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LEONARDO DA VINCI
Transfer of Innovation

Kristina Levišauskait÷

Investment Analysis and Portfolio Management
Leonardo da Vinci programme project

„Development and Approbation of Applied Courses
Based on the Transfer of Teaching Innovations
in Finance and Management for Further Education
of Entrepreneurs and Specialists in Latvia, Lithuania and Bulgaria”

Vytautas Magnus University
Kaunas, Lithuania

2010

Investment Analysis and Portfolio Management

Table of Contents
Introduction …………………………………………………………………………
...
Investment environment and investment management process…………………
...
1 Investing versus financing……………………………………………………7
1
...
Direct versus indirect investment ……………………………………………
...
3
...
11
1
...
1
...
11
1
...
2
...
19
1
...
Investment management process……………………………………………
...
26
Key-terms…………………………………………………………………………28
Questions and problems…………………………………………………………
...
30
Relevant websites…………………………………………………………………31
2
...
32
2
...
Investment income and risk…………………………………………………
...
1
...
Return on investment and expected rate of return…………………
...
1
...
Investment risk
...
35
2
...
Relationship between risk and return………………………………………
...
2
...
Covariance……………………………………………………………36
2
...
2
...
40
2
...
Relationship between the returns on stock and market portfolio……………42
2
...
1
...
43
2
...
2
...
44
Summary…………………………………………………………………………
...
48
Questions and problems…………………………………………………………
...
50
3
...
51
3
...
Portfolio theory………………………………………………………………51
3
...
1
...
51
3
...
2
...
54
3
...
Capital Asset Pricing Model…………………………………………………56
3
...
Arbitrage Price Theory………………………………………………………59
3
...
Market Efficiency Theory……………………………………………………62
Summary…………………………………………………………………………
...
66
Questions and problems……………………………………………………………67
References and further readings…………………………………………………
...
Investment in stocks…………………
...
1
...
71
4
...
Stock analysis for investment decision making………………………………72
4
...
1
...
73
4
...
2
...
75
4
...
Decision making of investment in stocks
...
77
4
...
Formation of stock portfolios………………………………………………
...
5
...
84
Summary…………………………………………………………………………
...
90
References and further readings…………………………………………………
...
93
5
...
94
5
...
Identification and classification of bonds……………………………………94
5
...
Bond analysis: structure and contents………………………………………
...
2
...
Quantitative analysis…………………………………………………
...
2
...
Qualitative analysis…………………………………………………
...
2
...
Market interest rates analysis………………………………………
...
3
...
Bond valuation………………
...
4
...
Immunization…………………………
...
116
Questions and problems…………………………………………………………
...
118
Relevant websites………………………………………………………………
...
Psychological aspects in investment decision making…………………………
...
1
...
120
6
...
Disposition effect…………………………………………………………
...
3
...
124
6
...
Mental accounting and investing…………………………………………
...
5
...
128
Summary………………………………………………………………………
...
132
Questions and problems…………………………………………………………
...
Using options as investments……………………………………………………
...
1
...
135
7
...
Options pricing……………………………………………………………
...
3
...
Profit and loss on options…………………………………
...
4
...
Hedging………………………………
...
146
References and further readings…………………………………………………147
Relevant websites………………………………………………………………
...
Portfolio management and evaluation…………………………………………
...
1
...
2
...
3
...
152
8
...
Portfolio performance measures……………………………………………154
Summary…………………………………………………………………………156
Key-terms………………………………………………………………………
...
158
References and further readings…………………………………………………160
Relevant websites………………………………………………………………
...
162
Bibliography…………………………………………………………………………164
Annexes……………………………………………………………………………
...

Innovative Content of the Course
The course is developed to include the following innovative content:
•

Key concepts of investment analysis and portfolio management which are
explained

from

an

applied

perspective

emphasizing

the

individual

investors‘decision making issues
...


•

Summaries, Key-terms, Questions and problems are provided at the end of
every chapter, which aid revision and control of knowledge acquisition during
self-study;

•

References for further readings and relevant websites for broadening
knowledge and analyzing real investment environment are presented at the end
of every chapter
...


Target Audience for the Course
The target audience is: entrepreneurs, finance and management specialists from
Latvia, Lithuania and Bulgaria
...

The course is intended for 32 academic hours (2 credit points)
...
Following this
objective, key concepts are presented to provide an appreciation of the theory and
practice of investments, focusing on investment portfolio formation and management
issues
...
Both descriptive and quantitative materials on investing are presented
...

The structure of the course
The Course is structured in 8 chapters, covering both theoretical and analytical
aspects of investment decisions:
1
...
Quantitative methods of investment analysis;
3
...
Investment in stocks;

5

Investment Analysis and Portfolio Management

5
...
Psychological aspects in investment decision making;
7
...
Portfolio management and evaluation
...
The types of question include open ended questions as
well as multiple choice questions
...

Summary for the Course
The course provides the target audience with a broad knowledge on the key
topics of investment analysis and management
...

Special attention is given to the formulation of investment policy and strategy
...


6

Investment Analysis and Portfolio Management

1
...
1
...
2
...
3
...
3
...
Investment vehicles
1
...
2
...
4
...
1
...
Funds to be invested come from
assets already owned, borrowed money and savings
...

But it is useful to make a distinction between real and financial investments
...
Financial investments involve contracts in paper or
electronic form such as stocks, bonds, etc
...
Corporate finance typically covers such issues
as capital structure, short-term and long-term financing, project analysis, current asset
management
...
Current assets and current liabilities management addresses how to

7

Investment Analysis and Portfolio Management

manage the day-by-day cash flows of the firm
...
But one of the most important questions for the company is
financing
...
These securities are
traded in the financial markets and the investors have possibility to buy or to sell
securities issued by the companies
...
Corporate
finance area of studies and practice involves the interaction between firms and
financial markets and Investments area of studies and practice involves the interaction
between investors and financial markets
...

Investment problems in many cases allow for a quantitative analysis and modeling
approach and the qualitative methods together with quantitative methods are more
often used analyzing corporate finance problems
...

But at the same time both Corporate Finance and Investments are built upon a
common set of financial principles, such as the present value, the future value, the cost
of capital)
...
For example, when issuing the securities and
selling them in the market the company perform valuation looking for the higher price
and for the lower cost of capital, but the investor using valuation search for attractive
securities with the lower price and the higher possible required rate of return on his/
her investments
...

Speculation can be described as investment too, but it is related with the short-term
investment horizons and usually involves purchasing the salable securities with the
hope that its price will increase rapidly, providing a quick profit
...
But as the fluctuations in the financial markets are and become

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Investment Analysis and Portfolio Management

more and more unpredictable speculations are treated as the investments of highest
risk
...

There are two types of investors:



individual investors;




Institutional investors
...

Sometimes individual investors are called retail investors
...
In recent years the process of
institutionalization of investors can be observed
...

One of important preconditions for successful investing both for individual
and institutional investors is the favorable investment environment (see section 1
...

Our focus in developing this course is on the management of individual
investors’ portfolios
...

1
...
Direct versus indirect investing
Investors can use direct or indirect type of investing
...

The primary difference between these two types of investing is that applying
direct investing investors buy and sell financial assets and manage individual
investment portfolio themselves
...

Contrary, using indirect type of investing investors are buying or selling
financial instruments of financial intermediaries (financial institutions) which invest
large pools of funds in the financial markets and hold portfolios
...
As shareholders with
the ownership interest in the portfolios managed by financial institutions (investment

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Investment Analysis and Portfolio Management

companies, pension funds, insurance companies, commercial banks) the investors are
entitled to their share of dividends, interest and capital gains generated and pay their
share of the institution’s expenses and portfolio management fee
...
In general, indirect investing is more related
with the financial institutions which are primarily in the business of investing in and
managing a portfolio of securities (various types of investment funds or investment
companies, private pension funds)
...

Investors can “employ” their funds by performing direct transactions,
bypassing both financial institutions and financial markets (for example, direct
lending)
...
Cambridge
University Press 2006)
...
From
the other side, direct transactions in the businesses are strictly limited by laws avoiding
possibility of money laundering
...
1
...
1
...
Alternatively, they can obtain funds indirectly from the general
public by using financial intermediaries
...


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Investment Analysis and Portfolio Management

1
...
Investment environment
Investment environment can be defined as the existing investment vehicles in
the market available for investor and the places for transactions with these investment
vehicles
...

1
...
1
...
1, in this course we are focused to the financial
investments that mean the object will be financial assets and the marketable securities
in particular
...

Investment in financial assets differs from investment in physical assets in
those important aspects:
•

Financial assets are divisible, whereas most physical assets are not
...
In case of
financial assets it means, that investor, for example, can buy or sell a small
fraction of the whole company as investment object buying or selling a number
of common stocks
...
Marketability (or
liquidity) reflects the feasibility of converting of the asset into cash quickly and
without affecting its price significantly
...

•

The planned holding period of financial assets can be much shorter than the

holding period of most physical assets
...
Investors acquiring physical asset usually plan to hold it for a long
period, but investing in financial assets, such as securities, even for some
months or a year can be reasonable
...


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Investment Analysis and Portfolio Management

•

Information about financial assets is often more abundant and less costly to

obtain, than information about physical assets
...
Since a big
portion of information important for investors in such financial assets as stocks,
bonds is publicly available, the impact of many disclosed factors having
influence on value of these securities can be included in the analysis and the
decisions made by investors
...
The on going processes of globalization and integration open
wider possibilities for the investors to invest into new investment vehicles which were
unavailable for them some time ago because of the weak domestic financial systems
and limited technologies for investment in global investment environment
...
Thus the investor must understand how investment vehicles differ from
each other and only then to pick those which best match his/her expectations
...
Each type of investment vehicles could be
characterized by certain level of profitability and risk because of the specifics of these
financial instruments
...
However the risk and return on investment
are close related and only using both important characteristics we can really
understand the differences in investment vehicles
...


Short - term investment vehicles are all those which have a maturity of one
year or less
...
The risk
as well as the return on investments of short-term investment vehicles usually is lower
than for other types of investments
...


Certificate of deposit is debt instrument issued by bank that indicates a
specified sum of money has been deposited at the issuing depository institution
...
Most certificates of deposit cannot be traded and they incur
penalties for early withdrawal
...

Treasury bills (also called T-bills) are securities representing financial
obligations of the government
...

They have the unique feature of being issued at a discount from their nominal value
and the difference between nominal value and discount price is the only sum which is
paid at the maturity for these short term securities because the interest is not paid in
cash, only accrued
...
But, of
course, the yield on T-bills changes over time influenced by changes in overall
macroeconomic situation
...
The issuer accepts
competitive bids and allocates bills to those offering the highest prices
...
Bills can be traded before the maturity, while their market price is
subject to change with changes in the rate of interest
...
Bills
are thus regarded as high liquid assets
...
Commercial paper is a means of short-term borrowing by large
corporations
...

