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1.1 & 1.2 REAL VERSUS FINANCIAL ASSETS

MONEY MARKETS & CAPITAL MARKETS

PRIMARY & SECONDARY MARKETS

1.3 & 1.5 MARKETS AND THE ECONOMY

Technical analysis : study of charts, graphs as a proxy for supply demand patterns in securities.

Fundamental analysis : study of company financial statements, forecasts of earnings.

Market efficiency : Informational role of markets.

Rational action by some investors causes mispricing to disappear relatively quickly so that rationality prevails in the aggregate.

Stated differently: prices do deviate from fundamental value, but the deviations are random (slight difference from your text book!).

Behavioral paradigm:

Investors collectively exhibit several biases that may make prices stay away from fundamental values for long periods of time: (markets can stay irrational longer than you can remain solvent).

Overconfidence and optimism. 80% of all drivers feel their driving is above average . Ever met an “average” money manager?

RISK – RETURN TRADEOFF (More in Chapter 5).

1.4 THE INVESTMENT PROCESS

TOP-DOWN or BOTTOM-UP, macro-level, industry-level, company-level. (CFA, mostly fundamental analysis).

Badrinath, Fin 327, 2013-1 of 17

Discuss the San Diego Chapter of the CFA Society. SDSU student teams have won the local CFA Challenge Cup, 2 years in a row. I will be picking a team later this Fall for a 3-peat!

1.4.1 ASSET ALLOCATION --divide money across different asset classes-- stocks/bonds, industry/sector, domestic/international or other. Asset allocation explains 90% of the variability in returns in a fund over time. So how to divide among cash, bonds, stocks etc? One approach is the life-cycle.a) Accumulation: younger workers, higher risksb) Consolidation mid-career, moderate risksc) Spending post-retirement, less risk

Active portfolio management-finding undervalued securities, or passive portfolio management (indexing). Vanguard S&P index trust and Magellan fund, PIMCO’s bond fund.

Casual empiricism is 110- age = % in equities.

Brokerage house typically put out recommended blends (currently about 65% stocks, 25% bonds)

US Stocks and Bonds make up about 60% of the world’stotal. Diversification implies 40% of assets be invested abroad!!

ARE THEY? SHOULD THEY? IS FAMILIAR BETTER?

Is your human capital correlated with stocks? Pension plans of Enron versus Microsoft.

Buy mutual funds ? Over 80% of mutual funds underperform the market. Do you know your funds top holdings ?


Do you have control over when profits are taken ?

1.4.2 INDIVIDUALS VERSUS INSTITUTIONS

Funds are usually fully invested, do individuals have to be?

Buy and hold versus more frequent trading (market timing? )

Value (contrarian) vs. growth (momentum).

Individuals care about absolute performance, institutions tend to be focus on relative performance.

Why pay someone when there are ETF’s? Describe them.

1.6 THE PLAYERS

Investment banks. Mutual funds and hedge funds ($2.7 trillion now). Pension funds: defined benefit,401KBanks and Insurance

Companies: Tend to be in high quality fixed assets, bonds, mortgages and MBS (all mat).

Colleges and foundations

1.6.1 The Macro-environment

Europe out of recession ? US growth slowing? Growth in emerging markets slowing, market performance weak?

US: Monetary policy: what is happening to interest rates ? US: Fiscal policy: Tax changes are likely.

State of financial system?

GDP growth of past years 1-2% driven by stimuli (Fed, tax cuts, deficit spending, housing ATM, not organic.) Most recent


revision was around 1.5%!

Recession or depression? Prospects for economic growth? oil prices ? employment statistics, wage growth (not good).

Implications of housing markets ? Are consumers tapped out? Is business picking up the slack?

