FIN221: Lecture One Notes. Understanding Investments. Objectives. Investments Defined. Investment Decisions. Why Study Investments?

Transcription

1 FIN221: Lecture One Notes Understanding Investments Chapters 1, 2, and 3 Chapter 1 Charles P. Jones, Investments: Analysis and Management, Eighth Edition, John Wiley & Sons Prepared by G.D. Koppenhaver, Iowa State University Objectives To understand the investments field as currently practiced To help you make investment decisions that will enhance your economic welfare To create realistic expectations about the outcome of investment decisions Investments Defined Investments is the study of the process of committing funds to one or more assets Emphasis on holding financial assets and marketable securities Concepts also apply to real assets Foreign financial assets should not be ignored Why Study Investments? Most individuals make investment decisions sometime Need sound framework for managing and increasing wealth Essential part of a career in the field Security analyst, portfolio manager, registered representative, Certified Financial Planner, Chartered Financial Analyst Investment Decisions Underlying investment decisions: the tradeoff between expected return and risk Expected return is not usually the same as realized return Risk: the possibility that the realized return will be different than the expected return

2 The Tradeoff Between ER and Risk Investors manage risk at a cost - lower expected returns (ER) Any level of expected return and risk can be attained ER Bonds Risk-free Rate Risk Stocks The Investment Decision Process Two-step process: Security analysis and valuation Necessary to understand security characteristics Portfolio management Selected securities viewed as a single unit How and when should it be revised? How should portfolio performance be measured? Factors Affecting the Process Uncertainty in ex post returns dominates decision process Future unknown and must be estimated Foreign financial assets: opportunity to enhance return or reduce risk Institutional investors important How efficient are financial markets in processing new information? The Rise of the Internet Revolutionized the flow of investment information Dramatically lowered commission rates for individual investors Copyright 2002 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by use of these programs or from the use of the information contained herein. CHAPTER 2 INVESTMENT ALTERNATIVES

3 ORGANIZATION MONEY MARKET SECURITIES DIRECT INVESTING Debt Securities Equity Securities Other Securities INDIRECT INVESTING Investment Companies Mutual Funds Closed-end Funds Unit Investment Trusts Exchange-Traded Funds (ETFs) Treasury Bills Negotiable Certificates of Deposit Commercial Paper Repurchase Agreements Bankers Acceptances others DEBT SECURITIES TYPES OF BONDS Money Market short maturities high quality large denominations pays current going rates for short-term securities Capital Markets maturities greater than one year range of quality as measured by bond ratings various characteristics as to callability, tax status, retirement of debt, secured or not Federal government Government Agencies Municipals Corporates Default free some part of government, some not generally exempt from federal taxes need taxable equivalent yield are rated by rating agencies ASSET-BACKED SECURITIES Securitization--the transformation of illiquid, risky individual loans into more liquid, less risky securites produces Asset- Backed Securities Many different types of loans have been transformed--mortgages, credit card receivables, boat receivables, etc. higher risk, higher return EQUITY SECURITIES Equity securities represent ownership, while debt securities are creditor instruments Two types of equity securities common stock--the basic ownership of the corporation preferred stock--technically an equity security; it has no maturity debt although it may be retired by call, convertibility, etc.

4 PREFERRED STOCK Hybrid Security like common stock, has no maturity date like a bond, pays a fixed dividend Relatively small supply--therefore, relatively unimportant Dividends on the preferred are not deductible for the corporation Most investors treat it as a substitute for bonds COMMON STOCK Represents the ownership of the corporation Stockholders are the residual claimant-- they get what is left after the bondholders and preferred stockholders have been paid Therefore, payoffs can be large or small Risk is large because of the uncertain payoffs COMMON STOCKHOLDERS Stockholders can benefit directly from a common stock in only two ways: dividends--the cash payments of the corporation. A firm has no obligation. Dividends can be raised, lowered, or suspended price change--the difference between purchase price and sale price. This can be +, -, or 0 therefore, stock returns can be positive, negative or zero A NOTE ON DIVIDENDS Dividend yield (dividend divided by price) is one of the two components of Total Return for stockholders Dividend yield on the S&P 500 is at an alltime low ( ) of about 1.4% If the dividend yield remains this low, and stockholders expect to receive the same Total Returns, how can this happen? IMPORTANT TERMS WITH STOCKS Dividend Yield--annual dividend divided by current stock price Payout Ratio--the ratio of dividends to earnings (the percentage of earnings paid out as dividends) P/E Ratio--the number of times earnings that investors are willing to pay for a stock, used in valuation of stocks OTHER SECURITIES Derivative Securities derive their value from their connected underlying securities Options--typically, puts and calls; the right but not the obligation to buy or sell an asset Futures Contracts--available for financial assets; carry an obligation to act, but can be offset by taking the opposite position

