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Investment Management Notes
Investment Management Notes
Rate of return on investment is the income generated from the investment that
the investor would expect according to the market condition.
Rate of return comprises of risk free rate+ liquidity risk +default risk premium +
inflation+ others factors .
Risk free rate is the least rate of return that can be achieved by holding zero
risk , example -interest in bank deposit or fixed deposit , if an investor buys
mutual fund he has to be compensated for liquidity premium i.e , not
withdrawing amount for stated period or the lock in period , risk of default
which is always there because any company can default anytime and thus it
has to be compensated , inflation ,other economic and market factors.
The rate of return of return can be derived for every investment asset - i.e ,
stocks , bonds , real estate , gold , etc. Rate of return is based on how much
risky the asset class is.
Required Rate of return = risk free rate + beta (return on market -risk free
return)
Thus, return on market - risk free return is called as market risk premium. This
is the excess return which is earned by an investor for selecting the market
security.
4+1.2*3
=7.6%
Required rate of return is also called as CAPM i.e , capital asset pricing
method, thus It also helps in deciding whether to add an additional security in
the portfolio or not . Required rate helps in getting an view of what actual
return can be of the security, hence helping with prediction to buy /sell an
asset/security.
In both the theories, Investors are rational and maximize utility function based
on expected return and standard deviation of the returns of portfolio.
This happens because when interest rates are on the decline, investors try to
capture or lock in the highest rates they can for as long as they can. To do
this, they will scoop up existing bonds that pay a higher interest rate than the
prevailing market rate. This increase in demand translates into an increase in
bond prices.
On the flip side, if the prevailing interest rate is on the rise, investors would
naturally jettison bonds that pay lower interest rates. This would force bond
prices down.
However, the downside to a bond call is the investor is then left with a pile of
cash they might not be able to reinvest at a comparable rate. This
reinvestment risk can adversely impact investment returns over time.
To compensate for this risk, investors receive a higher yield on the bond than
they would on a similar bond that isn't callable. Active bond investors can
attempt to mitigate reinvestment risk in their portfolios by staggering the
potential call dates of differing bonds. This limits the chance that many bonds
will be called at once.
3. Inflation Risk
When an investor buys a bond, they essentially commit to receiving a rate of
return, either fixed or variable, for the time that the bond is held. And what
happens if the cost of living and inflation increase dramatically, and at a faster
rate than income investment? When this happens, investors will see
their purchasing power erode, and they may actually achieve a negative rate
of return when factoring in inflation.
4. Credit/Default Risk
When an investor purchases a bond, they are actually purchasing a
certificate of debt. Simply put, this is borrowed money the company must
repay over time with interest. Many investors don't realize that corporate
bonds aren't guaranteed by the full faith and credit of the U.S. government
but instead depend on the issuer's ability to repay that debt.4
Investors must consider the possibility of default and factor this risk into their
investment decision. As one means of analyzing the possibility of default,
some analysts and investors will determine a company's coverage
ratio before initiating an investment. They will analyze the company's income
and cash flow statements, determine its operating income and cash flow, and
then weigh that against its debt service expense. The theory is the greater
the coverage (or operating income and cash flow) in proportion to the debt
service expenses, the safer the investment.
5. Rating Downgrades
A company's ability to operate and repay its debt issues is frequently
evaluated by major rating institutions such as Standard & Poor's Ratings
Services or Moody's Investors Service. Ratings range from AAA for
high credit quality investments to D for bonds in default. The decisions made
and judgments passed by these agencies carry a lot of weight on investors.
6. Liquidity Risk
While there is almost always a ready market for government bonds, corporate
bonds are sometimes entirely different animals. There is a risk an investor
might not be able to sell their corporate bonds quickly due to a thin
market with few buyers and sellers for the bond.
Low buying interest in a particular bond issue can lead to substantial price
volatility and adversely impact a bondholder's total return upon sale.5 Much
like stocks that trade in a thin market, you may be forced to take a far lower
price than expected when selling your position in the bon
ROE
By measuring the earnings a company can generate from assets, ROE offers
a gauge of profit-generating efficiency. ROE helps investors determine
whether a company is a lean, profit machine or an inefficient operator.
