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Investment Analysis and Portfolio Management: Gareth Myles
Investment Analysis and Portfolio Management: Gareth Myles
Portfolio Management
Lecture 1
Gareth Myles
Website
The module website is
people.ex.ac.uk/gdmyles/GDM.html
The website provides
A complete set of notes
Powerpoint slides
Exercises
Solutions
Assessments/Assignments
Past exams
The slides are added before each lecture
Financial Data
Many of the exercises use real financial data
This is obtained from Yahoo Finance
Share prices are obtained by typing company
name into the “Get Quotes” box
“Historical Prices” provides data at a chosen
frequency (daily, weekly, monthly)
The data can be downloaded to a spreadsheet
Gains and Losses
Some investments can
be very successful.
£10,000 invested in
September 2001 in
Lastminute.com would
have been worth
£134,143 in August
2003
$10,000 invested in
August 1998 in
Cephalon would have
been worth $107,096 in
September 2003 (and
$180,000 in 2007)
Gains and Losses
But past performance is
a very poor guide to
future performance
And this is despite
recent headlines
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And Losses
Losses in value can be
even more spectacular
$10,000 invested in
September 2000 in Palm
Inc. would have been
reduced to $91 by April
2003
A holding in July 2000 of
£15 million in Exeter
Equity Growth Fund
would have been worth
£72,463 in August 2003
(the share price fell from
103.50 to 0.50)
Gains and Losses
Variability
The essentially feature of stock prices is
unpredictable variability
Even when averaged into an index this
variability is apparent
Portfolio management is about coping with the
variability
Investment analysis is about underlying
longer-term trends
The same principles apply to both
Variability
Variability
Variability
Variability
Today
Overview
This semester is about investment in financial
portfolios
Investment is defined as a sacrifice made now
to obtain a return later
It is current consumption that is sacrificed
Two forms of investment can be defined
Real investment is the purchase of land, machinery,
etc
Financial investment is the purchase of a "paper"
contract
Overview
Real investments and financial investments
are linked
The share issue of a firm finances the purchase of
capital
The commitment to a mortgage finances the
purchase of property
Financial investment can provide finance for
real investment decisions
Financial investment can guide real
investment decisions
Financial Investment
There are numerous components to financial
investment
Markets: where assets are bought and sold,
and the forms of trade
Securities: the kinds of securities available,
their returns and risks
Investment process: the decision about which
securities, and how much of each
Financial theory: the factors that determine the
rewards from investment (and the risks)
Markets
A market is any organized system for
connecting buyers and sellers
There are many security markets
Markets may have a physical location
The New York Stock Exchange
Or exist only as computer networks
The London Stock Exchange
Markets vary in the securities that are traded
and in the way securities are traded
Characteristics of Markets
There are a number of ways to classify
markets
Primary/Secondary
Primary markets are security markets where new
issues of securities are traded
A secondary market is a market where securities
are resold
The London Stock Exchange is a secondary
market
Most activity on stock exchanges is in the
secondary market
Characteristics of Markets
Trades on the primary market raise capital for
firms
Trades on the secondary market do not raise
additional capital for firms
The secondary market is still important
It gives liquidity to primary issues. New securities
would have a lower value if they could not be
subsequently traded
It signifies value. Trading in assets reveals
information and provides a valuation of the assets.
This helps to guide investment decisions
Characteristics of Markets
A second way to classify markets is the times
of trading
Call/continuous
In a call market trading takes place at a specified
time intervals
Some call markets have a provision that limits
movement from the prior price. This is to prevent a
temporary order imbalance from dramatically
moving the price
In a continuous market there is trading at all times
the market is open
Characteristics of Markets
Markets can also be characterized by the
lifespan of the assets traded
Money/Capital
Money market: the market for assets with a life of
less than 1 year
Capital market: the market for assets with a life
greater than 1 year
Some assets, such as most bonds, have a
fixed lifespan
Common stock have an indefinite lifespan
Brokers
A broker is a representative appointed by an
individual investor
Brokers have two conflicting roles
An advisor: a broker can offer investment advice
and information
A sales person: brokers are rewarded through
commission and have an incentive to encourage
trade
A full-service broker is a brokerage house that
can offer a full range of services including
investment advice and portfolio management
Brokers
A discount broker offers a restricted range
of services at a lower price
To complete a trade additional brokers are
needed
A floor broker is located on the floor of the
exchange and does the actual buying and
selling
A specialist ensures trade happens by
holding an inventory of stock and posting
prices
Securities
The standard definition
of a security is:
"A legal contract
representing the right to
receive future benefits
under a stated set of
conditions"
The piece of paper
defining the property
rights held by the owner
is the security
Securities
Money market securities
Short-term debt instruments sold by governments,
financial institutions and corporations
They have maturities when issued of one year or less
The minimum size of transactions is typically large,
usually exceeding $100,000
1. Treasury Bills
US Treasury Bills are the least risky and the most
marketable of all money markets instruments
They represent a short-term IOU of the US federal
government
Similar bills are issued by many other governments
Securities
New 91- and 182- day T-bills are issued weekly, by
auction whereas 52-week T-bills are issued
monthly.
