The DJIA is simply too small. They are short term, very safe, and highly liquid. Also, their unit value almost never changes. Investors may also purchase shares of foreign companies on foreign exchanges. Lastly, investors may use international mutual funds to own shares indirectly. Because they produce coupons that are tax free. The fed funds rate is simply the rate of interest on very short-term loans among financial institutions.
General obligation bonds are backed by the local governments, while revenue bonds have proceeds attached to specific projects. A revenue bond has less guarantees, therefore, it is riskier and will have a higher yield. Limited liability means that the most shareholders can lose in event of the failure of the corporation is their original investment.
The prices of money market securities are very stable, and they can be converted to cash i. The taxable bond. The after-tax yield for the taxable bond is: 0. You are indifferent. The after-tax yield on the corporate bonds is: [0. Therefore, the municipals must offer at least 6. The coupon rate is 4. The trend is to move toward electronic trading and the specialist system largely unique to the U.
On some trades only a commission is paid. On some trades only a spread may be paid. On many trades both a commission and at least a portion of the spread are paid.
This point can be made in an earlier section on PPP slides Buying on Margin PPT through PPT Instructors may wish to tell students that buying stock on margin is not the same thing as a margin arrangement in futures. While both futures and stock trading have maintenance margins and margin calls which are similar, the costs of borrowed funds must be factored into analysis of the returns of stock margin trading.
The degree of leverage available in equities is set by the Federal Reserve Board under Regulation T and is less than is typically available in futures. The IMR or initial margin requirement is the minimum amount of equity an investor must put up to purchase equities. An investor borrows from the broker. The amount of equity in the position will vary as the market value of the underlying stock varies.
Equity in the position is calculated as the Position Value — Amount Borrowed. The maintenance margin requirement MMR is the minimum amount of equity that the account may have.
The example also includes rate of return calculations including loan costs. Students are typically troubled by the return calculations so the instructor should take their time explaining this material. A brief description of the mechanics of a short sale is first introduced. The instructor may wish to use slide 57 or skip it. Slide 57 compares long positions with short positions and what they are designed to accomplish.
A short seller has a liability as opposed to an asset. The liability is that the short seller must buy the stock back. Short sales involve margin requirements. Rather the margin is used to ensure the investor will be able to buy the stock back if its value increases. Short sale proceeds must be pledged to the broker kept in the margin account. Short positions also have maintenance margins. As in buying on margin, a margin call may occur if the stock price rises sufficiently.
In the typical short sale the short seller sells stock by borrowing stock from the broker. The short seller is thus liable for any cash flows such as a dividend that may occur while the short sale is outstanding.
A naked short sale occurs when the short seller does not have the stock. Naked short selling can lead to excessive speculation not limited by existing supply of shares. It is problematic whether naked short sales should be allowed. Traditionally exchange traded stocks could only be sold short if the last price change that occurred was positive.
This is the so called zero tick, uptick rule. A short sale could be utilized if the last trade or tick was zero as long as the last time the price did change it went up. The zero tick, uptick rule was eliminated by the SEC in July but there has been discussion about reinstating the rule. During the financial crisis all short selling was banned for certain financial firms as regulators worried that excessive short selling exacerbated market declines.
This worry is probably overblown. The rule change had unintended negative consequences for hedge funds who were using short strategies to limit risk of other positions. This is an area that has received and continues to receive enormous amounts of coverage in the press. Numerous proposals for additional regulation have appeared even before the costs and efficiency of Sarbanes-Oxley can be assessed.
The changing landscape of trading arrangements and developments of new securities presents challenges in regulation. As a result financial innovation will suffer, although history shows us that the financial industry will find ways to evade regulations. It is safe to say however that government involvement in the markets is likely to increase and remain at a much higher level than in the recent past for quite some time.
I believe we will also probably see some reform of ratings agencies. The problem may stem from how the raters are funded they are paid by the firms they rate, creating a huge conflict of interest and from the lack of competition.