Commercial paper is issued either directly from the firm to the investor or through an
intermediary
...
The most common
maturity range of commercial paper is 30 to 60 days or less
...
Also,
commercial paper is not easily bought and sold after it is issued, because the issues are
relatively small compared with T-bills and hence their market is not liquid
...
These vehicles are called bankers acceptances because a bank accepts the
responsibility to repay a loan to the holder of the vehicle in case the debtor fails to
perform
...
This short-term loan
contract typically has a higher interest rate than similar short –term securities to
compensate for the default risk
...

Repurchase agreement (often referred to as a repo) is the sale of security with
a commitment by the seller to buy the security back from the purchaser at a specified
price at a designated future date
...
The collateral in a repo may be a Treasury security, other
money-market security
...
Because of
concern about default risk, the length of maturity of repo is usually very short
...
A reverse repo is the
opposite of a repo
...
Using repos helps to increase the
liquidity in the money market
...

Fixed-income securities are those which return is fixed, up to some
redemption date or indefinitely
...
This type of financial investments is
presented by two different groups of securities:
•

Long-term debt securities

•

Preferred stocks
...
Long term securities have maturity
longer than 1 year
...
Long-term debt securities are traded in the capital
markets
...
But in reality the safety of investment in fixed –income securities is strongly
related with the default risk of an issuer
...
), but by different schemes of interest payments which is a result of
bringing financial innovations to the long-term debt securities market
...
And it is really become the challenge for
investor to pick long-term debt securities relevant to his/ her investment expectations,
including the safety of investment
...

Preferred stocks are equity security, which has infinitive life and pay
dividends
...


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Investment Analysis and Portfolio Management

Though, this security provides for the investor the flow of income very similar to that
of the bond
...
The preferred
stockholders are paid after the debt securities holders but before the common stock
holders in terms of priorities in payments of income and in case of liquidation of the
company
...
If preferred stock is issued as noncumulative,
dividends for the years with losses do not have to be paid
...
Because of having the
features attributed for both equity and fixed-income securities preferred stocks is
known as hybrid security
...
In recent years the preferred stocks with option of convertibility to common
stock are proliferating
...
Common
stock represents the ownership interest of corporations or the equity of the stock
holders
...
The issuers of the common stock are the
companies which seek to receive funds in the market and though are “going public”
...
Thus
many companies are issuing their common stocks which are traded in financial
markets and investors have wide possibilities for choosing this type of securities for
the investment
...

Speculative investment vehicles following the term “speculation” (see p
...
Using
these investment vehicles speculators try to buy low and to sell high, their primary
concern is with anticipating and profiting from the expected market fluctuations
...
Of course, using short-term investment strategies investors can use
for speculations other investment vehicles, such as common stock, but here we try to

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Investment Analysis and Portfolio Management

accentuate the specific types of investments which are more risky than other
investment vehicles because of their nature related with more uncertainty about the
changes influencing the their price in the future
...
An options contract gives the
owner of the contract the right, but not the obligation, to buy or to sell a financial asset
at a specified price from or to another party
...
There is a big uncertainty about if the buyer of the option
will take the advantage of it and what option price would be relevant, as it depends not
only on demand and supply in the options market, but on the changes in the other
market where the financial asset included in the option contract are traded
...
The main aspects of using options for investment will be discussed
in Chapter 7
...
A future contract is an agreement
between two parties than they agree tom transact with the respect to some financial
asset at a predetermined price at a specified future date
...
It is very important, that in
futures contract case both parties are obligated to perform and neither party charges the
fee
...
Speculators buy and sell futures for the sole purpose of
making a profit by closing out their positions at a price that is better than the initial
price
...

In contrary, hedgers buy and sell futures to offset an otherwise risky position in the
market
...

There are derivatives, involving different commodities (coffee, grain, precious metals,

17

Investment Analysis and Portfolio Management

and other commodities)
...

Other investment tools:
•

Various types of investment funds;

•

Investment life insurance;

•

Pension funds;

•

Hedge funds
...
They receive money from investors
with the common objective of pooling the funds and then investing them in securities
according to a stated set of investment objectives
...


Open-end funds have no pre-determined amount of stocks outstanding and
they can buy back or issue new shares at any point
...

Closed-end funds are publicly traded investment companies that have issued a
specified number of shares and can only issue additional shares through a new public
issue
...

Insurance Companies are in the business of assuming the risks of adverse
events (such as fires, accidents, etc
...

Insurance companies are investing the accumulated funds in securities (treasury bonds,
corporate stocks and bonds), real estate
...
During recent years investment life insurance became very popular
investment alternative for individual investors, because this hybrid investment product
allows to buy the life insurance policy together with possibility to invest accumulated
life insurance payments or lump sum for a long time selecting investment program
relevant to investor‘s future expectations
...
Pension

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Investment Analysis and Portfolio Management

funds are investing the funds according to a stated set of investment objectives in
securities (treasury bonds, corporate stocks and bonds), real estate
...
They
require a substantial initial investment from investors and usually have some
restrictions on how quickly investor can withdraw their funds
...
It could be noted that
originally, the term “hedge” made some sense when applied to these funds
...
But today the word “hedge’ is misapplied to these
funds because they generally take an aggressive strategies investing in stock, bond and
other financial markets around the world and their level of risk is high
...
3
...
Financial markets
Financial markets are the other important component of investment
environment
...
In financial
markets funds are channeled from those with the surplus, who buy securities, to those,
with shortage, who issue new securities or sell existing securities
...

Financial market provides three important economic functions (Frank J
...
Financial market determines the prices of assets traded through the
interactions between buyers and sellers;
2
...
Financial market reduces the cost of transactions by reducing explicit costs,
such as money spent to advertise the desire to buy or to sell a financial
asset
...


By sequence of transactions for selling and buying securities:



Primary market




Secondary market

All securities are first traded in the primary market, and the secondary market
provides liquidity for these securities
...
If a
company’s share is traded in the primary market for the first time this is referred to as
an initial public offering (IPO)
...


Secondary market - where previously issued securities are traded among
investors
...

They use security brokers to act as intermediaries for them
...
Finally, clearing and settlement processes ensure that both sides to these
transactions honor their commitment
...
, advice to buy or sell);

•

Online broker is a brokerage firm that allows investors to execute trades
electronically using Internet
...


An organized security exchange provides the facility for the members to trade
securities, and only exchange members may trade there
...
Other exchange members by or sell

20

Investment Analysis and Portfolio Management

for their own account, functioning as dealers or market makers who set prices at which
they are willing to buy and sell for their own account
...
This requires not only regulation of an
orders and transaction costs but also a liquid market in which there are
many buyers and sellers, allowing investors to buy or to sell their securities
quickly;

•

Organization of the clearing and settlement of transactions;

•

The regulation of he admission of companies to be listed on the exchange
and the regulation of companies who are listed on the exchange;

•

The dissemination of information (trading data, prices and announcements
of companies listed on the exchange)
...

The over-the-counter (OTC) market is not a formal exchange
...
There are no
membership requirements and many brokers register as dealers on the OTC
...
OTC stocks are usually considered as very risky because they are the
stocks that are not considered large or stable enough to trade on the major exchange
...
The brokers
who use ATS are acting on behalf of their clients and do not trade on their own
account
...

By term of circulation of financial assets traded in the market:

21

Investment Analysis and Portfolio Management


Money market;

Capital market
Money market - in which only short-term financial instruments are traded
...

The capital markets allow firms, governments to finance spending in excess of their
current incomes
...
2
...

From the perspective of a given country financial markets are:

Internal or national market;

22

Investment Analysis and Portfolio Management


External or international market
...
Domestic market is where the securities issued by domestic issuers
(companies, Government) are traded
...

The external market also is called the international market includes the
securities which are issued at the same time to the investors in several countries and
they are issued outside the jurisdiction of any single country (for example, offshore
market)
...
Because of the globalization of financial
markets, potential issuers and investors in any country become not limited to their
domestic financial market
...
4
...

The investment management process describes how an investor should go about
making decisions
...


Setting of investment policy
...


Analysis and evaluation of investment vehicles
...


Formation of diversified investment portfolio
...


Portfolio revision

5
...


Setting of investment policy is the first and very important step in investment
management process
...
The
investment policy should have the specific objectives regarding the investment return
requirement and risk tolerance of the investor
...
Identifying investor’s tolerance for risk is the most
important objective, because it is obvious that every investor would like to earn the
highest return possible
...
Investment objectives should be stated in terms of both risk
and return
...
Constrains can include any liquidity needs for
the investor, projected investment horizon, as well as other unique needs and
preferences of investor
...

Projected time horizon may be short, long or even indefinite
...
The required rate of return
for investment depends on what sum today can be invested and how much investor
needs to have at the end of the investment horizon
...
The investment policy can include the tax status
of the investor
...

The identification of the potential categories is based on the investment objectives,
amount of investable funds, investment horizon and tax status of the investor
...
3
...
As
an example, for the investor with low tolerance of risk common stock will be not
appropriate type of investment
...
When the investment policy
is set up, investor’s objectives defined and the potential categories of financial assets
for inclusion in the investment portfolio identified, the available investment types can
be analyzed
...
For example, if the common
stock was identified as investment vehicle relevant for investor, the analysis will be
concentrated to the common stock as an investment
...
There are many different approaches how to make such analysis
...

Technical analysis involves the analysis of market prices in an attempt to
predict future price movements for the particular financial asset traded on the market
...
Fundamental analysis in its
simplest form is focused on the evaluation of intrinsic value of the financial asset
...
By comparison of the intrinsic value and market
value of the financial assets those which are under priced or overpriced can be
identified
...

This step involves identifying those specific financial assets in which to
invest and determining the proportions of these financial assets in the investment
portfolio
...
Investment portfolio is the set of investment vehicles, formed by
the investor seeking to realize its’ defined investment objectives
...
Selectivity refers to micro forecasting and focuses on
forecasting price movements of individual assets
...
Diversification involves forming the investor’s portfolio for
decreasing or limiting risk of investment
...

Investment management theory is focused on issues of objective portfolio
diversification and professional investors follow settled investment objectives then
constructing and managing their portfolios
...
This step of the investment management process concerns
the periodic revision of the three previous stages
...
Investor
should form the new portfolio by selling some assets in his portfolio and buying the

25

Investment Analysis and Portfolio Management

others that are not currently held
...
Thus investor should sell one asset ant
buy the other more attractive in this time according to his/ her evaluation
...
For institutional investors portfolio
revision is continuing and very important part of their activity
...
Periodic reevaluation of the investment objectives and portfolios based on them is necessary,
because financial markets change, tax laws and security regulations change, and other
events alter stated investment goals
...
This the last step in
investment management process involves determining periodically how the portfolio
performed, in terms of not only the return earned, but also the risk of the portfolio
...
A benchmark is the performance of predetermined set of
assets, obtained for comparison purposes
...
The benchmarks are widely used by
institutional investors evaluating the performance of their portfolios
...
Market globalization offers investors new possibilities, but at the
same time investment management become more and more complicated with growing
uncertainty
...
The common target of investment activities is to “employ” the money (funds)
during the time period seeking to enhance the investor’s wealth
...

