California. ―But often, they end up being Washington State University in Pullman,
optimistic and pessimistic at just the wrong Washington. ―We‘re afraid to do anything,
time.‖ because we‘re afraid we‘ll regret it.‖

Consider some results from the UBS Index Once again, it‘s driven by recent market
of Investor Optimism, a monthly poll action When markets are flying high; folks
conducted by UBS and the Gallup attribute their portfolio‘s gains to their own
Organization. Each month, the poll asks brilliance. That gives them the confidence to
investors what gain they expect from their trade more and to take greater risks.
portfolio during the next 12 months. Result? Overreacting to short-term market results is,
You guessed it: The answers rise and fall of course, a great way to lose a truckload of
with the stock market. For instance, during money.
the bruising bear market, investors grew
increasingly pessimistic, and at the market But with any luck, if you are aware of this
bottom they were looking for median pitfall, maybe you will avoid it. Or maybe
[this is] too optimistic. ―You can tell
portfolio gains of just 5%. But true to form,
last year‘s rally brightened investors‘ spirits
somebody that investors have all these
and by January they were expecting 10% behavioral biases,‖ says Terrance Odean, a
returns. finance professor at the University of
California at Berkeley. ―So what happens?
Getting Even The investor thinks, ‗Oh that sounds like my
This year‘s choppy stock market hasn‘t husband. I don‘t think many investors say,
scared off just bond investors. It has also ‗Oh that sounds like me.‘ ‖
made it difficult for stock investors to Source: Jonathan Clements, The Wall Street
rejigger their portfolios. Journal Online, June 23, 2004. © 2004 Dow
Jones & Company, Inc. All rights reserved.

Example 4.2
Fundamental Risk
In much of 2007, the Nasdaq index fluctuated at a level around 2,500. From that
perspective, the value the index had reached 7 years earlier, around 5,000, seemed
obviously crazy. Surely some investors living through the Internet ―bubble‖ of the late
1990s must have identified the index as grossly overvalued, suggesting a good selling
opportunity. But this hardly would have been a riskless arbitrage opportunity. Consider that
Nasdaq may also have been overvalued in 1999 when it first crossed above 3,500 (40%
higher than its value in 2007). An investor in 1999 who believed (as it turns out, quite
correctly) that Nasdaq was overvalued at 3,500 and decided to sell it short would have
suffered enormous losses as the index increased by another 1,500 points before finally
peaking at 5,000. While the investor might have derived considerable satisfaction at
eventually being proven right about the overpricing, by entering a year before the market
―corrected,‖ he might also have gone broke.

Implementation costs
Exploiting overpricing can be particularly difficult. Short selling a security entails costs;
short-sellers may have to return the borrowed security on little notice, rendering the
horizon of the short sale uncertain; other investors such as many pension or mutual fund
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managers face strict limits on their discretion to short securities. This can limit the ability
of arbitrage activity to force prices to fair value. Model risk One always has to worry that
an apparent profit opportunity is more apparent than real. Perhaps you are using a faulty
model to value the security, and the price actually is right. Mispricing may make a
position a good bet, but it is still a risky one, which limits the extent to which it will be
pursued.
Limits to Arbitrage and the Law of One Price
While one can debate the implications of much of the anomalies literature, surely the
Law of One Price (positing that effectively identical assets should have identical prices)
should be satisfied in rational markets. Yet there are several instances where the law
seems to have been violated. These instances are good case studies of the limits to
arbitrage. “Siamese twin” companies 4 In 1907, Royal Dutch Petroleum and Shell
Transport merged their operations into one firm. The two original companies, which
continued to trade separately, agreed to split all profits from the joint company on a 60/40
basis. Shareholders of Royal Dutch receive 60% of the cash flow, and those of Shell
receive 40%. One would therefore expect that Royal Dutch should sell for exactly 60/40
_ 1.5 times the price of Shell. But this is not the case. Figure 9.2 shows that the relative
value of the two firms has departed considerably from this ―parity‖ ratio for extended periods
of time.

Figure 4.2 Pricing of Royal Dutch relative to Shell (deviation from parity)
Source: O. A. Lamont and R. H. Thaler, ―Anomalies: The Law of One Price in Financial
Markets,‖ Journal of Economic Perspectives 17 (Fall 2003), pp. 191–202.

Doesn‘t this mispricing give rise to an arbitrage opportunity? If Royal Dutch sells for
more than 1.5 times Shell, why not buy relatively underpriced Shell and short-sell
overpriced Royal? This seems like a reasonable strategy, but if you had followed it in
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February 1993 when Royal sold for about 10% more than its parity value, Figure 9.2
shows that you would have lost a lot of money as the premium widened to about 17%
before finally reversing after 1999. As in Example 9.2 , this opportunity posed
fundamental risk.
Equity carve-outs
Several equity carve-outs also have violated the Law of One Price. To illustrate, consider
the case of 3Com, which in 1999 decided to spin off its Palm division. It first sold 5% of
its stake in Palm in an IPO, announcing that it would distribute the remaining 95% of its
Palm shares to 3Com shareholders 6 months later in a spinoff. Each 3Com shareholder
would receive 1.5 shares of Palm in the spinoff. Once Palm shares began trading, but
prior to the spinoff, the share price of 3Com should have been at least 1.5 times that of
Palm. After all, each share of 3Com entitled its owner to 1.5 shares of Palm plus an
ownership stake in a profitable company. Instead, Palm shares at the IPO actually sold
for more than the 3Com shares. The stub value of 3Com (i.e., the value of each 3Com
share net of the value of the claim to Palm represented by that share) could be computed
as the price of 3Com minus 1.5 times the price of Palm. This calculation, however,
implies that 3Com‘s stub value was negative, this despite the fact that it was a profitable
company with cash assets alone of about $10 per share. Again, an arbitrage strategy
seems obvious. Why not buy 3Com and sell Palm? The limit to arbitrage in this case was
the inability of investors to sell Palm short. Virtually all available shares in Palm were
already borrowed and sold short, and the negative stub values persisted for more than 2
months.

Closed-end funds
We previously noted that closed-end funds often sell for substantial discounts or
premiums from net asset value. This is ―nearly‖ a violation of the Law of One Price,
since one would expect the value of the fund to equal the value of the shares it holds. We
say nearly, because in practice, there are a few wedges between the value of the closed-
end fund and its underlying assets. One is expenses. The fund incurs expenses that
ultimately are paid for by investors, and these will reduce share price. On the other hand,
if managers can invest fund assets to generate positive risk-adjusted returns, share price
might exceed net asset value. Lee, Shleifer, and Thaler (1991) argue that the patterns of
discounts and premiums on closed-end funds are driven by changes in investor sentiment.
They note that discounts on various funds move together and are correlated with the
return on small stocks, suggesting that all are affected by common variation in sentiment.

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One might consider buying funds selling at a discount from net asset value and selling
those trading at a premium, but discounts and premiums can widen, subjecting this
strategy too to fundamental risk. Pontiff (1996) demonstrates that deviations of price
from net asset value in closed-end funds tend to be higher in funds that are more difficult
to arbitrage, for example, those with more idiosyncratic volatility.

CONCEPT
Fundamental risk may be limited by a ―deadline‖ that forces a
convergence between price and intrinsic value. What do you think would
happen to a closed-end fund‘s discount if the fund announced that it
plans to liquidate in 6 months, at which time it will distribute NAV to its
shareholders?

Closed-end fund discounts are a good example of so-called anomalies that also may have
rational explanations. Ross (2002) demonstrates that they can be reconciled with rational
investors even if expenses or fund abnormal returns are modest. He shows that if a fund
has a dividend yield of ơ, an alpha (risk-adjusted abnormal return) of α, and expense ratio
of € , then using the constant-growth dividend discount model, the premium of the fund
over its net asset value will be:

If the fund manager‘s performance more than compensates for expenses (i.e., if α > €),
the fund will sell at a premium to NAV; otherwise it will sell at a discount. For example,
suppose α = .015, the expense ratio is € =.0125, and the dividend yield is ơ = .02. Then
the premium will be .14, or 14%. But if the market turns sour on the manager and revises
its estimate of α downward to .005, that premium quickly turns into a discount of 43%.
This analysis might explain why closed-end funds often are issued to the public at a
premium; if investors do not expect α to exceed €, they won‘t purchase shares in the
fund. But the fact that most premiums eventually turn into discounts indicates how
difficult it is for management to fulfill these expectations.

Bubbles and Behavioral Economics

In Example 9.2 above, we pointed out that the stock market run-up of the late 1990s, and
even more spectacularly, the run-up of the technology-heavy Nasdaq market, seems in
retrospect to have been an obvious bubble. In a 6-year period beginning in 1995, the
Nasdaq index increased by a factor of more than 6. Former Fed Chairman Alan
Greenspan famously characterized the dot-com boom as an example of ―irrational
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exuberance,‖ and his assessment turned out to be correct: By October 2002, the index fell
to less than one-fourth the peak value it had reached only 2½ years earlier. This episode
seems to be a case in point for advocates of the behavioral school, exemplifying a market
moved by irrational investor sentiment. Moreover, in accord with behavioral patterns, as
the dot-com boom developed, it seemed to feed on itself, with investors increasingly
confident of their investment prowess (overconfidence bias) and apparently willing to
extrapolate short-term patterns into the distant future (representativeness bias).

On the other hand, bubbles are a lot easier to identify as such once they are over. While
they are going on, it is not as clear that prices are irrationally exuberant, and, indeed,
many financial commentators at the time justified the boom as consistent with glowing
forecasts for the ―new economy.‖ A simple example shows how hard it can be to tie down the
fair value of stock investments.

Example 4.3
A Stock Market Bubble?
In 2000, the dividends paid by the firms included in the S&P 500 totaled $154.6 million.
If the discount rate for the index was 9.2% and the expected dividend growth rate was
8%, the value of these shares according to the constant-growth dividend discount model
(see Chapter 13 for more on this model) would be:

This was quite close to the actual total value of those firms at the time. But the estimate is
highly sensitive to the input values, and even a small reassessment of their prospects
would result in a big revision of price. Suppose the expected dividend growth rate fell to
7.4%. This would reduce the value of the index to:

which was about the value to which the S&P 500 firms had fallen by October 2002. In
light of this example, the run-up and crash of the 1990s seems easier to reconcile with
rational behavior.

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On the Market Front

As two economists debate markets, the But with more than one billion
tide shifts. shares a day changing hands on the
For forty years, economist Eugene Fama New York Stock Exchange, the
argued that financial markets were highly market appears overrun with
efficient in reflecting the underlying value traders making bets all the time.
of stocks. His longtime intellectual
nemesis, Richard Thaler, a member of the Robert Shiller, a Yale University
―behaviorist‖ school of economic thought, economist, has long argued that
contended that markets can veer off efficient-market theorists made one
course when individuals make stupid huge mistake: Just because markets
decisions. are unpredictable doesn‘t mean
they are efficient. The leap in logic,
This long-running argument has big he wrote in the 1980s, was one of
implications for real-life problems, ―the most remarkable errors in the
ranging from the privatization of Social history of economic thought.‖ Mr.
Security to the regulation of financial Fama says behavioral economists
markets to the way corporate boards are made the same mistake in reverse:
run. Mr. Fama‘s ideas helped foster the The fact that some individuals
free-market theories of the 1980s and might be irrational doesn‘t mean
spawned the $1 trillion index-fund the market is inefficient.
industry. Mr. Thaler‘s theory suggests
policymakers have an important role to Mr. Thaler‘s views have seeped
play in guiding markets and individuals into the mainstream through the
where they‘re prone to fail. support of a number of prominent
economists who have devised
Behavioral economists argue that markets similar theories about how markets
are imperfect because people often stray operate. In 2002, Daniel Kahneman
from rational decisions. They believe this won a Nobel Prize for pioneering
behavior creates market breakdowns and research in the field of behavioral
also buying opportunities for savvy economics. Even [former] Federal
investors. Reserve Chairman Alan
Greenspan, a firm believer in the
Small Anomalies benefits of free markets, famously
Even before the late 1990s, Mr. Thaler adopted the term ―irrational
and a growing legion of behavioral exuberance‖ in 1996.
finance experts were finding small
anomalies that seemed to fly in the face of Defending efficient markets has
efficient market theory. For example, gotten harder, but it‘s probably too
researchers found that value stocks, soon for Mr. Thaler to declare
companies that appear undervalued victory. He concedes that most of
relative to their profits or assets, tended to his retirement assets are held in
outperform growth stocks, ones that are index funds, the very industry that
perceived as likely to increase profits Mr. Fama‘s research helped to
rapidly. If the market was efficient and launch. And despite his research on
impossible to beat, why would one asset market inefficiencies, he also
class outperform another? (Mr. Fama says concedes that ―it is not easy to beat
there‘s a rational explanation: Value stocks the market, and most people
come with hidden risks and investors are don‘t.‖
rewarded for those risks with higher Source: Jon E. Hilsenrath, The Wall
returns.) Moreover, in a rational world, Street Journal, October 18, 2004, p.
share prices should move only when new A1. © 2004 Dow Jones & Company,
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information hits the market. Inc. All rights reserved.

Still, other evidence seems to tag the dot-com boom as at least partially irrational.
Consider, for example, the results of a study by Rau, Dimitrov, and Cooper (2001)
documenting that firms adding ―.com‖ to the end of their names during this period
enjoyed a meaningful stock price increase. That doesn‘t sound like rational valuation to
us.
Evaluating the Behavioral Critique
As investors, we are concerned with the existence of profit opportunities. The behavioral
explanations of efficient market anomalies do not give guidance as to how to exploit any
irrationality. For investors, the question is still whether there is money to be made from
mispricing, and the behavioral literature is largely silent on this point. However, as we
have emphasized above, one of the important implications of the efficient market
hypothesis is that security prices serve as reliable guides to the allocation of real capital.
If prices are distorted, then capital markets will give misleading signals (and incentives)
as to where the economy may best allocate resources. In this crucial dimension, the behavioral
critique of the efficient market hypothesis is certainly important irrespective of any
implication for investment strategies.

There is considerable debate among financial economists concerning the strength of the
behavioral critique. Many believe that the behavioral approach is too unstructured, in
effect allowing virtually any anomaly to be explained by some combination of
irrationalities chosen from a laundry list of behavioral biases. While it is easy to ―reverse
engineer‖ a behavioral explanation for any particular anomaly, these critics would like to
see a consistent or unified behavioral theory that can explain a range of anomalies. More
fundamentally, others are not convinced that the anomalies literature as a whole is a
convincing indictment of the efficient market hypothesis. Fama (1998) reviews the
anomalies literature and mounts a counterchallenge to the behavioral school. He notes
that the anomalies are inconsistent in terms of their support for one type of irrationality
versus another. For example, some papers document long-term corrections (consistent
with overreaction) while others document long-term continuations of abnormal returns
(consistent with under reaction).

Moreover, the statistical significance of many of these results is less than meets the eye.
Even small errors in choosing a benchmark against which to compare returns can
cumulate to large apparent abnormalities in long-term returns. Therefore, many of the

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results in these studies are sensitive to small benchmarking errors, and Fama argues that
seemingly minor changes in methodology can have big impacts on conclusions.
Behavioral finance is still in its infancy, however. Its critique of full rationality in
investor decision making is well taken, but the extent to which limited rationality affects
asset pricing is controversial. It is probably still too early to pass judgment on the
behavioral approach, specifically, which behavioral models will ―stick‖ and become part
of the standard tool-kit of financial analysts. The nearby box discusses the ongoing
debate between stock market ―rationalists‖ and ―behaviorists.‖

4.2 Technical Analysis and Behavioral Finance

Technical analysis attempts to exploit recurring and predictable patterns in stock prices to
generate superior investment performance. Technicians do not deny the value of
fundamental information, but believe that prices only gradually close in on intrinsic
value. As fundamentals shift, astute traders can exploit the adjustment to a new
equilibrium. For example, one of the best-documented behavioral tendencies is the
disposition effect, which refers to the tendency of investors to hold on to losing
investments. Behavioral investors seem reluctant to realize losses. Grinblatt and Han
(2005) show that the disposition effect can lead to momentum in stock prices even if
fundamental values follow a random walk.

The fact that the demand of ―disposition investors‖ for a company‘s shares depends on
the price history of those shares means that prices close in on fundamental values only
over time, consistent with the central motivation of technical analysis. Behavioral biases
may also be consistent with technical analysts‘ use of volume data. An important
behavioral trait noted above is overconfidence, a systematic tendency to overestimate
one‘s abilities. As traders become overconfident, they may trade more, inducing an
association between trading volume and market returns (Gervais and Odean, 2001).
Technical analysis thus uses volume data as well as price history to direct trading
strategy.
Finally, technicians believe that market fundamentals can be perturbed by irrational or
behavioral factors, sometimes labeled sentiment variables. More or less random price
fluctuations will accompany any underlying price trend, creating opportunities to exploit
corrections as these fluctuations dissipate.

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Trends and Corrections
Much of technical analysis seeks to uncover trends in market prices. This is in effect a
search for momentum. Momentum can be absolute, in which case one searches for
upward price trends, or relative, in which case the analyst looks to invest in one sector over
another (or even take on a long-short position in the two sectors). Relative strength
statistics are designed to uncover these potential opportunities.

Dow Theory
The grandfather of trend analysis is the Dow Theory, named after its creator, Charles
Dow (who established The Wall Street Journal). Many of today‘s more technically
sophisticated methods are essentially variants of Dow‘s approach. The Dow Theory
posits three forces simultaneously affecting stock prices:
1. The primary trend is the long-term movement of prices, lasting from several months to
several years.
2. Secondary or intermediate trends are caused by short-term deviations of prices from
the underlying trend line. These deviations are eliminated via corrections when prices
revert back to trend values.
3. Tertiary or minor trends are daily fluctuations of little importance.

Figure 4.3 represents these three components of stock price movements. In this figure,
the primary trend is upward, but intermediate trends result in short-lived market declines
lasting a few weeks. The intraday minor trends have no long-run impact on price. Figure
4.4 depicts the course of the DJIA during 1988. The primary trend is upward, as evidenced
by the fact that each market peak is higher than the previous peak (point F versus D versus B ).

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Figure 4.3
Dow Theory trends
Source: From
Melanie F.
Bowman and
Thom Hartle,
“Dow Theory,”
Technical Analysis
of Stocks and
Commodities,
September 1990,
p.690.

Figure 4.4
Dow Jones
Industrial Average
in 1988
Source: From
Melanie F. Bowman
and Thom Hartle,
“Dow Theory”
Technical Analysis
of Stocks and
Commodities,
September 1990, p.
690.

Similarly, each low is higher than the previous low (E versus C versus A). This pattern of
upward-moving ―tops‖ and ―bottoms‖ is one of the key ways to identify the underlying
primary trend. Notice in Figure 9.4 that, despite the upward primary trend, intermediate
trends still can lead to short periods of declining prices (points B through C, or D through
E). In evaluating the Dow Theory, don‘t forget the lessons of the efficient market
hypothesis. The Dow Theory is based on a notion of predictably recurring price patterns.
Yet the EMH holds that if any pattern is exploitable, many investors would attempt to
profit from such predictability, which would ultimately move stock prices and cause the
trading strategy to self-destruct.

While Figure 4.4 certainly appears to describe a classic upward primary trend, one
always must wonder whether we can see that trend only after the fact. Recognizing
patterns as they emerge is far more difficult. Recent variations on the Dow theory are the
Elliott wave theory and the theory of Kondratieff waves. Like the Dow Theory, the idea
behind Elliott waves is that stock prices can be described by a set of wave patterns. Long-
term and short-term wave cycles are superimposed and result in a complicated pattern of
price movements, but by interpreting the cycles, one can, according to the theory, predict

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broad movements. Similarly, Kondratieff waves are named after a Russian economist
who asserted that the macro economy (and therefore the stock market) moves in broad
waves lasting between 48 and 60 years. The Kondratieff waves are therefore analogous to
Dow‘s primary trend, although they are of far longer duration.

Kondratieff‘s assertion is hard to evaluate empirically, however, because cycles that last
about 50 years provide only two independent data points per century, which is hardly
enough data to test the predictive power of the theory.

Point and figure charts

A variant on pure trend analysis is the point and figure chart depicted in Figure 4.5. This
figure has no time dimension. It simply traces significant upward or downward
movements in stock prices without regard to their timing. The data for Figure 4.4 come
from Table 4.1. Suppose, as in Table 9.1, that a stock‘s price is currently $40. If the price
rises by at least $2, you put an X in the first column at $42 in Figure 9.5. Another
increase of at least $2 calls for placement of another X in the first column, this time at the
$44 level. If the stock then falls by at least $2, you start a new column and put an O next
to $42. Each subsequent $2 price fall results in another O in the second column. When
prices reverse yet again and head upward, you begin the third column with an X denoting
each consecutive $2 price increase.
WEB master
Charting and Technical Analysis Yahoo! Finance 1- Which if either of the
(finance.yahoo.com) offers significant capabilities companies is priced above
in charting and other technical indicators. Under its 50- and 200-day
the charting function, you can specify averages?
comparisons between companies by choosing the 2- Would you consider their
technical analysis tab. Short interest ratios are charts as bullish or bearish?
found under the Company Profile report. Prepare Why?
charts of moving averages and obtain short 3- What are the short interest
interest ratios for GE and SWY. Prepare a one- ratios for the two
year chart of the 50- and 200-day average price of companies?
GE, SWY, and the S&P 500 Index. 4- Has short interest displayed
any significant trend?

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Technical Analysis and Behavioral Finance

Figure 4.5
Point and figure
chart for Table 4.1

Table 4.1 Stock price history

‫ـــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــ‬
*Indicates an event that has resulted in a stock price increase or decrease of at least $2.
†Denotes a price movement that has resulted in either an upward or a downward reversal in the
stock price.

The single asterisks in Table 9.1 mark an event resulting in the placement of a new X or
O in the chart. The daggers denote price movements that result in the start of a new
column of Xs or Os. Sell signals are generated when the stock price penetrates previous
lows, and buy signals occur when previous high prices are penetrated. A congestion area
is a horizontal band of Xs and Os created by several price reversals. These regions
correspond to support and resistance levels and are indicated in Figure 4.6, which is an
actual chart for Atlantic Richfield.

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Technical Analysis and Behavioral Finance

Figure 4.6 Point and figure chart for Atlantic Richfield

One can devise point and figure charts using price increments other than $2, but it is
customary in setting up a chart to require reasonably substantial price changes before
marking pluses or minuses.

Moving averages
The moving average of a stock index is the average level of the index over a given
interval of time. For example, a 52-week moving average tracks the average index value
over the most recent 52 weeks. Each week, the moving average is recomputed by
dropping the oldest observation and adding the latest. Figure 9.7 is a moving average
chart for Apple Computer. Notice that the moving average plot (the colored curve) is a
―smoothed‖ version of the original data series (dark curve).

After a period in which prices have generally been falling, the moving average will be
above the current price (because the moving average ―averages in‖ the older and higher
prices). When prices have been rising, the moving average will be below the current
price. When the market price breaks through the moving average line from below, as at
point A in Figure 4.7, it is taken as a bullish signal because it signifies a shift from a
falling trend (with prices below the moving average) to a rising trend (with prices above
the moving average). Conversely, when prices fall below the moving average as at point

159
Technical Analysis and Behavioral Finance
B, it‘s considered time to sell. (In this instance, however, the buy/sell signal turned out to
be faulty.) There is some variation in the length of the moving average considered most

predictive of market movements. Two popular measures are 200-day and 53-week
moving averages.

Figure 4.7: Share price and 50-day moving average for Apple Computer
Source: Copyright 2006 Yahoo! Inc., December 13, 2006, http://finance.yahoo.com.
Reproduced with permission of Yahoo! Inc. © 2006 by Yahoo! Inc. Yahoo and the
Yahoo! logo are trademarks of Yahoo! Inc.

Example 4.4
Moving Averages
Consider the following price data. Each observation represents the closing level of the
Dow Jones Industrial Average (DJIA) on the last trading day of the week. The 5-week
moving average for each week is the average of the DJIA over the previous 5 weeks. For
example, the first entry, for week 5, is the average of the index value between weeks 1
and 5: 12,290, 12,380, 12,399, 12,379, and 12,450. The next entry is the average of the
index values between weeks 2 and 6, and so on.

Figure 4.8 plots the level of the index and the 5-week moving average. Notice that while
the index itself moves up and down rather abruptly, the moving average is a relatively
smooth series, since the impact of each week‘s price movement is averaged with that of

the previous weeks. Week 16 is a bearish point according to the moving average rule.
The price series crosses from above the moving average to below it, signifying the beginning
of a downward trend in stock prices.

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Technical Analysis and Behavioral Finance

Figure 4.8 Moving averages

Breadth
The breadth of the market is a measure of the extent to which movement in a market
index is reflected widely in the price movements of all the stocks in the market. The most
common measure of breadth is the spread between the number of stocks that advance and
decline in price. If advances outnumber declines by a wide margin, then the market is
viewed as being stronger because the rally is widespread. These breadth numbers are
reported daily in The Wall Street Journal (see Figure 4.9).

Some analysts cumulate breadth data each day as in Table 42. The cumulative breadth for
each day is obtained by adding that day‘s net advances (or declines) to the previous day‘s
total. The direction of the cumulated series is then used to discern broad market trends.
Analysts might use a moving average of cumulative breadth to gauge broad trends.