The chapter discusses services provided by mutual funds and describes expenses and loads associated with investment in investment companies. Investment policies of different funds are described and sources of information on investment companies are identified. Students should be able to describe the expenses associated with investment in mutual funds, calculate net asset value and fund returns and identify the major types of investment policies of mutual funds.
They should be able to understand the implications of turnover on expenses and taxes and finally, students should be able to describe services provided by mutual funds and be able to identify sources of information on investment companies. Investment Companies PPT through PPT Key services provided by investment companies are include elements of services that are related to scale factors such as reducing transaction costs, diversification and divisibility.
Mutual funds can trade securities at lower costs because of the size of the trades and because they are trading larger dollar volumes with brokerage firms. Services related to professional management and administration involve compensation for expertise. Investing in a fund family also infers some benefits. Advantages include professional administration of the account, record keeping to keep track of all of your investments in one location and keeping track of all of your distributions from the funds.
It is also easy to reinvest any distributions. Investors will have knowledgeable management of their portfolio so they can concentrate on their own careers. The fund managers generally have an MBA and plenty of experience trading securities.
Economies of scale also allow for reduced transaction costs. Source: The Fool A unit trust is a pool of funds invested in a portfolio that is fixed for the life of the fund. Trusts are often set up for fixed-income securities. The trust life is dependent on the maturity of the securities.
Since the shares in closed-end funds are acquired in secondary markets, prices for such shares may differ from the underlying net asset value NAV. Closed end fund shares may trade at a premium or a discount from NAV. In an open end fund the investor buys and sells fund shares from the fund at the NAV.
An investor has no liquidity concerns in an open end fund. However, the open end fund must keep a cash reserve to meet planned redemptions and may have to liquidate securities if redemptions are sufficiently higher than anticipated. This can affect fund performance. It is unclear whether closed end fund discounts represent a good deal for investors. There may be unrealized tax gains in the fund or the discounts may exist to offset lower liquidity.
Commingled funds are partnerships for investors that pool their funds. Commingled funds are commonly used in trust accounts for which investors do not have large enough pools of funds to warrant separate management. They invest in real estate equity trust or in loans secured by real estate mortgage trusts.
REITs employ financial leverage and offer an investor the possibility to invest in real estate with professional management. Hedge funds pool funds of private investors.
They are only open to wealthy and institutional investors. Hedge funds engage in short selling, risk arbitrage and other derivatives. Some may have been involved in excessive naked short selling. This is far more likely to be a serious problem for smaller firms than firms with a large public float.
Most hedge funds are registered as private partnerships and thus avoid SEC regulation. Secretary of Treasurer Tim Geithner has indicated that hedge funds should have increased regulatory oversight.
Some are also calling for greater transparency on short positions to avoid problems with excessive short sales. These funds will typically have a front end load. A front end load is an up front cost fee to purchase a share of a mutual fund. Some funds may have a back end load and or a 12b-1 fee instead of or in addition to the front end load.
These other charges are described below. There may also be revenue sharing on sales force distributed funds between the recommender and the fund. This creates a potential conflict of interest between the broker or planner and the investor. Other funds are directly marketed. The investor has to find them on their own. These funds should not have a front end load although they may have a back end load or even in some cases a 12b-1 charge.
Potential Conflicts of Interest: Revenue Sharing Brokers put investors in funds that may that may not be appropriate for the investor. Mutual funds could direct trading to higher cost brokers because the broker recommends their fund. Revenue sharing is legal but it must be disclosed to the investor. Revenue sharing, soft dollar commissions and other such practices should be prohibited. These practices create conflicts of interest and reduce transparency.
Restoring trust with the public is even more important after the financial crisis. Some funds are sold in financial supermarkets such as at Charles Schwab. Investors can purchase load funds from Schwab or others without paying the load. However there is no free lunch, the fund may charge higher expenses to offset.
Nevertheless investors often get the benefit of low cost switching even between fund families and easier to interpret record keeping when investing this way. Investors should be aware however that large differences exist between different funds within the same category. An investor should never invest in any particular fund without reading and understanding the prospectus.