2
...
Both Corporate Finance
and Investments are built upon a common set of financial principles, such as the

26

Investment Analysis and Portfolio Management

present value, the future value, the cost of capital)
...

3
...


The primary difference between these two types of

investing is that applying direct investing investors buy and sell financial assets
and manage individual investment portfolio themselves; contrary, using indirect
type of investing investors are buying or selling financial instruments of financial
intermediaries (financial institutions) which invest large pools of funds in the
financial markets and hold portfolios
...

4
...

5
...
Each type of investment vehicles could be characterized
by certain level of profitability and risk because of the specifics of these financial
instruments
...

6
...
In financial
markets funds are channeled from those with the surplus, who buy securities, to
those, with shortage, who issue new securities or sell existing securities
...
All securities are first traded in the primary market, and the secondary market
provides liquidity for these securities
...
Secondary market - where previously issued
securities are traded among investors
...
They use security brokers to act as intermediaries for
them
...
Financial market, in which only short-term financial instruments are traded, is
Money market, and financial market in which only long-term financial instruments
are traded is Capital market
...
The investment management process describes how an investor should go about
making decisions
...

10
...
The other
constrains which investment policy should include and which could influence the
investment management are any liquidity needs, projected investment horizon and
preferences of the investor
...
Investment portfolio is the set of investment vehicles, formed by the investor
seeking to realize its’ defined investment objectives
...

Selectivity refers to micro forecasting and focuses on forecasting price movements
of individual assets
...

Diversification involves forming the investor’s portfolio for decreasing or limiting
risk of investment
...


Distinguish investment and speculation
...


Explain the difference between direct and indirect investing
...


How could you describe the investment environment?

4
...


Comment the differences between investment in financial and physical assets
using following characteristics:
a) Divisibility
b) Liquidity
c) Holding period
d) Information ability

6
...


Why Treasury bills considered being a risk free investment?

29

Investment Analysis and Portfolio Management

8
...


9
...


10
...
Explain the differences between
a) Money market and capital market;
b) Primary market and secondary market
...
Why the role of the organized stock exchanges is important in the modern
economies?
13
...
Define the objective and the content of a five-step procedure
...
What are the differences between technical and fundamental analysis?
16
...

17
...

a) What could be your investment objectives?
b) What amount of funds you could invest for 3 years period?
c) What investment vehicles could you use for investment? (What types of
investment vehicles are available in your investment environment?)
d) What type(-es) of investment vehicles would be relevant to you? Why?
e) What factors would be critical for your investment decision making in
this particular investment environment?
References and further readings
1
...
Oxford Dictionary of
Economics
...
Oxford University Press Inc
...


2
...
Marcus (2005)
...
6th ed
...


3
...
(1999)
...
2nd
...
Prentice Hall Inc
...


Francis, Jack C
...
Investments: A Global Perspective
...


30

Investment Analysis and Portfolio Management

5
...
European Financial
Markets and Institutions
...


6
...
(2010)
...
John Wiley &
Sons, Inc
...


LeBarron, Dean, Romesh Vaitlingam (1999)
...
Capstone
...


Levy, Haim, Thierry Post (2005)
...
FT / Prentice Hall
...


Rosenberg, Jerry M
...
Dictionary of Investing
...


10
...
Gordon J
...
Bailey
...
Investments
...
Prentice –Hall International
...
cmcmarkets
...
uk

CMC Markets

•

www
...
com

Development Capital Exchange

•

www
...
com

Euronext

•

www
...
com

NASDAQ OMX

•

www
...
org

World Federation of Exchange

•

www
...
net

Hedge Fund

•

www
...
com

Information and learning tools from LIFFE to
help the private investor

•

www
...
com

Association of Mutual Funds Investors

•

www
...
com

Standard &Poors Funds

•

www
...
com/markets

Bloomberg

31

Investment Analysis and Portfolio Management

2
...
1
...

2
...
1
...

2
...
2
...
Variance and standard deviation
...
2
...

2
...
1
...

2
...
2
...

2
...
Relationship between the returns on asset and market portfolio
2
...
1
...

2
...
2
...

Summary
Key terms
Questions and problems
References and further readings

3 basic questions for the investor in decision making:
1
...
How does one asset in the same portfolio influence the other one in the
same portfolio? And what could be the influence of this relationship to the investor’s
portfolio?
3
...

2
...
Investment income and risk
A return is the ultimate objective for any investor
...
As finance and investments areas are built
upon a common set of financial principles, the main characteristics of any investment
are investment return and risk
...

2
...
1
...
In
most cases the investor can estimate his/ her historical return precisely
...


The rate of return is the percentage increase in returns associated with the
holding period:
Rate of return = Income + Capital gains / Purchase price (%)

(2
...
2)

D - dividends;
Pmb - market price of stock at the beginning of holding period;
Pme

-

market price of stock at the end of the holding period
...
2 and 2
...
All the
investor knows is that there is a beginning of the investment period and an end
...
Investor must be very careful with the interpretation of holding period returns
in investment analysis
...

Statistical data which can be used for the investment analysis and portfolio formation
deals with a series of holding period returns
...
How he/ she can compare these series of returns? In
these cases arithmetic average return or sample mean of the returns (ř) can be
used:
n

∑ ri
i=1

ř = ---------,
n
here

(2
...


33

Investment Analysis and Portfolio Management

But both holding period returns and sample mean of returns are calculated
using historical data
...
Of course, no one
investor knows the future, but he/ she can use past information and the historical data
as well as to use his knowledge and practical experience to make some estimates about
it
...

Theoretically it could be a series of discrete possible rates of return in the future for the
same asset with the different probabilities of earning the particular rate of return
...
In mathematical statistics it is called simple probability distribution
...
4)

i=1

Here

hi - probability of rate of return;
ri - rate of return
...
But sometimes sample mean of return (arithmetic
average return) are a useful proxy for the concept of expected rate of return
...
But this is the only one scenario in estimating expected rate
of return
...
However, the assumption,
that the underlying probability distribution does not change its shape for the longer
period becomes more and more unrealistic
...


34

Investment Analysis and Portfolio Management

2
...
2
...
Obvious, that most investors are concerned that
the actual outcome will be less than the expected outcome
...
Risk is associated with the
dispersion in the likely outcome
...
So, the total risk
of investments can be measured with such common absolute measures used in
statistics as
•

variance;

•

standard deviation
...
5)

i=1

To compute the variance in formula 2
...

The other an equivalent to variance measure of the total risk is standard
deviation which is calculated as the square root of the variance:
______________
δ(r) = √ ∑ hi ×[ri - E(r)]²

(2
...
7)

Sample standard deviation (δ
δr) consequently can be calculated as the square
root of the sample variance:
____
δr = √ δ²r

(2
...

Variance and standard deviation are used when investor is focused on
estimating total risk that could be expected in the defined period in the future
...

2
...
Relationship between risk and return
The expected rate of return and the variance or standard deviation provide
investor with information about the nature of the probability distribution associated
with a single asset
...
But how does one asset having some specific trade-off
between return and risk influence the other one with the different characteristics of
return and risk in the same portfolio? And what could be the influence of this
relationship to the investor’s portfolio? The answers to these questions are of great
importance for the investor when forming his/ her diversified portfolio
...
Covariance and correlation are related and they
generally measure the same phenomenon – the relationship between two variables
...

2
...
1
...

The sample covariance is estimated than the investor hasn‘t enough
information about the underlying probability distributions for the returns of two assets
and then the sample of historical returns is used
...
9):

n

36

Investment Analysis and Portfolio Management

∑ [( rA,t - ŕA ) × ( rB,t - ŕB)]
t=1

Cov (ŕA, ŕB) = -----------------------------------------,
n–1
here

(2
...

As can be understood from the formula, a number of sample covariance can

range from “–” to “+” infinity
...
It is difficult to conclud if the relationship
between returns of two assets (A and B) is strong or weak, taking into account the
absolute number of the sample variance
...
Positive number of covariance shows that rates of return
of two assets are moving to the same direction: when return on asset A is above its
mean of return (positive), the other asset B is tend to be the same (positive) and vice
versa: when the rate of return of asset A is negative or bellow its mean of return, the
returns of other asset tend to be negative too
...
Though, in analyzing relationship between the
assets in the same portfolio using covariance for portfolio formation it is important to
identify which of the three possible outcomes exists:

positive covariance (“+”),

negative covariance (“-”) or

zero covariance (“0”)
...

If the negative covariance between the pair of assets is identified the common
recommendation for the investor would be to include both of these assets to the

37

Investment Analysis and Portfolio Management

portfolio, because their returns move in the contrariwise directions and the risk in
portfolio could be diversified or decreased
...
The assets could be included in
the same portfolio, but it is rare case in practice and usually covariance tends to be
positive or negative
...
9) could be a good alternative
...
1, 2
...
3 the identification of positive, negative and zero covariances is demonstrated in
graphical way
...
When the sample mean of
return for both assets is calculated from historical data given, the all area of possible
historical rates of return can be divided into four sections (I, II, III and IV) on the basis
of the mean returns of two assets (ŕA, ŕB consequently)
...

When the historical rates of return of two assets known for the investor are
marked in the area formed by axes ŕA, ŕB, it is very easy to identify what kind of
relationship between two assets exists simply by calculating the number of
observations in each:

if the number of observations in sections I and III prevails over the
number of observations in sections II and IV, the covariance between two
assets is positive (“+”);

if the number of observations in sections II and IV prevails over the
number of observations in sections I and III, the covariance between two
assets is negative(“-”);

if the number of observations in sections I and III equals the number
of observations in sections II and IV, there is the zero covariance between
two assets (“0”)
...
1
...

Rate of return
on security B
rB

II
II

rB

I
IV

of return
r A Rate
on security A

rA

Figure 2
...
Relationship between two assets: negative covariance
...
3
...


39

Investment Analysis and Portfolio Management

The population covariance is estimated when the investor has enough
information about the underlying probability distributions for the returns of two assets
and can identify the actual probabilities of various pairs of the returns for two assets at
the same time
...
10)

i=1

Similar to using the sample covariance, in the population covariance case the
graphical method can be used for the identification of the direction of the relationship
between two assets
...

Despite of it, if investor observes that more pairs of returns are in the sections I and III
than in II and IV, the population covariance will be positive, if the pairs of return in II
and IV prevails over I and III, the population covariance is negative
...
2
...
Correlation and Coefficient of determination
...

The correlation coefficient between two assets is closely related to their
covariance
...
11)

δ (rA) and δ(rB) are standard deviation for asset A and B consequently
...
The more
close the absolute meaning of the correlation coefficient to 1,0, the stronger the
relationship between the returns of two assets
...
2
...
2
...
But most often
correlation between assets returns is imperfect (see Fig
...
6)
...
2
...
Combining two assets with zero correlation with each other
reduces the risk of the portfolio
...


rB

rB

rA

Fig
...
4
...


rA

Fig
...
5
...



