Analysis of Investments and

Management of Portfolios
by
by Keith
Keith C.
C. Brown
Brown && Frank
Frank K.
K. Reilly
Reilly

Selecting Investments
in a Global Market
–The Case for Global Investments
–Global Investment Choices
Chapter 3

–Historical Risk-Returns on Alternative

Investments
 Important Terminologies
Reasons for Global Investment, Risk Diversification,
Investment Choices, Fixed-Income Investments,
Equity and Special Equity Investments, Futures
Contracts, Investment in Investment Companies, Real
Assets, Low Liquidity Investments, etc.

Video Link: https://www.youtube.com/watch?

v=RB7ZbujJlY8

3-2
 Growing Investment Opportunities

• More investment instruments available in the

financial markets as a results of technological
advances and new regulations
• Ability to invest from a global perspective
thanks to the globalization or integration of
domestic and foreign financial markets
• Investment vehicles with a variety of maturities,
risk-return characteristics, and cash flow
patterns being spawned due to competition
and deregulations in the financial sector

3-3
 The Case for Global Investments

• Three reasons investors (U.S./Japanes)

should think of constructing global investment
portfolios
– Ignoring foreign markets can substantially reduce
the investment choices for U.S./Japanese investors
– The rates of return on non-U.S.//Japanese
securities often have substantially exceeded those
for U.S.-only/Japanese only securities
– The low correlation between U.S.//Japanese stock
markets and many foreign markets can help to
substantially reduce portfolio risk

3-4
 The Case for Global Investments
• Relative Size of U.S. Financial Markets
– Overall value of the securities available in world
capital market has increased from $2.3 Trillion in
1969 to $103 Trillion in 2006 and the U.S. portion
has declined to less than half.
– The share of the U.S. in world stock and bond
markets has dropped from about 65 percent of the
total in 1969 to about 46 percent in 2006.
– The growing importance of foreign securities in
world capital markets is likely to continue.
– Exhibit 3.1 shows the breakdown of securities in
the global capital market.
3-5
 Exhibit 3.1

3-6
 The Case for Global Investments
• Rates of Return on U.S. and Foreign Securities
– Global Bond-Market Return:
• From 1999–2007, the return performance of the U.S.
bond market ranked fifth out of the six countries when
the returns are measured in U.S. dollar.
• The better performance of the non-U.S. markets is
partly due to the weakened dollar in this time frame
• See Exhibit 3.2
– Global Equity-Market Return
• From 2003 through 2006, the United States’ average
rank in annual return measured in U.S. dollar was
29.5 out of 34 countries.

3-7
 Exhibit 3.2

3-8
 The Case for Global Investments
• Risk of Combined Country Investments
– Diversification with foreign securities can help reduce
portfolio risk because foreign markets have low
correlation with U.S. capital markets.
– The correlation of returns between a single pair of
countries changes over time because the factors
influencing the correlation change over time.
– Diversified portfolios reduce variability of returns over
time.
– Correlation coefficients measure diversification
contribution.

3-9
 The Case for Global Investments
• Global Bond Portfolio Risk
– Low positive correlation (Exhibit 3.4)
• For a U.S. investor, the average correlation between
foreign bond return and U.S. bond return in U.S. dollars
is about 0.63 from 1988 to 2006.
• The U.S.–Canada correlation is 0.74, whereas the U.S.–
Japan correlation is only 0.38.
– Opportunities for U.S. investors to reduce risk
– Correlation changes over time
– Adding non-correlated foreign bonds to a portfolio of
U.S. bonds increases the rate of return and reduces
the risk of the portfolio. (Exhibit 3.5)
3-10
 Exhibit 3.4

3-11
 Exhibit 3.5

3-12
 The Case for Global Investments
• Global Equity Portfolio Risk
– Low positive correlation (Exhibit 3.6)
• The correlation of world equity markets resembles
that for bonds; however, the average correlation
between U.S. and foreign markets is about 0.56,
lower than that for bonds from 1988 to 2006.
• Again, the U.S.–Canada correlation is 0.73, whereas
the U.S.–Japan correlation is only 0.34.
– Opportunities to reduce risk of a stock portfolio by
including foreign stocks, as illustrated in Exhibit 3.7.