If one is willing to pay a load charge the investor can obtain advice from a broker or planner. Domestic Stock Funds a. Aggressive Growth i. Growth i. Small, Medium, Large, Blend ii. Small, Medium, Large Value d. Countercyclical i. Bear Market Investors in these type funds should be seeking capital gains rather than stable income. You can expect fairly high turnover and substantial potential for capital loss in any one year. The instructor may wish to pull recent data from Morningstar on average returns in each of these categories.
Index funds a. Broad market b. Industry or market subset c. International market d. Size subset The goal of these funds is duplicate the performance of an index or market sector. These funds have low turnover and low expenses. In this category bigger funds tend to be more efficient and have lower costs. These funds suit investors who believe in efficient markets and those who are looking for low expenses and turnover. This risk depends on the type chosen.
Some sector funds are quite risky. Balanced funds a. Allocation funds i. World, moderate, conservative ii. Convertibles b. Target date funds i. These funds vary, some may be riskier and can generate higher turnovers and tax liabilities while some have an income focus and may generate more tax liability. Convertibles invest in convertible securities. Target date funds are designed for investors who need the money during the targeted year.
Typically investors reduce risk as retirement nears. They change their asset allocation and reduce the weight on stocks and particularly risky stocks. Target date funds change these allocations automatically as the target date nears.
Fixed Income Funds a. Federal Government i. Short, Intermediate, Long Term ii. Inflation Protected b. Corporate i. Ultrashort, Short, Intermediate, Long Term ii. High Yield, Multisector iii. Bank Loans These funds focus on income and current yield more so than capital gains. They have a lower potential for capital loss, and inflation risk except for a.
These funds are suitable for more risk averse investors with short to intermediate time frames. These funds add diversification, income and safety to a portfolio. Investors should be aware of the potential higher tax liability involved in these funds however. International Stock Funds a. Foreign i. Global or World i. Geographic region d. Emerging Market Foreign funds usually exclude the U.
The risk of these funds varies but it can be high. Investors may also have indirect foreign exchange exposure as currency movements can affect the dollar returns. Expense ratios on some of these funds have also been high. Investors should be aware that some of these funds such as emerging market funds may have substantial potential for capital loss.
On the positive side these funds can provide additional diversification benefits. Money Market Funds a. Taxable b. There are no capital gains or losses, just income distributions. These funds provide some income while maintaining safety of principal. They earn more than bank accounts with little additional risk, although two out of thousands have now broke the buck or failed. Trading Scandals Late trading allowed some investors to purchase or sell fund shares after the NAV has been determined for the day.
NAVs are established once per day at the end of trading. Market timing is allowing investors to buy or sell on stale net asset values based on information from international markets. For example a fund NAV may be based on prices in foreign markets which close at different times. If the U. The effect of these activities is to transfer wealth from existing owners to those engaging in these activities, in effect creating a privileged fund holder class.
Reforms have included a strict four P. Late orders must be executed the following day. Fair value pricing may also be employed where the NAV is updated based on trading in open markets. Finally, redemption fees may be imposed on short term holding periods under one week. This makes the cost of a front end load higher and investors who feel comfortable picking their own funds should pick a no load fund. A 12b-1 fee is a different way to assess a front load charge.
In a 12b-1 fee the load is assessed against the NAV of the fund, in effect, all investors share in paying the 12b-1 fee. The 12b-1 fee is an annual assessment that an investor must pay as long as they are invested in the fund whereas the front load is a one time fee.
Hence if investors plan on holding the mutual fund for a sufficiently long time the front end load may be preferable to a 12b-1, even though the front load reduces the invested amount. As investors have become more savvy the number of load funds has declined and average load charges have fallen. Some funds have both a front end load and a 12b-1 fee and presumably the investor has a choice which to pay. If the fund is charging both then this fund should be avoided.
A back-end load or exit fee may be charged when the shares are redeemed. It is common for an exit fee or the back-end load to become smaller with longer investment periods. This is called a holding period contingent fee. When comparing expense ratios on funds, the 12 b-1 charges should be added to the fund expenses since the 12b-1 fees represent an annual charge.
