Introduction%20Overview%20of%20Financial%20Markets%20and%20Investment%20Risk%20and%20Return

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IntroductionOverview of Financial Markets and
InvestmentRisk and Return
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Investment Management Process

1. Setting investment Objective
2. Establishing Investment Policy
3. Selecting a portfolio strategy
4. Selecting the assets
5. Measuring and Evaluating Performance

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1.Setting investment Objective
Investment Management Process

• Understand profiles and risk tolerant level in
  order to set objective to satisfy the obligations
  stipulated in the policy.
• i.e. pension fund, insurance company, retirement
  person etc.

2.Establishing Investment Policy

• Must be correspond with the objectives
• Make asset allocation decision

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Investment Alternatives
Major Categories
Financial Assets
Real Assets
Direct Investing
Indirect Investing
Real Estate
Precious Metals
Fix Assets
Mutual Funds
Hedge Funds
Non marketable
Money market
Capital market
Derivative Securities

• Saving deposit
• CD
• Whole Life Insurance

• T-bill
• NCD
• Commercial Paper i.e. B/E and P/N
• Foreign Exchange

• Fixed Income i.e. Gov.bond, State Enterprise
  bond, Corporate bond, T-note, Prefer stocks,
  Mortgage pass-through
• Common Stock

• Options i.e.Calls/Puts
• Corporate created i.e Convertibles, Warrants
• Forward
• Futures

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Investment Alternatives
The Historical RecordA First Look
McGraw Hill / Irwin
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Investment Alternatives
Average Returns The First Lesson
McGraw Hill / Irwin
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Market sizes of developed stock markets
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Market coverage of developed stock market
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Market capitalization of emerging markets
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Size of govy bond market
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4.Selecting the assets
Investment Management Process
3. Selecting a portfolio strategy

• Actives - use information and forecasting
  techniques to seek a better performance
• Passives diversification
• Structured match the funds received from
  contributions to the future liabilities

• Picking securities to build your portfolio
• Efficient portfolio provides the greatest
  expected return at a given level of risk

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5. Measuring and Evaluating Performance
Investment Management Process

• Benchmark
• Return vs. Risk
• Risk management

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Risk and Return

• Two key observations emerge
• There is a reward for bearing risk, and at least
  on average, that reward has been substantial.
• Greater rewards are usually accompanied by
  greater risks.
• In summary, high risk should compensated by high
  return

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Return Components

• Returns consist of two elements
• Periodic cash flows such as interest or dividends
  (income return)
• Price appreciation or depreciation (capital gain
  or loss)
• Total Return Yield Price Change

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Measuring Returns

• For comparing performance over time or across
  different securities
• Total Return is a percentage relating all cash
  flows received during a given time period,
  denoted CFt (PE - PB), to the start of period
  price, PB

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Measuring Returns

• Example Calculating Returns
• Suppose you invested 1,000 in a stock at 25 per
  share. After one year, the price increases to
  35. For each share, you also received 2 in
  dividends.
• Total dollar return 48 of 1,000 480
• At the end of the year, the value of your 1,000
  investment is 1,480.

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Measuring Returns

• Total Return can be either positive or negative
• When cumulating or compounding, negative returns
  are problem
• A Return Relative solves the problem because it
  is always positive

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Measuring Returns

• Example
• What is Relative Return in the previous example?

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Measuring Returns

• To measure the level of wealth created by an
  investment rather than the change in wealth, need
  to cumulate returns over time
• Cumulative Wealth Index, CWIn, over
• n periods,

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Measuring Returns

• Example
• The Return Relatives of a particular stock
  investment in two consecutive years are 1.48 and
  0.95, assume CW0 is 1000, what is Cumulative
  Wealth Index, CWI2, over these 2 years?

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Measures Describing a Return Series

• Arithmetic mean, or simply mean,

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Arithmetic Versus Geometric

• Arithmetic mean does not measure the compound
  growth rate over time
• Does not capture the realized change in wealth
  over multiple periods
• Does capture typical return in a single period
• Geometric mean reflects compound, cumulative
  returns over more than one period

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Geometric Mean

• Defined as the n-th root of the product of n
  return relatives minus one or G
• Difference between Geometric mean and Arithmetic
  mean depends on the variability of returns, s

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Adjusting Returns for Inflation

• Returns measures are not adjusted for inflation
• Purchasing power of investment may change over
  time
• Consumer Price Index (CPI) is possible measure of
  inflation

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Measuring Risk

• Risk is the chance that the actual outcome is
  different than the expected outcome
• Standard Deviation measures the deviation of
  returns from the mean

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Risk Sources

• Financial Risk
• Tied to debt financing
• Liquidity Risk
• Marketability with-out sale prices
• Exchange Rate Risk
• Country Risk
• Political stability

• Interest Rate Risk
• Affects income return
• Market Risk
• Overall market effects
• Inflation Risk
• Purchasing power variability
• Business Risk

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Risk Types

• Two general types
• Systematic (general) risk
• Pervasive, affecting all securities, cannot be
  avoided
• Interest rate or market or inflation risks
• Nonsystematic (specific) risk
• Unique characteristics specific to issuer
• Total Risk General Risk Specific Risk

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Risk Premiums

• Premium is additional return earned or expected
  for taking additional risk
• Equity risk premium is the difference between
  stock and risk-free returns
• Equity Risk Premium, ERP,

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Risk and Return
McGraw Hill / Irwin
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The Lesson

• The greater the potential reward, the greater the
  risk.