Relative strength
Relative strength measures the extent to which a security has outperformed or
underperformed either the market as a whole or its particular industry. Relative strength is

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Technical Analysis and Behavioral Finance

Figure 4.9
Market diary

Table 4.2 Breadth

computed by calculating the ratio of the price of the security to a price index for the
industry. For example, the relative strength of Ford versus the auto industry would be
measured by movements in the ratio of the price of Ford divided by the level of an auto
industry index. A rising ratio implies Ford has been outperforming the rest of the
industry. If relative strength can be assumed to persist over time, then this would be a
signal to buy Ford. Similarly, the relative strength of an industry relative to the whole
market can be computed by tracking the ratio of the industry price index to the market
price index.
Sentiment Indicators
Trin statistic Market volume is sometimes used to measure the strength of a market rise
or fall. Increased investor participation in a market advance or retreat is viewed as a
measure of the significance of the movement. Technicians consider market advances to
be a more favorable omen of continued price increases when they are associated with
increased trading volume. Similarly, market reversals are considered more bearish when
associated with higher volume. The trin statistic is defined as:

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Therefore, trin is the ratio of average trading volume in declining issues to average
volume in advancing issues. Ratios above 1.0 are considered bearish because the falling
stocks would then have higher average volume than the advancing stocks, indicating net
selling pressure. The Wall Street Journal reports trin every day in the market diary
section, as in Figure 4.9.

Note
However, that for every buyer, there must be a seller of stock. Rising volume in a rising
market should not necessarily indicate a larger imbalance of buyers versus sellers. For
example, a trin statistic above 1.0, which is considered bearish, could equally well be
interpreted as indicating that there is more buying activity in declining issues.

Confidence index
Barron’s computes a confidence index using data from the bond market. The
presumption is that actions of bond traders reveal trends that will emerge soon in the
stock market. The confidence index is the ratio of the average yield on 10 top-rated
corporate bonds divided by the average yield on 10 intermediate-grade corporate bonds.
The ratio will always be below 100% because higher rated bonds will offer lower
promised yields to maturity. When bond traders are optimistic about the economy,
however, they might require smaller default premiums on lower rated debt. Hence, the
yield spread will narrow, and the confidence index will approach 100%. Therefore,
higher values of the confidence index are bullish signals.

Short interest
Short interest is the total number of shares of stock currently sold-short in the market.
Some technicians interpret high levels of short interest as bullish, some as bearish. The
bullish perspective is that, because all short sales must be covered (i.e., short-sellers
eventually must purchase shares to return the ones they have borrowed), short interest
represents latent future demand for the stocks. As short sales are covered, the demand
created by the share purchase will force prices up. The bearish interpretation of short
interest is based on the fact that short-sellers tend to be larger, more sophisticated
investors. Accordingly, increased short interest reflects bearish sentiment by those
investors ―in the know,‖ which would be a negative signal of the market‘s prospects.

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Put/call ratio
Call options give investors the right to buy a stock at a fixed ―exercise‖ price and
therefore are a way of betting on stock price increases. Put options give the right to sell a
stock at a fixed price and therefore are a way of betting on stock price decreases. The
ratio of outstanding put options to outstanding call options is called the put/call ratio.
Because put options do well in falling markets while call options do well in rising
markets, deviations of the ratio from historical norms are considered to be a signal of
market sentiment and therefore predictive of market movements. Interestingly, however,
a change in the ratio can be given a bullish or a bearish interpretation. Many technicians
see an increase in the ratio as bearish, as it indicates growing interest in put options as a
hedge against market declines. Thus, a rising ratio is taken as a sign of broad investor
pessimism and a coming market decline. Contrarian investors, however, believe that a
good time to buy is when the rest of the market is bearish because stock prices are then
unduly depressed. Therefore, they would take an increase in the put/call ratio as a signal
of a buy opportunity.
A Warning
The search for patterns in stock market prices is nearly irresistible, and the ability of the
human eye to discern apparent patterns is remarkable. Unfortunately, it is possible to
perceive patterns that really don‘t exist. Consider Figure 9.10 , which presents simulated
and actual values of the Dow Jones Industrial Average during 1956 taken from a famous
study by Harry Roberts (1959). In Figure 4.10B, it appears as though the market presents
a classic head-and-shoulders pattern where the middle hump (the head) is flanked by two
shoulders. When the price index ―pierces the right shoulder‖—a technical trigger point—
it is believed to be heading lower, and it is time to sell your stocks. Figure 9.10A also looks
like a ―typical‖ stock market pattern.

Figure 4.10 Actual and simulated levels for stock market prices of 52 weeks

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Can you tell which of the two graphs is constructed from the real value of the Dow and
which from the simulated data? Figure 4.10A is based on the real data. The graph in
panel B was generated using ―returns‖ created by a random-number generator. These
returns by construction were patternless, but the simulated price path that is plotted
appears to follow a pattern much like that of panel A.
Figure 4.11 shows the weekly price changes behind the two panels in Figure 4.10. Here
the randomness in both series—the stock price as well as the simulated sequence—is
obvious.
A problem related to the tendency to perceive patterns where they don‘t exist is data
mining. After the fact, you can always find patterns and trading rules that would have
generated enormous profits. If you test enough rules, some will have worked in the past.
Unfortunately, picking a theory that would have worked after the fact carries no
guarantee of future success. In evaluating trading rules, you should always ask whether
the rule would have seemed reasonable before you looked at the data. If not, you might
be buying into the one arbitrary rule among many that happened to have worked in the
recent past. The hard but crucial question is whether there is reason to believe that what
worked in the past should continue to work in the future.

Figure 4.11 Actual and simulated changes in weekly stock prices for 52 weeks

Summary
- Behavioral finance focuses on systematic irrationalities that characterize investor
decision making. These ―behavioral shortcomings‖ may be consistent with
several efficient market anomalies.
- Among the information processing errors uncovered in the psychology literature
are memory bias, overconfidence, conservatism, and representativeness.

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- Behavioral tendencies include framing, mental accounting, regret avoidance, and
loss aversion.
- Limits to arbitrage activity impede the ability of rational investors to exploit
pricing errors induced by behavioral investors. For example, fundamental risk
means that even if a security is mispriced, it still can be risky to attempt to exploit
the mispricing. This limits the actions of arbitrageurs who take positions in
mispriced securities. Other limits to arbitrage are implementation costs, model
risk, and costs to short-selling. Occasional failures of the Law of One Price
suggest that limits to arbitrage are sometimes severe.
- The various limits to arbitrage mean that even if prices do not equal intrinsic
value, it still may be difficult to exploit the mispricing. As a result, the failure of
traders to beat the market may not be proof that markets are in fact efficient, with
prices equal to intrinsic value.
- Technical analysis is the search for recurring and predictable patterns in stock
prices. It is based on the premise that prices only gradually close in on intrinsic
value. As fundamentals shift, astute traders can exploit the adjustment to a new
equilibrium.
- Technical analysis also uses volume data and sentiment indicators. These are
broadly consistent with several behavioral models of investor activity.
- The Dow Theory attempts to identify underlying trends in stock indexes. Moving
averages, relative strength, and breadth are used in other trend-based strategies.
- Some sentiment indicators are the trin statistic, the confi dence index, and the
put/call ratio.
Selected problems
1- Don Sampson begins a meeting with his fi nancial advisor by outlining his
investment philosophy as shown below:

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- Select the statement from the table above that best illustrates each of the
following behavioral finance concepts. Justify your selection.
i. Mental accounting.
ii. Overconfidence (illusion of control).
iii. Reference dependence (framing).

2- Monty Frost‘s tax-deferred retirement account is invested entirely in equity

securities. Because the international portion of his portfolio has performed poorly in the
past, he has reduced his international equity exposure to 2%. Frost‘s investment

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adviser has recommended an increased international equity exposure. Frost
responds with the following comments:
a. Based on past poor performance, I want to sell all my remaining international
equity securities once their market prices rise to equal their original cost.
b. Most diversified international portfolios have had disappointing results over the
past 5 years. During that time, however, the market in Country XYZ has
outperformed all other markets, even our own. If I do increase my international
equity exposure, I would prefer that the entire exposure consist of securities
from Country XYZ.
c. International investments are inherently more risky. Therefore, I prefer to
purchase any international equity securities in my ―speculative‖ account, my
best chance at becoming rich. I do not want them in my retirement account,
which has to protect me from poverty in my old age. Frost‘s adviser is familiar
with behavioral finance concepts but prefers a traditional or standard finance
approach (modern portfolio theory) to investments. Indicate the behavioral
finance concept that Frost most directly exhibits in each of his three comments.
Explain how each of Frost‘s comments can be countered by using an argument
from standard finance.

3- Louise and Christopher Maclin live in London, United Kingdom, and currently rent
an apartment in the metropolitan area. During an initial discussion of the Maclins‘
financial plans, Christopher Maclin makes the following statements to the
Maclins‘ financial adviser, Grant Webb:
a. ―I have used the Internet extensively to research the outlook for the housing
market over the next 5 years, and I believe now is the best time to buy a
house.‖
b. ―I do not want to sell any bond in my portfolio for a lower price than I paid for
the bond.‖
c. ―I will not sell any of my company stock because I know my company and I
believe it has excellent prospects for the future.‖ For each statement ( a )–( c )
identify the behavioral finance concept most directly exhibited. Explain how
each behavioral finance concept is affecting the Maclins‘ investment decision
making.

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4- During an interview with her investment adviser, a retired investor made the
following two statements:
a. ―I have been very pleased with the returns I‘ve earned on Petrie stock over the
past 2 years and I am certain that it will be a superior performer in the future.‖
b. ―I am pleased with the returns from the Petrie stock because I have specifi c uses
for that money. For that reason, I certainly want my retirement fund to
continue owning the Petrie stock.‖ Identify which principle of behavioral
finance is most consistent with each of the investor‘s two statements.

5- Claire Pierce comments on her life circumstances and investment

outlook: I must support my parents who live overseas on Pogo Island.
The Pogo Island economy has grown rapidly over the past 2 years with
minimal inflation, and consensus forecasts call for a continuation of
these favorable trends for the foreseeable future. Economic growth has
resulted from the export of a natural resource used in an exciting new
technology application. I want to invest 10 percent of my portfolio in
Pogo Island government bonds. I plan to purchase long-term bonds
because my parents are likely to live more than 10 years. Experts
uniformly do not foresee a resurgence of inflation on Pogo Island, so I
am certain that the total returns produced by the bonds will cover my
parents‘ spending needs for many years to come. There should be no
exchange rate risk because the bonds are denominated in local currency.
I want to buy the Pogo Island bonds, but am not willing to distort my
portfolio‘s long-term asset allocation to do so. The overall mix of stocks,
bonds, and other investments should not change. Therefore, I am
considering selling one of my U.S. bond funds to raise cash to buy the
Pogo Island bonds. One possibility is my High Yield Bond Fund, which has
declined 5% in value year to date. I am not excited about this Fund‘s
prospects; in fact I think it is likely to decline more, but there is a small
probability that it could recover very quickly. So I have decided instead
to sell my Core Bond Fund that has appreciated 5% this year. I expect
this investment to continue to deliver attractive returns, but there is a
small chance this year‘s gains might disappear quickly. Once that shift is
accomplished, my investments will be in great shape. The sole exception
is my Small Company Fund, which has performed poorly. I plan to sell

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this investment as soon as the price increases to my original cost.
Identify three behavioral finance concepts illustrated in Pierce‘s
comments and describe each of the three concepts. Discuss how an
investor practicing standard or traditional finance would challenge each
of the three concepts.

6- Use the data from The Wall Street Journal in Figure 9.9 to verify the trin ratio for
the NYSE. Is the trin ratio bullish or bearish?

7- Calculate breadth for the NYSE using the data in Figure 9.9 . Is the signal bullish
or bearish?

8- Collect data on the DJIA for a period covering a few months. Try to identify
primary trends. Can you tell whether the market currently is in an upward or
downward trend?

9- Baa-rated bonds currently yield 9%, while A-rated bonds yield 8%. Suppose that
due to an increase in the expected inflation rate, the yields on both bonds increase
by 1%. What would happen to the confi dence index? Would this be interpreted
as bullish or bearish by a technical analyst? Does this make sense to you?

10- Table 10A presents price data for Computers, Inc., and a computer industry index.
Does Computers, Inc., show relative strength over this period?

11- Use again the data in Table 10A to compute a 5-day moving average for
Computers, Inc. Can you identify any buy or sell signals?

12- Construct a point and figure chart for Computers, Inc., using again the data in
Table 10 A. Use $2 increments for your chart. Do the buy or sell signals derived
from your chart correspond to those derived from the moving average rule (see
the previous problem)?

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13- Yesterday, the Dow Jones industrials gained 54 points. However, 1,704 issues
declined in price while 1,367 advanced. Why might a technical analyst be
concerned even though the market index rose on this day?

14- Table 14A contains data on market advances and declines. Calculate cumulative
breadth and decide whether this technical signal is bullish or bearish.

15- If the trading volume in advancing shares on day 1 in the previous problem was
330 million shares, while the volume in declining issues was 240 million shares,
what was the trin statistic for that day? Was trin bullish or bearish?

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16- Given the following data, is the confidence index rising or falling? What might
explain the pattern of yield changes?

17- Go to www.mhhe.com/bkm and link to the material for Chapter 9, where you
will find 5 years of weekly returns for the S&P 500.
a. Set up a spreadsheet to calculate the 26-week moving average of the index. Set
the value of the index at the beginning of the sample period equal to 100. The
index value in each week is then updated by multiplying the previous week‘s
level by (1 _ rate of return over previous week).
b. Identify every instance in which the index crosses through its moving average
from below. In how many of the weeks following a cross-through does the
index increase? Decrease?
c. Identify every instance in which the index crosses through its moving average
from above. In how many of the weeks following a cross-through does the
index increase? Decrease?
d. How well does the moving average rule perform in identifying buy or sell
opportunities?

18- Go to www.mhhe.com/bkm and link to the material for Chapter 9, where you
will find 5 years of weekly returns for the S&P 500 and Fidelity‘s Select Banking
Fund (ticker FSRBX).
a. Set up a spreadsheet to calculate the relative strength of the banking sector
compared to the broad market. (Hint: as in the previous problem, set the initial
value of the sector index and the S&P 500 index equal to 100, and use each
week‘s rate of return to update the level of each index.)
b. Identify every instance in which the relative strength ratio increases by at least
5% from its value 5 weeks earlier. In how many of the weeks following a
substantial increase in relative strength does the banking sector outperform the
S&P 500? In how many of those weeks does the banking sector underperform
the S&P 500?

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c. Identify every instance in which the relative strength ratio decreases by at least
5% from its value 5 weeks earlier. In how many of the weeks following a
substantial decrease in relative strength does the banking sector underperform
the S&P 500? In how many of those weeks does the banking sector outperform
the S&P 500?
d. How well does the relative strength rule perform in identifying buy or sell
opportunities?

Use data from the Standard & Poor’s Market Insight Database at
www.mhhe.com/edumarketinsight to answer the following questions.
1- Find the monthly closing prices for the most recent 4 years for Abercrombie &
Fitch (ANF) from the Excel Analytics section of Market Insight. Also collect the
closing level of the S&P 500 Index over the same period.
a. Calculate the 4-month moving average of both the stock and the S&P 500 over
time. For each series, use Excel to plot the moving average against the actual level
of the stock price or index. Examine the instances where the moving average and
price series cross. Is the stock more or less likely to increase when the price
crosses through the moving average? Does it matter whether the price crosses the
moving average from above or below? How reliable would an investment rule
based on moving averages be? Perform your analysis for both the stock price and
the S&P 500.
b. Calculate and plot the relative strength of the stock compared to the S&P 500 over
the sample period. Find all instances in which relative strength of the stock
increases by more than 10 percentage points (e.g., an increase in the relative
strength index from .93 to 1.03) and all those instances in which relative strength
of the stock decreases by more than 10 percentage points. Is the stock more or less
likely to outperform the S&P in the following 2 months when relative strength has
increased or to underperform when relative strength has decreased? In other
words, does relative strength continue? How reliable would an investment rule
based on relative strength be?

2- Go to the Market Insight database and click on the Company tab. Enter ticker
symbol WMT for Wal-Mart Stores and click on Go.
a. Select the Charting by Profit link on the menu. When the chart first appears you
will need to reenter the WMT symbol in the box at the top left corner and click on

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Go. Click on the plus sign next to Technical Studies, then click on the plus sign
next to Moving Averages. Double click on Simple Moving Average to see the
Wal-Mart chart with a simple moving average. Do you see any patterns that might
lead to a successful trading rule?
b. Click on the plus sign next to Support & Resistance. Next, double click on
Projection Bands. What observations do you have about how often the price has
passed outside of these bands and what tends to happen after the price crosses the
band line?
c. At the top of the graph locate the selection box next to the stock symbol. The
default setting is Bar. Change this to Candle to see a Candle chart for Wal-Mart.
Change the frequency (three boxes to the right of the stock symbol) from ―D‖
(daily) to ―W‖ (weekly) to get a better view of the candles. As you move the
cursor along the plotted data look at the price information on top of the chart to
see how the Candle chart was plotted.
d. Explore some of the other graphs in the Technical Studies section. Do you have
any favorites that you think might be particularly useful for making investment
decisions?

WEB master
Technical Analysis versus Market 2. Is there verifiable evidence to
Efficiency Go to suggest that this method works in
bigcharts.marketwatch.com and practice? If you can identify a
search the Internet for other rule that seems to work, try it out
charting and technical analysis on real historical data that can be
sites. found at many sites such as:
1. Is there a consensus among finance.yahoo.com.
technical analysts concerning a
specific technique that works
best to generate excess returns?

4.1- Conservatism implies that investors will at first respond too slowly to new
information, leading to trends in prices. Representativeness can lead them to
extrapolate trends too far into the future and overshoot intrinsic value. Eventually,
when the pricing error is corrected, we observe a reversal.

4.2. Out-of-favor stocks will exhibit low prices relative to various proxies for intrinsic
value such as earnings. Because of regret avoidance, these stocks will need to offer
a more attractive rate of return to induce investors to hold them. Thus, low P/E
stocks might on average offer higher rates of return.

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4.3. At liquidation, price will equal NAV. This puts a limit on fundamental risk. Investors
need only carry the position for a few months to profit from the elimination of the
discount. Moreover, as the liquidation date approaches, the discount should
dissipate. This greatly limits the risk that the discount can move against the
investor. At the announcement of impending liquidation, the discount should
immediately disappear, or at least shrink considerably.

4.5. By the time the news of the recession affects bond yields, it also ought to affect stock
prices. The market should fall before the confidence index signals that the time is
ripe to sell.

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Quantitative methods of investment analysis

3basic questions for the investor in decision making: One: How to

compare different assets in investment selection process? What are the
quantitative characteristics of the assets and how to measure them? Two:
How does one asset in the same portfolio influence the other one in
the same portfolio? And what could be the influence of this relationship
to the investor‘s portfolio? Three: What is relationship between the
returns on an asset and returns in the whole market (market
portfolio)? The answers of these questions need quantitative methods of
analysis, based on the statistical concepts and they will be examined in
this chapter.

2.1. Investment income and risk

A return is the ultimate objective for any investor. But a relationship between
return and risk is a key concept in finance. As finance and investments areas are built
upon a common set of financial principles, the main characteristics of any investment
are investment return and risk. However to compare various alternatives of
investments the precise quantitative measures for both of these characteristics are
needed.

2.2. Return on investment and expected rate of return

General definition of return is the benefit associated with an investment. In
most cases the investor can estimate his/ her historical return precisely.

Many investments have two components of their measurable return:

 a capital gain or loss;
 some form of income.
The rate of return is the percentage increase in returns associated with the
holding period:

Rate of return = Income + Capital gains / Purchase price (%) (2.1)

For example, rate of return of the share (r) will be estimated:

D + (Pme - Pmb)
R = ------------------------------- (%) (2.2)
Pmb

Here D - dividends;
Pmb - market price of stock at the beginning of holding period;
Pme - market price of stock at the end of the holding period.
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Example 1):

Robin wishes to determine the return on two stocks that she owned during
2009, Apple Inc. and Wal-Mart. At the beginning of the year, Apple stock traded for
$90.75 per share, and Wal-Mart was valued at $55.33. During the year, Apple paid no
dividends, but Wal-Mart shareholders received dividends of $1.09 per share. At the end
of the year, Apple stock was worth $210.73 and Wal-Mart sold for $52.84. Substituting
into Equation 2.1, and 2.2, we can calculate the annual rate of return, r, for each stock.

Apple: ($0 + $210.73 - $90.75) ÷ $90.75 = 132.2%

Wal-Mart: ($1.09 + $52.84 - $55.33) ÷ $55.33 = -2.5%

Robin made money on Apple and lost money on Wal-Mart in 2009, but notice that her
losses on Wal-Mart would have been greater had it not been for the dividends that she
received on her Wal-Mart shares. When calculating the total rate of return, it is important
to take into account the effects of both cash disbursements and changes in the price of the
investment during the year.

A matter of fact:

Investment returns vary both over time and between different types of investments. By
averaging historical returns over a long period of time, we can focus on the differences in
returns that different kinds of investments tend to generate. Table 8.1 shows both the
nominal and real average annual rates of return from 1900 to 2009 for three different
types of investments: Treasury bills, Treasury bonds, and common stocks. Although bills
and bonds are both issued by the U.S. government and are therefore viewed as relatively
safe investments, bills have maturities of 1 year or less, while bonds have maturities
ranging up to 30 years. Consequently, the interest rate risk associated with Treasury
bonds is much higher than with bills. Over the last 109 years, bills earned the lowest
returns, just 3.9 percent per year on average in nominal returns and only 0.9 percent
annually in real terms. The latter number means that average Treasury bill returns barely
exceeded the average rate of inflation. Bond returns were higher, 5.0 percent in nominal
terms and 1.9 percent in real terms. Clearly, though, stocks outshined the other types of
investments, earning average annual nominal returns of 9.3 percent and average real
returns of 6.2 percent. In light of these statistics, you might wonder, ―Why would anyone
invest in bonds or bills if the returns on stocks are so much higher?‖ The answer, as you
will soon see, is that stocks are much riskier than either bonds or bills and that risk leads

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some investors to prefer the safer, albeit lower, returns on Treasury securities.

The rate of return, calculated in formulas 2.2 and 2.3 is called holding period
return, because its calculation is independent of the passages of the time. All the
investor knows is that there is a beginning of the investment period and an end. The
percent calculated using this formula might have been earned over one month or other
the year. Investor must be very careful with the interpretation of holding period returns
in investment analysis. Investor can‗t compare the alternative investments using
holding period returns, if their holding periods (investment periods) are different.
Statistical data which can be used for the investment analysis and portfolio formation
deals with a series of holding period returns. For example, investor knows monthly
returns for a year of two stocks. How he/ she can compare these series of returns? In
these cases arithmetic average return or sample mean of the returns (ř) can be
used:
n
ri
i=1
ř = ---------, (2.3)
n

here ri - rate of return in period i;

n - number of observations.

But both holding period returns and sample mean of returns are calculated
using historical data. However what happened in the past for the investor is not as
important as what happens in the future, because all the investors' decisions are
focused to the future, or to expected results from the investments. Of course, no one
investor knows the future, but he/ she can use past information and the historical data
as well as to use his knowledge and practical experience to make some estimates about
it. Analyzing each particular investment vehicle possibilities to earn income in the
future investor must think about several "scenarios" o f probable changes in macro
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economy, industry and company which could influence asset prices ant rate of return.
Theoretically it could be a series of discrete possible rates of return in the future for the
same asset with the different probabilities of earning the particular rate of return. But
for the same asset the sum of all probabilities of these rates of returns must be equal to
1 or 100 %. In mathematical statistics it is called simple probability distribution.
The expected rate of return E(r) of investment is the statistical measure of
return, which is the sum of all possible rates of returns for the same investment
weighted by probabilities:
n
E(r) = hi ri , (2.4)
i=1

Here hi - probability of rate of return;

ri - rate of return.

In all cases than investor has enough information for modeling of future
scenarios of changes in rate of return for investment, the decisions should be based on
estimated expected rate of return. But sometimes sample mean of return (arithmetic
average return) are a useful proxy for the concept of expected rate of return. Sample
mean can give an unbiased estimate of the expected value, but obviously it‗s not
perfectly accurate, because based on the assumption that the returns in the future will
be the same as in the past. But this is the only one scenario in estimating expected rate
of return. It could be expected, that the accuracy of sample mean will increase, as the
size of the sample becomes longer (if n will be increased). However, the assumption,
that the underlying probability distribution does not change its shape for the longer
period becomes more and more unrealistic. In general, the sample mean of returns
should be taken for as long time, as investor is confident there has not been significant
change in the shape of historical rate of return probability distribution.

2.2.2. Investment risk

Risk can be defined as a chance that the actual outcome from an investment
will differ from the expected outcome. Obvious, that most investors are concerned that
the actual outcome will be less than the expected outcome. The more variable the
possible outcomes that can occur, the greater the risk. Risk is associated with the
dispersion in the likely outcome. And dispersion refers to variability. However, in the
most basic sense, risk is a measure of the uncertainty surrounding the return that an
investment will earn. Investments whose returns are more uncertain are generally

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viewed as being riskier. More formally, the term risk is used interchangeably with
uncertainty to refer to the variability of returns associated with a given asset. A $1,000
government bond that guarantees its holder $5 interest after 30 days has no risk,
because there is no variability associated with the return. A $1,000 investment in a
firm‘s common stock, the value of which over the same 30 days may move up or down
a great deal, is very risky because of the high variability of its return.

- Risk of a Single Asset

In this section we refine our understanding of risk. Surprisingly, the concept of

risk changes when the focus shifts from the risk of a single asset held in isolation to the
risk of a portfolio of assets. Here, we examine different statistical methods to quantify
risk, and next we apply those methods to portfolios.

- Risk Assessment

The notion that risk is somehow connected to uncertainty is intuitive. The more
uncertain you are about how an investment will perform, the riskier that investment
seems. Scenario analysis provides a simple way to quantify that intuition, and
probability distributions offer an even more sophisticated way to analyze the risk of an
investment.