An active secondary market with very low
transactions costs exists for trading T-bills
T-bills are sold at a discount from face value and
pay no explicit interest payments.
T-bills are considered to have no risk of
default, have very short-term maturities, and
have a known return
T-bills are the closest approximations that
exist to a risk-free investment
Securities
Capital market securities
Instruments having maturities greater than one year
and those having no designated maturity at all
1. Fixed income securities
Fixed income securities have a specified payment
schedule
Bonds promise to pay specific amounts at specific
times
Failure to meet any specific payment puts the bond
into default with all remaining payments. The
creditor can put the defaulter into bankruptcy
Securities
Fixed income securities differ from each
other in promised return for several reasons
The maturity of the bonds
The creditworthiness of the issuer
V1 V0
Return is r
V0
V1 V0
Or as a percentage r 100
V0
Return
Example 1
An initial investment of $10,000 is made. One
year later, the value of the investment has risen
to $12,500. The return on the investment is
12500 10000
r 100 25%
10000
Example 2
An investment initially costs $5,000. Three
months later, the investment is sold for $6,000.
The return on the investment per three months is
6000 5000
r 100 20%
5000
Return and Risk
The risk inherent in holding a security is the
variability, or the uncertainty, of its return
Factors that affect risk are
1. Maturity
Underlying factors have more chance to change
over a longer horizon
Maturity value of the security may be eroded by
4. Portfolio Evaluation
Assess the performance of portfolio
5. Portfolio Revision
Repeat previous three steps
Buying Common Stocks
execution uncertain
price certain
Buying Common Stocks
Type of Order
Stop Order – a stop price is specified
Sell if price falls below the stop price
(A stop-loss is used to lock-in profits)
Buy if price rises above the stop price
Execution is certain if stop price passed
Price is uncertain
Stop Limit Order
A minimum price is placed below the stop-price for a sell
or
A maximum price is placed above the stop-price for a buy
Price is certain within a range
Execution is uncertain
Margin Account
A margin account with a broker allows for
limited borrowing to purchase assets
A margin account needs a hypothecation
agreement
a. broker can pledge securities as collateral
b. broker can lend the securities to others
For a. and b., shares are held in street name
Owned legally by brokerage
Dividends, voting rights, reports go to investor
Margin Account
Margin Purchase
Borrow money from broker to invest
The cost of borrowing is interest plus a service charge
Initial margin requirement
The minimum % of investment from investor’s own
funds
Actual margin
market value of assets - loan
Actual Margin
market value of assets
Margin Account
A margin account is marked to market at the
end of each trading day
A daily calculation of actual margin
A margin account is subject to a maintenance
margin requirement
The minimum acceptable value of the actual margin
If actual margin < maintenance margin then a
margin call is issued
The investor is obliged to add cash or
securities to the margin account
Margin and Return
Buying on the margin raises return
Example
Let purchase price of a security be £50
Let price of security now be £65
Assume 100 units were purchased and no
dividends were paid
Return on cash purchase
65 - 50
Cash Re turn 30%
50
Margin and Return
Return on margin purchase
Total cost = £50 x 100 = £5000
Interest rate = 11%
Initial margin = 60% so loan = £2000
Margin Re turn
65 - 50 100 2000 0.11 42.7%
5000 0.6
Return is increased
Margin and Return
But if price falls
Assume price now is £40 rather than £65
40 - 50
Cash Re turn 20%
50
Margin Re turn
40 - 50 100 2000 0.11
40.7.7%
5000 0.6
Hence buying on the margin also magnifies losses
Conclusion: use margin when belief is that prices
will rise
Short Sales
A short sale is the sale of a security you do not
own
This is achieved by borrowing share
certificates from someone else
The borrowing process is arranged by a broker
To allow shares to be borrowed the broker
either
a. Uses shares held in street name
b. Borrows from another broker
Short Sales
Broker
Provides Lends Pays Receives Told C
margin stock price stock owns stock
Broker
Cash for Dividends, reports, Reports
dividends voting rights
Dividends, reports,
voting rights
Short Sales
Margin
There is a risk involved so short seller (A)
must make an initial margin advance to the
broker
The broker then calculates the margin each
day
Short sales should be used when prices are
expected to fall