4 July 2008

Investment Management
4 July 2008

Investment Defined
Commitment of funds for a period of time in order to derive future payments Future payments must compensate the investor for:
1. Time the funds are committed 2. Expected rate of inflation 3. Uncertainty of future payments

1. Time the funds are committed

Those who defer consumption expect to receive a greater amount than they gave up Those who consume more than their current income must be willing to pay back more than they borrowed This gives rise to an interest rate referred to as the pure time value of money Real Risk Free Rate (RRFR)

2. Expected Rate of Inflation

Nominal Risk Free Rate (NRFR) NRFR = (1 + RRFR) x (1 + Expected Inflation Rate) -1 Determinants:
Expected Rate of Inflation Ease/Tightness in the Capital Market

Yield of short dated government bonds of the currency in question (e.g. 3 Month US Treasury Bill)
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3. Uncertainty of Future Payments

Investors must be paid to assume risk They require a higher rate of return if they perceive uncertainty in the expected rate of return The difference between the required rate of return for an asset and the economys NRFR is the assets Risk Premium (RP)

Security Market Line (SML)

Reflects the combination of risk and return available on all assets at a given time
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Security Market Line

Overvalued and Undervalued Assets Shift of an asset along the SML due to change in its risk-return characteristics Shift in the SML due to a change in NRFR

Tilt in the SML due to a change in investors attitude towards risk

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Yield (%) of 2 Different Bonds vs. Time

3M LIBOR

3M US Government Bond Yield (NRFR) An expected loosening in

monetary policy led to an increased demand for short dated government bonds while risk aversion led to a rise in 3M LIBOR

Yield Spread (3M Corporate Bond RP)

Sub-Prime Mortgage Crisis caused increased risk aversion and thus a higher RP

Assets on the SML

Certificates of Deposit Bonds Equities Investment Trusts Structured Products Derivatives

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Assets on the SML

Certificates of Deposit

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Certificates of Deposit
Tenure usually between 1 and 36 months Virtually Risk-free Fixed Interest Rate Larger Principle, Higher Interest Rate Mimics Yield Curve Specific Currency Withdrawals before maturity are subject to a penalty
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Assets on the SML

Bonds

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Bonds - Overview
An IOU given by a borrower (the issuer) to a lender (the investor) Issuers:
Government (Sovereign Bonds) Firms (Corporate Bonds)

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Bonds - Terms
Face Value: amount received upon maturity Maturity: date on which the Face Value will be repaid Coupon Rate: amount received in a period of 1 year, expressed as a percentage of the Face Value.
Notes & Bonds: Usually, Coupons are paid semi-annually Bills: No Coupon Payment. They are Zero Coupon Bonds

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Bonds - Terms
Price: The bonds market price in $ per $100 Face Value
Price is determined by demand and supply for the bond.

Yield to Maturity (YTM): Internal Rate of Return (IRR) per year of holding the bond to maturity
Depends solely on Bond Price Usually Inversely Related to Price

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Bonds - Terms
Price vs. Face Value Yield vs. Coupon Rate Maturity vs. Duration
Measure of the sensitivity of a bonds price to changes in its yield Duration = % change in price / change in yield Duration has a unit of years Macaulay Duration = Weighted average no. of years to receive each cash flow. Weight of a cash flow = its present value/bond price.
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Bonds - Risks
Credit and Default Risk Interest Rate Risk

Liquidity Risk
Reinvestment Risk & Call Risk (for Callable Bonds only)
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Bonds Pros & Cons

Reliable stream of Income Relatively Low Risk No Potential for Capital Appreciation Returns underperform stocks in the long run

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Assets on the SML

Equities

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Equities - Overview
Common Stock Share of ownership in a corporation

Carries voting rights (no. of votes is proportional to the no. of shares owned) Traded in the Secondary Market (Stock Market) or in the Primary Market (Initial Public Offering)
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Equities - Terms
Bid and Offer Price Volume Market Capitalization Earnings per Share (EPS) Price/Earnings Ratio (P/E) Dividend Yield Short Selling Margin Financing
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Equities Market Indices

Price weighted, Value weighted or unweighted Allows investors to watch aggregate market movements Used as a benchmark to grade an investors or fund managers performance Examples:
Dow Jones Industrial Average FT Straits Times Index NASDAQ 100 Stock Index MSCI World
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Equities - Risks
Business Risk Financial Risk (Leverage) Country Risk Exchange Rate Risk Many other Fundamental sources of Unsystematic Risk

In a Diversified Portfolio, all the above is represented by one statistical risk measure: Systematic Risk (Beta)
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Equities - Beta
Diversification involves owning many stocks with low correlations with one another Diversification virtually eliminates unsystematic risk However, a portfolio of diversified stocks tend to be highly correlated to the broader market Thus, some risk remains after diversification. This is know as Systematic Risk.

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Equities - Beta
Implication: Even if your portfolio is diversified, it will still move with the broader market In such a portfolio, the only important risk measure for each stock is its sensitivity to movements in the broader market Such sensitivity is represented by the stocks Beta Beta = % Change in stock price / % Change in Market Index Beta Sensitivity Volatility Risk
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Jewelry Company (Tiffany & Co.)