- Scenario Analysis

Scenario analysis uses several possible alternative outcomes (scenarios) to

obtain a sense of the variability of returns.2 One common method involves considering
pessimistic (worst), most likely (expected), and optimistic (best) outcomes and the
returns associated with them for a given asset. In this one measure of an investment‘s
risk is the range of possible outcomes. The range is found by subtracting the return
associated with the pessimistic outcome from the return associated with the optimistic
outcome. The greater the range, the more variability, or risk, the asset is said to have.
Example 2):

Norman Company, a manufacturer of custom golf equipment, wants to choose

the better of two investments, A and B. Each requires an initial outlay of $10,000, and
each has a most likely annual rate of return of 15%. Management has estimated returns
associated with each investment‘s pessimistic and optimistic outcomes. The three
estimates for each asset, along with its range, are given in Table 8.2. Asset A appears to
be less risky than asset B; its range of 4% (17% minus 13%) is less than the range of
16% (23% minus 7%) for asset B. The risk-averse decision maker would prefer asset A
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over asset B, because A offers the same most likely return as B (15%) with lower risk
(smaller range).

It‘s not unusual for financial managers to think about the best and worst possible
outcomes when they are in the early stages of analyzing a new investment project. No
matter how great the intuitive appeal of this approach, looking at the range of outcomes
that an investment might produce is a very unsophisticated way of measuring its risk.
More sophisticated methods require some basic statistical tools.

Probability Distributions

Probability distributions provide a more quantitative insight into an asset‘s risk. The
probability of a given outcome is its chance of occurring. An outcome with an 80
percent probability of occurrence would be expected to occur 8 out of 10 times. An
outcome with a probability of 100 percent is certain to occur. Outcomes with a
probability of zero will never occur.

Example 3):

Norman Company‘s past estimates indicate that the probabilities of the

pessimistic, most likely, and optimistic outcomes are 25%, 50%, and 25%,
respectively. Note that the sum of these probabilities must equal 100%; that is, they
must be based on all the alternatives considered.

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A probability distribution is a model that relates probabilities to the

associated outcomes. The simplest type of probability distribution is the bar chart. The
bar charts for Norman Company‘s assets A and B are shown in Figure 8.1. Although
both assets have the same average return, the range of return is much greater, or more
dispersed, for asset B than for asset A—16 percent versus 4 percent. Most investments
have more than two or three possible outcomes. In fact, the number of possible
outcomes in most cases is practically infinite. If we knew all the possible outcomes and
associated probabilities, we could develop a continuous probability distribution.
This type of distribution can be thought of as a bar chart for a very large number of
outcomes. Figure 2.2 presents continuous probability distributions for assets C and D.
Note that although the two assets have the same average return (15 percent), the
distribution of returns for asset D has much greater dispersion than the distribution for
asset C. Apparently, asset D is more risky than asset C.
Risk Measurement:

In addition to considering the range of returns that an investment might

produce, the risk of an asset can be measured quantitatively by using statistics. The
most common statistical measure used to describe an investment‘s risk is its variance
or standard deviation.

Variance can be calculated as a potential deviation of each possible investment rate of

return from the expected rate of return:
n
²(r) = hi ri - E(r) ² (2.5)
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i=1

To compute the variance in formula 2.5 all the rates of returns which were
observed in estimating expected rate of return (ri) have to be taken together with their
probabilities of appearance (hi).

The other an equivalent to variance measure of the total risk is standard

deviation which is calculated as the square root of the variance. Standard deviation, r
measures the dispersion of an investment‘s return around the expected return. The
expected return, is the average return that an investment is expected to produce over
time. For an investment that has j different possible returns, the expected return is
calculated as follows:

Or

(r) = √ hi ri - E(r)² (2.6)

In the cases than the arithmetic average return or sample mean of the returns
(ř) is used instead of expected rate of return, sample variance (²r ) can be calculated:
n
(rt - ř) ²
t=1
²r = -------------------- (2.7)
n– 1

Sample standard deviation (r) consequently can be calculated as the square

root of the sample variance:

r = √ ²r (2.8)

Example 4):
The expected values of returns for Norman Company‘s assets A and B are presented in
Table 8.3. Column 1 gives the Prj‘s and column 2 gives the rj‘s. In each case n equals 3.
The expected value for each asset‘s return is 15%.

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Example 4):
Table 8.4 presents the standard deviations for Norman Company‘s assets A and B, based
on the earlier data. The standard deviation for asset A is 1.41%, and the standard
deviation for asset B is 5.66%. The higher risk of asset B is clearly reflected in its higher
standard deviation.

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Historical Returns and Risk

We can now use the standard deviation as a measure of risk to assess the historical
(1900–2009) investment return data in Table 8.1. Table 8.5 repeats the historical nominal
average returns in column 1 and shows the standard deviations associated with each of
them in column 2. A close relationship can be seen between the investment returns and
the standard deviations: Investments with higher returns have higher standard deviations.
For example, stocks have the highest average return at 9.3 percent, which is more than
double the average return on Treasury bills. At the same time, stocks are much more
volatile, with a standard deviation of 20.4 percent, more than four times greater than the
standard deviation of Treasury bills. Because higher standard deviations are associated
with greater risk, the historical data confirm the existence of a positive relationship
between risk and return. That relationship reflects risk aversion by market participants,
who require higher returns as compensation for greater risk. The historical data in
columns 1 and 2 of Table 8.5 clearly show that during the 1900–2009 period, investors
were, on average, rewarded with higher returns on higher-risk investments.

Variance and the standard deviation are similar measures of risk and can be
used for the same purposes in investment analysis; however, standard deviation in
practice is used more often. Variance and standard deviation are used when investor is
focused on estimating total risk that could be expected in the defined period in the
future. Sample variance and sample standard deviation are more often used when
investor evaluates total risk of his /her investments during historical period – this is
important in investment portfolio management.
2.3. Risk Preferences:
Different people react to risk in different ways. Economists use three
categories to describe how investors respond to risk. The first category, and the one that
describes the behavior of most people most of the time, is called risk aversion. A person

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who is a risk-averse investor prefers less risky over more risky investments, holding
the rate of return fixed. A risk-averse investor who believes that two different
investments have the same expected return will choose the investment whose returns
are more certain. Stated another way, when choosing between two investments, a risk-
averse investor will not make the riskier investment unless it offers a higher expected
return to compensate the investor for bearing the additional risk. A second attitude
toward risk is called risk neutrality. An investor who is risk-neutral chooses
investments based solely on their expected returns, disregarding the risks. When
choosing between two investments, a risk-neutral investor will always choose the
investment with the higher expected return regardless of its risk. Finally, a risk-seeking
investor is one who prefers investments with higher risk and may even sacrifice some
expected return when choosing a riskier investment. By design, the average person who
buys a lottery ticket or gambles in a casino loses money. After all, state governments
and casinos make money off of these endeavors, so individuals lose on average. This
implies that the expected return on these activities is negative. Yet people do buy lottery
tickets and visit casinos, and in doing so they exhibit risk-seeking behavior.
Coefficient of Variation—Trading Off Risk and Return
The coefficient of variation, CV, is a measure of relative dispersion that is useful in
comparing the risks of assets with differing expected returns. Equation 2.9 gives the
expression for the coefficient of variation:

A higher coefficient of variation means that an investment has more volatility relative to
its expected return. Because investors prefer higher returns and less risk, intuitively one
might expect investors to gravitate towards investments with a low coefficient of
variation. However, this logic doesn‘t always apply for reasons that will emerge in the
next section. For now, consider the coefficients of variation in column 3 of Table 8.5.
That table reveals that Treasury bills have the lowest coefficient of variation and
therefore the lowest risk relative to their return. Does this mean that investors should load
up on Treasury bills and divest themselves of stocks? Not necessarily.
Example 4):
When the standard deviations (from Table 8.4) and the expected returns (from Table 8.3)
for assets A and B are substituted into Equation 8.4, the coefficients of variation for A
and B are 0.094 (1.41% ÷ 15%) and 0.377 (5.66% ÷ 15%), respectively. Asset B has the
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higher coefficient of variation and is therefore more risky than asset A—which we
already know from the standard deviation. (Because both assets have the same expected
return, the coefficient of variation has not provided any new information.)
Example 4):
Marilyn Ansbro is reviewing stocks for inclusion in her investment portfolio. The stock
she wishes to analyze is Danhaus Industries, Inc. (DII), a diversified manufacturer of pet
products. One of her key concerns is risk; as a rule she will invest only in stocks with a
coefficient of variation below 0.75. She has gathered price and dividend data (shown in
the accompanying table) for DII over the past 3 years, 2010–2012, and assumes that each
year‘s return is equally probable.

Because the coefficient of variation of returns on the DII stock over the 2010–2012
period of 0.53 is well below Marilyn‘s maximum coefficient of variation of 0.75, she
concludes that the DII stock would be an acceptable investment.
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2.1.Risk of a Portfolio
In real-world situations, the risk of any single investment would not be viewed
independently of other assets. New investments must be considered in light of their
impact on the risk and return of an investor‘s portfolio of assets. The financial manager‘s
goal is to create an efficient portfolio, one that provides the maximum return for a given
level of risk. We therefore need a way to measure the return and the standard deviation of
a portfolio of assets. As part of that analysis, we will look at the statistical concept of
correlation, which underlies the process of diversification that is used to develop an
efficient portfolio.

Portfolio Return and Standard Deviation

The return on a portfolio is a weighted average of the returns on the individual assets
from which it is formed. We can use Equation 8.5 to find the portfolio return, rp:

Example 5):
Assume that we wish to determine the expected value and standard deviation of returns
for portfolio XY, created by combining equal portions (50% each) of assets X and Y. The
forecasted returns of assets X and Y for each of the next 5 years (2013–2017) are given
in columns 1 and 2, respectively, in part A of Table 8.6. In column 3, the weights of 50%
for both assets X and Y along with their respective returns from columns 1 and 2 are
substituted into Equation 8.5. Column 4 shows the results of the calculation—an
expected portfolio return of 12% for each year, 2013 to 2017. Furthermore, as shown in
part B of Table 8.6, the expected value of these portfolio returns over the 5-year period is
also 12% (calculated by using Equation 8.2a, in footnote 3). In part C of Table 8.6,
portfolio XY‘s standard deviation is calculated to be 0% (using Equation 8.3a, in

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footnote 4). This value should not be surprising because the portfolio return each year is
the same—12%. Portfolio returns do not vary through time.

2.4. Relationship between risk and return

The expected rate of return and the variance or standard deviation provide
investor with information about the nature of the probability distribution associated
with a single asset. However all these numbers are only the characteristics of return
and risk of the particular asset. But how does one asset having some specific trade-off
between return and risk influence the other one with the different characteristics of
return and risk in the same portfolio? And what could be the influence of this
relationship to the investor‘s portfolio? The answers to these questions are of great
importance for the investor when forming his/ her diversified portfolio. The statistics
that can provide the investor with the information to answer these questions are
covariance and correlation coefficient. Covariance and correlation are related and they
generally measure the same phenomenon – the relationship between two variables.

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Both concepts are best understood by looking at the math behind them.

Correlation
Correlation is a statistical measure of the relationship between any two series of
numbers. The numbers may represent data of any kind, from returns to test scores. If two
series tend to vary in the same direction, they are positively correlated. If the series vary
in opposite directions, they are negatively correlated. For example, suppose we gathered
data on the retail price and weight of new cars. It is likely that we would find that larger
cars cost more than smaller ones, so we would say that among new cars weight and price
are positively correlated. If we also measured the fuel efficiency of these vehicles (as
measured by the number of miles they can travel per gallon of gasoline), we would find
that lighter cars are more fuel efficient than heavier cars. In that case, we would say that
fuel economy and vehicle weight are negatively correlated. The degree of correlation is
measured by the correlation coefficient, which ranges from + 1 for perfectly positively
correlated series to – 1 for perfectly negatively correlated series. These two extremes
are depicted for series M and N in Figure 8.4. The perfectly positively correlated series
move exactly together without exception; the perfectly negatively correlated series move
in exactly opposite directions.

Diversification:
The concept of correlation is essential to developing an efficient portfolio. To reduce
overall risk, it is best to diversify by combining, or adding to the portfolio, assets that
have the lowest possible correlation. Combining assets that have a low correlation with
each other can reduce the overall variability of a portfolio‘s returns. Figure 8.5 (see page
324) shows the returns that two assets, F and G, earn over time. Both assets earn the same
average or expected return, r, but note that when F‘s return is above average, the return
on G is below average and vice versa. In other words, returns on F and G are negatively
correlated, and when these two assets are combined in a portfolio, the risk of that
portfolio falls without reducing the average return (that is, the portfolio‘s average return
is also r).

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For risk-averse investors, this is very good news. They get rid of something that
they don‘t like (risk) without having to sacrifice what they do like (return). Even if assets
are positively correlated, the lower the correlation between them, the greater the risk
reduction that can be achieved through diversification.
Some assets are uncorrelated—that is, there is no interaction between their
returns. Combining uncorrelated assets can reduce risk, not as effectively as combining
negatively correlated assets but more effectively than combining positively correlated
assets. The correlation coefficient for uncorrelated assets is close to zero and acts as the
midpoint between perfect positive and perfect negative correlation.
The creation of a portfolio that combines two assets with perfectly positively
correlated returns results in overall portfolio risk that at minimum equals that of the least
risky asset and at maximum equals that of the most risky asset. However, a portfolio
combining two assets with less than perfectly positive correlation can reduce total risk to
a level below that of either of the components. For example, assume that you buy stock in
a company that manufactures machine tools. The business is very cyclical, so the stock
will do well when the economy is expanding, and it will do poorly during a recession. If
you bought shares in another machine-tool company, with sales positively correlated with
those of your firm, the combined portfolio would still be cyclical and risk would not be
reduced a great deal. Alternatively, however, you could buy stock in a discount retailer,
whose sales are countercyclical. It typically performs worse during economic expansions
than it does during recessions (when consumers are trying to save money on every
purchase). A portfolio that contained both of these stocks might be less volatile than
either stock on its own.

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Example 6):
Table 8.7 presents the forecasted returns from three different assets—X, Y, and
Z—over the next 5 years, along with their expected values and standard deviations. Each
of the assets has an expected return of 12% and a standard deviation of 3.16%. The assets
therefore have equal return and equal risk. The return patterns of assets X and Y are
perfectly negatively correlated. When X enjoys its highest return, Y experiences its
lowest return, and vice versa. The returns of assets X and Z are perfectly positively
correlated. They move in precisely the same direction, so when the return on X is high,
so is the return on Z. (Note: The

returns for X and Z are identical.)6 Now let‘s consider what happens when we combine
these assets in different ways to form portfolios. Portfolio XY Portfolio XY (shown in
Table 8.7) is created by combining equal portions of assets X and Y, the perfectly
negatively correlated assets. (Calculation of portfolio XY‘s annual returns, the expected
portfolio return, and the standard deviation of returns was demonstrated in Table 8.6 on
page 322.) The risk in this portfolio, as reflected by its standard deviation, is reduced to
0%, whereas the expected return remains at 12%. Thus, the combination results in the
complete elimination of risk because in each and every year the portfolio earns a 12%
return.7 Whenever assets are perfectly negatively correlated, some combination of the
two assets exists such that the resulting portfolio’s returns are risk free. Portfolio XZ
Portfolio XZ (shown in Table 8.7) is created by combining equal portions of assets X and
Z, the perfectly positively correlated assets. Individually, assets X and Z have the same
standard deviation, 3.16%, and because they always move together, combining them in a
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portfolio does nothing to reduce risk—the portfolio standard deviation is also 3.16%. As
was the case with portfolio XY, the expected return of portfolio XZ is 12%. Because both
of these portfolios provide the same expected return, but portfolio XY achieves that
expected return with no risk, portfolio XY is clearly preferred by risk-averse investors
over portfolio XZ.

CORRELATION, DIVERSIFICATION, RISK, AND RETURN

In general, the lower the correlation between asset returns, the greater the risk reduction
that investors can achieve by diversifying. The following example illustrates how
correlation influences the risk of a portfolio but not the portfolio‘s expected return.

Example 7):
Consider two assets—Lo and Hi—with the characteristics described in the table below:

Clearly, asset Lo offers a lower return than Hi does, but Lo is also less risky than Hi. It is
natural to think that a portfolio combining Lo and Hi would offer a return that is between
6% and 8% and that the portfolio‘s risk would also fall between the risk of Lo and Hi
(between 3% and 8%). That intuition is only partly correct. The performance of a
portfolio consisting of assets Lo and Hi depends not only on the expected return and
standard deviation of each asset (given above), but also on how the returns on the two
assets are correlated. We will illustrate the results of three specific scenarios: (1) returns
on Lo and Hi are perfectly positively correlated, (2) returns on Lo and Hi are
uncorrelated, and (3) returns on Lo and Hi are perfectly negatively correlated.
The results of the analysis appear in Figure 8.6. Whether the correlation between
Lo and Hi is + 1, 0, or – 1 a portfolio of those two assets must have an expected return
between 6% and 8%. That is why the line segments at left in Figure 8.6 all range between
6% and 8%. However, the standard deviation of a portfolio depends critically on the
correlation between Lo and Hi. Only when Lo and Hi are perfectly positively correlated
can it be said that the portfolio standard deviation must fall between 3% (Lo‘s standard
deviation) and 8% (Hi‘s standard deviation). As the correlation between Lo and Hi
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becomes weaker (that is, as the correlation coefficient falls), investors may find that they
can form portfolios of Lo and Hi with standard deviations that are even less than 3% (that
is, portfolios that are less risky than holding asset Lo by itself). That is why the line
segments at right in Figure 8.6 vary. In the special case when Lo and Hi are perfectly
negatively correlated, it is possible to diversify away all of the risk and form a portfolio
that is risk free.

INTERNATIONAL DIVERSIFICATION
One excellent practical example of portfolio diversification involves including foreign
assets in a portfolio. The inclusion of assets from countries with business cycles that are
not highly correlated with the U.S. business cycle reduces the portfolio‘s responsiveness
to market movements. The ups and the downs of different markets around the world
offset each other, at least to some extent, and the result is a portfolio that is less risky than
one invested entirely in the U.S. market.

Returns from International Diversification

Over long periods, internationally diversified portfolios tend to perform better (meaning
that they earn higher returns relative to the risks taken) than purely domestic portfolios.
However, over shorter periods such as a year or two, internationally diversified portfolios
may perform better or worse than domestic portfolios. For example, consider what
happens when the U.S. economy is performing relatively poorly and the dollar is
depreciating in value against most foreign currencies. At such times, the dollar returns to
U.S. investors on a portfolio of foreign assets can be very attractive. However,
international diversification can yield subpar returns, particularly when the dollar is
appreciating in value relative to other currencies. When the U.S. currency appreciates, the
dollar value of a foreign-currency denominated portfolio of assets declines. Even if this
portfolio yields a satisfactory return in foreign currency, the return to U.S. investors will
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be reduced when foreign profits are translated into dollars. Subpar local currency
portfolio returns, coupled with an appreciating dollar, can yield truly dismal dollar
returns to U.S. investors.
Overall, though, the logic of international portfolio diversification assumes that
these fluctuations in currency values and relative performance will average out over long
periods. Compared to similar, purely domestic portfolios, an internationally diversified
portfolio will tend to yield a comparable return at a lower level of risk.

Risks of International Diversification

In addition to the risk induced by currency fluctuations, several other financial risks are
unique to international investing. Most important is political risk, which arises from the
possibility that a host government will take actions harmful to foreign investors or that
political turmoil will endanger investments. Political risks are particularly acute in
developing countries, where unstable or ideologically motivated governments may
attempt to block return of profits by foreign investors or even seize (nationalize) their
assets in the host country. For example, reflecting President Chavez‘s desire to broaden
the country‘s socialist revolution, Venezuela issued a list of priority goods for import that
excluded a large percentage of the necessary inputs to the automobile production process.
As a result, Toyota halted auto production in Venezuela, and three other auto
manufacturers temporarily closed or deeply cut their production there. Chavez also has
forced most foreign energy firms to reduce their stakes and give up control of oil projects
in Venezuela. For more discussion of reducing risk through international diversification,
see the next Global Focus box.

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2.4.1. Covariance
Two methods of covariance estimation can be used: the sample covariance
and the population covariance.
The sample covariance is estimated than the investor hasn‗t enough
information about the underlying probability distributions for the returns of two assets
and then the sample of historical returns is used.

Sample covariance between two assets - A and B is defined in the next formula
(2.9):

[( rA,t - ŕA ) ( rB,t - ŕB)]

t=1
Cov (ŕA, ŕB) = -----------------------------------------, (2.9)
n–1

here rA,t , rB,t - consequently, rate of return for assets A and B in the time period t,
when t varies from 1 to n;
ŕA, ŕB - sample mean of rate of returns for assets A and B consequently.

As can be understood from the formula, a number of sample covariance can

range from ―–‖ to ―+‖ infinity. Though, the covariance number doesn‘t tell the
investor much about the relationship between the returns on the two assets if only this
pair of assets in the portfolio is analysed. It is difficult to conclud if the relationship
between returns of two assets (A and B) is strong or weak, taking into account the
absolute number of the sample variance. However, what is very important using the
covariance for measuring relationship between two assets – the identification of the
direction of this relationship. Positive number of covariance shows that rates of return
of two assets are moving to the same direction: when return on asset A is above its
mean of return (positive), the other asset B is tend to be the same (positive) and vice
versa: when the rate of return of asset A is negative or bellow its mean of return, the
returns of other asset tend to be negative too. Negative number of covariance shows
that rates of return of two assets are moving in the contrariwise directions: when return
on asset A is above its mean of return (positive), the returns of the other asset - B is
tend to be the negative and vice versa. Though, in analyzing relationship between the
assets in the same portfolio using covariance for portfolio formation it is important to
identify which of the three possible outcomes exists:
 positive covariance (―+‖),
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 negative covariance (―-‖) or
 zero covariance (―0‖).
If the positive covariance between two assets is identified the common
recommendation for the investor would be not to put both of these assets to the same
portfolio, because their returns move in the same direction and the risk in portfolio will
be not diversified.
If the negative covariance between the pair of assets is identified the common
recommendation for the investor would be to include both of these assets to the

portfolio, because their returns move in the contrariwise directions and the risk in
portfolio could be diversified or decreased.
If the zero covariance between two assets is identified it means that there is no
relationship between the rates of return of two assets. The assets could be included in
the same portfolio, but it is rare case in practice and usually covariance tends to be
positive or negative.
For the investors using the sample covariance as one of the initial steps in
analyzing potential assets to put in the portfolio the graphical method instead of
analytical one (using formula 2.9) could be a good alternative. In figures 2.1, 2.2 and
2.3 the identification of positive, negative and zero covariances is demonstrated in
graphical way. In all these figures the horizontal axis shows the rates of return on asset
A and vertical axis shows the rates of return on asset B. When the sample mean of
return for both assets is calculated from historical data given, the all area of possible
historical rates of return can be divided into four sections (I, II, III and IV) on the basis
of the mean returns of two assets (ŕA, ŕB consequently). In I section both asset A and
asset B have the positive rates of returns above their means of return; in section II the
results are negative for asset A and positive for asset B; in section III the results of
both assets are negative – below their meansof return and in section IV the results are
positive for asset A and negative for asset B.
When the historical rates of return of two assets known for the investor are
marked in the area formed by axes ŕA, ŕB, it is very easy to identify what kind of
relationship between two assets exists simply by calculating the number of
observations in each:
 if the number of observations in sections I and III prevails over the
number of observations in sections II and IV, the covariance between two

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assets is positive (―+‖);
 if the number of observations in sections II and IV prevails over the
number of observations in sections I and III, the covariance between two
assets is negative(―-‖);
 if the number of observations in sections I and III equals the number
of observations in sections II and IV, there is the zero covariance between
two assets (―0‖).

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Rate of return
on security B
rB 5
3

2 II I
rB
III IV
1
rA
Rate of return on security A
4

rA
Figure 2.1. Relationship between two assets: positive covariance.
Rate of return
on security B

r II I
II Rate of return

Figure 2.2. Relationship between two assets: negative covariance.

Rate of return
on security B

r I
II Rate of return

Figure 2.3. Relationship between two assets: zero covariance.

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The population covariance is estimated when the investor has enough

information about the underlying probability distributions for the returns of two assets
and can identify the actual probabilities of various pairs of the returns for two assets at
the same time.
The population covariance between stocks A and B:
m
Cov (rA, rB) = hi rA,i - E(rA) rB,i - E(rB) (2.10)
i=1

Similar to using the sample covariance, in the population covariance case the
graphical method can be used for the identification of the direction of the relationship
between two assets. But the graphical presentation of data in this case is more
complicated because three dimensions must be used (including the probability).
Despite of it, if investor observes that more pairs of returns are in the sections I and III
than in II and IV, the population covariance will be positive, if the pairs of return in II
and IV prevails over I and III, the population covariance is negative.

2.4.2. Correlation and Coefficient of determination.

Correlation is the degree of relationship between two variables.
The correlation coefficient between two assets is closely related to their
covariance. The correlation coefficient between two assets A and B (kAB) can be
calculated using the next formula:
Cov(rA,rB)
kA,B = ------------------- , (2.11)
(rA) (rB)

here (rA) and (rB) are standard deviation for asset A and B consequently.

Very important, that instead of covariance when the calculated number is

unbounded, the correlation coefficient can range only from -1,0 to +1,0. The more
close the absolute meaning of the correlation coefficient to 1,0, the stronger the
relationship between the returns of two assets. Two variables are perfectly positively
correlated if correlation coefficient is +1,0, that means that the returns of two assets
have a perfect positive linear relationship to each other (see Fig. 2.4), and perfectly
negatively correlated if correlation coefficient is -1,0, that means the asset returns
have a perfect inverse linear relationship to each other (see Fig. 2.5). But most often
correlation between assets returns is imperfect (see Fig. 2.6). When correlation
coefficient equals 0, there is no linear relationship between the returns on the two

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assets (see Fig. 2.7). Combining two assets with zero correlation with each other
reduces the risk of the portfolio. While a zero correlation between two assets returns
is better than positive correlation, it does not provide the risk reduction results of a
negative correlation coefficient.

rB rB

rA rA

Fig. 2.4. Perfect positive correlation Fig. 2.5. Perfect negative correlation
between returns of two assets. between returns of two assets.