...
2
...
Imperfect positive correlation
between returns on two assets
...
2
...
Zero correlation between
returns on two assets
...
12)

Therefore, as it was pointed out earlier, the covariance primarily provides
information to the investor about whether the relationship between asset returns is
positive, negative or zero, because simply observing the number itself without any
context with which to compare the number, is not very useful
...


But using correlation

coefficients instead of covariance investor can immediately asses the degree of
relationship between assets returns
...
AB) is calculated as the square of
correlation coefficient:
Det
...
13)

The coefficient of determination shows how much variability in the returns of
one asset can be associated with variability in the returns of the other
...
The interpretation of this number for the investor is that
approximately 64 percent of the variability in the returns of one asset can be explained
by the returns of the other asset
...

2
...
Relationship between the returns on stock and market portfolio
When picking the relevant assets to the investment portfolio on the basis of
their risk and return characteristics and the assessment of the relationship of their
returns investor must consider to the fact that these assets are traded in the market
...
The statistics can be explored to
answer these questions as well
...
3
...
The characteristic line and the Beta factor
Before examining the relationship between a specific asset and the market
portfolio the concept of “market portfolio” needs to be defined
...
But
going from conceptual to practical approach - how to measure the return of the market
portfolio in such a broad its understanding - the market index for this purpose can be
used
...
And if
the investor following his/her investment policy makes the decision to invest, for
example, only in stocks, the market portfolio practically can be presented by one of the
available representative indexes in particular stock exchange
...
With the given historical
data about the returns on the particular common stock (rJ) and market index return (rM)
in the same periods of time investor can draw the stock’s characteristic line (see Fig
...
8
...
8
...


43

Investment Analysis and Portfolio Management

Stock’s characteristic line:

describes the relationship between the stock and the market;

shows the return investor expect the stock to produce, given that a
particular rate of return appears for the market;

helps to assess the risk characteristics of one stock relative to the market
...
2
...

The slope of the characteristic line is called the Beta factor
...
14)

Cov(rJ,rM) – covariance between returns of stock J and the market portfolio;
δ²(rM) - variance of returns on market portfolio
...
The Beta gives the answer
to the investor how much the stock return will change when the market return will
change by 1 percent
...

Intercept AJ (the point where characteristic line passes through the vertical
axis) can be calculated using following formula:
AJ = rJ - βJ × rM,
here:

(2
...

The intercept technically is a convenient point for drawing a characteristic line
...

2
...
2
...
A
characteristic line is what in statistics is called as time-series regression line
...
2
...

In statistics this propensity is called the residual variance
...
15)

εJ,t - residual of the stock J in period t;
n - number of periods observed
...
Residual is the vertical distance between the point which reflect
the pair of returns (stock J and market) and the characteristic line of stock J
...
1
c
...
16)

It is useful for the interpretation of residual to investor to accentuate two
components in formula of residual (see 2
...


Note the difference between the variance and the residual variance:

The variance describes the deviation of the asset returns from its expected
value ;

The residual variance describes the deviation of the asset returns from its
characteristic line
...
The main characteristics of any investment are investment return and risk
...

2
...
Many
investments have two components of their measurable return: (1) a capital gain or

45

Investment Analysis and Portfolio Management

loss; (2) some form of income
...

3
...
In these cases arithmetic
average return or sample mean of the returns can be used
...
Both holding period returns and sample mean of returns are calculated using
historical data
...
The expected rate of return of investment is
the statistical measure of return, which is the sum of all possible rates of returns for
the same investment weighted by probabilities
...
Risk can be defined as a chance that the actual outcome from an investment will
differ from the expected outcome
...
Variance can be calculated as a potential deviation of each possible
investment rate of return from the expected rate of return
...
The more variable the possible
outcomes that can occur, the greater the risk
...
In the cases than the arithmetic average return or sample mean of the returns is
used instead of expected rate of return, sample variance and sample standard
deviation is calculated
...
Covariance and correlation coefficient are used to answer the question, what is the
relationship between the returns on different assets
...

8
...
The population covariance is estimated
when the investor has enough information about the underlying probability
distributions for the returns of two assets and can identify the actual probabilities
of various pairs of the returns for two assets at the same time
...
Analyzing relationship between the assets in the same portfolio using covariance
for portfolio formation it is important to identify which of the three possible
outcomes exists: positive covariance, negative covariance or zero covariance
...

10
...
But instead of covariance when the calculated number is unbounded,
the correlation coefficient can range only from -1,0 to +1,0
...
Using correlation coefficients instead of
covariance investor can immediately asses the degree of relationship between
assets returns
...
The coefficient of determination is calculated as the square of correlation
coefficient and shows how much variability in the returns of one asset can be
associated with variability in the returns of the other
...
Theoretical interpretation of the market portfolio is that it involves every single
risky asset in the global economic system, and contains each asset in proportion to
the total market value of that asset relative to the total value of all other assets
(value weighted portfolio)
...

13
...

14
...
The Beta factor of the
stock is an indicator of the degree to which the stock reacts to the changes in the
returns of the market portfolio
...
The intercept is the point where characteristic line passes through the vertical axis
...

16
...

Key-terms
•

Beta factor

•

Probability

•

Characteristic line

•

Residual

•

Coefficient of correlation

•

Residual variance

•

Coefficient of determination

•

Return on investment

•

Correlation

•

Sample mean of return

•

Covariance

•

Sample standard deviation

•

Expected rate of return

•

Sample covariance

•

Holding period return

•

Sample variance

•

Intercept

•

Simple probability distribution

•

Investment risk

•

Standard deviation

•

Market portfolio

•

Variance

•

Population covariance

Questions and problems
1
...

2
...

3
...
Can any of these components be
negative?
4
...
What does a probability distribution describe?
6
...
Explain, why doesn’t an estimated absolute covariance number tell the investor
much about the relationship between the returns on the two assets?
8
...
What is the interpretation of the coefficient of determination for the investor? If the
coefficient of correlation for two securities is 0,7, what is the coefficient of
determination?
10
...

11
...
With which of stock’s characteristic line definitions presented below you disagree?
a) Stock’s characteristic line describes the relationship between the stock
and the market;
b) Stock’s characteristic line shows the return investor expect the stock to
produce, given that a particular rate of return appears for the market;
c) Stock’s characteristic line describes the relationship between rate of
return of any two different stocks in the market;
d) I agree with all definitions presented above
...
Refer to the following information on joint stock returns for stock 1, 2, and 3 in
the table
Probability
0
...
30
0
...
25

Stock 1
0
...
05
0
...
25
0
...
05
-0
...
10
0
...
05

If you must choose only two stocks to your investment portfolio, what would be
your choise?
a) stocks 1 and 2; b) stocks 1 and 3; c) stocks 2 and 3; d) other decision
...

14
...
24
-0,04
0,10
0,06
0,10

Rate of return
Market portfolio
0,12
0,08
-0,10
-0,02
0,08
0,07

49

Investment Analysis and Portfolio Management

a) Calculate the main statistic measures to explain the relationship between stock
A and the market portfolio:
•

The sample covariance between rate of return for the stock A and the
market;

•

The sample Beta factor of stock A;

•

The sample correlation coefficient between the rates of return of the
stock A and the market;

•

The sample coefficient of determination associated with the stock A and
the market
...

d) Do you recommend this stock for the investor with the lower tolerance of risk?
References and further readings
1
...
(1999)
...
2nd
...
Prentice Hall Inc
...
Francis, Jack, C
...
Investments: A Global Perspective
...

3
...
2001)
...
5th ed
...

4
...
Investments
...

5
...
(1993)
...
John Wiley &Sons Inc
...
Sharpe, William F
...
Alexander, Jeffery V
...
(1999)
...

International edition
...

7
...
(1993)
...


50

Investment Analysis and Portfolio Management

3
...
1
...

3
...
1
...

3
...
2
...

3
...
Capital Asset Pricing Model (CAPM)
...
3
...

3
...
Market efficiency theory
...
1
...
1
...
Markowitz portfolio theory
The author of the modern portfolio theory is Harry Markowitz who introduced
the analysis of the portfolios of investments in his article “Portfolio Selection”
published in the Journal of Finance in 1952
...

Prior to this investors would examine investments individually, build up portfolios of
attractive stocks, and not consider how they related to each other
...

The diversification plays a very important role in the modern portfolio theory
...
Because a portfolio is a collection of
securities, this decision is equivalent to selecting an optimal portfolio from a set of
possible portfolios
...

The method that should be used in selecting the most desirable portfolio involves
the use of indifference curves
...
These curves should be drawn, putting the investment return on the
vertical axis and the risk on the horizontal axis
...
1)
...
3
...
Each indifference curve here (I1, I2, I3 ) represents the
most desirable investment or investment portfolio for an individual investor
...

Features of indifference curves:

All portfolios that lie on a given indifference curve are equally desirable to
the investor
...


An investor has an infinitive number of indifference curves
...

Every investor has a map of the indifference curves representing his or her
preferences for expected returns and risk (standard deviations) for each
potential portfolio
...
3
...
Map of Indiference Curves for a Risk-Averse Investor
Two important fundamental assumptions than examining indifference curves
and applying them to Markowitz portfolio theory:
1
...
Thus, given two
portfolios with the same standard deviation, the investor will choose the

52

Investment Analysis and Portfolio Management

portfolio with the higher expected return
...

2
...
It means that the investor when given the choise,
will choose the investment or investment portfolio with the smaller risk
...

Expected
rate of
return ( r )

rA = rB
rC

A

B

C

σA = σC

σB

Risk ( σ )

Fig
...
2
...
3
...
gives an example how the investor chooses between 3 investments –
A,B and C
...
Following the assumption of
risk aversion investor will choose A, despite of the same level of expected returns for
investment A and B, because the risk (standard deviation) for investment A is lower
than for investment B
...

In reality there are an infinitive number of portfolios available for the
investment
...

Efficient set of portfolios involves the portfolios that the investor will find
optimal ones
...
The efficient frontier can be described by the

53

Investment Analysis and Portfolio Management

curve in the risk-return space with the highest expected rates of return for each level of
risk
...
The feasibility set represents all portfolios that could be formed from the
number of securities and lie either or or within the boundary of the feasible set
...
3
...
Considering
the assumptions of nonsiation and risk aversion discussed earlier in this section, only
those portfolios lying between points A and B on the boundary of feasibility set
investor will find the optimal ones
...
Furthermore, if a risk-free investment is introduced into the
universe of assets, the efficient frontier becomes the tagental line shown in Fig
...
3 this
line is called the Capital Market Line (CML) and the portfolio at the point at which it
is tangential (point M) is called the Market Portolio
...
3
...
Feasible Set and Efficient Set of Portfolios (Efficient Frontier)
3
...
2
...
Thus, the methods for
calculating expected rate of return and standard deviation of the portfolio must be
discussed
...
The Markowitz focus was on the end-of-period wealth (terminal
value) and using these expected end-of-period values for each security in the portfolio
the expected end-of-period return for the whole portfolio can be calculated
...
4)
...
1)

i=1

here

wi - the proportion of the portfolio’s initial value invested in security i;
Ei(r) - the expected rate of return of security I;
n -

the number of securities in the portfolio
...
Nothing else is relevant
...
But
why the majority of investors don‘t do so and keep several different securities in their
portfolios? Because they try to diversify their portfolios aiming to reduce the
investment portfolio risk
...
As we know from chapter 2, the most often used
measure for the risk of investment is standard deviation, which shows the volatility of
the securities actual return from their expected return
...