Operating expenses that are reported may not fully reflect operating costs because of soft-dollar payments. Some brokerage houses provide supposedly free services to mutual funds including such services as research, database costs, etc. Items purchased with the soft dollars are not reported in expense data so funds may understate actual expenses.
Soft dollar payments should be prohibited by the SEC. The research with respect to the relationship of performance and expenses indicates that funds with high expense ratios and high levels of turnover tend to be poor performers.
Several examples of the effects of expense are provided in the PowerPoint. Taxation of Mutual Funds PPT through PPT Mutual funds are not taxed as long as the fund meets certain diversification requirements and the fund distributes virtually all income earned, including capital gains, less fees and expenses to fund shareholders. The fund itself pays commission costs on purchases and sales of portfolio holdings, which are charged against NAV although these commissions are lower than what you and I pay.
Nevertheless, total commission expenses are higher if the portfolio has higher turnover. Investor directed portfolios can take advantage of tax consequences and time when to take taxable gains, while investment in most mutual funds cannot be structured to take advantage of specific tax considerations. High turnover may lead to higher taxes and results in greater expenses for the fund. ETFs allow investors to trade portfolios of indexes as individual shares of stock.
A wide variety of indexes, both international and domestic can be traded. Some advantages include lower taxes and costs as well as the ability to trade the index portfolios intra- day and to engage in margin purchases and short sales.
Potential disadvantages include price deviation from NAV and payment of brokerage fees to trade the funds. Evidence shows a tendency for some persistence in superior performance by funds but the evidence is far from conclusive.
Mutual fund marketing literature emphasizes past performance but the evidence indicates that historical performance is not a good predictor of future performance.
There is some evidence that funds with higher expense ratios are more likely to be poorer performers. As the popularity of mutual funds has grown in recent years, nearly all major business publications feature some reporting on performance of mutual funds. Several agencies or publications rank mutual fund performance, including Morningstar.
However fund rankings which are based on historical data are not necessarily good predictors of future fund performance. Be aware that multiple funds and multiple categories may be desirable. The choice may be a function of the age of investor; younger investors can normally tolerate more risk. Decide whether to go with a load or a no load fund.
If you are willing to pay a load, you can obtain advice from a broker or commission based planner about fund choice. Either you must research no load funds or can hire a fee based financial planner. Be aware that historical performance may not be repeated in the future. Be leery of fund's claims about historical performance. Funds emphasize the most favorable periods and higher returns may be the result of higher risk. The performance statistics should be compared to a benchmark with similar risk.
There is little evidence that funds can successfully engage in frequent major changes in asset allocation market timing.
Be aware that the fund's growth rate is largely a function of marketing expenditures rather than truly superior returns.
Larger funds may have larger overhead and may have a harder time finding sufficient numbers of better investments needed to generate superior returns for fund investors. Diversification is a great advantage of investing in mutual funds.
Investing in several funds may be necessary to optimally diversify. Substantial additional diversification benefits can be achieved with the purchase of international mutual funds. Management style and tenure: Learn the investment style of the fund and ensure it matches your own preferences value, growth, allocation, index, etc.
To induce rational investors to accept more risk they must be promised a sufficient large enough return to overcome their risk aversion. The concept of excess returns or risk premiums is developed and Value at Risk VaR and the Sharpe performance measure are introduced. The primary focus of the chapter however is to calculate the expected return and risk of an individual security and to determine the return and risk of combinations of risky assets and risk free investments.
The chapter also presents historical return and risk data for some asset classes. The difference between real returns and nominal returns is presented along with the Fisher effect. This chapter is a foundation chapter for understanding modern portfolio theory and the efficient frontier, topics covered in Chapter 6.
Readers should understand the differences between time weighted and dollar weighted returns, geometric and arithmetic averages and have some idea when to use each. Students will also gain a basic understanding of returns and risk of various asset classes and understand that securities that offer higher returns have higher risk.