Soap Company (P&G)

Broad Market (DJIA)

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Equities Pros & Cons

Outperform Bonds in the long run
In the US, equity returns beat bonds in 82% of 5y periods, 88% of 10y periods and 100% of 20y periods US equities returned an annualized 11.8% per annum over the last 30 years

High Potential for Capital Appreciation Some stocks provide significant income Volatile Requires a long investment time horizon
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Assets on the SML

Investment Trusts

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Investment Trusts - Overview

Real Estate Investment Trust (REIT)
Ownership of a share in a fund which invests in properties Receive periodic payouts due to rental income earned by the REIT Potential for Capital Appreciation Trades like a stock on stock exchanges E.g. Suntec REIT

Business Trusts
E.g. First Ship Lease
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Investment Trusts Pros & Cons

Exposure to Real Estate market with a small amount of money A source of Income

Volatile, much like stocks

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Assets on the SML

Structured Products

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Structured Products
Packaged investment products. Includes:
Financial Assets Financial Derivatives

Returns can be made to depend on:

Single stocks, bonds or commodity prices Indices Interest Rates

In some cases, Principal is protected if held till Maturity

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Structured Products Pros & Cons

Principal Protection (In some cases) Gain exposure to hard-to-access assets Potential hefty loss if liquidated before maturity Most probably become worthless if the issuer goes bankrupt Usually difficult to understand the product and its risk-return characteristics
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E.g. Rabobank Certs Series 1

If, on the valuation date, the price of at least one of the underlying shares is below 88% of its launch price, the investor may sustain a partial or total loss of the investment The certificate performs best when the share price is between 88% and 95% of the launch price during the entire life of the certificate

Investor will receive the maximum return of 20% if a Knock-out Event has not occurred, the closing price of each underlying share is above 88% of its launch price at each quarterly valuation date, and the certificate has not been terminated earlier.
The certificate is subject to early termination if the closing price of each underlying share is above its Knock-out level at the quarterly date.
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Assets on the SML

Derivatives

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Derivatives Overview
Financial Instruments which value is derived from underlying stock indices, interest rates, commodity prices or currencies Provides very high leverage Complex and very risky Commonly used for Hedging purposes Possible to lose more than capital outlay Traded on Stock Exchanges and 24/5 Commodity cum Futures Exchanges
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Derivatives Examples
Futures Options
Put Options Call Options

Swaps

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Assets on the SML

Certificates of Deposit Bonds Equities Investment Trusts Structured Products Derivatives

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Alternative Investments
Foreign Exchange
Yield & Capital Growth Foreign Currency Fixed Deposits Leveraged Spot Contracts Currency ETFs

Commodities
Commodity Unit Trusts & ETFs Commodity Futures
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Gaining Exposure
Actively Managed Funds
Mutual Funds (aka Unit Trusts)

Passively Managed Funds

Exchange Traded Funds

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The Investment Process

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The Investment Process

1. Analyze your future cash flow needs

List out all future expenses living expenses, purchases of big ticket items Forecast your future income how much will I earn? How much of my income can I save? Be conservative and account for the possibility of emergencies (unemployment, medical emergencies, etc.)

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The Investment Process

2. Decide on your investment time horizon

How long will it be before I have to draw from my investments/savings to fund my expenditure? Can I afford to not liquidate my investments throughout the entire planned time horizon? If not, I should shorten my investment time horizon or allocate the funds to less volatile (i.e. risky) investments

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The Investment Process

3. Determine your risk profile & investment goals
Capital Growth can I stomach the volatility? Capital Preservation am I taking less risk than I am capable of taking on? Income if I have a job, I should reinvest income earned from my investments Never let emotions such as greed or fear drive your decisions Instead, trust in your knowledge of economics and historical data of market return and volatility to guide your investment decisions
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The Investment Process

4. *Set weights to various asset classes

Decide on how much of each asset class I want in your portfolio With a long time horizon (e.g. 10 - 45 years), I can afford to have my entire portfolio in stocks If I am retiring in 5-10 years time, I want to ensure that my portfolio can (1) generate a steady stream of income during retirement and (2) not have fallen in value significantly when I need to draw from it. Hence, I should consider an asset allocation of 50-70% in stocks and 30-50% in bonds
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*a top-down approach

The Investment Process

5. *Diversify across companies, sectors and geographical regions
Trying to outperform the broad market is very tough. More than 50% of professional fund managers were unable to do so in the past 10 years. If I am not capable of spotting the next hot sector, I should just diversify! Taking US stocks as a gauge, a diversified stock portfolio would have made me a staggering 11.8% per annum over the last 30 years Thats $2.84m today if I had invested only $100,000 in 1978 ($2.84m = $1.25m in 1978 dollars, taking inflation to be 3% on average)
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*a top-down approach

The Investment Process

6. *Select Securities and Funds & make the trade

Select Stocks, Unit Trusts, ETFs and Bonds to achieve your desired asset allocation Awesome Unit Trust & SGS retailer: www.fundsupermart.com (MAS approved) most convenient and widest variety of funds & with the lowest fees Buying Stocks & ETFs listed on the SGX or foreign bourses requires a brokerage account. Retail brokers include Phillip Capital, Lim & Tan, iOCBC, DBS Vickers. You have to open a CDP account too.
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*a top-down approach

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*a top-down approach

Time Value of Money (TVM)

What makes a TVM problem? Cash Flow Diagram Parameters Present Value (PV) Future Value (FV) No. of Periods (N) Payment made each Period (pmt) Payments per year (P/Y) Compounding per year (C/Y) Pmt at Beginning or End of each Period (Begin, End)

Cash Flow Analysis

What makes a Cash Flow problem? Parameters Initial Cash Flow (CF0) Subsequent Cash Flows List L1: Cash Flow Amounts List L2: Cash Flow Frequency Internal Rate of Return (IRR) irr(CF0,L1,L2) Net Present Value npv(CF0,L1,L2)

darylchia89@hotmail.com 82332122