Topic 1: Introduction

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Topic 1 Introduction
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What is investment?

• Traditional view the current commitment of
  resources (monies) to achieve later benefits.
• A broader view tailor the pattern of cash flows
  over time to be as desirable as possible.

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Tailoring cash flow pattern

• Suppose that there are two one-year investments.
  They both require 1 initial capital today.
  There is 50 chance that the economy is going to
  accelerate and the first (second) investment will
  have a return of 3 (0) when the economy is
  good. There is 50 chance that the economy is
  going to decelerate and the first (second)
  investment will have a return of 0 (3) when the
  economy is bad.
• Which investment has a more desirable cash flow
  pattern? Would you pay more for it?
• This example is related to asset pricing.

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Risk aversion

• Individuals seeking investment rather than
  outright speculation/gambling will elect a more
  certain wealth stream over a less certain one,
  holding average payoffs and returns constant.
  This is the risk aversion principle.

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Investments and public markets

• Investment decisions differ from other business
  decisions in an important aspect investment
  decisions are usually made with respect to
  alternatives available in public (financial)
  markets.
• Example suppose that your mother-in-law would
  like to borrow from you at 10 interest rate.
  Would you do it?

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The comparison principle

• The previous borrowing scenario is an example of
  the comparison principle.
• Another example residential appraisals are
  usually done with the framework of the comparison
  principle.

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Arbitrage

• Arbitrage earning (almost sure) monies without
  investing anything.
• When two similar (almost identical) investment
  alternatives are available in the market,
  conclusions about arbitrage, i.e., those stronger
  than the comparison principle, may hold.
• The law of one price.

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A real-life example of arbitrage

• Interest rate parity the forward premium
  (discount) is equal (close) to the interest rate
  differential.
• (F S) / S rF rD
• Example Suppose that the current spot, S, /
  0.80000, the 1-year forward, F, / 0.80800, r
  14, and r 10.

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The no-arbitrage principle

• In academic finance it is often assumed that no
  arbitrage opportunity exists.
• The reason for this assumption is that financial
  markets are competitive. When there are many
  computer algorithms looking for arbitrage
  opportunities, those arbitrage-based trades
  ensure that the no-arbitrage principle is largely
  correct.
• Many modern asset pricing relationships, e.g.,
  option pricing, utilize this principle.

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Major investment problems pricing/valuation

• Asset pricing can be addressed in two seemingly
  different ways (actually closely related) (1)
  what is the right price, i.e., the
  intrinsic/fundamental price? and/or (2) what is
  the expected rate of return?
• Asset pricing is related to risk. Holding other
  factors constant, higher risk leads to higher
  expected return and lower price.

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Major investment problems hedging

• Hedging is the process of reducing the risk that
  either arise in the course of corporate
  operations or are associated with investments.
• An example of hedging insurance.
• Another example a bakery buys flour futures to
  lock in current flour futures price to eliminate
  flour price uncertainty in the future.
• The major use of futures and options is for
  hedging--not for speculation.

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Major investment problems asset allocation

• Determine more than 90 of return variability for
  a typical institutional portfolio (Brinson, Hood,
  and Beebower, 1986).
• Asset allocation is the allocation of capital at
  the asset class level.
• Asset class a group of securities/assets with
  similar characteristics.
• A major task for fund/plan sponsors.

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Strategic asset allocation

• It establishes acceptable exposures (i.e.,
  portfolio weights) to investment policy statement
  (IPS)-pemissible asset classes to achieve the
  clients long-term objectives and constraints.
• An example of strategic asset allocation (policy
  portfolio) MIP, Chapter 5, Exhibit 5-1, p. 232.

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IPS

• A written document that sets out a clients
  return objectives and risk tolerance over the
  clients relevant time horizon, along with
  applicable constraints such as liquidity needs,
  tax considerations, regulatory requirements, and
  unique circumstances.

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The elements of an IPS

• A brief client/institution description.
• The purpose of establishing policies and
  guidelines.
• The duties and responsibilities of parties
  involved.
• Investment goals, objectives, and constraints.
• The schedule for review.
• Performance measures and benchmarks.
• Considerations for developing the strategic asset
  allocation.
• Investment strategies (passive or active) and
  styles.
• Guidelines for rebalancing.

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Asset classes

• Criteria for specifying asset classes (MIP,
  5.4.1, p. 248-249.

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Assignment

• Please study Calpers 2014 asset allocation
  strategy.
• http//www.calpers.ca.gov/eip-docs/investments/pol
  icies/asset-allocation/asset-alloc-strgy.pdf
• Submit a report that includes (1) a summary, and
  (2) the things that you learned from this
  reading. 2-3 pages. Due in a week.