The reason is that the relationship between the securities in the same portfolio must be
taken into account
...
2, the relationship between the
assets can be estimated using the covariance and coefficient of correlation
...

Risk of the portfolio, which consists of 2 securities (A ir B):
δp = (w²A × δ²A + w²B ×δ²B + 2 wA × wB × kAB × δA×δB)1/2,

(3
...

Standard deviation of the portfolio consisting n securities:
n

δ=

n

(∑∑

wi wj kij δi δj )1/2 ,

(3
...


3
...
Capital Asset Pricing Model (CAPM)
CAPM was developed by W
...
Sharpe
...
Markowitz showed that for a given level of
expected return and for a given feasible set of securities, finding the optimal portfolio
with the lowest total risk, measured as variance or standard deviation of portfolio
returns, requires knowledge of the covariance or correlation between all possible
security combinations (see formula 3
...
When forming the diversified portfolios
consisting large number of securities investors found the calculation of the portfolio
risk using standard deviation technically complicated
...
)

56

Investment Analysis and Portfolio Management

Unsystematic risk is unique to an individual asset (business risk, financial risk,
other risks, related to investment into particular asset)
...
4)
...
Though, CAPM only links
investments via the market as a whole
...
3
...
Portfolio risk and the level of diversification
The essence of the CAPM: the more systematic risk the investor carry, the
greater is his / her expected return
...


•

Investors are risk-averse,

•

Taxes and transaction costs are irrelevant
...


Following these assumptions, the CAPM predicts what an expected rate of
return for the investor should be, given other statistics about the expected rate of
return in the market and market risk (systematic risk):

57

Investment Analysis and Portfolio Management

E(r j) = Rf + β(j) * ( E(rM) - Rf ),
here:

(3
...


Several of the assumptions of CAPM seem unrealistic
...
And the investors usually do look ahead more than one period
...
All things considered, the
assumptions of the CAPM constitute only a modest gap between the thory and reality
...

As can be seen in Fig
...
5, Equation in formula 3
...
This relationship between
the expected return and Beta is known as Security Market Line (SML)
...


E(r
)
rK
rL
rM
Rf

SML1
K

SML

L
M

1
...
3
...
Security Market Line (SML)
Coefficient Beta (β
β )
...
Coefficient Beta (β) indicates how
the price of security/ return on security depends upon the market forces (note: CAPM
uses the statistic measures which we examined in section 2
...

Thus, coefficient Beta for any security can be calculated using formula 2
...
1
Interpretation of coefficient Beta (β
β)
Beta

2,0
1,0
0,5
0
Minus
0,5
Minus
1,0
Minus
2,0

Direction of changes
in security’s return
in comparison to the
changes in market’s
return
The same as market
The same as market
The same as market
There is no
relationship
The opposite from the
market
The opposite from the
market
The opposite from the
market

Interpretation of β meaning

Risk of security is twice higher than market risk
Security’s risk is equal to market risk
Security’s risk twice lower than market risk
Security’s risk are not influenced by market risk
Security’s risk twice lower than market risk, but in
opposite direction
Security’s risk is equal to market risk but in
opposite direction
Risk of security is twice higher than market risk,
but in opposite direction

One very important feature of Beta to the investor is that the Beta of portfolio is
simply a weighted average of the Betas of its component securities, where the
proportions invested in the securities are the respective weights
...
+ wnβn = ∑ wi * βi ,

(3
...

Earlier it was shown that the expected return on the portfolio is a weighted

average of the expected returns of its components securities, where the proportions
invested in the securities are the weights
...
That means, that not only every security, but also
every portfolio must plot on an upward sloping straight line in a diagram (3
...

3
...
Arbitrage Pricing Theory (APT)
APT was propsed ed by Stephen S
...
Still there is a potential for it and it may sometimes displace the CAPM
...
The
key point behind APT is the rational statement that the market return is determined by
a number of different factors
...
If
these factors are essential, there to be no arbitrage opportunities there must be
restrictions on the investment process
...
Arbitrage is is widely applied investment tactic
...
+ βnJ InJ + εJ ,
here:

(3
...
, n);

βiJ - coefficient Beta, showing sensitivity of security’s J rate of return
upon the factor i (this influence could be both positive or negative);
εJ - error of rounding for the security J (expected value – 0)
...

There could presumably be an infinitive number of factors, although the
empirical research done by S
...
Roll (1984) identified four factors
– economic variables, to which assets having even the same CAPM Beta, are
differently sensitive:
•

inflation;

•

industrial production;

•

risk premiums;

•

slope of the term structure in interst rates
...
The examples
of possible macroeconomic factors which could be included in using APT model :
•

GDP growth;

•

an interest rate;

•

an exchange rate;

•

a defaul spread on corporate bonds, etc
...
The institutional investors
and analysts closely watch macroeconomic statistics such as the money supply,
inflation, interest rates, unemployment, changes in GDP, political events and many
others
...
But it is
important to point out that not all investors or analysts are concerned with the same set
of economic information and

they differently assess

the importance of various

macroeconomic factors to the assets they have invested already or are going to invest
...
The noise is coming from
minor factors, with a little influence to the result – expected rate of return
...
Much of the current
empirical APT research are focused on identification of these factors and the
determination of the factors’ Betas
...
Although more
than two decades have passed since S
...

The CAPM and APT are not really essentially different, because they are
developed for determing an expected rate of return based on one factor (market
portfolio – CAPM) or a number of macroeconomic factors (APT)
...


61

Investment Analysis and Portfolio Management

3
...
Market efficiency theory
The concept of market efficiency was proposed by Eugene Fama in 1965, when
his article “Random Walks in Stock Prices” was published in Financial Analyst
Journal
...
The key term in the concept of the market efficiency is the
information available for investors trading in the market
...
All known information, including:

Past information, e
...
, last

year’s or last quarter’s, month’s

earnings;

Current information as well as events, that have been announced but
are still forthcoming, e
...
shareholders’ meeting
...
Information that can reasonably be inferred, for example, if many investors
believe that ECB will increase interest rate in the nearest future or the government
deficit increases, prices will reflect this belief before the actual event occurs
...

What is the important information for the investor? From economic point of
view the important information is defined as such information which has direct
influence to the investor’s decisions seeking for his defined financial goals
...

Market efficiency requires thet the adjustment to new information occurs very
quikly as the information becomes known
...

There are 3 forms of market efficiency under efficient market hypothesis:
•

Weak form of efficiency;

•

Semi- strong form of efficiency;

•

Strong form of the efficiency
...
So, if the
market is characterized by weak form of efficiency, no one investor or any group of
investors should be able to earn over the defined period of time abnormal rates of
return by using information about historical prices available for them and by using
technical analysis
...

Under the semi-strong form of efficiency all publicly available information is
presumed to be reflected in stocks’ prices
...
Note that
the market with a semi strong form of efficiency encompasies the weak form of the
hypothesis because the historical market data are part of the larger set of all publicly
available information
...

The strong form of efficiency which asserts that stock prices fully reflect all
information, including private or inside information, as well as that which is publicly
available
...

Under this form of market efficiency securities’ prices quickly adjust to reflect both
the inside and public information
...

The validity of the market efficiency hypothesis whichever form is of great
importance to the investors because it determines whether anyone can outperform the
market, or whether the successful investing is all about luck
...


63

Investment Analysis and Portfolio Management

The concept of the market efficiency now is criticezed by some market analysts
and participants by stating that no one market can be fully efficient as some irrational
behavior of investors in the market occurs which is more based on their emotions and
other psychological factors than on the information available (the psychological
aspects of investment decision making will be disscussed further, in chapter 6)
...

Summary
1
...
The Markowitz approach included portfolio formation by considering
the expected rate of return and risk of individual stocks measured as standard
deviation, and their interrelationship as measured by correlation
...


2
...
These
curves should be drawn, putting the investment return on the vertical axis and the
risk on the horizontal axis
...


Two important fundamental assumptions than applying indifference curves to
Markowitz portfolio theory
...
An assumption of risk aversion assumes that the
investor when given the choise,

will choose the investment or investment

portfolio with the smaller risk, i
...
the investors are risk averse
...


Efficient set theorem states that an investor will choose his/ her optimal portfolio
from the set of the portfolios that (1) offer maximum expected return for varying
level of risk, and (2) offer minimum risk for varying levels of expected return
...


Efficient set of portfolios involves the portfolios that the investor will find
optimal ones
...
The efficient frontier can be
described by the curve in the risk-return space with the highest expected rates of
return for each level of risk
...
The feasibility set represents all
portfolios that could be formed from the number of securities and lie either or or
within the boundary of the feasible set
...


Capital Market Line (CML) shows the trade off-between expected rate of return
and risk for the efficient portfolios under determined risk free return
...


The expected rate of return on the portfolio is the weighted average of the
expected returns on its component securities
...


The calculation of standard deviation for the portfolio can‘t simply use the
weighted average approach
...
When forming the diversified portfolios consisting large
number of securities investors found the calculation of the portfolio risk using
standard deviation technically complicated
...


Measuring Risk in Capital asset Pricing Model (CAPM) is based on the
identification of two key components of total risk: systematic risk and
unsystematic risk
...

Unsystematic risk is unique to an individual asset and can be diversified away by
holding many different assets in the portfolio
...


10
...

11
...
Coefficient Beta (β) indicates how the price of security/ return
on security depends upon the market forces
...

12
...
Each security can be described by its specific security market
line, they differ because their Betas are different and reflect different levels of
market risk for these securities
...
Arbitrage Pricing Theory (APT) states, that the expected rate of return of security
is the linear function from the complex economic factors common to all
securities
...
The
examples of possible macroeconomic factors which could be included in using
APT model are GDP growth; an interest rate; an exchange rate; a defaul spread
on corporate bonds, etc
...
Market efficiency means that the price which investor is paying for financial
asset (stock, bond, other security) fully reflects fair or true information about the
intrinsic value of this specific asset or fairly describe the value of the company –
the issuer of this security
...

15
...
Under the weak form of efficiency stock prices are assumed to reflect
any information that may be contained in the past history of the stock
prices
...
The strong form of efficiency which
asserts that stock prices fully reflect all information, including private or inside
information, as well as that which is publicly available
...
Explain why most investors prefer to hold a diversified portfolio of securities as
opposed to placing all of their wealth in a single asset
...
In terms of the Markowitz portfolio model, explain, how an investor identify his /
her optimal portfolio
...
How many portfolios are on an efficient frontier? How is an investor’s risk
aversion indicated in an indiference curve?
4
...