In addition, the student should be able to construct portfolios of different risk levels, given information about risk free rates and returns on risky assets. The student should be able to calculate the expected return and standard deviation of these combinations.
Students will learn that theoretically one can easily construct portfolios of varying degrees of risk by simply altering the composition of the portfolio between risk free securities and mutual funds. In addition, the student is introduced to the concept of further increasing returns and risk by buying additional risky securities with borrowed funds. Annualizing with and without compounding is illustrated.
This should be a review of their basic finance course. There are several methods for averaging returns over multiple periods. The first choice with respect to averaging is the choice of using the arithmetic or geometric average. The arithmetic average, by the nature of its calculation, assumes that at the start of each period any earnings are withdrawn and the original principal is maintained.
Geometric mean calculations assume reinvestment of all gains and losses. The geometric mean will normally be lower because it is a compound return and a smaller growth rate is required for a given set of values if there is compounding. This is a common student question. The geometric mean is lower if the returns vary and the differences between the two will grow with a greater standard deviation of returns, particularly if negative returns are included in the series.
Time series returns may be averaged through calculating time weighted returns or via dollar weighted returns. In time weighted returns the investor is assumed to hold only 1 share of the security in each time period. The calculated returns are solely a function of the security performance over the time under evaluation.
Once the return series is calculated, either a geometric or an arithmetic average may be calculated. Thus dollar weighted returns give the investor a truer estimate of the rate of return they earned based on security return performance and their own choices of when they bought and sold the security. Risk and Risk Premiums PPT through PPT This section begins by illustrating calculations of expected returns and standard deviation ex ante for individual securities via scenario analysis.
Ex post average return and standard deviation calculations are also provided. Basic characteristics of probability distributions are then covered including definitions of mean, variance, skewness and kurtosis. For distributions that are skewed, the median and mean returns are different. For normal distributions the mean and variance or standard deviation are sufficient statistics to characterize the distribution. Value at Risk Value at Risk attempts to answer the following question: How many dollars can I expect to lose on my portfolio in a given time period at a given level of probability?
In the Norminv function in Excel the 0. The VaR calculation does not require normal distributions. The text illustrates calculating VaR if you have a normal distribution. If options or other complex instruments are included in the portfolio you will not have a normal distribution.
You then have to approximate the distribution or perhaps use a Monte Carlo simulation to build a distribution of future returns. VaR adds value as a risk measure when return distributions are not normally distributed. In these cases the standard deviation is a not a sufficient statistic to measure risk. Risk Premium and Risk Aversion The risk free rate is the rate of return that can be earned with certainty.
The risk premium is the difference between the expected return of a risky asset and the risk-free rate.
Mean Arith. World Stk 9. Stk 9. Stk Nevertheless the arithmetic average is the best measure of the expected return. This is because of the high variance and the higher proportion of negative returns in the small stock portfolio.
Kurtosis of the normal distribution is zero. The world stock, US small stock and world bond portfolio appear to exhibit kurtosis. This indicates a higher percentage of observations in the tails that is predicted by the normal distribution. The world stock and US large stock portfolios may exhibit negative skewness. This indicates a higher probability of extreme negative returns than is predicted in a normal distribution.
Actual vs. The reason for needing the exact version of the Fisher Effect is given in a hidden slide with a hyperlink so that the instructor may use it or not. Note that the approximation version and the exact version of the Fisher Effect will diverge at higher rates of inflation.
Note that since taxes are paid out of nominal earnings you must take taxes out of the nominal return before finding the real return. Stk 6. Stk 8. The Sharpe ratio is a measure of the excess return per unit of standard deviation risk. It literally measures the return per unit of risk taken. Higher Sharpe ratios indicate better the performance for that asset class.
Notice that the Sharpe ratios are higher for the three stock portfolios than the bonds. Thus the stocks offered a higher rate of return per unit of risk. Does that mean investors should not hold bonds? No, adding bonds to a stock portfolio will eliminate proportionally more risk than the return sacrificed and can lead to higher Sharpe ratios.