How Should Return on Equity (ROE) Be Interpreted?
ROE offers a useful signal of financial success since it might indicate whether
the company is earning profits without pouring new equity capital into the
business. A steadily increasing ROE is a hint that management is giving
shareholders more for their money, which is represented by shareholders'
equity. Simply put, ROE indicates how well management is using investors'
capital.
It turns out, however, that a company cannot grow earnings faster than its
current ROE without raising additional cash. That is, a firm that now has a
15% ROE cannot increase its earnings faster than 15% annually without
borrowing funds or selling more shares. However, raising funds comes at a
cost. Servicing additional debt cuts into net income, and selling more shares
shrinks earnings per share (EPS) by increasing the total number of shares
outstanding.
In addition to return and risk objectives, the IPS has to be cognizant of other investment
constraints such as liquidity requirements, the investment time horizon, tax concerns,
legal and regulatory factors, and unique circumstances.
Liquidity
The IPS should detail the likely withdrawal of funds from the portfolio. For institutions,
there could be rules around this, like spending requirements in the case of endowment
funds. When a client has a known liquidity requirement, the portfolio manager should
allocate a portion of the portfolio to cover this liability by ensuring that the allocated
assets can quickly be converted to cash whenever the obligation needs to be met.
Allocating to a bond that has a maturity profile which matches the liability time horizon is
an often-used strategy.
Time Horizon
The IPS should state the time horizon over which the client is investing. Illiquid or risky
assets may be unsuitable for an investor with a short time horizon as they may not have
sufficient time to recover from investment losses.
Tax Concerns
Different investors will have different tax status. The tax status should be stated in the
IPS. Often, tax regimes will treat capital gains and income differently. Capital gains may
be subject to a lower tax rate payable only when they are realized rather than when they
are received. In this instance, there is a time value of money benefit to deferring tax. A
taxable investor may, for example, wish to hold a portfolio which emphasizes capital
gains over dividend income. A tax-exempt investor, on the other hand, may be relatively
indifferent to the two.
Unique Circumstances
The IPS should also cover any unique circumstances that are applicable. A client may
have religious or ethical objections to investing in particular stocks or sectors. These
types of considerations are often referred to as ESG (environment, social, governance)
factors and investing in accordance with ESG factors is referred to as SRI (socially
responsible investing).
Difference between traditional finance model and behavioural
based model are as follows;
Loss aversion, an aspect of prospect theory, asserts that losses loom larger
than gains .
To account for the deviations from rationality, economic issues are looked at
through a psychological lens that more accurately predicts and explains
human behavior.
Drawbacks of CML
Presence of friction − CML considers that there is always some friction in the
market irrespective of the volume and size.
Taxes and transaction costs − Taxes and transaction costs are needed to be paid by
the investors and these costs can vary from person to person and also in different
geographies.
The difference in investors worldwide − In the practical world, all investors do not
have access to all the information required to make a good investment decision
Moreover, CML takes into consideration that all investors will behave rationally,
which is not necessary all of the time.
Absence of risk-free asset − The CML concept is built on the principle of the
existence of risk-free assets. In reality, there is hardly any asset that is a risk-free
asset.
Difference between SML and CML
The security line is derived from the capital market line. CML is used to see a specific
portfolio’s rate of return while the SML shows a market risk and a given time’s return. SML
also shows the anticipated returns of individual assets.
CML shows the total risk and measures it in terms of the SML (beta or systematic risk). Fair-
priced securities are always plotted on the SML and CML. The notable factor is that the
securities which generate higher results for a certain risk, are usually found above the SML or
CML, and they are always underpriced and vice versa.
Treasury Bills
Treasury bills, also called T-bills, are short term government
securities with a maturity period of less than one year issued by
the central government of India.
Treasury bills are short term instruments and issued three
different types:
1) 91 days
2) 182 days
3) 364 days
Several financial instruments pay interest to you on your
investment; treasury bills do not pay interest because they are
also called zero-coupon securities.