5
...
Does that fact invalidate model’s calculations? Explain
...
If the risk-free rate of return is 6% and the return on the market portfolio is 10%,
what is the expected return on an asset having a Beta of 1,4, according to the
CAPM?
7
...
Given the following information:
•

Expected return for stock A = 18%

•

Expected return for stock B = 25%

•

Standartd deviation of stock A = 12%

•

Standard deviation of stock B = 20%

•

Correlation coefficient = 1,0
...


9
...

10
...
The Betas of these stocks
and their proportions in portfolio are shown in the table
...
How does the CAPM differs from the APT model?
12
...
Which of them are more /less
risky and why?
Stock
A
B
C
D
E
F

Beta
0,92
2,20
0,97
-1
...
18
0,51

13
...
If the efficient market hypothesis is true, what are the implications for the
investors?

68

Investment Analysis and Portfolio Management

15
...

16
...


17
...
The characteristics of the securities
and their proportions in the portfolio are presented in the table
...
The following table presents the three-stock portfolio
...

a)

What is the Beta coefficient of the portfolio?

b)

What is the expected rate of return on the portfolio?

c)

What is an actual

variance of the portfolio, if the following actual

covariance between the stock’s returns is given:
Cov (rA, rB) = 0,020
Cov (rA, rC) = 0,035
Cov (rB, rC) = 0,035

69

Investment Analysis and Portfolio Management

References and further readings
1
...
Random Walks in Stock Prices
...

2
...
Efficient Capital Markets: A

Review of Theory and

Empirical Work// Journal of Business
...
Haugen, Robert A
...
The New Finance
...
Prentice Hall
...
Haugen, Robert A
...
Modern Investment Theory
...
Prentice Hall
...
Jones, Charles P
...
Investments Principles and Concepts
...

6
...
(1952)
...
// Journal of Finance,7(1), p
...

7
...
(1964)
...
425-442
...
Sharpe, William F
...
Alexander, Jeffery V
...
(1999)
...

International edition
...

9
...
(1993)
...


70

Investment Analysis and Portfolio Management

4
...
1
...

4
...
Stock analysis for investment decision making
...
2
...
E-I-C analysis
...
2
...
Fundamental analysis
...
3
...
Stock
...
4
...

4
...
Strategies for investing in stocks
...
1
...

2 main types of stock (see Chapter 1)
•

Common stock

•

Preferred stock

In this chapter we focus only on the investment in common stocks
...


•

Investor receives benefits in the form of dividends, capital gains or both
...


•

Common stock has no stated maturity
...
But: some corporations pay
cash to their shareholders by purchasing their own shares
...


71

Investment Analysis and Portfolio Management

•

Common stocks on the whole historically have provided a higher return,
but they also have higher risk
...


Main advantages of common stock as investment:
•

the investment income is usually higher;

•

the investor can receive operating income in cash dividends;

•

common stock has a very high liquidity and can easily be moved from one
investor to the other;

•

the costs of transaction with common stocks involved are relatively low;

•

the nominal price of common stock is lower in comparison with the other
securities
...


4
...
Stock analysis for investment decision making
In this section the focus is on the fundamental analysis of common stocks
...
By performing fundamental analysis investor forecasts among other
things, the future changes in GDP, changes sales, other performance indicators for a
number of

industries and, in particular, future sales, earnings for a number of the

firms
...

Analysts and investors use two alternative approaches for fundamental
analysis:
•

“Top-down” forecasting approach;

•

“Bottom-up” forecasting approach
...
The industry forecasts are based on the forecasts for the economy and a
company’s forecasts are based on the forecasts for both its industry and the economy
...

In practice “top down” approach prevail in analysis and forecasting because
logically for forecasting of the companies performance the changes in macroeconomic
environment must be analyzed first otherwise the inconsistent assumptions could be
drawn
...
For example,
analysis and forecasts are made for the economy using “top-down” approach and then
using “bottom-up” approach continuing with the forecasts for individual companies
...

4
...
1
...


I - Industry analysis (evaluates the situation in the particular industry/
economic sector and its potential influence on the profitability of
stocks)
...
)

•

Monetary policy (the stability of national currency against other foreign
currencies; the ability of authorities (Central Bank) to use the money
market instruments on time, etc
...
)

•

What is the stage of the industry’s development cycle? (Introductory?
Growth? Maturity? Decline?)

The other way for the development of Industry’s analysis by focusing it into
four important areas:
I
...
Pricing:
•

How consolidated (concentrated) is this industry?

•

What are the barriers for entrance to this industry? Are they high?

•

How powerful and demanding are the consumers in this industry?

•

Is where in the market of industry’s goods the surplus, how strong is
the fight for market share?

•

Is where in this industry a high competition in the international
environment?

III
...
The influence of the whole economics and financial market to the
industry:
•

Is this industry defensive or growing? How it could function in
period of economic recession?

•

How is this industry influenced by interest rates?

•

Are severe stocks dominated in this industry?

•

Is this sector global?

•

How the fluctuations in currency exchange rate are influencing the
sector? Are these fluctuations of currency exchange rate influencing
the amount of profit received from abroad or the competitiveness of
the sector?

•

Is it possibility that political and/ or regulation risk could influence
the sector?

4
...
2
...

Ratio analysis is useful when converting raw financial statement information into
a form that makes easy to compare firms of different sizes
...
Profitability ratios, which measure the earning power of the firm
...
Liquidity ratios, which measure the ability of the firm to pay its immediate
liabilities
...
Debt ratios, which measure the firm’s ability to pay the debt obligations over
the time
...
Asset – utilization ratios, which measure the firm’s ability to use its assets
efficiently
...
Market value ratios are an additional group of ratios which reflect the market
value of the stock and the firm
...
1
Financial ratios by category
Ratio

Equation

Profitability ratios
Gross profit margin

Gross profit/ Sales

Operating profit margin

Operating profit / Sales

Net profit margin

Net income/ Sales

Return on assets (ROA)

Net income / Total assets

Return on equity (ROE)

Net income / Stockholders’ equity

Liquidity ratios
Current ratio

Current assets / Current liabilities

Quick ratio

(Current assets – Inventory) / Current liabilities

Net working capital

Current assets - Current liabilities

Debt ratios
Debt to assets

Total liabilities / Total assets

Debt to equity

Total Debt / Equity

Times interest earned

Income before interest and taxes / Interest

76

Investment Analysis and Portfolio Management

Asset utilization ratios
Inventory turnover

Cost of goods sold / Inventory

Receivables turnover

Sales (credit) / Receivables

Fixed asset turnover

Sales/ Fixed assets

Total assets turnover

Sales/ Total assets

Market Value Ratios
Capitalization
Earnings per share (EPS)
Price/Earnings ratio (PER)
Book value of the stock
Market price to Book value
Dividends per share
Payout Ratio

Number of common stock *
Market price of the common stock
(Net Income – Cash Dividends of Preferred stock) /
Number of Common Stocks
Market price of the stock/ Earnings per share
(Equity–Preferred stock- Preferred stock dividends) /
Number of Common Stock
Market price of the stock /
Book value of the stock
(Dividends - Preferred stock dividends)/
Number of Common Stock
Dividends per share / Earnings per share

Market value ratios provide an investor with a shortest way to understand how
attractive the stock in the market is
...
Thus, only using the other groups of
financial ratios investor can receive “a full picture” of the financial condition of the
firm and when continue with stock valuation
...
The selection of the appropriate benchmark is
a difficult decision
...
However, such
comparisons do not always reveal whether the company is buy-worthy, because the
whole size category, country or industry may under perform
...

4
...
Decision making of investment in stocks
...
The distinction between fundamental and speculative value of stock is very
important one
...

Stock valuation process:
1
...

2
...

3
...
This result is intrinsic
(investment) value of stock
...
Comparison of intrinsic value of stock and current market price of the stock
and decision making: to buy or to sell the stock
...
Method of income capitalization
...
Discounted dividend models
...
Valuation using multiples
...
The value of any investment could be estimated as present value of
future cash flows generated by this investment, using formula:
V = CF1 / (1 + k) + CF2/ (1 + k)² + … + CFn / (1 + k)ⁿ =
= ΣCFt/ (1 + k)t
here

(4
...


Discounted dividend models
The discounted dividends models (DDM) is based on the method of income
capitalization and considers the stock price as the discounted value of future dividends,
at the risk adjusted required return of equity, for dividend paying firms
...

Common stock value using DDM:
V = D1 /(1 + k) + D2 / (1 + k)² + … + Dn/(1 + k)ⁿ =

Σ Dt / (1 + k)t ,

(4
...

The forecasted dividends during long-term valuation period of dividends are

the key factor influencing the stock value
...
3)

Various types of DDM, depending upon the assumptions about the expected
growth rate in dividends (g):

“Zero” growth DDM

Constant growth DDM

Multistage growth DDM
“Zero” growth DDM
Assumption: D1 = D2 = D3 =
...

The basic DDM formula for stock valuation using “zero” growth model
becomes as follows:
V = D1/ k

or

D0 / k0

(4
...
5)

t=1

or
V = D1/ (k - g)

(Gordon formula)

(4
...
Dividends before period T (D1, D2, D3,
...
Investor individually defines then the period T will
start
...
7)

t=1

Valuation, when the stock keeping period is fixed
Example for 1 year:
V =

(D1 + P1) / (1 + k) = + P1 / (1 + k) ,

(4
...
2)

t=1

Decisions for the investor in stocks:



If Pm < V -

decision to buy the stock, because it is under valuated;




If Pm > V -

decision to sell the stock, because it is over valuated;




If Pm = V -

stock is valuated at the same range as in the market and
its current market price shows the intrinsic value
...

The most common used multiply is the Price Earning Ratio (PER):
PER = P / EPS,
here:

(4
...
10)

Observed PER
...
Earnings per share are observed or estimates
of analysts
...
What should be the PER, according to analysts, might
differ from observed PER
...

PER* = V / EPS0 ,

(4
...

Investor might consider that the PER* that should apply to the firm, of which
stock value has to be estimated, should be in line with peer firms selected or the
industry average
...
In
this case the decision depends on the additional observations of investor
...
This is
because PERs are a synthetic measure combining all effects of different equity value
drivers: growth, profitability, risk
...
PER is decreasing then the risk of the firm is
increasing
...

The other alternative multiples used for stock valuation by investors include:
•

Sales / Market capitalization of the firm

•

Sales / Equity value

•

Market capitalization /Book Value of the Equity Ratio
...

Example could be the high growth (Internet) firms with negative net income, negative
EPS and actual stock price irrelevant usage
...

4
...
Formation of stock portfolios
In this section we review the important principles behind the stock selection
process that are relevant in the formation and management of the stock portfolios
...