.
rB rB

rA rA

Fig. 2.6. Imperfect positive correlation Fig. 2.7. Zero correlation between
between returns on two assets. returns on two assets.

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It can be useful to note, that when investor knows correlation coefficient, the
covariance between stocks A and B can be estimated, because standard deviations of
the assets‘ rates of return will already are available:

Cov(rA, rB ) = kA,B (rA) (rB) (2.12)

Therefore, as it was pointed out earlier, the covariance primarily provides

information to the investor about whether the relationship between asset returns is
positive, negative or zero, because simply observing the number itself without any
context with which to compare the number, is not very useful. When the covariance is
positive, the correlation coefficient will be also positive, when the covariance is
negative, the correlation coefficient will be also negative. But using correlation
coefficients instead of covariance investor can immediately asses the degree of
relationship between assets returns.
The coefficient of determination (Det.AB) is calculated as the square of
correlation coefficient:
Det.A, B = k²A,B (2.13)

The coefficient of determination shows how much variability in the returns of

one asset can be associated with variability in the returns of the other. For example, if
correlation coefficient between returns of two assets is estimated + 0,80, the coefficient
of determination will be 0,64. The interpretation of this number for the investor is that
approximately 64 percent of the variability in the returns of one asset can be explained
by the returns of the other asset. If the returns on two assets are perfect correlated, the
coefficient of determination will be equal to 100 %, and this means that in such a case
if investor knows what will be the changes in returns of one asset he / she could predict
exactly the return of the other asset.

2.5. Relationship between the returns on stock and market portfolio

When picking the relevant assets to the investment portfolio on the basis of
their risk and return characteristics and the assessment of the relationship of their
returns investor must consider to the fact that these assets are traded in the market.
How could the changes in the market influence the returns of the assets in the
investor‘s portfolio? What is the relationship between the returns on an asset and
returns in the whole market (market portfolio)? These questions need to be answered

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when investing in any investment environment. The statistics can be explored to

answer these questions as well.

2.5.1. The characteristic line and the Beta factor

Before examining the relationship between a specific asset and the market
portfolio the concept of ―market portfolio‖ needs to be defined. Theoretical
interpretation of the market portfolio is that it involves every single risky asset in the
global economic system, and contains each asset in proportion to the total market value
of that asset relative to the total value of all other assets (value weighted portfolio). But
going from conceptual to practical approach - how to measure the return of the market
portfolio in such a broad its understanding - the market index for this purpose can be
used. Investors can think of the market portfolio as the ultimate market index. And if
the investor following his/her investment policy makes the decision to invest, for
example, only in stocks, the market portfolio practically can be presented by one of the
available representative indexes in particular stock exchange.
The most often the relationship between the asset return and market portfolio
return is demonstrated and examined using the common stocks as assets, but the same
concept can be used analyzing bonds, or any other assets. With the given historical
data about the returns on the particular common stock (rJ) and market index return (rM)
in the same periods of time investor can draw the stock‘s characteristic line (see Fig.
2.8.). Rate of return
on security J
rJ 5

ΕJ,3= rJ,3 – (AJ + βJ rM,3)

Y 3
βJ= y/x =slope
2 X
1
AJ
r
M

Rate of return on market portfolio

Figure 2.8. Stock’s J characteristic line.

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Stock‘s characteristic line:

 describes the relationship between the stock and the market;
 shows the return investor expect the stock to produce, given that a
particular rate of return appears for the market;
 helps to assess the risk characteristics of one stock relative to the market.
Stock‘s characteristic line as a straight line can be described by its slope and
by point in which it crosses the vertical axis - intercept (point A in Fig. 2.8.).
The slope of the characteristic line is called the Beta factor, which will be
discussed in details in a next chapter. Beta factor for the stock J and can be calculated
using following formula:

Cov (rJ,rM)
J = ------------------- , (2.14)
²(rM)

here: Cov(rJ,rM) – covariance between returns of stock J and the market portfolio;
²(rM) - variance of returns on market portfolio.

The Beta factor of the stock is an indicator of the degree to which the stock
reacts to the changes in the returns of the market portfolio. The Beta gives the answer
to the investor how much the stock return will change when the market return will
change by 1 percent. Further in Chapter 3 the use of Beta factor in developing capital
asset pricing model will be discussed.
Intercept AJ (the point where characteristic line passes through the vertical
axis) can be calculated using following formula:

AJ = rJ - J rM, (2.15)

here: rJ - rate of return of stock J;

J - Beta factor for the stock J;
rM - rate of return of the market.
The intercept technically is a convenient point for drawing a characteristic line.
The interpretation of the intercept from the investor‘s point of view is that it shows
what would be the rate of return of the stock, if the rate of return in the market is zero.

2.5.2. Residual variance

The characteristic line is a line-of-best-fit through some data points. A
characteristic line is what in statistics is called as time-series regression line. But in
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reality the stock produce returns that deviate from the characteristic line (see Fig. 2.8).
In statistics this propensity is called the residual variance.
Residual variance is the variance in the stock‘s residuals and for the stock J
can be calculated using formula:
n
Σ ²J,t
t =1
²,t = -------------- , (2.15)
n -2

here J,t - residual of the stock J in period t;

n - number of periods observed.
To calculate residual variance the residual in every period of observations
must be identified. Residual is the vertical distance between the point which reflect
the pair of returns (stock J and market) and the characteristic line of stock J. The
residual of the stock J can be calculated:

J,t = rJ,t - ( AJ + J r M,t ) (2.16)

c.1 c.2

It is useful for the interpretation of residual to investor to accentuate two

components in formula of residual (see 2.16):
• Component 1 reflects the return actually generated by the stock J during
period t;
• Component 2 (in the bracket) represents investor‘s expectations for the
stock‘s return, given its characteristic line and market‘s returns.
Note the difference between the variance and the residual variance:
 The variance describes the deviation of the asset returns from its expected
value ;
 The residual variance describes the deviation of the asset returns from its
characteristic line.

Summary
1. The main characteristics of any investment are investment return and risk.
However to compare various alternatives of investments the precise quantitative
measures for both of these characteristics are needed.
2. General definition of return is the benefit associated with an investment. Many
investments have two components of their measurable return: (1) a capital gain or

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loss; (2) some form of income. The holding period return is the percentage increase
in returns associated with the holding period.
3. Investor can‗t compare the alternative investments using holding period returns, if
their holding periods (investment periods) are different. In these cases arithmetic
average return or sample mean of the returns can be used.
4. Both holding period returns and sample mean of returns are calculated using
historical data. However all the investors‘ decisions are focused to the future, or to
expected results from the investments. The expected rate of return of investment is
the statistical measure of return, which is the sum of all possible rates of returns for
the same investment weighted by probabilities.
5. Risk can be defined as a chance that the actual outcome from an investment will
differ from the expected outcome. The total risk of investments can be measured
with such common absolute measures used in statistics as variance and standard
deviation. Variance can be calculated as a potential deviation of each possible
investment rate of return from the expected rate of return. Standard deviation is
calculated as the square root of the variance. The more variable the possible
outcomes that can occur, the greater the risk.
6. In the cases than the arithmetic average return or sample mean of the returns is
used instead of expected rate of return, sample variance and sample standard
deviation is calculated.
7. Covariance and correlation coefficient are used to answer the question, what is the
relationship between the returns on different assets. Covariance and correlation
coefficient are related and they generally measure the same phenomenon – the
relationship between two variables.
8. The sample covariance is estimated than the investor hasn‗t enough information
about the underlying probability distributions for the returns of two assets and then
the sample of historical returns is used. The population covariance is estimated
when the investor has enough information about the underlying probability
distributions for the returns of two assets and can identify the actual probabilities
of various pairs of the returns for two assets at the same time.
9. Analyzing relationship between the assets in the same portfolio using covariance
for portfolio formation it is important to identify which of the three possible
outcomes exists: positive covariance, negative covariance or zero covariance. If the

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positive covariance between two assets is identified the common recommendation

for the investor would be not to put both of these assets to the same portfolio,
because their returns move in the same direction and the risk in portfolio will be
not diversified; if the negative - the common recommendation for the investor
would be to include both of these assets to the portfolio, because their returns move
in the contrariwise directions and the risk in portfolio could be diversified; if the
zero covariance - it means that there is no relationship between the rates of return
of two assets.
10. The correlation coefficient between two assets is closely related to their
covariance. But instead of covariance when the calculated number is unbounded,
the correlation coefficient can range only from -1,0 to +1,0. The more close the
absolute meaning of the correlation coefficient to 1,0, the stronger the relationship
between the returns of two assets. Using correlation coefficients instead of
covariance investor can immediately asses the degree of relationship between
assets returns.
11. The coefficient of determination is calculated as the square of correlation
coefficient and shows how much variability in the returns of one asset can be
associated with variability in the returns of the other.
12. Theoretical interpretation of the market portfolio is that it involves every single
risky asset in the global economic system, and contains each asset in proportion to
the total market value of that asset relative to the total value of all other assets
(value weighted portfolio). Investors can think of the market portfolio as the
ultimate market index.
13. Stock‘s characteristic line describes the relationship between the stock and the
market, shows the return investor expect the stock to produce, given that a
particular rate of return appears for the market and helps to assess the risk
characteristics of one stock relative to the market.
14. The slope of the characteristic line is called the Beta factor. The Beta factor of the
stock is an indicator of the degree to which the stock reacts to the changes in the
returns of the market portfolio.
15. The intercept is the point where characteristic line passes through the vertical axis.
The interpretation of the intercept from the investor‘s point of view is that it shows
what would be the rate of return of the stock, if the rate of return in the market is
zero.
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16. The residual variance describes the deviation of the asset returns from its
characteristic line.

Key-terms
• Beta factor • Probability
• Characteristic line • Residual
• Coefficient of correlation • Residual variance
• Coefficient of determination • Return on investment
• Correlation • Sample mean of return
• Covariance • Sample standard deviation
• Expected rate of return • Sample covariance
• Holding period return • Sample variance
• Intercept • Simple probability distribution
• Investment risk • Standard deviation
• Market portfolio • Variance
• Population covariance

Questions and problems

1. Comment why methods and tools of the statistics are so important in investment
decision making.
2. Distinguish between historical returns and expected returns.
3. Define the components of holding period return. Can any of these components be
negative?
4. When should the sample mean of return be used instead of expected rate of return?
5. What does a probability distribution describe?
6. What does covariance measure? If two assets are said to have positive covariance,
what does it mean?
7. Explain, why doesn‘t an estimated absolute covariance number tell the investor
much about the relationship between the returns on the two assets?
8. How do you understand an investment risk and what statistic tools can be used to
measure it?

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9. What is the interpretation of the coefficient of determination for the investor? If the
coefficient of correlation for two securities is 0,7, what is the coefficient of
determination?
10. Describe the Beta factor.
11. What does the characteristic line tells to investor? Why stock characteristic lines
are different for the securities traded in the same market?
12. With which of stock‘s characteristic line definitions presented below you disagree?
a) Stock‘s characteristic line describes the relationship between the stock
and the market;
b) Stock‘s characteristic line shows the return investor expect the stock to
produce, given that a particular rate of return appears for the market;
c) Stock‘s characteristic line describes the relationship between rate of
return of any two different stocks in the market;
d) I agree with all definitions presented above.
13. Refer to the following information on joint stock returns for stock 1, 2, and 3 in
the table
Probability Return for stock
Stock 1 Stock 2 Stock 3
0.20 0.20 0.25 0.10
0.30 -0.05 0.10 0.05
0.25 0.10 0.05 0
0.25 0 -0.10 -0.05

If you must choose only two stocks to your investment portfolio, what would be
your choise?
a) stocks 1 and 2; b) stocks 1 and 3; c) stocks 2 and 3; d) other decision.
Present your arguments and calculations, to explain your decision.
14. Refer to the following observations for stock A and the market portfolio in the
table:

Month Rate of return

Stock A Market portfolio
1 0,30 0,12
2 0.24 0,08
3 -0,04 -0,10
4 0,10 -0,02
5 0,06 0,08
6 0,10 0,07

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a) Calculate the main statistic measures to explain the relationship between

stock A and the market portfolio:
• The sample covariance between rate of return for the stock A and
the market;
• The sample Beta factor of stock A;
• The sample correlation coefficient between the rates of return of
the stock A and the market;
• The sample coefficient of determination associated with the stock A
and the market.
b) Draw in the characteristic line of the stock A and give the interpretation -
what does it show for the investor?
c) Calculate the sample residual variance associated with stock‗s A
characteristic line and explain how the investor would interpret the number
of this statistic.
d) Do you recommend this stock for the investor with the lower tolerance of
risk?

Warm-Up Exercises
1 An analyst predicted last year that the stock of Logistics, Inc., would offer a total
return of at least 10% in the coming year. At the beginning of the year, the firm
had a stock market value of $10 million. At the end of the year, it had a market
value of $12 million even though it experienced a loss, or negative net income,
of $2.5 million.
- Did the analyst‘s prediction prove correct? Explain using the values for total
annual return.
2 Four analysts cover the stock of Fluorine Chemical. One forecasts a 5% return for
the coming year. A second expects the return to be negative 5%. A third
predicts a 10% return. A fourth expects a 3% return in the coming year. You are
relatively confident that the return will be positive but not large, so you
arbitrarily assign probabilities of being correct of 35%, 5%, 20%, and 40%,
respectively, to the analysts‘ forecasts. Given these probabilities, what is
Fluorine Chemical‘s expected return for the coming year?

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3 The expected annual returns are 15% for investment 1 and 12% for investment 2.
The standard deviation of the first investment‘s return is 10%; the second
investment‘s return has a standard deviation of 5%.
- Which investment is less risky based solely on standard deviation?
- Which investment is less risky based on coefficient of variation? Which is a
better measure given that the expected returns of the two investments are not
the same?
4 Your portfolio has three asset classes. U.S. government T-bills account for 45% of
the portfolio, large-company stocks constitute another 40%, and small-company
stocks make up the remaining 15%.
- If the expected returns are 3.8% for the T-bills, 12.3% for the large-company
stocks, and 17.4% for the small-company stocks, what is the expected return
of the portfolio?
5 Rate of return
Douglas Keel, a financial analyst for Orange Industries, wishes to estimate the rate of
return for two similar-risk investments, X and Y. Douglas‘s research indicates that the
immediate past returns will serve as reasonable estimates of future returns. A year
earlier, investment X had a market value of $20,000; investment Y had a market value
of $55,000. During the year, investment X generated cash flow of $1,500 and
investment Y generated cash flow of $6,800. The current market values of
investments X and Y are $21,000 and $55,000, respectively.
a. Calculate the expected rate of return on investments X and Y using the most
recent year‘s data.
b. Assuming that the two investments are equally risky, which one should
Douglas recommend? Why?
6 Return calculations
For each of the investments shown in the following table, calculate the rate of return
earned over the unspecified time period.

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7 Risk preferences
Sharon Smith, the financial manager for Barnett Corporation, wishes to evaluate
three prospective investments: X, Y, and Z. Sharon will evaluate each of these
investments to decide whether they are superior to investments that her company
already has in place, which have an expected return of 12% and a standard deviation
of 6%. The expected returns and standard deviations of the investments are as
follows:

a. If Sharon were risk neutral, which investments would she select? Explain why.
b. If she were risk averse, which investments would she select? Why?
c. If she were risk seeking, which investments would she select? Why?
d. Given the traditional risk preference behavior exhibited by financial managers,
which investment would be preferred? Why?
8 Risk analyses
Solar Designs is considering an investment in an expanded product line. Two possible
types of expansion are being considered. After investigating the possible outcomes,
the company made the estimates shown in the following table.

a. Determine the range of the rates of return for each of the two projects.
b. Which project is less risky? Why?
c. If you were making the investment decision, which one would you choose? Why?
What does this imply about your feelings toward risk?

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d. Assume that expansion B‘s most likely outcome is 21% per year and that all other
facts remain the same. Does this change your answer to part c? Why?
9 Risk and probability
Micro-Pub, Inc, is considering the purchase of one of two microfilm cameras, R and
S. Both should provide benefits over a 10-year period, and each requires an initial
investment of $4,000. Management has constructed the accompanying table of
estimates of rates of return and probabilities for pessimistic, most likely, and
optimistic results.
a. Determine the range for the rate of return for each of the two cameras.
b. Determine the expected value of return for each camera
c. Purchase of which camera is riskier? Why?

10 Bar charts and risk

Swan‘s Sportswear is considering bringing out a line of designer jeans. Currently, it is
negotiating with two different well-known designers. Because of the highly
competitive nature of the industry, the two lines of jeans have been given code names.
After market research, the firm has established the expectations shown in the
following table about the annual rates of return:

Use the table to:

a. Construct a bar chart for each line‘s annual rate of return.

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b. Calculate the expected value of return for each line.

c. Evaluate the relative riskiness for each jean line‘s rate of return using the bar charts.
11 Coefficient of variation
Metal Manufacturing has isolated four alternatives for meeting its need for increased
production capacity. The following table summarizes data gathered relative to each of
these alternatives.

a. Calculate the coefficient of variation for each alternative.

b. If the firm wishes to minimize risk, which alternative do you recommend? Why?
12 Standard deviation versus coefficient of variation as measures of risk
Greengage, Inc., a successful nursery, is considering several expansion projects. All
of the alternatives promise to produce an acceptable return. Data on four possible
projects follow.

a. Which project is least risky, judging on the basis of range?

b. Which project has the lowest standard deviation? Explain why standard deviation
may not be an entirely appropriate measure of risk for purposes of this comparison.
c. Calculate the coefficient of variation for each project. Which project do you
think Greengage‘s owners should choose? Explain why.

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13 Rate of return, standard deviation, coefficient of variation

Mike is searching for a stock to include in his current stock portfolio. He is interested
in Hi-Tech Inc.; he has been impressed with the company‘s computer products and
believes Hi-Tech is an innovative market player. However, Mike realizes that any
time you consider a technology stock, risk is a major concern. The rule he follows is
to include only securities with a coefficient of variation of returns below 0.90. Mike
has obtained the following price information for the period 2009 through 2012. Hi-
Tech stock, being growth-oriented, did not pay any dividends during these 4 years.

a. Calculate the rate of return for each year, 2009 through 2012, for Hi-Tech stock.
b. Assume that each year‘s return is equally probable, and calculate the average return
over this time period.
c. Calculate the standard deviation of returns over the past 4 years. (Hint: Treat these
data as a sample.)
d. Based on b and c determine the coefficient of variation of returns for the security.
e. Given the calculation in d what should be Mike‘s decision regarding the inclusion
of Hi-Tech stock in his portfolio?
14 Assessing return and risk Swift Manufacturing must choose between two asset
purchases. The annual rate of return and the related probabilities given in the
following table summarize the firm‘s analysis to this point.

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a. For each project, compute:

(1) The range of possible rates of return.
(2) The expected return.
(3) The standard deviation of the returns.
(4) The coefficient of variation of the returns.
b. Construct a bar chart of each distribution of rates of return.
c. Which project would you consider less risky? Why?

15 Integrative—Expected return, standard deviation, and coefficient of variation

Three assets: F, G, and H are currently being considered by Perth Industries. The
probability distributions of expected returns for these assets are shown in the
following table.

a. Calculate the expected value of return r, for each of the three assets. Which
provides the largest expected return?

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b. Calculate the standard deviation, sr, for each of the three assets‘ returns. Which
appears to have the greatest risk?
c. Calculate the coefficient of variation, CV, for each of the three assets‘ returns.
Which appears to have the greatest relative risk?
16 Normal probability distribution
Assuming that the rates of return associated with a given asset investment are
normally distributed; that the expected return, r, is 18.9%; and that the coefficient of
variation, CV, is 0.75; answer the following questions:
a. Find the standard deviation of returns, ơ s,
b. Calculate the range of expected return outcomes associated with the following
probabilities of occurrence: (1) 68%, (2) 95%, (3) 99%.
c. Draw the probability distribution associated with your findings in parts a and b.

17 Correlation, risk, and return

Matt Peters wishes to evaluate the risk and return behaviors associated with various
combinations of assets V and W under three assumed degrees of correlation: perfect
positive, uncorrelated, and perfect negative. The expected returns and standard
deviations calculated for each of the assets are shown in the following table.

a. If the returns of assets V and W are perfectly positively correlated (correlation

coefficient = + 1), describe the range of (1) expected return and (2) risk associated
with all possible portfolio combinations.
b. If the returns of assets V and W are uncorrelated (correlation coefficient = 0),
describe the approximate range of (1) expected return and (2) risk associated with
all possible portfolio combinations.
c. If the returns of assets V and W are perfectly negatively correlated (correlation
coefficient = - 1), describe the range of (1) expected return and (2) risk associated
with all possible portfolio combinations.
18 International investment returns

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Joe Martinez, a U.S. citizen living in Brownsville, Texas, invested in the common
stock of Telmex, a Mexican corporation. He purchased 1,000 shares at 20.50 pesos
per share. Twelve months later, he sold them at 24.75 pesos per share. He received no
dividends during that time.
a. What was Joe‘s investment return (in percentage terms) for the year, on the basis of
the peso value of the shares?
b. The exchange rate for pesos was 9.21 pesos per US$1.00 at the time of the
purchase. At the time of the sale, the exchange rate was 9.85 pesos per US$1.00.
Translate the purchase and sale prices into US$.
c. Calculate Joe‘s investment return on the basis of the US$ value of the shares.
d. Explain why the two returns are different. Which one is more important to Joe?
Why?

References and further readings

1. Fabozzi, Frank J. (1999). Investment Management. 2nd. ed. Prentice Hall Inc.

2. Francis, Jack, C. Roger Ibbotson (2002). Investments: A Global

Perspective. Prentice Hall Inc.

3. Haugen, (Robert A. 2001). Modern Investment Theory. 5th ed. Prentice Hall.

4. Levy, Haim, Thierry Post (2005). Investments. FT / Prentice Hall.

5. Rosenberg, Jerry M. (1993).Dictionary of Investing. John Wiley &Sons Inc.

6. Sharpe, William F., Gordon J.Alexander, Jeffery V.Bailey. (1999).

Investments. International edition. Prentice –Hall International.
7. Strong, Robert A. (1993). Portfolio Construction, Management and Protection.

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Portfolio theory

6.1.1Markowitz portfolio theory

The author of the modern portfolio theory is Harry Markowitz who
introduced the analysis of the portfolios of investments in his
article ―Portfolio Selection‖ published in the Journal of Finance in
1952. The new approach presented in this article included portfolio
formation by considering, the expected rate of return and risk of
individual stocks and crucially, their interrelationship as
measured by correlation. Prior to this investors would examine
investments individually, build up portfolios of attractive stocks,
and not consider how they related to each other. Markowitz showed
how it might be possible to better of these simplistic portfolios by
taking into account the correlation between the returns on these
stocks.

The diversification plays a very important role in the modern portfolio theory.
Markowitz approach is viewed as a single period approach: at the beginning of the
period the investor must make a decision in what particular securities to invest and
hold these securities until the end of the period. Because a portfolio is a collection of
securities, this decision is equivalent to selecting an optimal portfolio from a set of
possible portfolios. Essentiality of the Markowitz portfolio theory is the problem of
optimal portfolio selection.

The method that should be used in selecting the most desirable portfolio involves the
use of indifference curves. Indifference curves represent an investor‘s preferences for
risk and return. These curves should be drawn, putting the investment return on the
vertical axis and the risk on the horizontal axis. Following Markowitz approach, the
measure for investment return is expected rate of return and a measure of risk is
standard deviation (these statistic measures we discussed in previous chapter, section
2.1). The exemplified map of indifference curves for the individual risk-averse

investor is presented in Fig.3.1. Each indifference curve here (I1, I2, I3 ) represents the
most desirable investment or investment portfolio for an individual investor. That

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means, that any of investments (or portfolios) plotted on the indifference curves (A,B,C

or D) are equally desirable to the investor.

Features of indifference curves:

 All portfolios that lie on a given indifference curve are equally desirable to
the investor. An implication of this feature: indifference curves cannot
intersect.
 An investor has an infinitive number of indifference curves. Every investor
can represent several indifference curves (for different investment tools).
Every investor has a map of the indifference curves representing his or her
preferences for expected returns and risk (standard deviations) for each
potential portfolio.

Expected rate
of return (r )
rB
rC

rA I1
rD

σA σ C σD σ B Risk (σ)

Fig. 6.1. Map of Indifference Curves for a Risk-Averse Investor

Two important fundamental assumptions than examining indifference curves and

applying them to Markowitz portfolio theory:
1. The investors are assumed to prefer higher levels of return to lower levels
of return, because the higher levels of return allow the investor to spend
more on consumption at the end of the investment period. Thus, given two
portfolios with the same standard deviation, the investor will choose the

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portfolio with the higher expected return. This is called an assumption of

nonsatiation.
2. Investors are risk averse. It means that the investor when given the choice
will choose the investment or investment portfolio with the smaller risk.
This is called assumption of risk aversion.
Expected rate of
return ( r )

r r
A B B

r
C
C

o σ σ Risk ( σ )
A C B

Fig. 6.2. Portfolio choice using the assumptions of nonsatiation and risk aversion

Fig. 6.2. gives an example how the investor chooses between 3 investments – A,B and
C. Following the assumption of nonsatiation, investor will choose A or B which
have the higher level of expected return than C. Following the assumption of risk
aversion investor will choose A, despite of the same level of expected returns for
investment A and B, because the risk (standard deviation) for investment A is lower
than for investment B. In this choice the investor follows so called "furthest
northwest" rule.
In reality there are an infinitive number of portfolios available for the investment. Is
it means that the investor needs to evaluate all these portfolios on return and risk
basis? Markowitz portfolio theory answers this question using efficient set theorem:
an investor will choose his/ her optimal portfolio from the set of the portfolios that (1)
offer maximum expected return for varying level of risk, and (2) offer minimum risk
for varying levels of expected return.
Efficient set of portfolios involves the portfolios that the investor will find optimal
ones. These portfolios are lying on the ―northwest boundary‖ of the feasible set and
is called an efficient frontier. The efficient frontier can be described by the

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curve in the risk-return space with the highest expected rates of return for each level of
risk.
Feasible set is opportunity set, from which the efficient set of portfolio can be
identified. The feasibility set represents all portfolios that could be formed from the
number of securities and lie either or within the boundary of the feasible set.
In Fig.3.3 feasible and efficient sets of portfolios are presented. Considering the
assumptions of nonsatiation and risk aversion discussed earlier in this section, only
those portfolios lying between points A and B on the boundary of feasibility set
investor will find the optimal ones. All the other portfolios in the feasible set are
inefficient portfolios. Furthermore, if a risk-free investment is introduced into the
universe of assets, the efficient frontier becomes the tegmental line shown in Fig. 3.3 this
line is called the Capital Market Line (CML) and the portfolio at the point at which it
is tangential (point M) is called the Market Portfolio.