These securities do not pay any interest; instead, they are issued
at a discount rate and redeemed at face value on the date of the
maturity.
For example a 91 day T-bill with a face value of Rs. 200 may be
issued at Rs.196, with a discount of RS. 4 and redeemed at face
value of Rs. 200.
However, RBI performs weekly auctions to issue treasury bills.
Zero-Coupon Bonds
Zero-coupon bonds are generally issued at a discount to face
value and redeemed at par. These bonds were issued on January
19th 1994.
The securities do not carry any coupon or interest rate as the
tenure is fixed for the security. In the end, the security is
redeemed at face value on its maturity date.
Investment objectives depend on the risk taking ability of the risk of loss. Investment
selection is the risk return trade off which is affected by the following constraints:
a. Liquidity / Marketability.
b. Taxes: Tax shelters should be incorporated while making investment decision.
c. Times horizon: Long term / Short term.
Growth stocks.
Technology stocks.
Cyclic stocks.
2. Passive Strategy: The passive strategy is based on the premises that the capital
market is fairly efficient with respect to the available information. It involves adhering to
the following guidelines:
Create a well-diversified portfolio at a predetermine level of risk.
a. Hold the portfolio relatively unchanged over times, unless it becomes inadequately
diversified or inconsistent with the investor’s risk – return preference.
1. Selection of fixed incomes avenues(bonds)
a. Yield to maturity.
b. Risk of default.
c. Tax shield.
d. Liquidity.
2. Selection of Stocks: Three broad approaches are employed for the selection of
equity shares.a. Technical analysis: This analysis looks at price behavior and volume
data to determine whether the share will move up or down or remain trend less.
b. Fundamental analysis: Fundamental analysis focuses on fundamental factors like
earning level, growth prospect and risk exposure to establish the intrinsic value of a
share.
c. The random selection approach: It is based on the premises that the market is
efficient and securities are properly prices.
3. Selection of Real Estate / Commodities.
Phase 7: Portfolio Revision: Portfolio revision means changing the assets allocation
of a portfolio.
Due to dynamic developments in the capital markets and the changes in the
circumstance, even a well constructed portfolio tends to become inefficient and hence
need to be monitored and revised periodically. This usually entails two things i.e.
Portfolio rebalancing and portfolio upgrading.
a. Buy and hold policy: where no change is effected and portfolio mix of debt
equity is allowed to drift.
b. Constant mix policy: where the desired target proportion of debt and equity is
maintained when relative values of debt and equity in the portfolio changes. E.g. if the
target debt equity mix was 50:50 portfolio rebalancing is done to maintain this target of
50:50 when any changes takes place in their market values.
c. Portfolio insurance policy: increasing the exposure to stocks when portfolio
appreciates in value and vice- versa.
(b) Risks: The risk of a portfolio can be measured in various ways. The two most
commonly used measures of risk are variance and beta.
A callable bond (CB), also termed as a redeemable (RB) bond, is one that can be redeemed by
the issuer before the maturity date. This enables the issuing firm to settle its debt ahead of
schedule. If market (IR) interest rates fall, a company may decide to call their bond, allowing
them to refinance at a reduced rate. CB compensates investors for this risk by typically offering a
higher IR or coupon (CR) rate because of this callable nature.
Embedded Option
A CB includes a call option. This call option is also valuable. As a result, the CB has a lower
value than a regular bond.
1. Life (L)
A CB has two lives. The first is normal maturity, and the second is the shorter life it has as a
result of undertaking the call option.
2. Yield (Y)
A CB, like two lives, has two yields.
3. Maturity Yield (YTM)
This is the bond's yield assuming it is held until maturity. It is identical to the yield on a
conventional bond with a comparable CR and maturity.
4. Yield to Call (YTC)
If the bond is called before actual maturity, this is the YTC. It will be approximated if users
understand the callable windows and the price or rate at which the bond will be called.