5 PUTS AND CALLS Call--the right to buy 100 shares of an asset at a stated price within a stated time Put--the right to sell 100 shares of an asset at a stated price within a stated time These options have short maturities of up to a few months--therefore, they are wasting assets LEAPs have longer maturities, up to three years PUTS AND CALLS Puts and Calls are bought by investors who think prices will move in a certain direction, and are sold by investors with opposite beliefs The premium is paid by the buyer, and received by the seller. Both pay brokerage costs Options trade on organized exchanges FUTURES CONTRACTS Available on commodities and on financial assets They are agreements providing for the future exchange of a particular asset between buyer and seller Margin must be put up to ensure performance--a small percentage of the value of the contract FUTURES CONTRACTS Are standarized and trade on organized exchanges Most are not exercised--they are offset by taking the opposite position Most participants are either hedgers or speculators hedging--seek to reduce price uncertainty speculate--seek to profit from the uncertainty HOUSEHOLDS CHAPTER 3 INVESTMENT COMPANIES Households have opted more and more for indirect investing in pension fund assets in investment companies, primarily mutual funds Indirect investing involves turning one s funds over to an intermediary to invest Investors can invest directly, invest indirectly, or do a combination

6 INVESTMENT COMPANIES Definition--a financial services organization that sells shares in itself and uses the funds to invest in a portfolio of securites Three types: open-end investment companies--mutual funds closed-end investment companies unit investment trusts CLOSED-END INVESTMENT COMPANIES Trade on Exchanges like other stocks Are relatively few in number, with relatively small total assets Include various types of equity and bond funds Almost always sell at discounts and premiums rather than at NAV per share MUTUAL FUNDS Technically, mutual funds are open-end investment companies because the number of its own shares outstanding is constantly changing Investors buy from and sell back to the investment company itself As of August, 2001 there were about 8300 mutual funds in the United States MAJOR TYPES OF MUTUAL FUNDS Money Market Funds--invest in money market securities such as Treasury bills, commercial paper, and negotiable CDs Equity and Bond & Income Funds--invest in portfolios of stocks or bonds, or in the case of balanced funds, both. There are various types of stock funds as well as bond funds (short or long-term, taxable or not) NET ASSET VALUE SALES CHARGES Each investment company has a Net Asset Value (NAV) per share It is calculated as the value of the securities in the portfolio, less any liabilities, divided by the number of shares of the fund outstanding Therefore, it is the per share value of the portfolio of securities NO-LOAD no sales charge LOW LOAD low sales charge, such as 2-3% LOAD sales charge currently, maximum of 5 to 6%

7 ADDITIONAL COSTS The load fee is the sales charge, primarily used to compensate the sales force The fund may charge a 12b-1 fee, as much as 1% of assets annually, to cover distribution costs Class B and Class C shares can carry a redemption fee SHARE CLASSES Many funds have at least three classes of shares, referred to as A, B and C A shares are the norm, carrying a load fee B shares carry no load, but have a redemption charge that declines over 5 or 6 years for investors redeeming shares early C shares have a redemption charge for one year but an annual 12b-1 fee of maybe 1% OPERATING EXPENSE RATIO Unless waived for marketing reasons, all funds charge an annual operating expense for managing the fund. This cost is calculated as a percentage of average assets under management The average for equity funds is about 1.4%, for bond funds perhaps 1%, and for money market funds less than 1% MEASURING FUND PERFORMANCE Cumulative Total Return measures the actual cumulative performance over some period of time, such as 3, 5 or 10 years Average Annual Return is the compound rate that if achieved annually would have produced the same cumulative total return (this is a compound annual return, not the actual returns of the fund each year) INDEX FUNDS Index Funds are designed to replicate some market index or benchmark, with no active management Costs are very low because no research or active management is needed Vanguard s Index 500 fund is now the largest mutual fund in the United States FUND PERFORMANCE Fund performance has been often debated as to consistency and actual results Many comparisons indicate that a majority of mutual funds do not outperform the proper benchmark such as the S&P 500 Given an annual average expense ratio of 1.4%, equity funds must earn more than that plus the benchmark return to add value

8 INVESTING INTERNATIONALLY International funds concentrate primarily on international stocks Global funds keep a significant portion of assets in U. S. stocks Single-country funds concentrate on the securities of a single country Investing internationally exposes investors to currency risk (exchange-rate risk) FUND SUPERMARKETS Some large brokerage firms like Schwab and Fidelity offer fund supermarkets. Investors can buy a variety of funds through their brokerage accounts, meaning they do it all in one account.