Expected rate of
return Capital Market

Line
Efficient

Frontier

set
Risk free rate

Risk (σ )
P

Fig.3.3. Feasible Set and E f f i c i e n t Set of Portfolios (Efficient Frontier)

In brief, the investm ent portfolio is: a collect ion of invest ment s assembled
to meet one or more invest ment goals . In t he Growth-Oriented Portfolio:
The primar y object ive is long -t erm price appreciat ion. In t he Incom e-
Oriented Portfolio: t he primar y object ive is to produce regular dividend
and int erest inco me. However, t he efficient portfolio is t he port folio t hat
provides t he highest ret urn for a given level of r isk . It requires search for
invest ment alt ernat ives to get t he best combinat ions of risk and return .

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6.1.2 The Expected Rate of Return and Risk of Portfolio

Following Markowitz efficient set portfolios approach an investor should evaluate

alternative portfolios inside feasibility set on the basis of their expected returns and
standard deviations using indifference curves. Thus, the methods for calculating
expected rate of return and standard deviation of the portfolio must be discussed.

The expected rate of return of the portfolio can be calculated in some alternative
ways. The Markowitz focus was on the end-of-period wealth (terminal value) and
using these expected end-of-period values for each security in the portfolio the
expected end-of-period return for the whole portfolio can be calculated. But the
portfolio really is the set of the securities thus the expected rate of return of a portfolio
should depend on the expected rates of return of each security included in the portfolio
(as was presented in Chapter 2, formula 2.4). This alternative method for calculating
the expected rate of return on the portfolio (E(r)p) is the weighted average of the
expected returns on its component securities:

Or
n
E(r)p = Σ wi * Ei (r) = w1 * E1(r) + w2 * E2(r) +…+ wn * En(r), (2.1)
i=1

here wi - the proportion of the portfolio‘s initial value invested in security i;

Ei(r) - the expected rate of return of security I;
n - the number of securities in the portfolio.
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Because a portfolio‗s expected return is a weighted average of the expected returns

of its securities, the contribution of each security to the portfolio‗s expected rate of
return depends on its expected return and its proportional share from the initial
portfolio's market value (weight). Nothing else is relevant. The conclusion here could
be that the investor who simply wants the highest possible expected rate of return must
keep only one security in his portfolio which has a highest expected rate of return. But
why the majority of investors don‗t do so and keep several different securities in their
portfolios? Because they try to diversify their portfolios aiming to reduce the
investment portfolio risk.

Example 1):

Suppose you invested $1,000 in AIG‘s stock at $25 per share. After one year, the
stock price increases to $35. For each AIG stock, you also receive $1 cash
dividend during the year.

a. How many shares did you buy?

b. What is your investment rate of return in % and in $?

Calculating Investment Return: Dividend Yield vs. Capital Gain:

Obviously, you bought 40 stocks.

Dividend Yield = $1/$25 = 4%

Capital Gain = ($35 - $25)/$25 = 40%

Total Percentage Return = 4% + 40% = 44%

Total Dollar Return = 44% of $1,000 = $440

At the end of the year, the value of your $1,000 investment becomes $1,440, from
which $1,400 is the value of the 40 AIG stocks and $40 is cash due to dividend
payment.

What if Dividends are invested?

Example 2):

Suppose now that AIG paid the dividend in the beginning of the year and you invested
the dividend in a risk free cash account delivering 2% annual return.

- What is the investment return?

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Answer:

Capital gain – 40% (does not change)

Invested dividend – 4%×1.02 = 4.08%

Total return – 44.08%

Stock Split

On January 1, you buy 10 stocks of Google. The stock price is $800. In the middle of
the year Google announces a two-to-one split. That is, shareholders hold twice as many
stocks. In the end of the year Google pays $5 per share dividend. The ex-dividend share
price is $402.

And now answer?

a. Why would a company initiate a split?

b. What is the annual return on holding Google Share of stock?

c. What is the long run performance following stock split?

Multi-Period Rate of Return

- The previous examples compute a single period (e.g., one day, one month, or
one year) rate of return.

- Suppose your investment spans three periods, e.g., three months or three years.

- The corresponding periodical returns are 𝑅1, 𝑅2, 𝑅3.

- The total three-period holding period return (HPR) is

𝐻𝑃𝑅 = (1+ 𝑅1) (1+ 𝑅2) (1+ 𝑅3)−1

Example 3):

Let 𝑅1=10%, 𝑅2=5%, 𝑎𝑛𝑑 𝑅3=7%.

So: 𝐻𝑃𝑅 = (1+0.1) (1+0.05) (1+0.07) −1 = 23.59%

So if you start with $100,000 - after three years you have $123,590.

A common mistake is to compute HPR = 10 + 5 + 7 = 22%.

As Albert Einstein points out: There is no greater force than compounded interest.

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Annualizing Returns:

- Often times, you want to compare various investments, each of which applies to
a different time period.

- Then you should express returns on a per-year, or annualized, basis.

- Such a return is often called an effective annual return (EAR).

𝐸𝐴𝑅 = (1 + ℎ𝑜𝑙𝑑𝑖𝑛𝑔 𝑝𝑒𝑟𝑖𝑜𝑑 𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑟𝑒𝑡𝑢𝑟𝑛) −1 where 𝑚 is the number of

holding periods in a year.

Example 4):

Suppose that you bought GILD for $34 and sold it 3 months later for $38. There were
no dividend payments.

What is your holding period percentage return and your EAR?

Answer:

𝐻𝑃𝑅 = (38−34) / 34 = 4 / 34 = 0.117647 = 11.7647%

𝐸𝐴𝑅 = (1 + 0.117647)4 −1 =56%

Example 5):

What if the holding period corresponds to six months (m=2)?

Answer:

𝐸𝐴𝑅 = (1 + ℎ𝑜𝑙𝑑𝑖𝑛𝑔 𝑝𝑒𝑟𝑖𝑜𝑑 𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑟𝑒𝑡𝑢𝑟𝑛) −1

= (1 + 0.117647)2 −1 = 24.9%

Example 6):

What if the holding period amounts to two years (𝑚 =1/2)?

Answer:

𝐸𝐴𝑅 = (1 + ℎ𝑜𝑙𝑑𝑖𝑛𝑔 𝑝𝑒𝑟𝑖𝑜𝑑 𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑟𝑒𝑡𝑢𝑟𝑛) −1

= (1 + 0.117647)1/2 −1 = 5.7%

Risk of the portfolio. As we know from chapter 3, the most often used measure for the

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risk of investment is standard deviation, which shows the volatility of the securities
actual return from their expected return. If a portfolio‗s expected rate of return is a
weighted average of the expected rates of return of its securities, the calculation
of standard deviation for the portfolio can‗t simply use the same approach. The reason
is that the relationship between the securities in the same portfolio must be taken into
account. As it was discussed in section 2.2, the relationship between the assets can
be estimated using the covariance and coefficient of correlation. As covariance can
range from ―–‖ to ―+‖ infinity, it is more useful for identification of the direction of
relationship (positive or negative), coefficients of correlation a l w a y s lies between -1
and +1 and is the convenient measure of intensity and direction of the relationship
between the assets.

Risk of the portfolio, which consists of 2 securities (A ir B):

p = (w²A ²A + w²B ²B + 2 wA wB kAB AB)1/2, (3.2)

here: wA ir wB - the proportion of the portfolio‘s initial value invested in security

A and B ( wA + wB = 1);
A ir B - standard deviation of security A and B;
kAB - coefficient of coreliation between the returns of security A and B.
Standard deviation of the portfolio consisting n securities:
n n

= ( wi wj kij i j )1/2 , (3.3)

i=1 j=1

here: wi ir wj - the proportion of the portfolio‘s initial value invested in security i

and j ( wi + wj = 1);
i ir j - standard deviation of security i and j;
kij - Coefficient of correlation between the returns of security i and j.

6.2 Capital Asset Pricing Model (CAPM)

CAPM was developed by W. F. Sharpe. CAPM simplified Markowitz‗s Modern

Portfolio theory, made it more practical. Markowitz showed that for a given level of
expected return and for a given feasible set of securities, finding the optimal portfolio
with the lowest total risk, measured as variance or standard deviation of portfolio
returns, requires knowledge of the covariance or correlation between all possible
security combinations (see formula 3.3). When forming the diversified portfolios

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consisting large number of securities investors found the calculation of the portfolio
risk using standard deviation technically complicated.
Measuring Risk in CAPM is based on the identification of two key components of
total risk (as measured by variance or standard deviation of return):
6.2.2 Systematic risk
6.2.3 Unsystematic risk
Systematic risk is that associated with the market (purchasing power risk, interest
rate risk, liquidity risk, etc.)
Unsystematic risk is unique to an individual asset (business risk, financial risk, other
risks, related to investment into particular asset).
Unsystematic risk can be diversified away by holding many different assets in the
portfolio, however systematic risk can‘t be diversified (see Fig 4.4). In CAPM
investors are compensated for taking only systematic risk. Though, CAPM only links
investments via the market as a whole.
Portfolio Risk

Total risk

Unsystematic risk

Systematic risk

0 1 2 3 4 5 6 7 8 9 10
Number of securities in portfolio
Fig.3.4. Portfolio risk and the level of diversification

The essence of the CAPM: the more systematic risk the investor carry, the
greater is his / her expected return.
The CAPM being theoretical model is based on some important assumptions:
• All investors look only one-period expectations about the future;
• Investors are price takers and they cant influence the market individually;
• There is risk free rate at which an investors may either lend (invest) or
borrow money.
• Investors are risk-averse,
• Taxes and transaction costs are irrelevant.
• Information is freely and instantly available to all investors.

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Following these assumptions, the CAPM predicts what an expected rate of return
for the investor should be, given other statistics about the expected rate of return
in the market and market risk (systematic risk):

Or

E(r j) = Rf + (j) * ( E(rM) - Rf ), (4.4)

here: E(r j) - expected return on stock j;

Rf - risk free rate of return;
E(rM) - expected rate of return on the market
(j) - coefficient Beta, measuring undiversified risk of security j.

Several of the assumptions of CAPM seem unrealistic. Investors really are

concerned about taxes and are paying the commissions to the broker when buying
or selling their securities. And the investors usually do look ahead more than one
period. Large institutional investors managing their portfolios sometimes can influence
market by buying or selling big amounts of the securities. All things considered, the
assumptions of the CAPM constitute only a modest gap between the theory and reality.
But the empirical studies and especially wide use of the CAPM by practitioners show
that it is useful instrument for investment analysis and decision making in reality.

As can be seen in Fig.4.5, Equation in formula 3.4 represents the straight line having
an intercept of Rf and slope of (j) * ( E(rM) - Rf ). This relationship between the
expected return and Beta is known as Security Market Line (SML). Each security can
be described by its specific security market line, they differ because their Betas are
different and reflect different levels of market risk for these securities.

SML

r
L
SML

Rf

1.0 β
Fig.3.5. Security Market Line (SML)
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Beta Coefficient ().

The beta coefficient, b, is a relative measure of nondiversifiable risk. It is an index
of the degree of movement of an asset‘s return in response to a change in the market
return. An asset‘s historical returns are used in finding the asset‘s beta coefficient. The
market return is the return on the market portfolio of all traded securities. The Standard
& Poor’s 500 Stock Composite Index or some similar stock index is commonly used as
the market return. Betas for actively traded stocks can be obtained from a variety of
sources, but you should understand how they are derived and interpreted and how they
are applied to portfolios.
Deriving Beta from Return Data
An asset‘s historical returns are used in finding the asset‘s beta coefficient. Figure 8.8
plots the relationship between the returns of two assets—R and S—and the market return.
Note that the horizontal (x) axis measures the historical market returns and that the
vertical (y) axis measures the individual asset‘s historical returns. The first step in
deriving beta involves plotting the coordinates for the market return and asset returns
from various points in time. Such annual ―market return–asset return‖ coordinates are
shown for asset S only for the years 2005 through 2012. For example, in 2012, asset S‘s
return was 20 percent when the market return was 10 percent. By use of statistical
techniques, the ―characteristic line‖ that best explains the relationship between the asset
return and the market return coordinates is fit to the data points. The slope of this line is
beta. The beta for asset R is about 0.80, and that for asset S is about 1.30. Asset S‘s
higher beta (steeper characteristic line slope) indicates that its return is more responsive
to changing market returns. Therefore asset S is more risky than asset R.

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Interpreting Betas
The beta coefficient for the entire market equals 1.0. All other betas are viewed in
relation to this value. Asset betas may be positive or negative, but positive betas are the
norm. The majority of beta coefficients fall between 0.5 and 2.0. The return of a stock
that is half as responsive as the market (b = 0.5) should change by 0.5 percent for each 1
percent change in the return of the market portfolio. A stock that is twice as responsive as
the market (b = 2.0) should experience a 2 percent change in its return for each 1 percent
change in the return of the market portfolio. Table 8.8 provides various beta values and
their interpretations. Beta coefficients for actively traded stocks can be obtained from
published sources such as Value Line Investment Survey, via the Internet, or through
brokerage firms.
Betas for some selected stocks are given in Table 8.9.

Portfolio Betas

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The beta of a portfolio can be easily estimated by using the betas of the individual assets
it includes. Letting wj represent the proportion of the portfolio‘s total dollar value

represented by asset j, and letting bj equal the beta of asset j, we can use Equation 8.7 to
find the portfolio beta, bp:

Portfolio betas are interpreted in the same way as the betas of individual assets. They
indicate the degree of responsiveness of the portfolio’s return to changes in the market
return. For example, when the market return increases by 10 percent, a portfolio with a
beta of 0.75 will experience a 7.5 percent increase in its return (0.75 × 10%), a portfolio
with a beta of 1.25 will experience a 12.5 percent increase in its return (1.25 × 10%).
Clearly, a portfolio containing mostly low-beta assets will have a low beta, and one
containing mostly high-beta assets will have a high beta.

Example ?):
Mario Austino, an individual investor, wishes to assess the risk of two small portfolios he
is considering—V and W. Both portfolios contain five assets, with the proportions and
betas shown in Table 8.10. The betas for the two portfolios, bV and bW, can be calculated
by substituting data from the table into Equation 8.7:

bV = (0.10 * 1.65) + (0.30 * 1.00) + (0.20 * 1.30) + (0.20 * 1.10) + (0.20 * 1.25)
= 0.165 + 0.300 + 0.260 + 0.220 + 0.250 = 1.195 or = 1.20
bW = (0.10 * .80) + (0.10 * 1.00) + (0.20 * .65) + (0.10 * .75) + (0.50 * 1.05)
= 0.080 + 0.100 + 0.130 + 0.075 + 0.525 = 0.91

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Portfolio V‘s beta is about 1.20, and portfolio W‘s is 0.91. These values make sense
because portfolio V contains relatively high-beta assets, and portfolio W contains
relatively low-beta assets. Mario‘s calculations show that portfolio V‘s returns are more
responsive to changes in market returns and are therefore more risky than portfolio W‘s.
He must now decide which, if either, portfolio he feels comfortable adding to his existing
investments.

The Equation
Using the beta coefficient to measure nondiversifiable risk, the capital asset pricing
model (CAPM) is given in Equation 8.8:

The CAPM can be divided into two parts: (1) the risk-free rate of return, RF, which is
the required return on a risk-free asset, typically a 3-month U.S. Treasury bill (T-bill), a
short-term IOU issued by the U.S. Treasury, and (2) the risk premium. These are,
respectively, the two elements on either side of the plus sign in Equation 8.8. The (rm -
RF) portion of the risk premium is called the market risk premium because it represents
the premium the investor must receive for taking the average amount of risk associated
with holding the market portfolio of assets.

Historical Risk Premiums

Using the historical return data for stocks, bonds, and Treasury bills for the 1900–2009
period shown in Table 8.1, we can calculate the risk premiums for each investment
category. The calculation (consistent with Equation 8.8) involves merely subtracting the
historical U.S. Treasury bill‘s average return from the historical average return for a
given investment:

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Reviewing the risk premiums calculated above, we can see that the risk premium is
higher for stocks than for bonds. This outcome makes sense intuitively because stocks are
riskier than bonds (equity is riskier than debt).
Example ??):
Benjamin Corporation, a growing computer software developer, wishes to
determine the required return on an asset Z, which has a beta of 1.5. The risk-free rate of
return is 7%; the return on the market portfolio of assets is 11%. Substituting bZ = 1.5,
RF = 7%, and rm = 11% into the capital asset pricing model given in Equation 8.8 yields
a required return of rZ = 7% + 31.5 * (11% - 7%)4 = 7% + 6% = 13%
The market risk premium of 4% (11% - 7%), when adjusted for the asset‘s index of risk
(beta) of 1.5, results in a risk premium of 6% (1.5 * 4%). That risk premium, when added
to the 7% risk-free rate, results in a 13% required return.
Other things being equal, the higher the beta, the higher the required return, and
the lower the beta, the lower the required return.

Table 2.1 Interpretation of coefficient Beta ()

Direction of changes
in security’s return in
Beta comparison to the Interpretation of meaning
changes in market’s
return
2,0 The same as market Risk of security is twice higher than market risk
1,0 The same as market Security‘s risk is equal to market risk
0,5 The same as market Security‘s risk twice lower than market risk
0 There is no Security‘s risk are not influenced by market risk
relationship
Minus The opposite from the Security‘s risk twice lower than market risk, but in
0,5 market opposite direction
Minus The opposite from the Security‘s risk is equal to market risk but in
1,0 market opposite direction
Minus The opposite from the Risk of security is twice higher than market risk,
2,0 market but in opposite direction

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Table 2.2 Example for Portfolio Betas and Associated Changes in Returns

Examples:

Historical Average Return and Volatility

- Two useful statistics that help us summarize historical asset return data is the
average return and the standard deviation (STD).

- Average return stands for investment‘s reward.

- STD characterizes the investment‘s risk.

- The risk-return tradeoff: higher risk should be compensated by higher return.

- The risk-return tradeoff could be violated in the data (more later).

Estimating Average Return and Volatility for a single asset:

Example 7):

The spreadsheet below shows us how to calculate the average return, the variance, and
the standard deviation

(1) (2) (3) Average (4) (5) Squared

Year Return return Difference (4) × (4)
1926 13.75 12.12 (2)-(3)
1.63 2.66
1927 35.70 12.12 23.58 556.02
1928 45.08 12.12 32.96 1086.36
1929 -8.80 12.12 -20.92 437.65
1930 -25.13 12.12 -37.25 1387.56
Sum: 60.60 Sum: 3470.24
Average: 12.12 Variance: 867.56

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Standard 29.45
Deviation:

Practical notes about Portfolio Optimization and Asset Classes

Up to now, we already understand how to measure both of the average rate of return and
standard deviation as a measure of risk for the single assets, but what about these
measures for the investment portfolio!

Before talking about these measures, and in accordance with modern portfolio theory,
Investors can be worldwide characterized as:

- Investors worldwide are, on average, risk averse.

- In the US and other countries, average rate of return on equities has exceeded T-
Bill rate.

- Such a premium, often termed the equity premium, reflects a compensation for
risky investments.

- The equity premium is typically computed as the return on a market-wide index,

e.g., the S&P500, in excess of the return on the three-month T-Bill.

- Risk Aversion Leads to Diversification, where:

- The sensible strategy for a risk averse agent would be to diversify funds
across several securities.

- A risk neutral investor would simply pick the highest expected return
investment. No diversification!!

In brief, I will give examples displaying how diversification reduces risk, meanwhile, to
study the optimal diversification, or the optimal portfolio a risk-averse investor would
choose, you should know how to compute expected return and volatility of portfolios.
This is what we do next:

Example 8):

Suppose that you invest $4,000 in domestic equities, $3,000 in real estate, $2,000 in
commodities, and $1,000 in foreign bonds, portfolio weights are 0.4, 0.3, 0.2, and 0.1
respectively. Expected returns are 12%, 10%, 9%, and 8%, respectively.

- What is the portfolio expected rate of return?

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Solve:

Don not forget that:

- Portfolios are groups of assets such as stocks and bonds held by an investor.

- In these portfolios and in accordance with the notion of diversification, we

should not only consider: the portfolios' expected return or even their volatility,
but the most important are their weights and the Correlation that links between
the returns of their single assets as it follows:
n
E(r)p = Σ wi * Ei (r) = w1 * E1(r) + w2 * E2(r) +…+ wn * En(r), (2.1)
i=1

So:

E(r)p = 0.4×12% + 0.3×10% + 0.2×9% + 0.1×8% = 10.4%.

More challenging

What about Volatility and why does Diversification Work? (Correlation)

- Correlation: is the tendency of the returns on two assets to move together.

- Positively correlated assets tend to move up and down together, while

negatively correlated assets tend to move in opposite directions.

- Imperfect correlation is why diversification reduces portfolio risk.

We will start with a relatively simple case of a two-security portfolio, and then we will

generalize the concept to portfolios consisting of more than two securities.

Volatility of a Two-Security Portfolio

When two risky assets are combined to form a portfolio with weights WA and WB = (1−

WA), the portfolio variance is computed as:

p = (w²A ²A + w²B ²B + 2 wA wBAB kAB)1/2

Example 9):
If the volatilities of JP Morgan and Goldman Sachs are 16% and 20%, respectively,
meanwhile, the covariance is 0.01.
- What is the variance of a portfolio that invests 75% in JP and 25% in Goldman?
Solve:
(𝜎2𝑝)1/2 = {(0.75)2×(0.16)2+(0.25)2×(0.22)2 +2×(0.75 ×0.25)×(0.01)}1/2
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= 14.37%

- It means that the portfolio volatility is 14.37% (the square root of the variance),
which is lower than 16% (JP) or 20% (Goldman), and this is a diversification
benefit.
Volatility of a Two-Security Portfolio in a diagram:
Example 10):
(A): Volatility of a-two-assets portfolio (2.2) is lower than 14.3% (Stock A) or 13.5%
(Stock B), which is the diversification benefit.

Year Stock A (%) Stock B (%) Portfolio AB (%)

2001 10 15 12.5
2002 30 -10 10
2003 -10 25 7.5
2004 5 20 12.5
2005 10 15 12.5
Average return 9 13 11

Standard 14.3 13.5 2.2

deviation

(B) This is why diversification works as a descriptive diagram!

Example 11):
After getting through such a whole amount of information, how to display the impact of
the portfolio theory on both of the risk and return?
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Answer:
The following table displays this impact as it follows:

Table 2.3: Individual and Portfolio Returns and Standard Deviation of Returns
for IBM and Celgene

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Example 12):
More about Correlation

Extensive Challenge
Your assignment
Back to the previous two examples of (9) and (11):
1- In Example 9): What is the investment in JP Morgan that minimizes the portfolio
volatility?
2- In Example 11): What is the investment in IBM that minimizes the portfolio
volatility?
3- What are the two portfolios volatilities (risk)?
Indicators for answers:

For Example 9):

Answers:
The investment in JP Morgan = 65.79%
The portfolio volatility = 14.23%, even better.

Example 13): More complex cases

- What if you have more than two security classes?
- Extending to a Three-Security Portfolio:
In such a case:
The portfolio's average rate of return can be computed as it follows:

The portfolio's volatility (variance) will also be measured as it follows:

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Example 14):
- What if you also account for portfolio constraints?
- If you are accounting for the portfolio constraints, you would better use "Solver"
installed in Excel, but first you need to study how to properly set up the
optimization problem.
6.3 Arbitrage Pricing Theory (APT)

APT was proposed by Stephen S.Rose and presented in his article „The arbitrage
theory of Capital Asset Pricing―, published in Journal of Economic Theory in 1976. Still
there is a potential for it and it may sometimes displace the CAPM. In the CAPM
returns on individual assets are related to returns on the market as a whole. The key
point behind APT is the rational statement that the market return is determined by

a number of different factors. These factors can be fundamental factors or statistical. If

these factors are essential, there to be no arbitrage opportunities there must be
restrictions on the investment process. Here arbitrage we understand as the earning of
riskless profit by taking advantage of differential pricing for the same assets or
security. Arbitrage is is widely applied investment tactic.
APT states, that the expected rate of return of security J is the linear function from
the complex economic factors common to all securities and can be estimated using
formula:
E(rJ) = E(ŕJ) + β1J I1J + β2J I2J + ... + βnJ InJ + εJ , (3.6)

here: E(rJ) - expected return on stock J;

E(ŕJ) - expected rate of return for security J, if the influence of all factors is 0;
IiJ - the change in the rate of return for security J, influenced by
economic factor i (i = 1, ..., n);
βiJ - coefficient Beta, showing sensitivity of security‘s J rate of return

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upon the factor i (this influence could be both positive or negative);
εJ - error of rounding for the security J (expected value – 0).
It is important to note that the arbitrage in the APT is only approximate, relating
diversified portfolios, on assumption that the asset unsystematic (specific) risks are
negligible compared with the factor risks.
There could presumably be an infinitive number of factors, although the empirical
research done by S.Ross together with R. Roll (1984) identified four factors
– economic variables, to which assets having even the same CAPM Beta, are
differently sensitive:
• inflation;
• industrial production;
• risk premiums;
• slope of the term structure in interest rates.