1.6.2 RECENT MARKET INDEX HISTORY (also See 5.3, 122-127)

S&P 500 Annual r NDX-100 Annual r Dec-12 Dec-11 1261.12 0.3% 2277.83 2.7%Dec-10 1257.75 12.8% 2217.86 19.3%Dec-09 1115.10 23.5% 1860.30 53.5%Dec-08 903.25 -38.5% 1211.65 -41.9%Dec-07 1468.36 3.5% 2084.93 18.7%Dec-06 1418.30 13.6% 1756.90 6.8%Dec-05 1248.30 3.0% 1645.20 1.5%Dec-04 1211.90 9.0% 1621.10 11.2%Dec-03 1111.92 26.4% 1457.92 48.1%Dec-02 879.82 -23.4% 984.37 -37.6%Dec-01 1148.08 -13.0% 1577.10 -32.7%Dec-00 1320.28 -10.1% 2341.70 -36.8%Dec-99 1469.25 19.5% 3707.83 102.0%Dec-98 1229.23 26.7% 1836.01 85.3%Dec-97 970.43 31.0% 990.83 20.6%Dec-96 740.74 20.3% 821.36 42.5%

Dec-95 615.93 576.23


See long-term charts on website/Bloomberg.

1.6.2 Financial Analysts: (sell side and buy side)

a) issue research reports and recommendations (First Call). Assess financial reports, statements, management teams, strength of customer relationships, product markets. Used to be strong buy, buy, hold, sell, strong sell. Now different gradations. Majority of past recommendations were hold or above. Now a few more sells.b) generate orders for sales forcec) guide institutional clientsd) listen to pitches from investor relations

Tend to have expertise in the industry, work experience, technical knowledge, access to industry insiders.

Quality of analysis, conflicts with investment banking. SEC and Regulation Fair Disclosure (is quality of info better?)

Companies cannot disclose earnings info selectively. What if companies stop talking? Can make the case that it the

latter has actually made markets less efficient.Will it make an analysts job easier or not?

How many companies are followed by analysts. Only 35% of 9000 listed companies have at least one analyst. The rest are not followed.

How many analysts follow a company? GE has 15, Intel has 33, Cognos (that makes business intelligence software) has 36.

How do analysts pick companies to follow? Appears to be trading volume and market cap.

Are analyst recommendations useful to investors? Big upgrades or downgrades affect prices short term (1-2 days)

New initiations affect prices longer term – 30 days New initiations by major firms do not affect prices !!! Monday announcements are rare, but upgrades impact prices


CHAPTER 5: RATES OF RETURN (REVIEW AND MORE) (REFER TO SECTION 5.1) a) Single period (year)

0 1

100 120

HPR = (120-100)/100 = 20% (Tie to PV/FV)

0 1b) with div.

100 120 Div 5

(End Price – Beg. Price + Cash Flow)HPR = ---------------------------------------------

Beg. Price

HPR = (120 –100 + 5)/100 = 25%

= 20% (cap gain) + 5% (div yield)

Cash flow of dividends for stocks, and coupons for bonds.

c) APR (annualized percentage return) and EAR (effective annual rate) APR = per period rate * periods/yr.

Say a T-bill pays $10,000 at maturity in 1 months. Its current price is $9900.

HPR = (10000-9900)/9900 = 1.01%

APR = 1.01 * 12(months) = 12.12%

EAR = (1.01)12 – 1 = 12.82%


d) MULTIPLE PERIODS (YEARS)

0 1 2

100 * (1+ X)2 = 121X = 10% per year

0 1 2

100 108 1218% 12.04%

Total Return = 21% for 2-periods (years)

e) TO AVERAGE 8% and 12.04% RETURNS ABOVE? (P 111)

Arithmetic Average = (8 + 12.04)/2 = 10% Geometric Average = [(1.08) (1.1204)] (1/2) – 1] = 10%When averaging returns over time, use Geometric.

0 1 2

100 50 100-50% +100%

Arith. Avg = 25%Geom Avg = 0% (which is correct).

PV/FV calculations implicitly use the geometric average. f) DOLLAR WEIGHTED-RETURNS (Page 112)

When different amounts are being managed/invested, for different periods of time, then this is just the INTERNAL RATE OF RETURN (IRR).


PRE-TAX & AFTER-TAX RETURNS

Assume a tax rate of 30%.

10% 1 10% 2

100 * ( 1.10) = 110 121- tax = -3

After-tax = 107*(1.10) = 117.70 - tax = 3.21

After-tax = 114.49Together

100 * (1.07 ) = 107 * (1.07) = 114.49

or 10 % pre-tax 10 * (1-tax rate) 7% after tax.