The most widely used categories of stocks are:
•

blue chip stocks;

•

income stocks;

•

cyclical stocks;

•

defensive stocks;

•

growth stocks;

•

speculative stocks;

•

Penny stocks
...
These stocks represent the best-known firms among the investment community
...
One common definition of
Blue Chip Company is that this company has long continuous history of divided
payments
...
But it doesn’t mean that the younger successful companies running business
for some decades and paying dividends can’t be categorized as “blue chips” in the
specific investment environment
...
It is a practice that brokerage
firms recommend for their clients – individual investors the list of blue chip stock as
high quality ones in their understanding, based on the analysis of information about
the firm
...
It is considered a conservative,
dependable investment, suitable to supplement other income
...
In addition, income stocks usually are those that historically have paid a
larger-than-average percentage of their net income after taxes as dividends to their
shareholders and the payout ratio for these companies are high
...

Cyclical stocks are the securities that go up and down in value with the trend
of business and economy, rising faster in the periods of rapidly improving business
conditions and sliding very noticeably when business conditions deteriorate
...
The term cyclical does not imply that these stocks are more
predictable than other categories
...

The examples of cyclical stocks can be industrial chemicals, construction industry,
automobile producers, etc
...
These stocks shift little in price movements and are very
rarely of interest to speculators
...
Held by long-term investors seeking stability,
these stocks frequently withstand selling pressure in a falling market
...
Other defensive products include cosmetics, drugs, and health care products
...

Growth stocks (synonymous – performance stocks)

are stocks of

corporations whose existing and projected earnings are sufficiently positive to indicate
an appreciable and constant increase in the stock’s market value over the extended
time period
...
Income stocks pay out a relatively high percentage of their
earnings as dividends, but growth stocks do not
...
Many firms have never

83

Investment Analysis and Portfolio Management

paid a dividend and publicly state they have no plans to do so
...
Though the analysts and
the experienced investors themselves spend the time trying to discover little-known
growth stocks
...
Speculation, by
definition, involves a short time horizon, and the speculative stocks are those thet have
a potential to make their owners a lot of money quickly
...
Some analysts consider speculative stocks
to be a most risky growth stocks
...

Penny stocks are low-priced issues, often highly speculative, selling at very
small price a share
...

The categories of the stocks presented above are not really mutually exclusive
...

Similarly, both cyclical and defensive stocks can be income stocks
...
5
...


Sector rotation and business cycle strategy
...

Sector rotation and business cycle strategy intends the movement of invested
funds from one sector to the other depending on the changes in the economic
(business) conditions
...
The following groups are identified:

84

Investment Analysis and Portfolio Management




Defensive stocks




Interest-sensitive stocks




Consumer durables




Capital goods

Defensive stocks were defined in the previous section (4
...
These stocks are
usually

related

with

food

industry,

retail,

tobacco,

beverages

industries,

pharmaceuticals and other suppliers of the necessity goods and services
...

Interest-sensitive stocks are related with the sectors of communications,
utilities, housing industry, also with the insurance and other financial institutions
...
These stocks are considered as a good investment in the early phases
of business cycle, i
...
in the optimistic phase
...
These stocks are a
good investment in the middle of business cycle
...
Because of the remarkable
time gap between the orders of this production and the terms of their realization, these
stocks demonstrate their high and stabile prices in the latest phases of business cycle
...

Market timing strategy
...
e
...
e
...

Investors use several different techniques for forecasting the major ups and
downs in the market
...

The purpose of the stock valuation analysis is to examine whether the stock market is a
supply market, or is it a demand market
...
The concept and key methods of stock valuation was
discussed in section 4
...
The valuation tools frequently used when applying for market
timing strategy are:
•

Price/Earnings ratio (PER);

•

The average market price/ book value ratio;

•

The average dividend income
...
Investors by forecasting changes in the macro
economy and in interest rates endeavor to decrease the investment in stocks in the
phases of economic downturn and to return to these investments during upturn phases
of the economy
...
The essentiality of this strategy: by choosing
and applying one or combining several stock valuation methods and using available
information about the stocks from the data accumulated in the computer database, the
valuation screens are set by investor
...
Using these screens investors can form their
diversified stock portfolio and exercise the changes in the existent portfolio
...
The most often used are following
indicators:
•

Price/Earnings ratio (PER);

•

Dividend income

•

Return on Equity (ROE)

•

Return on Investments (ROI)
...


86

Investment Analysis and Portfolio Management

What could be the best choose? – rating of the stocks as alternatives using the screen
can be the answer
...
The examples of the other financial indicators used applying valuation
screening strategy:
•

Return on assets (ROA)

•

Net profit margin

•

Debt to assets

•

Debt to equity

•

Earnings per share (EPS)

•

Market price to Book value

Summary
1
...

2
...

3
...
Two alternative approaches used for analysis: (1) “Topdown” forecasting approach; (2) “Bottom-up” forecasting approach
...
Using
“bottom-up” forecasting approach, the investors start with the analysis and forecast
for companies, then made analysis and forecasts for industries and for the
economy
...

4
...


87

Investment Analysis and Portfolio Management

5
...
The alternative approach to the
industry analysis suggests the examining of four key areas: demand, pricing, costs
and the influence of the whole economics and financial markets
...
The base for the company analysis is fundamental analysis is the publicly disclosed
and audited financial statements of the company: (Balance Sheet; Profit/ Loss
Statement; Cash Flow Statement; Statement of Profit Distribution)
...

7
...
This analysis includes the
examination of the main financial ratios: profitability ratios, which measure the
earning power of the firm; liquidity ratios, which measure the ability of the firm to
pay its immediate liabilities; debt ratios, which measure the firm’s ability to pay
the debt obligations over the time; asset – utilization ratios, which measure the
firm’s ability to use its assets efficiently and market value ratios are an additional
group of ratios which reflect the market value of the stock and the firm
...
The investor must compare the ratios of the firm with the ratios of a relevant
benchmark
...

9
...
This result is intrinsic (investment) value of stock; (4)
comparison of and current and decision making: to buy or to sell the stock
...


88

Investment Analysis and Portfolio Management

10
...

11
...

Various types of DDM, depending upon the assumptions about the expected
growth rate in dividends (g):“Zero” growth DDM; Constant growth DDM;
Multistage growth DDM
...
The most common used multiply is the Price Earning Ratio (PER)
...
In this case the decision
depends on the additional observations of investor
...
The other alternative multiples used for stock valuation by investors include Sales /
Market capitalization of the firm; Sales / Equity value; Market capitalization /Book
Value of the Equity Ratio etc
...

14
...
are: blue chip stocks;
income stocks; cyclical stocks; defensive stocks; growth stocks; speculative stocks;
penny stocks
...
Sector rotation and business cycle strategy intends the movement of invested funds
from one sector to the other depending on the changes in the economic (business)
conditions
...

16
...
e
...
e
...

17
...
All stocks
on these screens are allocated on the basis of their ratings in such an order: on the
top of the screen – under valuated stocks, at the bottom – over valuated stocks
...

Key-terms
•

Asset – utilization ratios

•

Industry analysis

•

Blue chip stocks

•

Interest-sensitive stocks

•

“Bottom-up” forecasting

•

Intrinsic (investment) value

approach

•

Liquidity ratios

•

Capital goods

•

Market timing strategy

•

Cyclical stocks

•

Market value ratios

•

Company analysis

•

Multiples method

•

Constant growth DDM

•

Multistage growth DDM

•

Consumer durables

•

Penny stocks

•

Debt ratios

•

Profitability ratios

•

Defensive stocks

•

Sector rotation and business

•

Discounted dividend models

cycle strategy

(DDM)

•

Speculative stocks

•

Economic analysis

•

Stock valuation process

•

E-I-C analysis

•

Technical analysis

•

Fundamental analysis

•

“Top-down” forecasting

•

Growth stocks

•

Income stocks

•

Value screening strategy

•

Income capitalization

•

“Zero” growth DDM

approach

Questions and problems
1
...
How he/ she would
proceed?
2
...
How then can a stock that does not pay
dividends have any value? Give an examples of such firms listed in the domestic
market of your country
...
What is the difference between blue chip and income stocks?
4
...

5
...


90

Investment Analysis and Portfolio Management

6
...
How can investors obtain EPS forecasts? Which sources could be used?
8
...
What is meant by normalized price/earnings ratio?
10
...

11
...
That dividend is expected to
grow at a 5 % rate indefinitely
...
Estimate the intrinsic value of the firm’s stock based on the assumption that
the stock will be sold after 2 years from now at its expected intrinsic value
...
Using the given historical data of the company for 5 previous years analyze and
comment on the company‘s performance
...

FINANCIAL
RATIOS
LIQUIDITY
RATIOS
Current ratio
Quick ratio
PROFITABILITY
RATIOS
Gross profit margin
Profit from
operations margin
Net profit margin
ROA
ROE
DEBT RATIOS
Debt to assets
Debt to equity
ASSETUTILIZATION
RATIOS

2010-01-01 2009-01-01 2008-01-01 2007-01-01 2006-01-01

0
...
39

0
...
45

1
...
02

2
...
89

4
...
61

38
...
9%

57
...
0%

47
...
0%

26
...
3%

26
...
3%

7
...
6%
15
...
8%
18
...
5%

33
...
8%
38
...
0%
12
...
6%

14
...
8%
9
...
2%
41
...
5%
38
...
9%
53
...
9%
58
...
6%
38
...
37
0
...
05
turnover
Asset turnover
0
...
78
0
...

118,221,72 116,442,06 240,002,85
EURO
P/E ratio
7
...
60
8
...
60
0
...
17
EURO
Market price to book
1
...
18
3
...
01
3
...
06
EURO
Cash dividend per
0
...
16
0
...
2%
16
...
7%

166
34

240
51

0
...
63

0
...
47

71,950,00

42,373,38

6
...
03

1
...
50

1
...
94

6
...
33

0
...
12

20
...
2%

13
...
The firm paid dividends last year 3 EURO per share
...
The forecast of Tomas is as follows: 4 % of growth
in dividends indefinitely
...

a) What is the intrinsic value of the stock of the firm according to Tomas
forecast?
b) What is the intrinsic value of the stock of the firm according to Arnas
forecast?
c) If the stocks of this firm currently are selling in the market for 40 EURO
per share, what would be the decisions of Tomas and Arnas, based on their
forecasting: is this stock attractive investment? Explain
...
Look through the listed companies on the domestic stock exchange
...
Arnold, Glen (2010)
...
2nd ed
...

2
...
Determining Value: Valuation Models and Financial
Statements
...

3
...
(2009)
...
John Wiley & Sons, Ltd
...
Fabozzi, Frank J
...
Investment Management
...
ed
...

5
...
, Roger Ibbotson (2002)
...

Prentice Hall Inc
...
Jones, Charles P
...
Investments Principles and Concepts
...

7
...
(1993)
...
John Wiley &Sons Inc
...
Sharpe, William F
...
Alexander, Jeffery V
...
(1999)
...

International edition
...

9
...
(1993)
...

10
...
(2009)
...
5th ed
...

Relevant websites
http://www
...
com

Market Watch

http://www
...
com

Bloomberg

http://www
...
com

ADVFN

http://www
...
com/screening

Zaks Investment Research

http://www
...
com/

Reuters

www
...
com

NASDAQ OMX

93

Investment Analysis and Portfolio Management

5
...
1
...
2
...