In practice an investor can choose the macroeconomic factors which seems

important and related with the expected returns of the particular asset. The examples
of possible macroeconomic factors which could be included in using APT model :
• GDP growth;
• an interest rate;
• an exchange rate;
• a defaul spread on corporate bonds, etc.
Including more factors in APT model seems logical. The institutional investors and
analysts closely watch macroeconomic statistics such as the money supply, inflation,
interest rates, unemployment, changes in GDP, political events and many others.
Reason for this might be their belief that new information about the changes in these
macroeconomic indicators will influence future asset price movements. But it is
important to point out that not all investors or analysts are concerned with the same set
of economic information and they differently assess the importance of various
macroeconomic factors to the assets they have invested already or are going to invest.
At the same time the large number of the factors in the APT model would be
impractical, because the models seldom are 100 percent accurate and the asset prices
are function of both macroeconomic factors and noise. The noise is coming from
minor factors, with a little influence to the result – expected rate of return.

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The APT does not require identification of the market portfolio, but it does require
the specification of the relevant macroeconomic factors. Much of the current
empirical APT research is focused on identification of these factors and the
determination of the factors‘ Betas. And this problem is still unsolved. Although more
than two decades have passed since S. Ross introduced APT model, it has yet to reach
the practical application stage.

The CAPM and APT are not really essentially different, because they are
developed for determining an expected rate of return based on one factor (market
portfolio – CAPM) or a number of macroeconomic factors (APT). But both models
predict how the return on asset will result from factor sensitivities and this is of great
importance to the investor.

6.4 Market efficiency theory

The concept of market efficiency was proposed by Eugene Fama in 1965, when his
article ―Random Walks in Stock Prices‖ was published in Financial Analyst Journal.
Market efficiency means that the price which investor is paying for financial asset
(stock, bond, other security) fully reflects fair or true information about the
intrinsic value of this specific asset or fairly describe the value of the company – the
issuer of this security. The key term in the concept of the market efficiency is the
information available for investors trading in the market. It is stated that the market
price of stock reflects:
1. All known information, including:
 Past information, e.g., last year‘s or last quarter‘s, month‘s
earnings;
 Current information as well as events, that have been announced but
are still forthcoming, e.g. shareholders‘ meeting.

2. Information that can reasonably be inferred, for example, if many investors

believe that ECB will increase interest rate in the nearest future or the government
deficit increases, prices will reflect this belief before the actual event occurs.
Capital market is efficient, if the prices of securities which are traded in the market
react to the changes of situation immediately, fully and credibly reflect all the
important information about the security’s future income and risk related with
generating this income.
What is the important information for the investor? From economic point of view

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the important information is defined as such information which has direct influence to
the investor‘s decisions seeking for his defined financial goals. Example, the essential
events in the joint stock company, published in the newspaper, etc.
Market efficiency requires that the adjustment to new information occurs very quickly
as the information becomes known. Obvious, that Internet has made the markets more
efficient in the sense of how widely and quickly information is disseminated.
There are 3 forms of market efficiency under efficient market hypothesis:
• Weak form of efficiency;
• Semi- strong form of efficiency;
• Strong form of the efficiency.

Under the weak form of efficiency stock prices are assumed to reflect any
information that may be contained in the past history of the stock prices. So, if the
market is characterized by weak form of efficiency, no one investor or any group of
investors should be able to earn over the defined period of time abnormal rates of
return by using information about historical prices available for them and by using
technical analysis. Prices will respond to news, but if this news is random then price
changes will also be random.

Under the semi-strong form of efficiency all publicly available information is

presumed to be reflected in stocks‘ prices. This information includes information in the
stock price series as well as information in the firm‘s financial reports, the reports of
competing firms, announced information relating to the state of the economy and any
other publicly available information, relevant to the valuation of the firm. Note that
the market with a semi strong form of efficiency encompasses the weak form of the
hypothesis because the historical market data are part of the larger set of all publicly
available information. If the market is characterized by semi-strong form of efficiency,
no one investor or any group of investors should be able to earn over the defined
period of time abnormal rates of return by using information about historical prices
and publicly available fundamental information(such as financial statements) and
fundamental analysis.

The strong form of efficiency which asserts that stock prices fully reflect all
information, including private or inside information, as well as that which is publicly
available. This form takes the notion of market efficiency to the ultimate extreme.

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Under this form of market efficiency securities‘ prices quickly adjust to reflect both
the inside and public information. If the market is characterized by strong form of
efficiency, no one investor or any group of investors should be able to earn over the
defined period of time abnormal rates of return by using all information available for
them.

The validity of the market efficiency hypothesis whichever form is of great

importance to the investors because it determines whether anyone can outperform the
market, or whether the successful investing is all about luck. Efficient market
hypothesis does not require to behave rationally, only that in response to information

there will be a sufficiently large random reaction that an excess profit cannot be made.

The concept of the market efficiency now is criticized by some market analysts and
participants by stating that no one market can be fully efficient as some irrational
behavior of investors in the market occurs which is more based on their emotions and
other psychological factors than on the information available (the psychological
aspects of investment decision making will be discussed further, in chapter 6). But, at
the same time, it can be shown that the efficient market can exist, if in the real markets
following events occur:
 A large number of rational, profit maximizing investors exist who are
actively and continuously analyzing valuing and trading securities;
 Information is widely available to market participants at the same time
and without or very small cost;
 Information is generated in a random walk manner and can be treated as
independent;
 Investors react to the new information quickly and fully, though causing
market prices to adjust accordingly.

Summary

1. Essentiality of the Markowitz portfolio theory is the problem of optimal portfolio

selection. The Markowitz approach included portfolio formation by considering
the expected rate of return and risk of individual stocks measured as standard
deviation, and their interrelationship as measured by correlation. The
diversification plays a key role in the modern portfolio theory.
2. Indifference curves represent an investor‘s preferences for risk and return. These

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curves should be drawn, putting the investment return on the vertical axis and the
risk on the horizontal axis.
3. Two important fundamental assumptions than applying indifference curves to
Markowitz portfolio theory. An assumption of no satiation assumes that the
investors prefer higher levels of return to lower levels of return, because the
higher levels of return allow the investor to spend more on consumption at the
end of the investment period. An assumption of risk aversion assumes that the
investor when given the choice, will choose the investment or investment
portfolio with the smaller risk, i.e. the investors are risk averse.

4. Efficient set theorem states that an investor will choose his/ her optimal portfolio
from the set of the portfolios that (1) offer maximum expected return for varying
level of risk, and (2) offer minimum risk for varying levels of expected return.
5. Efficient set of portfolios involves the portfolios that the investor will find
optimal ones. These portfolios are lying on the ―northwest boundary‖ of the
feasible set and are called an efficient frontier. The efficient frontier can be
described by the curve in the risk-return space with the highest expected rates of
return for each level of risk. Feasible set is opportunity set, from which the
efficient set of portfolio can be identified. The feasibility set represents all
portfolios that could be formed from the number of securities and lie either or
within the boundary of the feasible set.
6. Capital Market Line (CML) shows the trade off-between expected rate of return
and risk for the efficient portfolios under determined risk free return.
7. The expected rate of return on the portfolio is the weighted average of the
expected returns on its component securities.
8. The calculation of standard deviation for the portfolio can‗t simply use the
weighted average approach. The reason is that the relationship between the
securities in the same portfolio measured by coefficient of correlation must be
taken into account. When forming the diversified portfolios consisting large
number of securities investors found the calculation of the portfolio risk using
standard deviation technically complicated.
9. Measuring Risk in Capital asset Pricing Model (CAPM) is based on the
identification of two key components of total risk: systematic risk and
unsystematic risk. Systematic risk is that associated with the market.
Unsystematic risk is unique to an individual asset and can be diversified away by
holding many different assets in the portfolio. In CAPM investors are
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compensated for taking only systematic risk.
10. The essence of the CAPM: CAPM predicts what an expected rate of return for
the investor should be, given other statistics about the expected rate of return in
the market, risk free rate of return and market risk (systematic risk).
11. Each security has its individual systematic - undiversified risk, measured using
coefficient Beta. Coefficient Beta () indicates how the price of security/ return
on security depends upon the market forces. The Beta of the portfolio is simply a

weighted average of the Betas of its component securities, where the proportions
invested in the securities are the respective weights.
12. Security Market Line (SML) demonstrates the relationship between the expected
return and Beta. Each security can be described by its specific security market
line, they differ because their Betas are different and reflect different levels of
market risk for these securities.
13. Arbitrage Pricing Theory (APT) states, that the expected rate of return of security
is the linear function from the complex economic factors common to all
securities. There could presumably be an infinitive number of factors. The
examples of possible macroeconomic factors which could be included in using
APT model are GDP growth; an interest rate; an exchange rate; a default spread
on corporate bonds, etc.
14. Market efficiency means that the price which investor is paying for financial
asset (stock, bond, other security) fully reflects fair or true information about the
intrinsic value of this specific asset or fairly describe the value of the company –
the issuer of this security. The key term in the concept of the market efficiency is
the information available for investors trading in the market.
15. There are 3 forms of market efficiency under efficient market hypothesis: weak
form of efficiency; semi- strong form of efficiency; strong form of the
efficiency. Under the weak form of efficiency stock prices are assumed to reflect
any information that may be contained in the past history of the stock prices.
Under the semi-strong form of efficiency all publicly available information is
presumed to be reflected in stocks‘ prices. The strong form of efficiency which
asserts that stock prices fully reflect all information, including private or inside
information, as well as that which is publicly available.

Key-terms • Arbitrage
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• Arbitrage Pricing Theory

• (APT) • Efficient frontier
• Coefficient Beta () • Efficient set of portfolios
• Capital Market Line (CML) • Expected rate of return of the
• Capital Asset Pricing Model portfolio
• (CAPM) • Feasible set
• Indifference curves
• Map of Indifference Curves

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• Market efficiency • Standard deviation of the

• Markowitz Portfolio Theory • portfolio
• Market Portfolio • Semi- strong form of market
• Nonsatiation • efficiency
• Portfolio Beta • Strong form of market
• Risk aversion • efficiency
• Risk free rate of return • Total risk
• Risk of the portfolio • Unsystematic (specific) risk
• Security Market Line (SML) • Weak form of market
efficiency
• Systematic risk

Questions and problems

1. Explain why most investors prefer to hold a diversified portfolio of securities as
opposed to placing all of their wealth in a single asset.
2. In terms of the Markowitz portfolio model, explain, how an investor identify his /
her optimal portfolio. What specific information does an investor need to identify
optimal portfolio?
3. How many portfolios are on an efficient frontier? How is an investor‘s risk
aversion indicated in an indifference curve?
4. Describe the key assumptions underlying CAPM.
5. Many of underlying assumptions of the CAPM are violated in some degree in
―real world‖. Does that fact invalidate model‘s calculations? Explain.
6. If the risk-free rate of return is 6% and the return on the market portfolio is 10%,
what is the expected return on an asset having a Beta of 1,4, according to the
CAPM?
7. Under the CAPM, at what common point do the security market lines of individual
stocks intersect?
8. Given the following information:
• Expected return for stock A = 18%
• Expected return for stock B = 25%
• Standard deviation of stock A = 12%
• Standard deviation of stock B = 20%
• Correlation coefficient = 1,0.
Choose the investment below that represents the minimum risk portfolio:

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a) 100% invest in stock A;

b) 100% invest in stock B;
c) 50% in stock A and 50% in stock B;
d) 20% invest in stock A and 80% in stock B
e) 60% invest in stock A and 40% in stock B.
9. The following investment portfolios are evaluated by investor:
Portfolio Expected rate of Standard
return, % deviation
A 12 15
B 10 8
C 10 9

Using Markowitz portfolio theory explain the choice for investor between
portfolios A,B and C.
10. Investor owns the portfolio composed of three stocks. The Betas of these stocks
and their proportions in portfolio are shown in the table. What is the Beta of the
investor‘s portfolio?
Stock Beta Proportion in
portfolio, %
A 0,8 30
B 1,2 40
C -0,9 30

11. How does the CAPM differs from the APT model?
12. Comment on the risk of the stocks presented below. Which of them are more /less
risky and why?

Stock Beta
A 0,92
B 2,20
C 0,97
D -1.12
E 1.18
F 0,51

13. What is meant by an efficient market? What are the benefits to the economy from
an efficient market?
14. If the efficient market hypothesis is true, what are the implications for the
investors?

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15. What are the conditions for an efficient market? Discuss if are they met in
the reality.
16. If stock‘s prices are assumed to reflect any information that may be
contained in the past history of the stock price itself, this is
a) Strong form of efficiency;
b) Semi-strong form of efficiency;
c) Weak form of efficiency;
d) Not enough information to determine form of efficiency.
17. Investor owns a portfolio of four securities. The characteristics of the
securi
ties and their proportions in the portfolio are presented in the table.
Security Coefficient Beta Proportion, % Expected rate
of return, %
A 1,40 30 13
B 0,90 30 18
C 1,00 20 10
D -1,30 20 12

a) What is the expected rate of return of this portfolio?

b) What is the risk of the portfolio?
c) If the investor wants to reduce risk in his portfolio how he
could restructure his portfolio?
18. The following table presents the three-stock portfolio.
Stocks Portfolio Coefficient Expected Standard
Weight Beta return deviation

A 0,25 0,50 0,40 0,07

B 0,25 0,50 0,25 0,05
C 0,50 1,00 0,21 0,07

Variance of the market returns is 0.06.

a) What is the Beta coefficient of the portfolio?
b) What is the expected rate of return on the portfolio?
c) What is an actual variance of the portfolio, if the following
actual covariance between the stock‘s returns is given:

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Cov (rA, rB) = 0,020 Cov (rA, rC) = 0,035 Cov (rB, rC) =
0,035
Selected problems:
ST8–1 Portfolio analysis
You have been asked for your advice in selecting a portfolio of assets and have been
given the following data:

You have been told that you can create two portfolios—one consisting of assets A and
B and the other consisting of assets A and C—by investing equal proportions (50%)
in each of the two component assets.
a. What is the expected return for each asset over the 3-year period?
b. What is the standard deviation for each asset‘s return?
c. What is the expected return for each of the two portfolios?
d. How would you characterize the correlations of returns of the two assets
making up each of the two portfolios identified in part c?
e. What is the standard deviation for each portfolio?
f. Which portfolio do you recommend? Why?
ST8–2 Beta and CAPM
Currently under consideration is an investment with a beta, b, of 1.50. At this time,
the risk-free rate of return, RF, is 7%, and the return on the market portfolio of assets,
rm, is 10%. You believe that this investment will earn an annual rate of return of 11%.
a. If the return on the market portfolio were to increase by 10%, what would
you expect to happen to the investment‘s return? What if the market return
were to decline by 10%?
b. Use the capital asset pricing model (CAPM) to find the required return on this
investment.
c. On the basis of your calculation in part b, would you recommend this
investment? Why or why not?

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d. Assume that as a result of investors becoming less risk-averse, the market

return drops by 1% to 9%. What impact would this change have on your
responses in parts b and c?
ST8–2 You wish to calculate the risk level of your portfolio based on its beta. The
five stocks in the portfolio with their respective weights and betas are shown
in the accompanying table. Calculate the beta of your portfolio.

E8–6
a. Calculate the required rate of return for an asset that has a beta of 1.8, given a
risk-free rate of 5% and a market return of 10%.
b. If investors have become more risk-averse due to recent geopolitical events,
and the market return rises to 13%, what is the required rate of return for the
same asset?
c. Use your findings in part a to graph the initial security market line (SML),
and then use your findings in part b to graph (on the same set of axes) the
shift in the SML.
P8–13 Portfolio return and standard deviation
Jamie Wong is considering building an investment portfolio containing two stocks, L
and M. Stock L will represent 40% of the dollar value of the portfolio, and stock M
will account for the other 60%. The expected returns over the next 6 years, 2013–
2018, for each of these stocks are shown in the following table.

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a. Calculate the expected portfolio return, rp, for each of the 6 years.
b. Calculate the expected value of portfolio returns, , over the 6-year period.
c. Calculate the standard deviation of expected portfolio returns, ơrp, over the 6-year
period.

d. How would you characterize the correlation of returns of the two stocks L and M?
e. Discuss any benefits of diversification achieved by Jamie through creation of the
portfolio.
P8–14 Portfolio analysis
You have been given the expected return data shown in the first table on three
assets—F, G, and H—over the period 2013–2016.

Using these assets, you have isolated the three investment alternatives shown in the
following table.

a. Calculate the expected return over the 4-year period for each of the three
alternatives.
b. Calculate the standard deviation of returns over the 4-year period for each of the
three alternatives.
c. Use your findings in parts a and b to calculate the coefficient of variation for each
of the three alternatives.
d. On the basis of your findings, which of the three investment alternatives do you
recommend? Why?
P8–17 Total, nondiversifiable, and diversifiable risk

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David Talbot randomly selected securities from all those listed on the New York
Stock Exchange for his portfolio. He began with a single security and added securities
one by one until a total of 20 securities were held in the portfolio. After each security
was added, David calculated the portfolio standard deviation, srp. The calculated
values are shown in the following table.

a. Plot the data from the table above on a graph that has the number of securities on
the x-axis and the portfolio standard deviation on the y-axis.
b. Divide the total portfolio risk in the graph into its nondiversifiable and diversifiable
risk components, and label each of these on the graph.
c. Describe which of the two risk components is the relevant risk, and explain why it
is relevant. How much of this risk exists in David Talbot‘s portfolio?
P8–18 Graphical derivation of beta
A firm wishes to estimate graphically the betas for two assets, A and B. It has
gathered the return data shown in the following table for the market portfolio and for
both assets over the last 10 years, 2003–2012.
a. On a set of ―market return (x axis)–asset return (y axis)‖ axes, use the data given to
draw the characteristic line for asset A and for asset B.
b. Use the characteristic lines from part a to estimate the betas for assets A and B.
c. Use the betas found in part b to comment on the relative risks of assets A and B.

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P8–19 Graphical derivation and interpreting beta

You are analyzing the performance of two stocks. The first, shown in Panel A, is
Cyclical Industries Incorporated. Cyclical

Industries makes machine tools and other heavy equipment, the demand for which
rises and falls closely with the overall state of the economy. The second stock, shown
in Panel B, is Biotech Cures Corporation. Biotech Cures uses biotechnology to
develop new pharmaceutical compounds to treat incurable diseases. Biotech‘s
fortunes are driven largely by the success or failure of its scientists to discover new

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and effective drugs. Each data point on the graph shows the monthly return on the
stock of interest and the monthly return on the overall stock market. The lines drawn
through the data points represent the characteristic lines for each security.
a. Which stock do you think has a higher standard deviation? Why?
b. Which stock do you think has a higher beta? Why?
c. Which stock do you think is riskier? What does the answer to this question depend
on?
P8–20 Interpreting beta
A firm wishes to assess the impact of changes in the market return on an asset that has
a beta of 1.20.
a. If the market return increased by 15%, what impact would this change be expected
to have on the asset‘s return?
b. If the market return decreased by 8%, what impact would this change be expected
to have on the asset‘s return?

c. If the market return did not change, what impact, if any, would be expected on the
asset‘s return?
d. Would this asset be considered more or less risky than the market? Explain.
P8–21 Betas
Answer the questions below for assets A to D shown in the table.

a. What impact would a 10% increase in the market return be expected to have on
each asset‘s return?
b. What impact would a 10% decrease in the market return be expected to have on
each asset‘s return?
c. If you believed that the market return would increase in the near future, which asset
would you prefer? Why?
d. If you believed that the market return would decrease in the near future, which
asset would you prefer? Why?

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Personal Finance Problem

P8–22 Betas and risk rankings
You are considering three stocks—A, B, and C—for possible inclusion in your
investment portfolio. Stock A has a beta of 0.80, stock B has a beta of 1.40, and stock
C has a beta of 0.30.
a. Rank these stocks from the most risky to the least risky.
b. If the return on the market portfolio increased by 12%, what change would you
expect in the return for each of the stocks?
c. If the return on the market portfolio decreased by 5%, what change would you
expect in the return for each of the stocks?
d. If you felt that the stock market was getting ready to experience a significant
decline, which stock would you probably add to your portfolio? Why?
e. If you anticipated a major stock market rally, which stock would you add to your
portfolio? Why?
Personal Finance Problem
P8–23 Portfolio betas
Rose Berry is attempting to evaluate two possible portfolios, which consist of the
same five assets held in different proportions. She is particularly interested in using
beta to compare the risks of the portfolios, so she has gathered the data shown in the
following table.
a. Calculate the betas for portfolios A and B.
b. Compare the risks of these portfolios to the market as well as to each other. Which
portfolio is more risky?

P8–24 Capital asset pricing model (CAPM)

For each of the cases shown in the following table, use the capital asset pricing model
to find the required return.

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P8–25 Beta coefficients and the capital asset pricing model

Katherine Wilson is wondering how much risk she must undertake to generate an
acceptable return on her portfolio. The risk-free return currently is 5%. The return on
the overall stock market is 16%. Use the CAPM to calculate how high the beta
coefficient of Katherine‘s portfolio would have to be to achieve each of the following
expected portfolio returns.
a. 10%

b. 15%
c. 18%
d. 20%
e. Katherine is risk averse. What is the highest return she can expect if she is
unwilling to take more than an average risk?

P8–26 Manipulating CAPM

Use the basic equation for the capital asset pricing model (CAPM) to work each of the
following problems.
a. Find the required return for an asset with a beta of 0.90 when the risk-free rate and
market return are 8% and 12%, respectively.
b. Find the risk-free rate for a firm with a required return of 15% and a beta of 1.25
when the market return is 14%.
c. Find the market return for an asset with a required return of 16% and a beta of 1.10
when the risk-free rate is 9%.
d. Find the beta for an asset with a required return of 15% when the risk-free rate and
market return are 10% and 12.5%, respectively.

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P8–27 Portfolio return and beta

Jamie Peters invested $100,000 to set up the following portfolio one year ago:

a. Calculate the portfolio beta on the basis of the original cost figures.
b. Calculate the percentage return of each asset in the portfolio for the year.
c. Calculate the percentage return of the portfolio on the basis of original cost, using
income and gains during the year.
d. At the time Jamie made his investments, investors were estimating that the market
return for the coming year would be 10%. The estimate of the risk-free rate of
return averaged 4% for the coming year. Calculate an expected rate of return for
each stock on the basis of its beta and the expectations of market and risk-free
returns.
e. On the basis of the actual results, explain how each stock in the portfolio performed
relative to those CAPM-generated expectations of performance. What factors
could explain these differences?

P8–28 Security market line (SML)

Assume that the risk-free rate, RF, is currently 9% and that the market return, rm, is
currently 13%.
a. Draw the security market line (SML) on a set of ―nondiversifiable risk (x axis)–
required return (y axis)‖ axes.
b. Calculate and label the market risk premium on the axes in part a.
c. Given the previous data, calculate the required return on asset A having a beta of
0.80 and asset B having a beta of 1.30.
d. Draw in the betas and required returns from part c for assets A and B on the axes in
part a. Label the risk premium associated with each of these assets, and discuss
them.
P8–29 Shifts in the security market line

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Assume that the risk-free rate, RF, is currently 8%, the market return, rm, is 12%, and
asset A has a beta, bA, of 1.10.
a. Draw the security market line (SML) on a set of ―nondiversifiable risk (x axis)–
required return (y axis)‖ axes.
b. Use the CAPM to calculate the required return, rA, on asset A, and depict asset A‘s
beta and required return on the SML drawn in part a.
c. Assume that as a result of recent economic events, inflationary expectations have
declined by 2%, lowering RF and rm to 6% and 10%, respectively. Draw the new
SML on the axes in part a, and calculate and show the new required return for asset
A.
d. Assume that as a result of recent events, investors have become more risk averse,
causing the market return to rise by 1%, to 13%. Ignoring the shift in part c, draw
the new SML on the same set of axes that you used before, and calculate and show
the new required return for asset A.
e. From the previous changes, what conclusions can be drawn about the impact of (1)
decreased inflationary expectations and (2) increased risk aversion on the required
returns of risky assets?

Spreadsheet Exercise
Jane is considering investing in three different stocks or creating three distinct
twostock portfolios. Jane considers herself to be a rather conservative investor. She is
able to obtain forecasted returns for the three securities for the years 2013 through
2019. The data are as follows:

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References and further readings

1. Fama, Eugene (1965). Random Walks in Stock Prices. // Financial
Analysts Journal, September.
2. Fama, Eugene (1970).Efficient Capital Markets: A Review of Theory
and Empirical Work// Journal of Business.

3. Haugen, Robert A. (2010). The New Finance. 4th ed. Prentice Hall.

4. Haugen, Robert A. (2001). Modern Investment Theory. 5th ed. Prentice Hall.

5. Jones, Charles P.(2010).Investments Principles and Concepts. John Wiley &

Sons, Inc.
6. Markowitz, Harry. (1952). Portfolio Selection. // Journal of Finance,7(1), p. 77-
91.

7. Sharpe, William F. (1964). Capital Assets Prices: A Theory of Market

Equilibrium under Conditions of Risk // Journal of Finance, 19 (3), p. 425-442.
8. Sharpe, William F., Gordon J.Alexander, Jeffery V.Bailey. (1999).
Investments. International edition. Prentice –Hall International.
9. Strong, Robert A. (1993). Portfolio Construction, Management and Protection.

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7.1 Active versus passive portfolio management

2 types of investment portfolio management:
• Active portfolio management
• Passive portfolio management
The main points for the passive portfolio management:
• holding securities in the portfolio for the relatively long periods with small
and infrequent changes;
• Investors act as if the security markets are relatively efficient. The
portfolios they hold may be surrogates for the market portfolio (index
funds).
• Passive investors do not try outperforming their designated benchmark.
The reasons when the investors with passive portfolio management make changes in
their portfolios:
• the investor‟s preferences change;
• the risk free rate changes;
• the consensus forecast about the risk and return of the benchmark portfolio
changes.
The main points for the active portfolio management:
• active investors believe that from time to time there are mispriced
securities or groups of securities in the market;

• the active investors do not act as if they believe that security markets are
efficient;

• the active investors use deviant predictions – their forecast of risk and
return differ from consensus opinions.

