Lecture Presentation Software

to accompany

Investment Analysis and

Portfolio Management
Eighth Edition
by
Frank K. Reilly & Keith C. Brown

Chapter 3
 Selecting Investments in a
Global Market
Questions to be answered:
 Why should investors have a global perspective
regarding their investments?
 What has happened to the relative size of U.S. and
foreign stock and bond markets?
 What are the differences in the rates of return on U.S.
and foreign securities markets?
 How can changes in currency exchange rates affect the
returns that U.S. investors experience on foreign
securities?
 Questions to be Answered
 Is there an additional advantage of diversifying in
international markets beyond the benefits of domestic
diversification?
 What alternative securities are available? What are
their cash flow and risk properties?
 What is the historical return and risk characteristics of
the major investment instruments?
 What is the relationship among returns for foreign and
domestic investment instruments? What is the
implication of these relationships for portfolio
diversification?
 Three Reasons for the expansion of
foreign investment opportunities
1. Growth and development of foreign
financial markets
2. Advances in telecommunications
technology
3.  Mergers of firms and security exchanges
 The Case for Constructing Global
Investment Portfolios
1. Ignoring foreign markets can substantially
reduce investment choices
2. The rates of return on foreign securities
often have substantially exceeded those for
domestic securities
3. The low correlation between Canadian stock
markets and many foreign markets can help
to substantially reduce portfolio risk
 Relative Size of U.S. Financial
Markets
1. 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 51 percent in 2003
2. Overall value of the total investable capital
market has increased from $2.3 Trillion in 1969
to $70.9 Trillion in 2003 and the U.S. portion
has declined to less than half.
3. Canada’s capital markets comprise
approximately 2 – 3% of total global markets
4. The growing importance of foreign securities in
world capital markets is likely to continue
The Case for Global Investments
1. Rates of return available on foreign securities
often exceed yields on domestic securities due to
higher growth rates in foreign countries,
especially the emerging markets
2. Diversification with foreign securities can help
reduce portfolio risk because foreign markets
have low correlation with domestic capital
markets
3. For a refresher on correlation & risk reduction,
review www.dualinq.com/sw/co
 Covariance

  i  i  j  j  Cov = covariance
COVij 
N i = return for security I

i = mean return for

security i

Covariance is a measure of how much two assets

vary together (as compared to variance, which is a
measure of how much a single asset varies in
isolation)
 Correlation