3-13
 Exhibit 3.6

3-14
 Exhibit 3.7

3-15
 Global Investment Choices
• Fixed-Income Investments
– Bonds and preferred stocks
• Equity Investments
• Special Equity Instruments
– Warrants and options
• Futures Contracts
• Investment Companies
• Real Assets
• Low Liquidity Investments

3-16
 Fixed-Income Investments
• Basic concepts of fixed-income investments
– Contractual payment schedule
– Recourse varies by instrument
– Bonds
• Investors are lenders
• Expect interest payment and return of principal
– Preferred stocks
• Dividends require board of directors approval

3-17
 Fixed-Income Investments
• Savings Accounts
– Fixed earnings
– Convenient
– Liquid and low risk
– Low rates
– Certificates of Deposit (CDs)
– Money Market Certificates
• Compete against Treasury bills (T-bills)
• Minimum $10,000
• Minimum maturity of six months
• Redeemable only at bank of issue
• Penalty if withdrawn before maturity
3-18
 Capital Market Instruments
• Fixed income obligations that trade in
secondary market
• U.S. Treasury securities
• U.S. Government agency securities
• Municipal bonds
• Corporate bonds
– Secured bonds
– Debentures
– Subordinated bonds
– Income bonds
– Convertible bonds
3-19
 U.S. Treasury Securities
• Issued by the U.S. Treasury
• Depending on the maturity, they are:
– Bills with a maturity less than 1 year
– Notes with a maturity in 1 - 10 years
– Bonds with a maturity over 10 years
• Highly liquid
• Essentially free of credit risk: They are
backed by the full faith and credit of the U.S.
Government

3-20
 U.S. Government Agency Securities
• Sold by government agencies
– Federal National Mortgage Association (FNMA or
Fannie Mae)
– Federal Home Loan Bank (FHLB)
– Government National Mortgage Association
(GNMA or Ginnie Mae)
– Federal Housing Administration (FHA)
• Not direct obligations of the Treasury
– Still considered almost default-free and fairly
liquid

3-21
 Municipal Bonds
• Issued by state and local governments
usually to finance infrastructural projects.
• Exempt from taxation by the federal
government and by the state that issued the
bond, provided the investor is a resident of
that state.
• Two types:
– General obligation bonds (GOs)
– Revenue bonds

3-22
 Corporate Bonds
• Basic Concepts
– Issued by a corporation
– Fixed income
– Credit quality measured by ratings
– Maturity
– Features
• Indenture
• Call provision
• Sinking fund
– Seniority categories

3-23
 Corporate Bonds
• Secured bonds
– Senior secured bonds
• Most senior bonds in capital structure and have the
lowest risk of default
– Mortgage bonds
• Secured by liens on specific assets
– Collateral trust bonds
• Secured by financial assets
– Equipment trust certificates
• Secured by transportation equipment

3-24
 Corporate Bonds
• Debentures
– Unsecured promises to pay interest and principal
– In case of default, debenture owner can force
bankruptcy and claim any unpledged assets to
pay off the bonds
• Subordinated bonds
– Unsecured like debentures, but holders of these
bonds may claim assets after senior secured and
debenture holders claims have been satisfied

3-25
 Corporate Bonds
• Income bonds
– Interest payment contingent upon earning
sufficient income
– If subsequently earned, it must be paid off
– Riskier than debenture bonds
• Convertible bonds
– Offer the upside potential of common stock and
the downside protection of a bond
– Usually have lower interest rates

3-26
 Corporate Bonds

• Warrants
– Allows bondholder to purchase the firm’s common
stock at a fixed price for a given time period
– Interest rates usually lower on bonds with
warrants attached
• Zero coupon bond
– Offered at a deep discount from the face value
– No interest during the life of the bond, only the
principal payment at maturity

3-27
 Preferred Stock
• Hybrid security
• Fixed dividends
• Dividend obligations are not legally binding,
but must be voted on by the board of
directors to be paid
• Most preferred stock is cumulative
• Credit implications of missing dividends
• Corporations may exclude 80% of dividend
income from taxable income

3-28
 International Bond Investing
• Investors should be aware that there is a very
substantial fixed income market outside the
United States that offers additional opportunity
for diversification and returns.
• Bond identification characteristics
– Country of origin
– Location of primary trading market
– Home country of the major buyers
– Currency of the security denomination