Table 7.1 Active versus passive investment management

Area of Active investment management Passive
comparisons investment
Aim To achieve better results and management
To achieve the average
then average in the market market results
Strategies used and Short term positions, the quick and Long term positions,
decision making more risky decisions; keeping the slow decisions
“hot” strategy
Investor/manager tense laid-back
Taxes and turnover High taxes, relatively high Low taxes, small
of investment turnover of portfolio turnover of portfolio
portfolio
Performance results In average equal to the passively In average equal to the
before costs and managed portfolios actively managed portfolios
taxes
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Performance results In average lower than market In average higher than

after costs and taxes index after taxes the results of actively
managed portfolio
Individual Over 85 % from total individual returns
Over 15after taxestotal
% from
investors* investors individual investors
Institutional Over 56% from total institutional Over 44% from
investors* investors total institutional
Supporters All brokerage firms, investment investors managed
Passively
funds, hedging fund, specialized pension funds, index
investment companies funds
Analytical methods Qualitative: avoiding risk, Quantitative: risk
forecasts, emotions, intuition, management, long term
success, speculation, gambling statistical analysis, precise
fundamental
*Source: Statistical Data of Treasury Department USA, 2006. Compiled by authoranalysis
on the basis of
Cianciotto, 2008; Arnerich, Arnston, Perkins, Pruit at al. (2007); Voicu (2008); Wellington
(2002), Sharpe (1993).

There are arguments for both active and passive investing though it is
probably a case that a larger percentage of institutional investors invest passively than
do individual investors. Of course, the active versus passive investment management
decision does not have to be a strictly either/ or choice. One common investment
strategy is to invest passively in the markets investor considers to be efficient and
actively in the markets investor considers inefficient. Investors also combine the two
by investing part of the portfolio passively and another part actively. Some active and
passive management strategies commonly used for stocks and bonds portfolios were
discussed in Chapters 2 and 3.

7.2 Strategic versus tactical asset allocation

An asset allocation focuses on determining the mixture of asset classes that is
most likely to provide a combination of risk and expected return that is optimal for the
investor. Asset allocation is a bit different from diversification. It focus is on
investment in various asset classes. Diversification, in contrast, tends to focus more on
security selection – selecting the specific securities to be held within an asset class.

Asset Allocation tends to preserve capital by protecting against negative

developments while taking advantage of positive ones.

"In other words, don’t put all of your eggs in one basket, and choose your
baskets carefully".

Asset classes here is understood as groups of securities with similar

characteristics and properties (for example, common stocks; bonds; derivatives,
etc.). Asset allocation proceeds other approaches to investment portfolio
management, such as market timing (buy low, sell high) or selecting the individual
securities which are expected will be the “winners”. These activities may be
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integrated in the asset allocation process. But the main focus of asset allocation is to
find such a combination of the different asset classes in the investment portfolio
which the best matches with the investor‟s goals – expected return on investment and
investment risk. Asset allocation largely determines an investor‟s success or lack
thereof. In fact, studies have shown that as much as 90 % or more of a portfolio‟s
return comes from asset allocation. Furthermore, researchers have found that asset
allocation has a much greater impact on reducing total risk than does selecting the
best investment vehicle in any single asset category.
Two categories in asset allocation are defined:
 Strategic asset allocation;
 Tactical asset allocation.
Strategic asset allocation identifies asset classes and the proportions for those
asset classes that would comprise the normal asset allocation. Strategic asset allocation
is used to derive long-term asset allocation weights. The fixed-weightings approach in
strategic asset allocation is used. Investor using this approach allocates a fixed
percentage of the portfolio to each of the asset classes, of which typically are three to
five. Example of asset allocation in the portfolio might be as follows:

Asset class Allocation

Common stock 40%
Bonds 50%
Short-term securities 10%
Total portfolio 100%

Generally, these weights are not changed over time. When market values
change, the investor may have to adjust the portfolio annually or after major market
moves to maintain the desired fixed-percentage allocation.

Tactical asset allocation produces temporary asset allocation weights that

occur in response to temporary changes in capital market conditions. The investor‟s
goals and risk- return preferences are assumed to remain unchanged as the asset
weights are occasionally revised to help attain the investor‟s constant goals. For
example, if the investor believes some sector of the market is over- or under valuated.
The passive asset allocation will not have any changes in weights of asset classes in
the investor‟s portfolio – the weights identified by strategic asset allocation are used.
Alternative asset allocations are often related with the different approaches to
risk and return, identifying conservative, moderate and aggressive asset allocation.
The conservative allocation is focused on providing low return with low risk; the

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moderate – average return with average risk and the aggressive – high return and high
risk. The example of these alternative asset allocations is presented in Table 8.2.
Table 7.2. Comparison between the alternative asset allocations
Alternative asset allocation
Asset class Conservative Moderate Aggressive
Common stock 20% 35% 65%
Bonds 45% 40% 20%
Short-term securities 35% 15% 5%
Total portfolio 100% 100% 100%

For asset allocation decisions Markowitz portfolio model as a selection

techniques can be used. Although Markowitz model (see Chapter 3.1) was developed
for selecting portfolios of individual securities, but thinking in terms of asset classes,
this model can be applied successfully to find the optimal allocation of assets in the
portfolio. Programs exist to calculate efficient frontiers using asset classes and
Markowitz model is frequently used for the asset allocation in institutional investors‟
portfolios.
The correlation between asset classes is obviously a key factor in building an
optimal portfolio. Investors are looking to have in their portfolios asset classes that are
negatively correlated with each other, or at least not highly positively correlated with
each other (see Chapter 2.2). It is obvious that correlation coefficients between asset
classes returns change over time. It is also important to note that the historical
correlation between different asset classes will vary depending on the time period
chosen, the frequency of the data and the asset class, used to estimate the correlation.
Using not historical but future correlation coefficients between assets could influence
the results remarkably, because the historical data may be different from the
expectations.

Monitoring and revision of the portfolio

Portfolio revision is the process of selling certain issues in portfolio and
purchasing new ones to replace them. The main reasons for the necessity of the
investment portfolio revision:
• As the economy evolves, certain industries and companies become either
less or more attractive as investments;
• The investor over the time may change his/her investment objectives and in
this way his/ her portfolio isn‟t longer optimal;
• The constant need for diversification of the portfolio. Individual securities
in the portfolio often change in risk-return characteristics and their

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diversification effect may be lessened.

Three areas to monitor when implementing investor’s portfolio monitoring:
1. Changes in market conditions;
2. Changes in investor‟s circumstances;
3. Asset mix in the portfolio.
The need to monitor changes in the market is obvious. Investment decisions
are made in dynamic investment environment, where changes occur permanently. The
key macroeconomic indicators (such as GDP growth, inflation rate, interest rates,
others), as well as the new information about industries and companies should be
observed by investor on the regular basis, because these changes can influence the
returns and risk of the investments in the portfolio. Investor can monitor these changes
using various sources of information, especially specialized websites (most frequently
used are presented in relevant websites). It is important to identify he major changes in
the investment environment and to assess whether these changes should negatively
influence investor‟s currently held portfolio. If it so investor must take an actions to
rebalance his/ her portfolio.
When monitoring the changes in the investor‟s circumstances, following
aspects must be taken into account:
• Change in wealth
• Change in time horizon
• Change in liquidity requirements
• Change in tax circumstances
• Change in legal considerations
• Change in other circumstances and investor‟s needs.
Any changes identified must be assessed very carefully before usually they
generally are related with the noticeable changes in investor‟s portfolio.
Rebalancing a portfolio is the process of periodically adjusting it to maintain
certain original conditions. Rebalancing reduces the risks of losses – in general, a
rebalanced portfolio is less volatile than one that is not rebalanced. Several methods of
rebalancing portfolios are used:
 Constant proportion portfolio;
 Constant Beta portfolio;
 Indexing.
Constant proportion portfolio. A constant proportion portfolio is one in which
adjustments are made so as to maintain the relative weighting of the portfolio

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components as their prices change. Investors should concentrate on keeping their

chosen asset allocation percentage (especially those following the requirements for
strategic asset allocation). There is no one correct formula for when to rebalance. One
rule may be to rebalance portfolio when asset allocations vary by 10% or more. But
many investors find it bizarre that constant proportion rebalancing requires the
purchase of securities that have performed poorly and the sale of those that have
performed the best. This is very difficult to do for the investor psychologically (see
Chapter 6). But the investor should always consider this method of rebalancing as one
choice, but not necessarily the best one.
Constant Beta portfoli.
The base for the rebalancing portfolio using this alternative is the target
portfolio Beta. Over time the values of the portfolio components and their Betas
will change and this can cause the portfolio Beta to shift. For example, if the target
portfolio Beta is 1.10 and it had risen over the monitored period of time to 1.25, the
portfolio Beta could be brought back to the target (1.10) in the following ways:
• Put additional money into the stock portfolio and hold cash. Diluting the
stocks in portfolio with the cash will reduce portfolio Beta, because cash has
Beta of 0. But in this case cash should be only a temporary component in the
portfolio rather than a long-term;

• Put additional money into the stock portfolio and buy stocks with a Beta
lower than the target Beta figure. But the investor may be is not able to
invest additional money and this way for rebalancing the portfolio can be
complicated.
• Sell high Beta stocks in portfolio and hold cash. As with the first
alternative, this way reduces the equity holdings in the investor‟s portfolio
which may be not appropriate.
• Sell high Beta stocks and buy low Beta stocks. The stocks bought could
be new additions to the portfolio, or the investor could add to existing
positions.
Indexing:
This alternatives for rebalancing the portfolio are more frequently used by
institutional investors (often mutual funds), because their portfolios tend to be large
and the strategy of matching a market index are best applicable for them. Managing
index based portfolio investor (or portfolio manager) eliminates concern about
outperforming the market, because by design, it seeks to behave just like the
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market averages. Investor attempts to maintain some predetermined characteristics of

the portfolio, such as Beta of 1.0. The extent to which such a portfolio deviates from
its intended behaviors called tracking error.
Revising a portfolio is not without costs for an individual investor. These
costs can be direct costs – trading fees and commissions for the brokers who can
trade securities on the exchange. With the developing of alternative trading systems
(ATS) these costs can be decreased. It is important also, that the selling the securities
may have income tax implications which differ from country to country.

7.3 Portfolio performance measures

Portfolio performance evaluation involves determining periodically how the

portfolio performed in terms of not only the return earned, but also the risk
experienced by the investor. For portfolio evaluation appropriate measures of return
and risk as well as relevant standards (or “benchmarks”) are needed.
In general, the market value of a portfolio at a point of time is determined by
adding the markets value of all the securities held at that particular time. The market
value of the portfolio at the end of the period is calculated in the same way, only
using end-of-period prices of the securities held in the portfolio.

The return on (Ending value of the portfolio - Beginning value of the portfolio)
the portfolio (rp) = ‫ـــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــ‬
Beginning value of the portfolio

The essential idea behind performance evaluation is to compare the returns

which were obtained on portfolio with the results that could be obtained if more
appropriate alternative portfolios had been chosen for the investment. Such
comparison portfolios are often referred to as benchmark portfolios. In selecting them
investor should be certain that they are relevant, feasible and known in advance. The
benchmark should reflect the objectives of the investor.
Portfolio Beta (see Chapter 5) can be used as an indication of the amount of
market risk that the portfolio had during the time interval. It can be compared directly
with the betas of other portfolios.
Risk-adjusted Performance Measures
The final stage of the performance evaluation process is performance
appraisal. Performance appraisal is designed to assess whether the investment results
are more likely due to skill or luck. Should we hire or fire the manager? Risk-adjusted
performance measures are one set of tools to use in answering such questions. Each of
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the following is ex-post, meaning the actual return of the portfolio or manager is used
to assess how well the manager did on a risk-adjusted basis. Six commonly used
measures are:
1. Alpha (also known as Jensen's ex-post alpha or ex-post alpha).
2. The information ratio (IR).
3. The Treynor measure.
4. The Sharpe ratio.
5. M2 (Modigliani and Modigliani).
6. Messeary ratio (Lost returns approach).
1 . Ex - post alpha.
Alpha is the difference between the actual return and the return required to
compensate for systematic risk. Alpha uses the ex post security market line (SML) as a
benchmark to appraise performance. Positive alpha suggests superior performance but
the sponsor may also be concerned with the variability of alpha over time. On an ex-
ante basis, the SML and CAPM project return to be:

Or

Using data on actual returns (i.e., historical rather than expected returns), a simple
linear regression is used to calculate ex post alpha:

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Note: This may look mysterious but a Level III candidate will have done this a dozen
times in the course of Level I and II. Calculate the expected return of a portfolio given its
beta, the market return, and the risk-free rate over a past period. Subtract the result from
the actual return of the portfolio. The difference is Alpha. Also remember that
graphically, positive alpha means the portfolio plots above the SML and negative alpha
plots below.

2. The Treynor measure.

The Treynor measure is related to alpha by using beta, a systematic measure of risk.
Visually, a portfolio or manager with positive alpha will plot above the SML. If a line is
drawn from the risk-free return on the vertical axis through the portfolio, Treynor is the
slope of that line. That means a portfolio with positive alpha will have a Treynor
measure that is greater than the Treynor of the market. A portfolio with negative alpha
will have a Treynor that is less than the Treynor of the market.

Or

3 . The Sharpe ratio.

While the previous two ratios only consider systematic risk, Sharpe uses total risk
(standard deviation). Sharpe would be plotted against the CML, which also assesses risk
as standard deviation. The Sharp ratio of the market is the slope of the CML. For any
portfolio the line between the risk-free rate and the intersection of that portfolio's return
and standard deviation is its CAL and the slope of that portfolio's CAL is its Sharpe
ratio. A superior manager will have a higher Sharpe than the market and a steeper CAL
than the CML. Sharpe is similar to the Treynor measure in using excess return but the
Sharpe ratio uses standard deviation for risk and Treynor uses beta.

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Or

Example:
To illustrate these measures,
we will use a hypothetical portfolio for which monthly returns in the past five years
resulted in the following statistics. We also present comparable data for the market
portfolio for the same period.

Portfolio Market

Average return 16% 14%

Standard deviation 20% 24%
Beta 0.8 1.0

Finally, suppose the average return on risk-free assets during the five-year period was
6%. The Sharpe measure, the Treynor measure, and the Jensen measure are three risk-
adjusted performance statistics. The Sharpe measure is calculated as follows:
Answer:
Using our numbers, the Sharpe measure for the portfolio
is (16 - 6)/20 = 0.5, while for the market it is (14 - 6)/24 = 0.33.
In contrast, the Treynor measure is given as follows:
The Treynor measure for the portfolio over this period is (16 - 6)/0.8 = 12.5, while for
the market portfolio it is (14 - 6)/1.0 = 8.
A third popular performance measure, the Jensen measure, is as follows:
16 - [6 + 0.8(14 - 6)] = 3.6%.

Solve now:
Consider the following data for a particular sample period:

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Portfolio Management and Evaluation

Portfolio P Market M
Average return 35% 28%
Standard deviation 1.2 1.0
Beta 42% 30%

Calculate the following performance measures for portfolio P and the market: Sharpe,
Jensen (alpha), and Treynor. The T-bill rate during the period was 6%. By which
measures did portfolio P outperform the market?

4. The M2 measure (from Modigliani and Modigliani).

M2 also uses standard deviation as risk in the denominator and excess return in the
numerator, which makes it very similar to Sharpe. M2 measures the value added or lost
relative to the market if the portfolio had the same risk (standard deviation) as the
market. It measures the result of a hypothetical portfolio that uses leverage to increase
risk and return if the portfolio has less risk than the market or lends at the risk-free rate to
lower risk and return if the portfolio has more risk than the market:

To compute the M 2 measure, we imagine that a managed portfolio, P, is mixed with a

position in T-bills so that the complete, or “adjusted,” portfolio matches the volatility of
a market index such as the S&P 500. For example, if the managed portfolio has 1.5 times
the standard deviation of the index, the adjusted portfolio would be two-thirds invested
in the managed portfolio and one-third invested in bills. The adjusted portfolio, which
we call P * , would then have the same standard deviation as the index. (If the managed
portfolio had lower standard deviation than the index, it would be leveraged by
borrowing money and investing the proceeds in the portfolio.) Because the market index
and portfolio P * have the same standard deviation, we may compare their performance
simply by comparing returns. This is the M 2 measure:
M2 = r p* - rM

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Portfolio Management and Evaluation

In the example of Concept Check 18.1, P has a standard deviation of 42% versus a
market standard deviation of 30%. Therefore, the adjusted portfolio P * would be formed
by mixing bills and portfolio P with weights 30/42 = .714 in P and 1 - .714 = .286 in
bills. The average return on this portfolio would have been (.286 ×6%) + (.714 ×35%) =
2
26.7%, which is 1.3% less than the average market return. Thus portfolio P had an M
measure of - 1.3%. A graphical representation of the M 2 measure appears in Figure 7.2 .
We move down the capital allocation line corresponding to portfolio P (by mixing P
with T-bills) until we reduce the standard deviation of the adjusted portfolio to match
2
that of the market index. The M measure is then the vertical distance (i.e., the
difference in expected returns) between portfolios P * and M. You can see from Figure
7.2 that P will have an M 2 measure below that of the market when its capital allocation
line is less steep than the capital market line, that is, when its Sharpe ratio is less than
that of the market index.

5 . The information ratio.

The information ratio (IR) is quite similar to the Sharpe ratio in that excess return is
measured against variability. For the IR, the excess return is the portfolio return less the
return of an appropriate benchmark (rather than the risk-free rate). This excess return is
also called active return. The denominator of the IR is the standard deviation of the
excess return in the numerator (also called active risk) .

It is important to note, that if a portfolio is completely diversified, all of these

measures (Sharpe, Treynor‟s ratios and Jensen‟s alfa) will agree on the ranking of the
portfolios. The reason for this is that with the complete diversification total variance is
equal to systematic variance. When portfolios are not completely diversified, the
Treynor‟s and Jensen‟s measures can rank relatively undiversified portfolios much
higher than the Sharpe measure does. Since the Sharpe ratio uses total risk, both
systematic and unsystematic components are included.

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Portfolio Management and Evaluation

Note:
The Sharpe ratio and the IR are even more similar than they appear. Both use a form of
excess return for the numerator which is apparent from the formulas. Less obvious is that
both use the standard deviation of their numerator for their denominator. The Sharpe
ratio uses the standard deviation of the portfolio in the denominator. However because
the standard deviation of the risk-free asset in a single period is zero with a zero
correlation to the portfolio return, the standard deviation of the portfolio is equal to the
standard deviation of excess return used in the numerator of the Sharpe ratio.

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Portfolio Management and Evaluation

6. Messeary Ratio (Lost Returns Approach):

Actually, All scholars who evaluated the professional managers‟ performance
have got into a long debate and finally came down on different sides; some of them
suggest that truly active and skilled managers can and do generate returns above the
market net of fees, and rightly able to add a value throughout their actively managed
strategies, particularly for the long term (see e.g. Mint, 2012; Goldman, 2010).
Conversely, some others show that the average active fund manager cannot
outperform either the CAPM, or the passive benchmark of stocks (French, 2008), it is
a game of losers; a waste of money and time, in brief, investors should simply own the
market itself (Ken, 2009). Furthermore, investors who are overly optimistic about their
abilities to select active managers or overlook the dynamic elements of investing with
active managers may incur significant losses (Warren et al., 2013). Still some other
reveal that even for passive funds or trackers, there is no guarantee for garnering the
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Portfolio Management and Evaluation

performance of the relevant index because trackers may actually use different
techniques to track their target indices and, if their strategies are not sufficiently
effective, then passive funds can potentially underperform (Meyer, 2012).

Given this debate, we would better say "the active strategy is the only skill
managers need for surviving". In order to prove that, one might wonder: When to call
the fund manager a genius one whatever the goal he is after? In other words, what is
the proof that he is talented? Furthermore, how to measure this proof in real? In fact,
no area has received greater attention in portfolio management research than the
mutual funds, but little or nearly none has explored the topic of the best real active
portfolio and its rule when assessing the institutional managers‟ performance. Hence,
it is important to extend the recent literature with evidence and information of another
model as a basic input to this industry. Concurrently, since the emerging economies
provide a prime opportunity for attaining greater profits if compared with the mature
ones (Francis, 2012),this study investigates Egypt as one of the most important
emerging economies in the Middle East, where studies are still little too. It analyzes
the data of 37 mutual funds, two market indexes, in addition to the whole actually
traded stocks listed on the Egyptian Stock Exchange between June, 2007 and June,
2012 period. It seeks to build the Guide Portfolio (GP) that can beat the market, and
then can be used as an active benchmark for identifying how institutional managers
are geniuses in their businesses by the zero returns they lose.

The market portfolio as a comparison criterion

Since the mid-seventies Charles (1975) documents that investment
management business is built upon the basic belief: Professional managers can beat
the market. Ed Rose (2004) supports that belief adding „it is the industry‟s contention
that their active managers can beat the market, since they are in business to manage
your money, how could they claim otherwise? The individual pays dearly for this
service‟. However, among more than 128 measures, little could clarify the rule of the
market portfolio when judging the professionals‟ performance (see e.g. Markowitz,
1952; Roy, 1952; and Statman, 1987). But, Sharpe (1994) comes to transfer Charles‟
belief into a practical approach for deciding how institutional managers are
professionals in running the investors‟ resources. He modified his first ratio
throughout replacing the riskless asset by a benchmark (market portfolio) to describe
the rule of the market when judging the professionals‟ performance by the excess

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return they achieve.

2.2. Studies results, experts’ views and reasons of market beating inability
Actually, most of the previous studies that investigated Charles‟ belief report
that the market cannot be persistently beaten, and that this belief cannot be acceptable
any more. Even Charles (2010) himself shows that the premise of beating the market
appears to be false; he adds: Gambling in a casino where the house takes 20 percent of
every pot is obviously a Loser's Game, so money management has become a Loser's
Game; (John, 2010), many other academics supports that referring that the reason of
the market beating inability might be: The transaction costs (Sharpe, 2010), the risk
(Fama, 2010), the cost of the adopted strategies such as the cost of time wasted in
timing into and out of the funds (Dalbar, 2008), the market efficiency (Hopkins,
2011), the investors thoughts: By misunderstanding the mystery behind the evaluating
process (Keynes, 2010), the professional themselves: By their impatience and relying
on short – term strategies instead of the long – term ones (Jesse, 2010), and finally, the
market, under which, professionals are competing where, the professionals are the
market and then they cannot, as a group, outperform themselves, (Charles, 1975; and
Ed Rose, 2004).
Bearing in mind all or one of the previous reasons: If professionals cannot beat
the market; why actively managed funds are still existed. Why all of those investors
are still following them. And why they all did not prefer sleeping well by indexing.
Does it mean that these investors are ill-informed; it certainly cannot be true. The only
thing that can be accepted is that many of the earlier studies were based on a small
universe of actively managed funds, hardly enough to be a meaningful sample (Ken,
2009). However, if the reason was the transaction costs; it might be an accuse more
than an excuse; the professionals know from the beginning that the fund investors had
to charge these costs in order to reach the fund shares, so they also must be known that
they should reward those investors, otherwise why did professionals accept that field
of work?
In addition, if professional managers cannot beat the market because they
became the market; it either means that there is no exceptions among professionals
and experts or means that they all became exceptions or geniuses and will not be
beaten. Unfortunately, it is the same meaning: there are no exceptions or geniuses
among professionals. If there are losers, it must be a game, and if it was (investment
business already is), there are losers and winners, but no losers all along the way. If
managers could have the same information content, they cannot have the same talent
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in real. Finally, if they all as a market became professionals; the point will not be the
difficulty of differentiating between them because they all became professionals; it
will be the criteria which is used for comparing them with; it will be the market itself.
It is well-known, improper benchmark may destroy the purposes of performance
evaluation by misidentifying the better performing managers (Brown and Reilly,
2009), so if all institutional managers became professionals and we want to compare
between them, we should search and build a more restrict or a tougher criterion to
compare them with. We should build the best actively managed or efficient portfolio
to use as a benchmark or as a guide when assessing them. It means comparing their
performance at any period of time with that of the best actively managed or efficient
portfolio that can be built at the same point of time; in such a way, we can measure
how professionals‟ expectations well-matched these of the best real market.

2.3 Academics’ practices and experts’ opinions into a practical approach

Recalling Charles‟ belief: professional manager can beat the market; we can establish
these two points:
1): Professionals‟ performance (risk adjusted return) is expected to be equal or
higher than that of the market performance. It can be formulated as it follows:

Professionals’ performance ≥ Market portfolio’s performance (1 - 1)

2): Such an excess return is nothing but a reward or a premium for those managers,
who embodied all of their capabilities to capture a rate of return exceeding
that, which can possibly be made by the whole investors on their owns. Thus it
is possibly to say:

Professionals’ performance = Market portfolio’s performance +

Management premium (1 - 2)

Reformulating the limits of the formula (1 - 2) we can get:

Management premium = Professionals’ performance - Market portfolio’s
performance (1 - 3)

Actually, this is the alpha that Sharpe (1994) describes in his generalized
ratio. It illustrates that in order to evaluate the professionals‟ performance, there
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should be a trade-off between two returns; the first is that one, adjusted by the risk,
made by such a manager against his actual investments. The second is that one
adjusted by the risk too, but it is the one that should have been made by him in terms
of investments he himself selected to build his own portfolio. The difference between
these two rates in such a case is the difference between what already is and what
could be; it is an efficiency proof for the manager; it also is that value added to the
investor‟s wealth made by his being depending on a professional management for
running his investments.
However, given the inability of beating the market because the
professionals cannot beat themselves, then, the market portfolio should be replaced
by the best actively managed one as a guide portfolio (GP) as it follows:

Management premium = Professionals’ performance - Guide portfolio’s

Performance (1 - 4)

Yet, since we are talking about the performance of the best managed
portfolio, there will not be any management premium except for genius managers
alone, which rarely happens; if it is difficult to defeat the market‟s passive strategy,
how they can beat the best active one. Unfortunately, it leads to a negative value for
the equation (1 - 4). In effect, to avoid that; the content of this equation can be re-
adjusted by rearranging its limits as it follows:

Lost performance = Guide portfolio’s performance - Professionals’

performance (1 - 5)

Implying that in order to assess the institutional managers‟ performance we

should measure how far they are from the real active strategies and what is the return,
they lose due to their insufficient approaches, addressing that investment
management business can be built upon a new belief: "Genius managers alone can
persistently beat the market".