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Major investment problems security selection

• Security selection is related to asset pricing.
• Security selection is done mainly by comparing
  perceived intrinsic/fundamental value (VE) to
  market price (P) or, equivalently, by comparing
  required rate of return to expected rate of
  return.
• In practice, security selection is not purely
  quantitative social responsibility,
  informational availability, institutional
  restrictions (e.g., size, liquidity), trade
  behavior (e.g., momentum) and other factors are
  also important.

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Mispricing

• Perceived mispricing ( VE P ? 0) motivates
  active selection.
• Decomposition VE P (V P) (VE V)
  (true mispricing) (estimation error).
• Analysts try to minimize the second component so
  that they can discover the true mispricing.

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Mispricing and the EMH

• The EMH did not say that there is no mispricing
  for individual securities.
• The EMH says that on average exploiting those
  perceived mispricing will not lead to abnormal
  return or alpha, net of transaction costs.
• That is, the EMH says that active selection is
  useless.
• Alpha excess risk-adjusted return.

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The valuation process (5 steps)

• Understanding the business (and the economy).
• Forecasting company performance (e.g. pro forma).
• Selecting the appropriate valuation model (e.g.,
  dividend discounting model).
• Converting forecasts to a valuation.
• Applying the valuation conclusions.

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Analysts

• Sell-side analysts analysts who work at
  brokerage firms.
• Buy-side analysts analysts who work at
  investment management firms, trusts and bank
  trust departments, and similar institutions.

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Analysts due diligence

• Due diligence investigation and analysis in
  support of a recommendation.
• See EAV, Example 1-8, pp. 27-28.

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Format of a (long) research report

• EAV, Exhibit 1-2, pp. 31-32.
• 6 sections (1) Table of Contents, (2) Summary
  and Investment Conclusion, (3) Business Summary,
  (4) Risks, (5) Valuation, (6) Historical and Pro
  Forma Tables.

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Characteristics of a good report

• EAV, P. 29.
• Timely information.
• Clear, incisive writing.
• Objective well researched assumptions
  acknowledged.
• Facts vs. opinions well distinguished.
• Internally consistent.
• Sufficient info for reader critique.
• Clear about key risk factors.
• Potential conflicts of interest disclosed.

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Selected CFA standards

• EAV, Exhibit 1-3, p. 33.

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Quality of earnings

• Quality of earnings analysis the scrutiny of all
  financial statements to evaluate both the
  sustainability of a companys performance and how
  accurately the reported information reflects
  economic reality.
• Financial Shenanigans, by Schilit, McGraw Hill.
• EAV, Exhibit 1-1, p. 14.

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End-of-chapter

• EAV, Chapter 1 Problems 1-8

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EAV, Chapter 3 Discounted dividend (model)
valuation

• You should have learned DDM in your BSAD 180.
• Please read and study EAV, Chapter 3, pp. 83-143.

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Zero-growth DDM

• The easiest assumption one can make is to assume
  that there is no growth in dividends, i.e., D1
  D2 D.
• Because this is a perpetuity, the pricing is
  rather straightforward PV D / i.
• Suppose that GE paid 2 dividend per share last
  year. Investors expect no growth in GEs future
  dividends. The applicable discount rate is 10.
• PV 2 / 10 20.

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Constant-growth DDM

• Another easy assumption one can make is to assume
  that there is a constant growth rate, g, in
  dividends, i.e., D1 D0 (1 g), D2 D0 (1
  g)2, etc.
• That is, this is a growing perpetuity.
• Recall from BSAD 180, the PV of a growing
  perpetuity is PVt Dt1 / (i g).

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Constant-growth DDM example

• Vermont Financial Inc. paid a dividend of 1 last
  year. The constant growth rate of dividends is
  5, and the required rate of return is 10.
• PV D0 (1 g) / (i g) 1 (1 5) /
  (10 5) 21.

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Multiple-stage DDM model

• This model allows different growth rates for
  different stages.
• Typically, it takes care of recent, supernormal
  growth.
• There are formulas for PV. However, they do not
  look neat.
• Let us use Excel to visualize the discounting
  process.

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Multiple-stage example, I

• HP has a cost of equity at 14. HP just paid an
  annual dividend of 2.
• The expected dividend growth rate between year
  1-3 is 25. The expected dividend growth rate
  between year 4-5 is 15. The expected dividend
  growth rate for year 6 and afterwards is 5.

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Multiple-stage example, II
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Now, lets take a look at the entire portfolio
management process

• MIP, Chapter 1, Exhibit 1-1, p. 6.
• 3 steps (1) the planning step (i) investors
  objectives and constraints, (ii) creating the
  investment policy statemet (IPS), (iii) forming
  capital market expectations, (iv) creating the
  strategic asset allocation.
• (2) The execution step (security selection).
• (3) The feedback step (i) monitoring and
  rebalancing, (ii)performance evaluation.