3-29
 International Bond Investing

• Eurobond
– An international bond denominated in a currency other than
the country where it is issued
• Yankee bonds
– Sold in the United States and denominated is U.S. dollars,
but issued by foreign corporations or governments
– Eliminates exchange risk to U.S. investors
– Matadors, Bulldogs, Rembrandts, and Samurais are
foreign bonds issued in the United Kingdom, Spain, the
Netherlands and Japan, respectively.
• International domestic bonds
– Sold by issuer within its own country in that country’s
currency
3-30
 Equity Investments
• Common Stock
– Represents ownership of a firm
– Investor’s return tied to the performance of the
company and may result in loss or gain
• Common Stock Classifications
– Industrial: manufacturers of automobiles,
machinery, chemicals, beverages
– Utilities: electrical power companies, gas suppliers,
water industry
– Transportation: airlines, truck lines, railroads
– Financial: banks, savings and loans, credit unions

3-31
 Acquiring Foreign Equities
• American Depository Receipts (ADRs)
– Easiest way to directly acquire foreign shares
– Certificates of ownership issued by a U.S. bank
that represents indirect ownership of a certain
number of shares of a specific foreign firm on
deposit in a U.S. bank in the firm’s home country
– Buy and sell in U.S. dollars
– Dividends in U.S. dollars
– May represent multiple shares
– Listed on U.S. exchanges
– Very popular

3-32
 Acquiring Foreign Equities
• Purchase of American Shares
– Issued in the United States by transfer agent on
behalf of a foreign firm
– Higher expenses
– Limited availability
• Direct Purchase of Foreign Shares
– In the foreign firms’ own country
– Listed on a foreign stock exchange outside the
home country (e.g., French firms on LSE)
– Listed on a U.S. stock exchange

3-33
 Acquiring Foreign Equities
• Global Mutual Funds or Exchange-Traded
Funds (ETFs)
– Global funds: Invest in both U.S. and foreign
stocks
– International funds: Invest mostly outside the U.S.
– Funds can specialize
• Diversification across many countries
• Concentrate in a segment of the world
• Concentrate in a specific country
• Concentrate in types of markets
– Exchange-traded funds or ETFs are a recent
innovation in the world of index products
3-34
 Special Equity Instruments: Options
• These are equity-derivative securities which
have a claim on the common stock of a firm.
• Options are rights to buy or sell common stock
or other underlying assets at a stated price for
a period of time.
– Puts are options to sell
– Calls are options to buy
• Warrants
– An options issued by a company giving the holders
the right to buy its common stock
– Normally issued with bonds

3-35
 Futures Contracts
• Exchange of a particular asset at a specified
delivery date for a stated price paid at the
time of delivery
• Deposit (10% margin) is made by buyer at
contract to protect the seller
• Commodities trading is largely in futures
contracts
• Current price depends on expectations

3-36
 Futures Contracts
• Financial Futures
– Recent development of contracts on financial
instruments such as T-bills, Treasury bonds, and
Eurobonds
– Traded mostly on Chicago Mercantile Exchange
(CME) and Chicago Board of Trade (CBOT)
– Allow investors and portfolio managers to protect
against volatile interest rates
– Currency futures allow protection against changes
in exchange rates
– Various stock futures on market indexes such as
the S&P 500 and Value Line Index
3-37
 Investment Companies
• Rather than buy individual securities directly
from the issuer they can be acquired
indirectly through shares in an investment
company
• Investment companies sell shares in itself
and uses proceeds to buy securities
• Investors own part of the portfolio of
investments

3-38
 Investment Companies
• Money Market Funds
– Acquire high-quality, short-term investments
– Yields are higher than normal bank CDs
– Typical minimum investment is $1,000
– No sales commission charges
– Withdrawal is by check with no penalty
– Investments usually are not insured
– The total value of these funds reached more than
$2.5 trillion in 2007

3-39
 Investment Companies
• Bond Funds
– Invest in long-term government, corporate, or
municipal bonds
– Bond funds vary in bond quality from the risk-free
government bonds to the high-yield or junk bonds
– Expected returns also differ reflecting the risk
level of bonds in the fund

3-40
 Investment Companies
• Common Stock Funds
– Many different funds with varying stated
investment objectives
• Aggressive growth, income, precious metals,
international stocks
– Offer diversification to smaller investors
– Sector funds concentrate in an industry
– International funds invest outside the United
States
– Global funds invest in the U.S. and other
countries

3-41
 Investment Companies
• Balanced Funds
– Invest in a combination of stocks and bonds
depending on their stated objectives
• Index Funds
– These are mutual funds created to track the
performance of a market index like the S&P 500
– Appeal to passive investors who want to simply
experience returns equal to some market index
– Numerous non-stock indexes including various
bond indexes have been created