Performance measures
- Constructing the guide portfolio (GP)
Two main questions may arise when building the GP:
- What is the weight that should be assigned for each single asset?

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- And how many assets it should contain in order to be a well-diversified

portfolio?
The answer for these questions is to consider two key factors: the simple naïve
diversification and the lower level of return, investors can accept for their
investments. Many articles in corporate finance and investment textbooks refer
to the ability of benefiting completely from the naïve diversification in
eliminating the diversifiable risk without giving up the expected returns by
holding a portfolio of randomly selected 8 to nearly 40 stocks, or from 10 : 15
stocks on average, even if they were equally weighted, (Gordon, 2004;Moyer et
al., 1998).
Accordingly, the GP can be created by selecting any number between
8 and 40 (let us say from 8 : 20 stocks on average) of the highest profitable
stocks that their returns are greater than the rate of T-bills as a minimum
acceptable return (MAR), otherwise choosing the T-bills itself for completing the
intended number. It means excluding 3 types of stocks at the end of each
analyzed period (Ex, month): the stocks that their returns are lower than this of the
T-bills, the stocks that gain zero returns, and normally these that yield
negative returns. Hence, the managers‟ real skills or activity can be shown on
their continuous ability for selecting and replacing their stocks by the highest
positive or profitable ones only.
Ease of this idea can be attributed to the naïve investor‟s thoughts; he
wants nothing, but to perpetually have the best active portfolio he can afford buy
or hold. It is a safe one; it is a downside risk free portfolio, as long as mangers are
continuously able to select the highest profitable (positive) stocks alone. That is the
point; it is the portfolio that should be stimulated, as it helps managers maximize
the investors‟ wealth, but can they access it? The professional manager task
resembles this of the physician: the doctor who could not precisely diagnose the
ailment costs the patient his money, his time, and may be his life. The active
manager should be a bird, flies from one stock to the other once he reached his
gains. In such a way, where GP as the best active portfolio, is mainly built upon
the existence of a minimum rate of as an investment substitute, the downside
deviation will be the proper measure for its risk. It avoids the drawback of the
standard deviation, which considers that returns, which spine heavily above the
mean are bad from one hand, and helps advisers make better investment decisions
from the other hand, where above-average returns do not increase risk, as

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outperformance is beneficial to the investor (Washer et al., 2013).

Unfortunately, since using the downside deviations in the denominator of the

equation (1 – 5) may results into an infinity or negative vales, it would be better if the
GP average rate of return has multiplied by (1- downside deviation) when measuring
its risk adjusted return. Equation (1 – 6) shows that as follows:

Where:
MAR: is the minimum acceptable rate of return (T-bill for 3 months rate).
It has been calculated on a monthly base by using the following (1 – 9) equation of the
Effective Annual Rates EAR (Wikipedia, 2014).

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Manager Continuation Policy

The costs of hiring and firing investment managers can be considerable because the fired
manager's portfolios will have to be moved to the new manager(s). This can be quite
expensive, both in time and money:
1- A proportion of the existing manager's portfolio may have to be liquidated if the
new manager's style is significantly different.
2- Replacing managers involves a significant amount of time and effort for the fund
sponsor.
As a result, some fund sponsors have a formalized, written manager continuation policy
(MCP) which will include the goals and guidelines associated with the management
review process:
- Replace managers only when justified (i.e., minimize unnecessary manager
turnover).
- Short periods of underperformance should not necessarily mean automatic
replacement.
- Develop formal policies and apply them consistently to all managers.
- Use portfolio performance and other information in evaluating managers:
- Appropriate and consistent investment strategies (i.e., the manager doesn't
continually change strategies based upon near-term performance).
- Relevant benchmark (style) selections.
- Personnel turnover.
- Growth of the account.
Implementing the MCP process usually involves:
1- Continual manager monitoring.
2- Regular, periodic manager review.
The manager review should be handled much as the original hiring interview, which
should have included the manager's key personnel. Then, before replacing a manager,
management must determine that the move will generate value for the firm (like a
positive NPV project). That is, the value gained from hiring a new manager will
outweigh the costs associated with the process.

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Summary
1. The main points of passive portfolio management: holding securities in the
portfolio for the relatively long periods with small and infrequent changes;
investors act as if the security markets are relatively efficient; passive investors do
not try outperforming their designated benchmark.
2. The main points for the active portfolio management: active investors believe that
there are mispriced securities or groups of securities in the market; the active
investors do not act as if they believe that security markets are efficient; the active
investors use deviant predictions – their forecast of risk and return differ from
consensus opinions.
3. Strategic asset allocation identifies asset classes and the proportions for those asset
classes that would comprise the normal asset allocation. Strategic asset allocation
is used to derive long-term asset allocation weights. The fixed-weightings
approach in strategic asset allocation is used.
4. Tactical asset allocation produces temporary asset allocation weights that occur in
response to temporary changes in capital market conditions. The investor‟s goals
and risk- return preferences are assumed to remain unchanged as the asset weights
are occasionally revised to help attain the investor‟s constant goals.

5. For asset allocation decisions Markowitz portfolio model as a selection

techniques can be used. Thinking in terms of asset classes, this model can be
applied successfully to find the optimal allocation of assets in the portfolio.
The correlation between asset classes is a key factor in building such an optimal
portfolio. Investors are looking to have in their portfolios asset classes that are
negatively correlated with each other, or at least not highly positively correlated
with each other
6. Portfolio revision is the process of selling certain issues in portfolio and
purchasing new ones to replace them.
7. Three areas to monitor when implementing investor‟s portfolio monitoring: (1)
Changes in market conditions; (2) Changes in investor‟s circumstances; (3) Asset
mix in the portfolio.
8. When monitoring the changes in the investor‟s circumstances, following aspects
must be taken into account: change in wealth; change in time horizon; change in
liquidity requirements; change in tax circumstances; change in legal
considerations; change in other circumstances and investor‟s needs.
9. Rebalancing a portfolio is the process of periodically adjusting it to maintain
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certain original conditions. Rebalancing reduces the risks of losses – in general, a

rebalanced portfolio is less volatile than one that is not rebalanced.
10. A constant proportion portfolio is one of the portfolio rebalancing methods in
which adjustments are made so as to maintain the relative weighting of the
portfolio components as their prices change. Investors should concentrate on
keeping their chosen asset allocation percentage (especially those following the
requirements for strategic asset allocation).
11. The bases for the rebalancing portfolio using constant Beta portfolio alternative is
the target portfolio Beta. Over time the values of the portfolio components and
their Betas might change. This can cause the portfolio Beta to shift and then the
portfolio Beta should be brought back to the target.
12. Using indexing method for rebalancing the portfolio the investors match a market
index best applicable for them. Managing index based portfolio investor (or
portfolio manager) eliminates concern about outperforming the market, because by
design, it seeks to behave just like the market averages.
13. Portfolio performance evaluation involves determining periodically how the
portfolio performed in terms of not only the return earned, but also the risk
experienced by the investor. For portfolio evaluation appropriate measures of return
and risk as well as relevant standards (or “benchmarks”) are needed. In selecting
benchmark portfolios investor should be certain that they are relevant, feasible and
known in advance. The benchmark should reflect the objectives of the investor.
14- The appropriate performance measure depends on the investment context. The
Sharpe measure is most appropriate when the portfolio represents the entire
investment fund. The Treynor measure or Jensen measure is appropriate when the
portfolio is to be mixed with several other assets, allowing for diversification of firm
specific risk outside of each portfolio.

15- The shifting mean and variance of actively managed portfolios make it harder to
assess performance. A typical example is the attempt of portfolio managers to time
the market, resulting in ever-changing portfolio betas and standard deviations.

16- Common attribution procedures partition performance improvements to asset

allocation, sector selection, and security selection. Performance is assessed by
calculating departures of portfolio composition from a benchmark or neutral
portfolio.

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17- Active portfolio managers attempt to construct a risky portfolio that improves on the
reward-to-variability (Sharpe) ratio of a passive strategy. Active management has
two components: market timing (or, more generally, asset allocation) and security
analysis.

18- The value of perfect market-timing ability is enormous. The rate of return to a
perfect market timer will be uncertain, but the risk cannot be measured by standard
deviation, because perfect timing dominates a passive strategy, providing only
“good" surprises.
19. To adjust the return for risk before comparison of performance risk adjusted
measures of performance can be used. Sharpe‟s ratio shows an excess a return over
risk free rate, or risk premium, by unit of total risk, measured by standard deviation.
Treynor‟s ratio shows an excess actual return over risk free rate, or risk premium, by
unit of systematic risk, measured by Beta. Jensen„s Alpha shows excess actual return
over required return and excess of actual risk premium over required risk premium.
This measure of the portfolio manager‟s performance is based on the CAPM.

Summary Points

- Alpha and Treynor both measure risk as systematic risk (beta). They will agree in
that a manager with positive alpha will have a Treynor in excess of the market
Treynor. They may not always agree in relative ranking. A manager with the
highest alpha may not have the highest Treynor.

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- Superior (inferior) Sharpe will mean superior (inferior) M2. Both measure risk as
total risk (standard deviation).
- Both Alpha and Treynor are criticized because they depend on beta and
assumptions of the CAPM. The criticisms include (1) the assumption of a single
priced risk rather than some form of multifactor risk pricing and (2) the use of a
market proxy, such as the S&P 500, to stand for the market. Roll's critique shows
that small changes in what is assumed to be the market can significantly change
the alpha and Treynor calculations and even reverse the conclusions of superior
or inferior performance and rankings.
- Measures like M2 that use a benchmark are also subject to the criticism the
benchmark used may not be precisely replicable. As a related issue, transaction
cost to replicate the market or a custom benchmark are not considered.
- Any ex post calculation is a sample of true results and actual results can be
different in the future. Even if results do reflect true manager skill, the manager
can change approach or style in the future.
- Alpha, Treynor, and Sharpe are the more widely used measures.
- Also remember from Levels I and II that the highest relative return measure does
not necessarily mean the highest return. For example, a very low risk portfolio
with low beta or standard deviation could have a higher alpha and Sharpe but a
very risky portfolio with lower alpha and Sharpe can still have the higher
absolute return.

Problem:
1) Consider the following information regarding the performance of a money manager in
a recent month. The table presents the actual return of each sector of the manager‟s
portfolio in column (1), the fraction of the portfolio allocated to each sector in column
(2), the benchmark or neutral sector allocations in column (3), and the returns of
sector indexes in column (4).

(1) (2) (3) (4)

Actual Actual Benchmark Index
Return Weight Weight Return
Equity 2.0% 0.70 0.60 2.5% (S&P 500)
Bonds 1.0 0.20 0.30 1.2 (Aggregate
Bond index)
Cash 0.5 0.10 0.10 0.5

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a. What was the manager‟s return in the month? What was her over- or
underperformance?
b. What was the contribution of security selection to relative performance?
c. What was the contribution of asset allocation to relative performance? Confirm that
the sum of selection and allocation contributions equals her total “excess” return
relative to the bogey.
7. Conventional wisdom says one should measure a manager‟s investment performance
over an entire market cycle. What arguments support this contention? What
arguments contradict it?
8. Does the use of universes of managers with similar investment styles to evaluate
relative investment performance overcome the statistical problems associated with
instability of beta or total variability?
9. During a particular year, the T-bill rate was 6%, the market return was 14%, and a
portfolio manager with beta of 0.5 realized a return of 10%. Evaluate the manager
based on the portfolio alpha.
10. The chairman provides you with the following data, covering one year, concerning
the portfolios of two of the fund‟s equity managers (manager A and manager B ).
Although the portfolios consist primarily of common stocks, cash reserves are
included in the calculation of both portfolio betas and performance. By way of
perspective, selected data for the financial markets are included in the following table.

Total Return Beta

Manager A 24.0% 1.0
Manager B 30.0 1.5
S&P 500 21.0
Lehman Bond Index 31.0
91-day Treasury bills 12.0

a. Calculate and compare the risk-adjusted performance of the two managers relative to
each other and to the S&P 500.
b. Explain two reasons the conclusions drawn from this calculation may be misleading.
11. Go to www.mhhe.com/bkm and link to the material for Chapter 18, where you will
find five years of monthly returns for two mutual funds, Vanguard‟s U.S. Growth
Fund and U.S. Value Fund, as well as corresponding returns for the S&P 500 and the
Treasury bill rate.

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a. Set up a spreadsheet to calculate each fund‟s excess rate of return over T-bills in each
month.
b. Calculate the standard deviation of each fund over the five-year period.
c. What was the beta of each fund over the five-year period? (You may wish to review
the spreadsheets from Chapters 5 and 6 on the Index model.)
d. What were the Sharpe, Jensen, and Treynor measures for each fund?
12. Carl Karl, a portfolio manager for the Alpine Trust Company, has been responsible
since 2010 for the City of Alpine‟s Employee Retirement Plan, a municipal pension
fund. M Alpine is a growing community, and city services and employee payrolls
have expanded in each of the past 10 years. Contributions to the plan in fiscal 2015
exceeded benefit payments by a three-to-one ratio. The plan‟s Board of Trustees
directed Karl five years ago to invest for total return over the long term. However, as
trustees of this highly visible public fund, they cautioned him that volatile or erratic
results could cause them embarrassment. They also noted a state statute that mandated
that not more than 25% of the plan‟s assets (at cost) be invested in common stocks. At
the annual meeting of the trustees in November 2015, Karl presented the folling
portfolio and performance report to the Board.

19. A portfolio manager summarizes the input from the macro and micro forecasts in
the following table:

Micro Forecasts
Asset Expected Return (%) Beta Residual Standard
Deviation (%)
Stock A 20 1.3 58
Stock B 18 1.8 71
Stock C 17 0.7 60
Stock D 12 1.0 55

Macro Forecasts
Asset Expected Return (%) Standard Deviation (%)
T-bills 8 0
Passive equity portfolio 16 23

a. Calculate expected excess returns, alpha values, and residual variances for these
stocks.
b. Construct the optimal risky portfolio.

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c. What is Sharpe‟s measure for the optimal portfolio and how much of it is contributed
by the active portfolio? What is the M 2 ?

20. The following data has been collected to appraise the following four funds: If the
risk-free rate of return for the relevant period was 4%.
M Market
Fund A Fund B Fund C Fund D Index
Return 8.25% 7.21 o/o 9.44% 10.12% 8.60%
Beta 0.91 0.84 1 .02 1 .34 1 .00
Standard 3.24% 3.88% 3.66% 3.28% 3.55%
deviation
Tracking 0.43% 0.62% 0.33% 1 .09%
error*
* Tracking error is the standard deviation of the difference between the Fund Return and the
Market Index Return.

1- Calculate and rank the funds using the following methods:

(i) Jensen's alpha
(ii) Treynor measure
(iii) Sharpe ratio
(iv) M2
(v) Information
2 - Compare and contrast the methods and explain why the ranking differs between
methods.

Key-terms

• Asset classes • Indexing method

• Asset allocation • Rebalancing a portfolio
• Sharpe‟s ratio • Portfolio monitoring
• Treynor‟s ratio • Portfolio revision
• Jensen‟s Alpha • Strategic asset allocation
• Benchmark portfolios • Tactical asset allocation.
• Tracking error • Active portfolio management
• Constant proportion portfolio method • Passive portfolio management
• Constant Beta portfolio method

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Questions and problems

1. Give the arguments for active portfolio management.

2. What are the reasons which cause investors managing their portfolios passively to
make changes their portfolios?
3. What are the major differences between active and passive portfolio management?
4. Explain the role of revision in the process of managing a portfolio.
5. Distinguish strategic and tactical asset allocation.
6. What role does current market information play in managing investment portfolio?
7. Why is the asset allocation decision the most important decision made by
investors?
8. What is the point of investment portfolio rebalancing?
9. What changes in investor‟s circumstances cause the rebalancing of the investment
portfolio? Explain why.
10. Why is portfolio revision not free of cost?
11. Why benchmark portfolios are important in investment portfolio management?
12. Briefly describe each of the portfolio performance measures and explain how they
are used:
a) Sharpe‟s ratio;
b) Treynor‟s ratio;
c) Jensen‟s Alpha.
13. Assume that you plan to construct a portfolio aimed at achieving your stated
objectives. The portfolio can be constructed by allocating your money to the
following asset classes: common stock, bonds, and short-term securities.
a) Identify state and comment your investment objectives.
b) Determine an asset allocation to these three classes of assets considering
your stated investment objectives. Explain your decision.
c) What reasons could cause you to make changes in your asset allocations?
14. An investor‟s portfolio consists of 50000 EURO in stocks and 5000 EURO in
cash. the Beta of the portfolio is 1,10. How the investor could reduce Beta of the
portfolio to 0,95? Show and explain.
15. Select four stocks which were actively traded in the local stock exchange last
calendar year, find the information about their prices at the beginning and at the
end of the year, amount of dividends paid on each stock for this year and stock
Beta at the end of the year. Also find a risk-free rate of return and the market
return for the given year. Assume that these four stocks were put to the portfolio
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in equal proportions (25% in each stock). Assume that the standard deviation for
this portfolio is 16, 75% and that standard deviation for the market portfolio is
13, 50%.
a) Find the portfolio return for the given year (see chapter 3.1.2, formula 3.1).
b) Calculate Sharpe‟s, Treynor‟s ratios and Jensen‟s Alpha.
c) Compare and comment the results of measuring portfolio performance with
different measures.

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References and further readings

1. Arnerich, T., at al. (2007) Active .versus passive investment management: putting
the debate into perspective // Journal of Financial Research, spring.
2. Arnold, Glen (2010). Investing: the definitive companion to investment and the
financial markets. 2nd ed. Financial Times/ Prentice Hall.
3. Bogle, J.C. (2001) Three challenges of investing: active management, market
efficiency, and selecting managers // Journal of Financial Research, spring.
4. Brands, S., Brown, S. J., Gallagher, D.R. (2005) Portfolio concentration and
investment performance // Journal of Banking and Finance, spring.
5. Brands, S., Gallagher, D.R., Looi, A. (2003) Active investment manager portfolios
and preferences for stock characteristics: Australian evidence // Securities Industry
Research Centre of Asia-Pacific.
6. Cianciotto, Ph. (2008) Improving your investment returns – passive or active
investing // AAL financial planning association.
7. Fabozzi, Frank J. (1999). Investment Management. 2nd. ed. Prentice Hall Inc.
8. Francis, Jack C., Roger Ibbotson (2002). Investments: A Global Perspective.
Prentice Hall Inc.
9. Gallagher, D.R. (2003) Investment manager characteristics, strategy, top
management changes and fund performance // The Journal of Banking and
Finance, spring.
10. Gallagher, D.R., Nadarajah, P. (2004) Top management turnover: an analysis of
active Australian investment managers // The Journal of Banking and Finance,
winter.
11. Gitman, Lawrence J., Michael D. Joehnk (2008). Fundamentals of Investing.
Pearson / Addison Wesley.
12. Gold, M. (2004) Investing in pseudo-science: the `active versus passive` debate //
The Journal of Financial Research, spring.
13. Jones, Charles P. (2010). Investments Principles and Concepts. John Wiley &
Sons, Inc.
14. LeBarron, Dean, Romeesh Vaitilingam. (1999). Ultimate Investor. Capstone.
15. Nakamura, L. (2005) A comparison of active and passive investment strategies //
The Journal of Financial Research, spring.

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16. Rice, M., Strotman, G. (2007) The next chapter in the active vs. passive
management debate // LLC research and analysis, spring.
17. Rosenberg, Jerry M. (1993).Dictionary of Investing. John Wiley &Sons Inc.
18. Sharpe, William. The Arithmetic of Active Management. // Financial Analysis
Journal, 1991.
19. Strong, Robert A. (1993). Portfolio Construction, Management and Protection.
West Publishing Company.
20. Voicu, A., (2008) Passive vs. active investment management strategies // The
financial planning association, spring.
21. Wellington, J.W. (2002) Active vs. passive management // The Journal of
Financial Research, spring.

Relevant websites
• www.morningstar.co.uk Morningstar UK
• www.funds.ft.com/funds Financial Times Fund Services
• www.funds-sp.com Standard &Poor„s Fund Service

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ABBREVIATIONS AND SYMBOLS USED

Abbreviation or symbol Explanation

AJ Intercept – the point where the characteristic line of
security J passes through the vertical axis
ABS Asset-Backed Securities
APT Arbitrage Pricing Theory
ATS Alternative Trading System
βJ Beta of security J, the measure of systematic risk
βp Beta of portfolio
CAPM Capital Asset Pricing Model
CF Cash Flow
CML Capital Market Line
Cov (rA, rB) Covariance between returns of two assets – A and B
CY Current Yield
Ct Coupon payment in time period t
D Dividends
DL Long-term debt
DC Depreciation
DDM Dividend Discount Models
DetA,B Coefficient of determination between the returns of assets
A and B
DR Duration (Macaulay duration)
E Exercise (strike) price
EBIT Earnings Before Interest and Taxes
ECB European Central Bank
E(r) Expected rate of return
E(rm) Expected rate of return on the market
E(rp) Expected rate of return on the portfolio
EPS Earnings per Share
E-I-C Economy-Industry-Company Analysis
g Growth rate
GDP Gross Domestic Product
h Probability
HR Hedge Ratio
I Interest expense
IV Intrinsic value of the option
IPO Initial Public Offerings
k Discount rate
kA,B Coefficient of correlation between the returns of assets A
and B
LP Lease payments
NAV Net Asset Value
NI Net Income
OTC Over-the-Counter Market
Pm Market price

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 Investment Analysis and Portfolio Management

Pn Face value (nominal value) of the bond

Pop Option premium
PER Price/Earnings Ratio
PER* Normative Price/ Earnings ratio
r Rate of return
ŕ Arithmetic average return or Sample mean of returns
rm Return on the market
Rf Risk-free rate of return
REPO Repurchase Agreement
ROA Return on Assets
ROE Return on Equity
ROI Return on Investment
SET Total stockholders‟ equity
SML Security Market Line
Tr Income tax rate
TV Time value of the option
V Intrinsic (investment) value
YTC Yield-To-Call
YTM Yield-To-Maturity
YTM* Appropriate Yield-To -Maturity
σp Risk of the portfolio measured as standard deviation
σr Standard deviation of returns
σ²r Variance of Returns

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BIBLIOGRAPHY

Ackert, Lucy F., Deaves, Richard (2010). Behavioral Finance. South-Western Cengage
Learning.
Arnold, Glen (2010). Investing: the definitive companion to investment and the
financial markets. 2nd ed. Financial Times/ Prentice Hall.
Black, John, Nigar Hachimzade, Gareth Myles (2009). Oxford Dictionary of
Economics. 3rd ed. Oxford University Press Inc., New York.
Bode, Zvi, Alex Kane, Alan J. Marcus (2005). Investments. 6th ed. McGraw Hill.
Encyclopedia of Alternative Investments/ ed. by Greg N. Gregoriou. CRC Press, 2009.
Fabozzi, Frank J. (1999). Investment Management. 2nd. ed. Prentice Hall Inc.
Francis, Jack C., Roger Ibbotson (2002). Investments: A Global Perspective. Prentice
Hall Inc.
Gitman, Lawrence J., Michael D. Joehnk (2008). Fundamentals of Investing. Pearson /
Addison Wesley.
Haan, Jakob, Sander Oosterloo, Dirk Schoenmaker (2009). European Financial
Markets and Institutions. Cambridge University Press.
Haugen, Robert A. (2001). Modern Investment Theory. 5th ed. Prentice Hall.
Jones, Charles P. (2010). Investments Principles and Concepts. John Wiley & Sons,
Inc.
LeBarron, Dean, Romeesh Vaitilingam. (1999). Ultimate Investor. Capstone.
Levy, Haim ,Thierry Post (2005). Investments. FT / Prentice Hall.
Nicolaou, Michael A. (2000). The Theory and Practice of Security Analysis.
MacMillan Business.
Nofsinger, John R. (2008). The Psychology of Investing. 3rd ed. Pearson/Prentice
Hall.
Rosenberg, Jerry M. (1993).Dictionary of Investing. John Wiley &Sons Inc.
Sharpe, William, F. Gordon J. Alexander, Jeffery V.Bailey. (1999) Investments.
International edition. Prentice –Hall International.
Strong, Robert A. (1993). Portfolio Construction, Management and Protection.
Wilmott, Paul (2009). Frequently Asked Questions in Quantitative Finance. 2nd ed.
John Wiley and Sons, Ltd.

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Annex 1.

Definitions of long-term credit ratings

Moody's S&P Fitch Ratings Definition

Aaa AAA AAA Prime. Maximum Safety
Aa1 AA+ AA+ High Grade High Quality
Aa2 AA AA
Aa3 AA- AA-
A1 A+ A+ Upper Medium Grade
A2 A A
A3 A- A-
Baa1 BBB+ BBB+ Lower Medium Grade
Baa2 BBB BBB
Baa3 BBB- BBB-
Ba1 BB+ BB+ Non-Investment Grade
Ba2 BB BB
Ba3 BB- BB-
B1 B+ B+ Highly Speculative
B2 B B
B3 B- B-
Caa1 CCC+ CCC In Poor Standing
Caa2 CCC -
Caa3 CCC- -
Ca CC CC Extremely Speculative
C C C May be in Default
- - DDD Default
- - DD
- D D

Source: Ministry of Finance of the Republic of Lithuania. www.finmin.lt

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