NOTE: Assumption implicit in this calculation is that taxes are paid as you go, i.e, that gains are realized and taxed each year. With mutual funds, the amount to be taxed is determined by the fund at distribution time. For individuals, this may not be appropriate if you are holding stocks long-term.

FULLY EQUIVALENT TAXABLE YIELD (FETY)

A CA bond has a yield of 6%, exempt from both federal taxes (@30%) and state taxes @10%.

To compare this with a corporate bond on which both federal and state taxes apply, calculate FETY as:

6%/(1-0.4) = 10%


TAX LOSS CARRY FORWARDS

Individuals can carry losses forward beyond the $3000 deduction from ordinary income. In addition, firms can also carry it back for 3-years back.

TAX-LOSS SELLING

To sell a losing position in order to realize a loss for tax purposes. If you like the security, you can always buy it back (wait 30 days, else IRS decrees it a “wash” sale and the deduction is disallowed.

Chapter 5.4 NOMINAL AND REAL RATES OF RETURN

0 r = 9%(nominal) 1 |

100 nominal grows at 9% to 109

Cost of “basket” =100 (with 7% inflation) = 107.

At time 1, the $109 purchases 109/107 = 1.0187 “baskets.” So in terms of purchasing power, the 9% return translates into 1.87% more “baskets” with 7% inflation.

1 + nominal rateOr, real rate of return = ------------------------ - 1

1 + inflation rate

= (1 .09)/1.07) – 1 = 0.0187 or 1.87%

Common approximation:Real rate = Nominal rate – Inflation rate


TO INVESTORS, THE REAL, AFTER-TAX RATE OF RETURN IS THE ONE TO CONSIDER.

Key issue pertaining to measuring inflation is components of the Consumer Price Index (CPI). Now about 1-2% per year, different estimates, periodically revised.

TIPS (Treasury Inflation-Protection Securities). (Also Pg 32).

Structured so that face value adjusts with the CPI and the coupon is a fixed percentage of that “changing amount.” So as inflation increases, you get a higher dollar periodic payment. Principal is protected from declines, so it stays constant in a deflationary state.

YIELDS

T-bills sell at a discount from face value. A $10,000 face value bill may be selling at $9,600 with maturity in 182 days (half-year). Or at a discount of $400.

a) The effective 182-day return is 400/9600 = 4.17%b) simple interest => an annual rate of 8.34% (bond equivalent yield)c) With compound interest => an annual rate of (1.0417)2 –1=8.51%

BILLS ARE OFTEN QUOTED IN THE FINANCIAL PAGES AS CARRYING A BANK DISCOUNT YIELD OF 7.91%

The $400 discount is annualized as 400 * 360/182 = 791.21The yield is 791.21/10000 = 7.912%

THERE ARE THREE PROBLEMS WITH THIS.

(i) Annualized over 360 day year (bank calendar?).(ii) Annualizing assumes simple, not compound interest.(iii) Rate is calculated on face value not purchase price.


IRA versus NON-IRA Returns (Not in Ch 5 but useful anyway)

Purpose is to illustrate time-value calculations. There are lots of wrinkles and variations, Roths, Education IRAs and the like. Rules for the tax-free amounts investable depend on income. For details, check out any personal finance website.

Assume you have a single sum of $ 2000 to invest Invest at 12% per year for 25 years until retirement Tax rate is 30% now, 15% after 25 years

Under IRA: Principal and income are both taxed at retirement.

FV = 2000 * (1.12)25 = 34,000Less: Tax = -5,100After-tax value = 28,900

Outside the IRA: Both principal and income taxed each year.

FV = [2000 * (1-0.3)] * [1+ 0.12*(1-0.3)]25 = 1400 * (1+0.084)25 = 10516.23 (After-tax)

Q: What rate of return should be earned outside the IRA to make the two after-tax values comparable?

1400 * (1+X)25 = 28,900, X = 12.87% after-taxThis implies 12.87/(1-0.3) = 18.39% pre-tax returns.To be comparable to an IRA, an investment outside it should earn 18.39% (as opposed to 12%)

Q: What type of investment vehicles should be in an IRA?Stocks, bonds, municipal bonds?

A: Bonds throw off taxable income semi-annually.Stocks have tax implications only if gains are realized.