3-42
 Investment Companies
• Exchange-Traded Funds (ETFs)
– These are depository receipts for a portfolio of
securities deposited at a financial institution in a
unit trust that issues a certificate of ownership for
the portfolio of stocks
– The stocks in a portfolio are those in an index like
the S&P 500 and dozens of country or industry
indexes
– ETFs can be bought and sold continuously on an
exchange like common stock

3-43
 Real Estate
• Real Estate Investment Trusts (REITs)
– Investment fund that invests in a variety of real
estate properties, similar to a stock or bond
mutual fund
– Construction and development trusts provide
builders with construction financing
– Mortgage trusts provide long-term financing for
properties
– Equity trusts own various income-producing
properties

3-44
 Real Estate
• Direct Real Estate Investment
– Purchase of a home
– Purchase of raw land
• Intention of selling in future for a profit
• Ownership provides a negative cash flow due to
mortgage payments, taxes, and property
maintenance
– Land Development
• Divide the land into individual lots
• Build houses or a shopping mall on it
• Requires capital, time, and expertise
3-45
 Real Estate

• Rental Property
– Acquire apartment buildings or houses with low
down payments
– Derive enough income from the rents to pay the
expenses of the structure, including the mortgage
payments, and generate a good return
– Rental property provides a cash flow and an
opportunity to profit from the sale of the property

3-46
 Low-Liquidity Investments
• Basic Concepts
– Some investments don’t trade on securities
markets
– Lack of liquidity keeps many investors away
– Auction sales create wide fluctuations in prices
– Without notional markets, dealers incur high
transaction costs
– Some may consider them more as hobbies than
investments

3-47
 Low-Liquidity Investments
• Antiques
– Dealers buy at estate sales, refurbish, and sell
at a profit
– Serious collectors may enjoy good returns
– Individuals buying a few pieces to decorate a
home may have difficulty overcoming
transaction costs to ever enjoy a profit them
more as hobbies than investments

3-48
 Low-Liquidity Investments
• Art
– Investment requires substantial knowledge of art
and the art world
– Acquisition of work from a well-known artist
requires large capital commitments and patience
– High transaction costs
– Uncertainty and illiquidity

3-49
 Low-Liquidity Investments
• Coins and Stamps
– Enjoyed by many as hobby and as an
investment
– Market is more fragmented than stock market,
but more liquid than art and antiques markets
– Price lists are published weekly and monthly
– Grading specifications aid sales
– Wide spread between bid and ask prices

3-50
 Low-Liquidity Investments
• Diamonds
– Can be illiquid
– Grading determines value, but is subjective
– Investment-grade gems require substantial
investments
– No positive cash flow until sold
– Costs of insurance, storage, and appraisal

3-51
Historical Risk-Returns on Investments
• World Portfolio Performance
– Reilly and Wright (2004) examined the
performance of various investment alternatives
from the United States, Canada, Europe, Japan,
and the emerging markets for the period 1980-
2001, as shown in Exhibit 3.8
– Asset Returns and Total Risk
• The expected relationship between annual rates of
return and total risk (standard deviation) of these
securities was confirmed

3-52
Historical Risk-Returns on Investments
– Return and Systematic Risk
• The systematic risk measure (beta) did a better job
of explaining the returns during the period than did
the total risk measure
• The beta risk measure that used the Brinson index
as a market proxy was somewhat better than the
beta that used the S&P 500 Index
• See Exhibit 3.9
– Correlations between Asset Returns
• U.S. equities have a reasonably high correlation with
Canadian and U.K. stocks but low correlation with
emerging market stocks and Japanese stocks
• U.S. equities show almost zero correlation with world
government bonds, except U.S. bonds
3-53
 Exhibit 3.9

3-54
Historical Risk-Returns on Investments
• Art and Antiques
– Market data is limited
– Results vary widely, and change over time, making
generalization impossible, but showing a
reasonably consistent relationship between risk
and return
– Correlation coefficients vary widely, allowing for
great diversification potential
– Liquidity is still a concern

3-55
Historical Risk-Returns on Investments
• Real Estate
– Returns are difficult to derive due to lack of data
– Residential shows lower risk and return than
commercial real estate
– REITs have shown higher returns with lower risk
than stock in short-term but lower return with lower
risk than stock in long-term
– Negative correlation between residential and farm
real estate and stocks
– Low positive correlation between commercial real
estate and stocks
– Potential for diversification
3-56
 The Internet Investments Online

• http://www.site-by-site.com
• http://www.moneycafe.com
• http://www.emgmkts.com
• http://www.law.duke.edu/globalmark
• http://www.lebenthal.com
• http://www.sothebys.com

3-57