We may consider investments in a money market mutual fund as a proxy for the riskless investments that an investor might actually engage in. The PPT includes some calculations of weights in the risky and riskless portfolios and the weights in the complete including the risky and riskless components portfolio. The PPT slides then illustrate different asset allocations, i. These combinations fall on a straight line see below because the standard deviation of the riskless asset is zero and because the correlation between the risky and the riskless asset is zero.
Hence all combinations of the risky and the riskless portfolio are linear. The line that depicts the possible allocations between the risky and the riskless portfolio is termed the Capital Allocation Line or CAL. Risk aversion will impact the combinations chosen by an investor. An investor with a low tolerance for risk will likely prefer to invest some funds in the risk-less asset. An investor with a high tolerance for risk may choose to use leverage.
Understanding the CAL now will help students understand the modeling in the next chapter when we consider multiple risky asset combinations. Combinations y less than one represent varying percentages invested in the risky asset P and 1-y the percentage invested in the risk free F. Combinations above P are possible by borrowing money at F. This is conceptually equivalent to buying stock on margin.
More risk averse investors would choose a lower y and less risk averse investors would choose a larger y. Quantifying Risk Aversion Some efforts have been made to quantify risk aversion A. The text assumes that the risk premium or excess return is proportional to the product of the risk aversion level A and the variance of the portfolio.
Indifference curves describe different combinations of return and risk that provide equal utility U or satisfaction. The greater the A the steeper the indifference curve and all else equal, such investors will invest less in risky assets.
The smaller the A the flatter the indifference curve and all else equal, such investors will invest more in risky assets. The PPT slides contain illustrations of using indifference curves to choose the optimal asset allocation on a given CAL. Passive Strategies and the Capital Market Line PPT through PPT In a passive strategy the investor makes no attempt to neither find undervalued strategies nor actively switch their asset allocations.
Investing in a broad stock index and a risk free investment is an example of a passive strategy. In competitive markets active strategies that entail more information production and trading costs might not consistently perform better than passive strategies after considering those costs. As active investors trade upon their information prices will incorporate that information. However looking at the subperiod variation and the large standard deviation indicates that we cannot be very confident about using the historical data to estimate what the risk premium is likely to be in any given time period.
Sharpe ratios have varied considerably as well. Notice the higher risk premium and Sharpe ratio during the time period including the Great Depression. In periods of economic uncertainty we can expect to see higher risk premiums. The concept of risk reduction via diversification created by combining securities with different return patterns is introduced. The student is introduced to analytical tools that are used to create the lowest risk portfolio that meets a target expected return.
After finding the best diversified combinations the risk free asset is combined with the risky portfolio. The capital allocation line that is tangent to the so called efficient frontier of best diversified portfolios will dominate all risky portfolios, regardless of the level of risk aversion.
As in Chapter 5, investors will optimally vary their asset allocation decision according to their risk tolerance by varying the amount they invest in the tangency portfolio and the amount invested in the risk free asset.
See Text figure 6. The single factor index model is introduced; this model predicts stock returns based upon both the firm-specific and market risks of the security. Firm-specific risk may be eliminated by adding more securities to the portfolio.
In a diversified portfolio, firm-specific risk is eliminated, and thus beta systematic or market risk becomes the relevant risk measure of the portfolio. Upon completion of this chapter the student should have a full understanding of systematic and firm-specific risk, and of how one can reduce the amount of firm-specific risk in the portfolio by combining securities with differing patterns of returns. The student should be able to quantify this risk-reduction concept by being able to calculate and interpret covariance and correlation coefficients.
No Shipping Address Required. This is the Test Bank Only. Not The Textbook. Can be called test bank , test banks , TB , test questions , exam bank , question bank , past papers , exam questions and exam book is a collection of every question and answer your Instructor could possibly use when creating an exam or a quiz for your course. The Test Banks and Solutions Manuals as well as the classes and textbooks are essentially two sides of the same coin.
0コメント