A SIMPLE RETIREMENT SCENARIO

30 WORK (r = 10%) 65 RETIRE (r=6%) 85

INCOME = $50,000/yr CONSUME=$40,000/yr

Q: How much to save each year ? Say S. S * FV(ann) (35yrs, 10%) = 458797 = 40000 * PV(ann) (20yrs, 6%)

S = 1693/yr or 1693/50000 = 3.3% of income!

Q: TOO LITTLE?

Q: SAY, inflation is 3% per year over the next 55 years. What does $40,000 in year 85 buy?

[40000 / {(1.03)55 }]= 7870 of things in today’s dollars.

Note that $40,000 is nominal and $7870 are REAL (or inflation-adjusted) dollars.

ISSUES:a) Life expectancyb) Inflation Adjustmentc) Redo in real terms? d) Other Savingse) Fidelity/Vanguard Software, moneycentral.com,

quicken.com, Torrid-tech.com, esplanner.com, wealthwhen.com


Chapter 5.2: EXPECTED RETURNS = sum of (probabilities & possible returns)

Prob. Possible Return (over next year)

0.5 50%0.3 10%0.4 –20%

Exp. Return = 0.5 * 50% + 0.3 * 10% + 0.2 * -20% = 24%Standard deviation = 28%, link to Normal Distribution

RISK Business Risk Financial Risk Exchange rate/Country risks Systematic and unsystematic risks

RISK AND EXPECTED RETURNSTANDARD MODEL (CAPM) E(return)

SML (CAPM)

Risk (beta)

E(Rj) = Rf + [E(Rm)-Rf] * j = 2 + 6 j

Slope of line = 6 reward per unit risk

Intercept of line = risk free rate = 2%


WHERE DOES THIS COME FROM?

Asset Current Expected Beta Risk/rewardPrice Return E(R ) [E(R )- Rf]/Beta

A 15 14% 1.5 6.67

B 50 12% 1.0 8.00

Rf 4% 0.0 0

For A, the expected return of 14% from current price levels implies an expected future price of $17.1

For B, expected return of 12% => expected future price of $56

Case(i): Suppose B is priced correctly with a risk-reward of 8.

=> A is priced incorrectly. Investors will buy B, those owning A will sell it and move to B until A’s risk-reward is same as B. => A’s price will fall and its expected return will rise. => For A therefore, [E(R ) – 4]/1.5 = 8, E(R ) = 16% (increases)=> New Price (1.16) = 17.1, New Price for A = 14.74

Case (ii): Suppose instead that A is priced correctly. Then B is undervalued and its price will increase to 50.601, its expected return will drop to 10.67% and its risk-reward ratio will be 6.67. Confirm it!

Often, both can happen especially if the market risk-reward is 7 (say). The example illustrates a process of how assets get priced and repriced in markets.


The message is that prices will (should) move this way to equate risk/reward ratios across all assets. Or, prices should be set so that the risk/reward ratio for all assets are equal.

Here the risk-reward ratio has a specific form and using it,[E(Rj) – Rf]/j = [E(Rm) – Rf]/1.0 = 8, Rearranging:

E(Rj) = Rf + j [E(Rm) – Rf] or the CAPM.

In life, the risk-reward is probably more complicated than that assumed for the CAPM and other models for valuing assets exist.

ISSUES: a) How is beta estimated? Is the slope from a regression of returns to stock on returns to broad market index. Available from multiple published sources and beta books.

b) What about a stock that plots above the CAPM line (actual returns end up higher than expected => price was lower than expected => undervalued => positive alpha).

c) Assumes that only market factor (index) matters and that other risks are priced away. How good is such a model?

d) What does it mean to outperform the market?

Money managers think in terms of beating the S&P 500 (is this risk-adjusted ? shouldn’t it be? )

e) Do higher risks imply higher expected returns Do they? Over what time period? Only in January? Is the relationship linear?

f) Think it terms of risk-premiums [E(Rj) – Rf]What is an appropriate level for the market nowadays?


FROM A PRACTICAL PERSPECTIVE, A VERSION OF THE 2nd TERM IN THE CAPM is called the Sharpe ratio, as

= [E(Rj) – Rf ] / σj where j is any asset or portfolio and is used (and much abused) as a reward-to-variability ratio.

IGNORE SECTIONS 5.5 and 5.6 FOR NOW.


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