COVij Rho = correlation coef

ij  Cov = covariance
 i j σ = standard deviation

Correlation is a measure of the linear

relationship between two variables. It can vary
between perfect positive (+1) and perfect
negative (-1). There is no benefit to
diversification when correlation is perfect
positive. Can eliminate all risk when correlation
is perfect negative.
Global Investment Choices
1. Fixed-income investments
• bonds and preferred stocks
2. Equity investments
3. Special equity instruments
• warrants and options
4. Futures contracts
5. Investment companies
6. Real assets
Fixed-Income Investments
Characteristics:
 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
 Savings Accounts
 Fixed earnings
 Convenient
 Liquid
 Low risk
 Low rates
 Certificates of Deposit (CDs)
- instruments that require minimum deposits for
specified terms, and pay higher rates of interest than
savings accounts. Penalty imposed for early
withdrawal
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
Capital Market Instruments
 Fixed income obligations that trade in
secondary market
 Federal & Provincial government bonds
 Government agency securities
 Municipal bonds
 Corporate bonds
Government Bonds & Bills
 Bills, notes, or bonds - depending on
maturity
• Bills mature in less than 1 year
• Notes mature in 1 - 10 years
• Bonds mature in over 10 years
 Highly liquid
 Backed by the full faith and credit of the
Government
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 default-free and fairly liquid
 Municipal Bonds
 Issued by US state and local governments,
usually to finance infrastructural projects.
 Exempt from taxation by the US 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
 Corporate Bonds
 Issued by a corporation
 Fixed income
 Credit quality measured by ratings
 Maturity
 Features
• Indenture
• Call provision
• Sinking fund
 Corporate 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
 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 only claim assets after senior secured and
debenture holders claims have been satisfied
 Corporate Bonds
 Income bonds
• Interest payment contingent upon earning
sufficient income
 Convertible bonds
• Offer the upside potential of common
stock and the downside protection of a
bond
• Usually have lower yields
 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
 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
International Bond Investing
 Eurobond
• An international bond denominated in a currency not
native to the country where it is issued. Example:
Shogun bond
 Foreign bond
• Issued by a foreign company but in the currency of the
country where it is issued
• Yankee bond Matilda bond
• Samurai bond Bulldog bond
• Matador bond
 Equity Investments
 Returns are not contractual and may be better or
worse than on a bond
 Represents ownership of a firm
 Investor’s return tied to performance of the
company and may result in loss or gain
 Classification of Common Stock
Categorized By General Business Line
 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
 Acquiring Foreign Equities
1. Purchase of American Depository Receipts
(ADRs)
2. Direct purchase of foreign shares listed on
a stock exchange
4. Purchase of international mutual funds
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
 Buy and sell in U.S. dollars
 Dividends in U.S. dollars
 May represent multiple shares
 Listed on U.S. exchanges
 Very popular
 Direct Purchase or Sale of
Foreign Shares
 Direct investment in foreign equity
markets- difficult and complicated due to
administrative, information, taxation, and
market efficiency problems
 Purchase foreign stocks listed on a
Canadian or U.S. exchange – limited choice
Purchase or Sale of Global Mutual
Funds or ETFs
 Global funds - invest in both domestic and foreign
stocks
 International funds - invest mostly outside of
Canada
 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 (see
next page)
 Exchange Traded Funds
 DIAMONDs Shares in an ETF that tracks the Dow Jones Industrial
Average. The fund is structured as a unit investment trust.
 iShares A group of ETFs advised and marketed by Barclays Global
Investors. iShares are structured as open-end mutual funds.
 HOLDRs Holding company depository receipts, a type of ETF
marketed by Merrill Lynch. Unlike other ETFs, HOLDRs can only be
bought and sold in 100-share increments. Investors may exchange
100 shares of a HOLDR for its underlying stocks at any time.
Existing HOLDRs focus on narrow industry groups. Each initially
owns 20 stocks, but they are unmanaged, and so can become more
concentrated due to mergers, or the disparate performance of their
holdings.
 Qubes (QQQ) The Nasdaq-100 tracking stock, an ETF that tracks the
technology-laden Nasdaq-100 index. The popular name, Qubes,
derives from the ETF's ticker symbol, QQQ. Qubes are by far the most
heavily traded ETF.
 Spiders SPDRs, or Standard & Poors' Depository Receipts. A group
of ETFs that track a variety of Standard & Poors' indexes. SPDR
Trust, Series 1, usually referred to as "Spiders," tracks the S&P 500
index. Select Sector SPDRs track various sector indices that carve up
the S&P 500 index into separate industry groups.
Special Equity Instruments
 Equity-derivative securities have a claim on
the common stock of a firm
 Options are rights to buy or sell at a stated
price for a period of time
 Warrants are options to buy from the
company
 Puts are options to sell to an investor
 Calls are options to buy from an investor
 Futures Contracts
 Exchange of a particular asset at a specified
delivery date for a stated price paid at the time
of delivery
 Deposit (margin) is paid by the buyer of the
contract to protect the seller
 Commodities trading is largely in futures
contracts
 Current price depends on expectations
Investment Companies (Mutual
Funds)
 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
Real Estate Investment Trusts
(REITs)
 Investment fund that invests in a variety of
real estate properties
 Construction and development trusts provide
builders with construction financing
 Mortgage trusts provide long-term financing
for properties
 Equity trusts own various income-producing
properties
 Real Estate
 Negative correlation between residential
and farm real estate and stocks
 Low positive correlation between
commercial real estate and stocks
 Potential for diversification
Low-Liquidity Investments
 Some investments don’t trade on securities
markets
 Lack of liquidity keeps many investors away
 Auction sales create wide fluctuations in
prices
 Without markets, dealers incur high
transaction costs
 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
 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
 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
 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
 Historical Risk-Returns on
Alternative 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
• The expected relationship between annual rates of
return and total risk (standard deviation) of these
securities was confirmed
• The systematic risk measure (beta) did a better job of
explaining the returns during the period than did the
total risk measure
Reilly and Wright’s 2004 Study
 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
 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