The reason for issuing the CB by the companies
Corporations issue CB to take advantage of possible future IR decreases. The issuing company
may redeem CB before the maturity date in conformity with the terms of the bond. If IR falls, the
company can redeem outstanding bonds and reissue debt at a lower IR. This lowers the cost of
(Kc) capital. A bond is equivalent to a loan borrower remortgaging at a lower IR. The prior
mortgage with the higher IR is settled, and the borrower receives a new mortgage with a lower
IR.
Analyzing the sensitivity of an industry to the business cycle involves assessing how changes in the
overall economic climate affect the performance of that particular industry. A highly cyclical industry will
experience significant fluctuations in demand and profitability depending on the stage of the business
cycle, while a less cyclical industry will be more stable and less affected by economic fluctuations.
To analyze the sensitivity of an industry to the business cycle, one approach is to examine its historical
performance during different phases of the business cycle. For example, during an economic expansion,
consumer spending tends to increase, leading to higher demand for goods and services. Industries that
are highly sensitive to the business cycle, such as the automobile industry, may experience significant
growth during this phase as consumers purchase new cars and trucks.
However, during a recession or economic downturn, consumer spending tends to decrease, leading to
lower demand for goods and services. Industries that are highly sensitive to the business cycle, such as
the construction industry, may experience significant declines during this phase as demand for new
homes and commercial buildings decreases.
To further illustrate, let's consider the retail industry. During an economic expansion, consumers tend to
have more disposable income, which can lead to increased spending on non-essential items such as
clothing and electronics. As a result, the retail industry is generally more sensitive to the business cycle
than industries that provide essential goods and services such as healthcare or utilities.
During a recession or economic downturn, however, consumers tend to cut back on non-essential
spending, which can lead to a decline in demand for retail goods. As a result, the retail industry may
experience a significant decline in sales and profitability during this phase.
By analyzing the sensitivity of an industry to the business cycle, investors can gain a better understanding
of the risks and opportunities associated with investing in that industry. For example, if an investor
believes that an economic expansion is imminent, they may choose to invest in industries that are highly
sensitive to the business cycle, such as the automobile or construction industries, in anticipation of
increased demand and profitability. Conversely, if an economic downturn is expected, investors may
choose to invest in less cyclical industries that are less sensitive to economic fluctuations, such as the
healthcare or utility industries.
The divisor is altered when a component issues new stock through a secondary offering in a market
capitalisation-weighted index. However, the divisor does not need an adjustment when a component
issues a stock dividend or undergoes a stock split.
As Dow Jones is a price-weighted index, it adjusts its divisor for corporate actions, such as dividend
payments and stock splits.
Treynor introduced the concept of the security market line, which defines the
relationship between portfolio returns and market rates of returns whereby
the slope of the line measures the relative volatility between the portfolio and
the market (as represented by beta). The beta coefficient is the volatility
measure of a stock portfolio to the market itself. The greater the line's slope,
the better the risk-return tradeoff.
Sharpe Ratio
The Sharpe ratio is almost identical to the Treynor measure, except that the
risk measure is the standard deviation of the portfolio instead of considering
only the systematic risk as represented by beta. Conceived by Bill Sharpe,
this measure closely follows his work on the capital asset pricing
model (CAPM) and, by extension, uses total risk to compare portfolios to
the capital market line.
Unlike the Treynor measure, the Sharpe ratio evaluates the portfolio manager
on the basis of both the rate of return and diversification (it considers total
portfolio risk as measured by the standard deviation in its denominator).
Therefore, the Sharpe ratio is more appropriate for well-diversified portfolios
because it more accurately takes into account the risks of the portfolio.
Jensen Measure
Similar to the previous performance measures discussed, the Jensen
measure is calculated using the CAPM. Named after its creator, Michael C.
Jensen, the Jensen measure calculates the excess return that a portfolio
generates over its expected return. This measure of return is also known
as alpha.1
The Jensen ratio measures how much of the portfolio's rate of return is
attributable to the manager's ability to deliver above-average returns,
adjusted for market risk. The higher the ratio, the better the risk-adjusted
returns. A portfolio with a consistently positive excess return will have a
positive alpha while a portfolio with a consistently negative excess return will
have a negative alpha.