5
...
1
...
2
...
Qualitative analysis
5
...
3
...
3
...
Bond valuation
...
4
...
Immunization
...
1
...


•

Bonds usually pay fixed periodic interest installments, called coupon
payments
...


•

When investor buys bond, he or she becomes a creditor of the issuer
...


The main advantages of bonds to the investor:
•

They are good source of current income;

•

Investment to bonds is relatively safe from large losses;

•

In case of default bondholders receive their payments before shareholders
can be compensated
...

Currently in the financial markets there are a lot of various types of bonds and
investor must understand their differences and features before deciding what bonds
would be suitable for his/ her investment portfolio
...
Throughout the
bond’s life its interest is not earned, however the bond is redeemed at
maturity for face value
...


•

Deferred –interest bonds –bonds paying interest at a later date;

•

Income bonds – bonds on which interest is paid when and only when
earned by the issuing firm;

•

Indexed bonds - bonds where the values of principal and the payout rise
with inflation or the value of the underlying commodity;

•

Optional payment bonds – bonds that give the holder the choice to receive
payment on interest or principal or both in the currency of one or more
foreign countries, as well as in domestic currency
...
The difference between the cost of
the bond and its value when redeemed is the investor’s return
...



Collateral:
•

Secured bonds – bonds secured by the pledge of assets (plant or
equipment), the title to which is transferred to bondholders in case of
foreclosure;

95

Investment Analysis and Portfolio Management

•

Unsecured bonds – bonds backed up by the faith and credit of the issuer
instead of the pledge of assets
...

The issuing corporation makes these deposits to secure the principal of the
bonds, and it is sometimes required that the funds be invested in other
securities;

•

Asset-Backed Securities (ABS) – similar to mortgage bonds, but they are
backed by a pool of bank loans, leases and other assets
...
The main features of ABS for investor: relatively
high yield, shorter maturities (3-5 years) and monthly, rather than
semiannual principal/ interest payments
...
But the recent
financial crises showed that these debt instruments could be extremely risky
investment when banks loans portfolios as a guarantee of ABS become
worthless causing banks’ insolvency problems
...



Type of circulation:

96

Investment Analysis and Portfolio Management

•

Convertible bonds – bonds that give to its owner the privilege of
exchanging them for other securities of the issuing corporation on a
preferred basis at some future date or under certain conditions;

•

Interchangeable bonds – bonds in coupon form that can be converted to the
other form or its original form at the request of the holder paying the
service charge for this conversion
...
These
bonds are of the highest quality in each domestic market because of their
issuer – Government
...
The
government bonds are dominant in the fixed-income market
...
);

•

Corporate bonds – a long-term obligation of the corporation;

•

Industrial bonds – bonds issued by corporations other than utilities, banks
and railroads
...



Recall possibility:
•

Callable (redeemable) bonds – bonds issue, all or part of which may be
redeemed by the issuing corporation under definite conditions, before the
issue reaches maturity;

•

Noncallable (irredeemable) bonds – bonds issued which contains no
provision for being “called” or redeemed prior to maturity date
...
The term
Eurobond is often applied to these bonds that are offered outside the
country of the borrower and outside the country in whose currency the
securities are denominated
...


Quality:
•

Gilt-edged bonds – high-grade bonds issued by a company that has
demonstrated its ability to earn a comfortable profit over a period of years
and to pay its bondholders their interest without interruption;

•

Junk bonds - bonds with low rating, also regarded as high yield bonds
...

They have a high risk of default because they are issued as unsecured and
have a low claim on assets
...


5
...


Bond analysis: structure and contents

Similar to analysis when investing in stocks investor before buying bonds must
evaluate a wide range of the factors which could influence his/ her investment results
...
Various indicators are used for the
evaluation of these factors
...





Qualitative analysis
...
2
...
Quantitative analysis
...

Since the bonds are debt instruments and the investor in bonds really becomes
the creditor the most important during analysis is the assessment of the credibility of
the firm – issuer of the bonds
...
Similar to the

98

Investment Analysis and Portfolio Management

performing of fundamental analysis for common stock, bond analysis (or credit
analysis) uses financial ratios
...
Instead of this investor in bonds is more
interested in the credibility of the firm, its financial stability
...
) is one of the key instruments of quantitative
analysis
...
But
most important financial ratios for the bond analysis are:
1
...


Debt / Cash flow ratio;

3
...


Cash flow / Debt service ratio
...
1)

DL - long-term debt;
SET - total stockholders ‘equity
...
Equity represents

the conservative approach of the firm financing, because in the case of financial crises
of the firm dividends are not paid to the shareholders
...
The higher level of this ratio is the indicator of increasing credit risk
...

Debt / Cash flow ratio = (DL+ LP) / (NI + DC),

(5
...

Debt/ cash flow ratio shows the number of years needed to the firm to undertake
all its long-term liabilities and leasing contracts using current generated funds (cash
flow) by firm
...
Firms with the low Debt /Cash
flow ratio can borrow funds needed easily at any time
...
Estimation of this ratio is
based on the data from the balance sheet (long term debt), profit/loss statement (net
income, depreciation) or cash flow statement (if the depreciation is not showed a
profit/loss statement of the firm
...

Debt coverage ratio = EBIT / I,

(5
...


Debt coverage ratio sometimes is presented as “Interest turnover” ratio
...
The firm with the higher ratio is assessed as
financially stronger
...
It is especially important to analyze how the firm has managed to
pay the interest on the debt when it generated low income, i
...
in the period of
economic crises and other unfavorable conditions for the firm
...
The higher the reserve, the lower is the risk of the bonds issued by the
firm
...
4)

here: DR – debt retirement;
Tr – corporation tax rate
...
This is necessary
because the sum of the debt repayment must be increased by the sum of corporation
tax
...
Although Debt
coverage ratio is a good measure for the evaluation of the credit level of the firm
however many credit analysts consider Cash flow/Debt service ratio as the best
measure for evaluation of the firm’s credibility
...

5
...
2
...

Although the financial ratios discussed above allows evaluating the credit
situation of the firm, but this evaluation is not complete
...

Unfortunately the nature of the majority of these factors and their assessment are
subjective wherefore it is more difficult to manage these factors
...

Groups of qualitative indicators/ dimensions:

Economic fundamentals (the current economic climate – overall
economic and industry-wide factors);

Market position (market dominance and overall firm size: the larger
firm – the stronger is its credit rating);

Management capability (quality of the firm’s management team);

Bond market factors (term of maturity, financial sector, bond
quality, supply and demand for credit);

Bond ratings (relationship between bond yields and bond quality)
...
The main aim of the economic analysis is to examine how the
firm would be able to perform under the favorable and unfavorable conditions, because
this is extremely important for the investor, when he/ she is attempting to evaluate his/
her risk buying the bonds of the firm
...
The other conditions being equal, the firm which share in the market is
lager and which is larger itself generally has credit rating higher
...
Besides, the large firms are more effective because of the effect of the
production scale, their costs are lower and it is easier for such firms overcome the
periods of falls in prices
...
Thus it
is important for the creditor to take it in mind
...
It is often very difficult to assess the quality of the management team, but the
result of this part of analysis is important for the investor attempting to evaluate the
quality of the debt instruments of the firm
...
Contrary, the risktaking investors will search for the firms which management uses the aggressive policy
of borrowing and are running with the high financial leverage
...

Bond market factors (term of maturity, financial sector, bond quality, supply
and demand for credit); The investor must understand which factors and conditions
have the influence on the yield and the prices of the bonds
...
Generally term to maturity and the interest rate (the
yield) of the bond are directly related; thus, the bonds with the longer term
to maturity have the higher yield than the bonds with shorter terms to
maturity
...
The
yields of the bonds vary in various sectors of the economy; for example,
generally the bonds issued by the utility sector firms generate higher yields
to the investor than bonds in any other sector or government bonds
...
The higher the quality of the bond, the lower the
yield
...


102

Investment Analysis and Portfolio Management

•

The level of inflation; the inflation decreases the purchasing power of the
future income
...
Thus the yield of the bond increases (or decreases) with the
changes in the level of inflation
...
Contrary, when
the demand for the credits is low, in the period of economic crises, the
interest rates are relatively low also
...
The ratings of the bonds sum up the majority of the factors
which were examined before
...
Private independent rating services such as Standard & Poor's,
Moody's and Fitch provide these evaluations of a bond issuer's financial strength, or
it’s the ability to pay a bond's principal and interest in a timely fashion
...
The rating of the bond and the yield of
the bond are inversely related: the higher the rating, the lower the yield of the bond
...
Different rating services use the same letter
grades, but use various combinations of upper- and lower-case letters to differentiate
themselves (see more information about the bond ratings in Annex 1 and the relevant
websites of credit ratings agencies)
...
2
...
Market interest rates analysis
It s very important for the investor to the bonds to understand what causes the
changes in the interest rates in the market in the different periods of time
...
The understanding of the
macroeconomic processes and the causality of the various economic factors with the
interest rates helps the investors to forecast the direction of the changes in interest

103

Investment Analysis and Portfolio Management

rates
...

Macroeconomic factors with positive influence to the interest rates (from the
investors in bonds position - increase in interest rates):
•

Increase in investments;

•

Decrease in savings level;

•

Increase in export;

•

Decrease in import;

•

Increase in government spending;

•

Decrease in Taxes
...


By observing and examining macroeconomic indicators presented above the
investors can assess the situation in the credit securities market and to revise his/ her
portfolio (the investment strategies in bonds will be discussed later in this chapter)
...
Term structure of interest rates is a yield curve displaying the
relationship between spot rates of zero-coupon securities and their term to maturity
...
Unfortunately, most
bonds carry coupons, so the term structure must be determined using the prices of
these securities
...
Usually, longer term
interest rates are higher than shorter term interest rates
...
A small or negligible difference between short and long term interest rates is

104

Investment Analysis and Portfolio Management

called a "flat" yield curve
...

The 3 main factors influencing the yield curve are identified:
•

market forecasts and expectations about the direction of changes in interest
rates;

•

presumable liquidity premium in the yield of the bond
...


On the bases of these key factors three interest rates term structure theories
are developed to explain the shape of the yield curve
...
The Market expectations theory, which states that since short term bonds
can be combined for the same time period as a longer term bond, the total
interest earned should be equivalent, given the efficiency of the market and the
chance for arbitrage (speculators using opportunities to make money)
...
Mathematically, the
yield curve can then be used to predict interest rates at future dates
...
The Liquidity preference theory, which states that the profile of yield curve
depends upon the liquidity premiums
...
Thus, Liquidity preference theory states that the yield curve of
interest term structure depends not only upon the market expectations, but upon
the spread of liquidity premiums between shorter-term and longer-term bonds
...
The Market segmentation theory is based on the understanding of market
inefficiency in defining the prices of the bonds
...
These
segments are represented by different groups of investors which are resolute
about the necessity to invest in the bonds with this particular yield to maturity
...
) need to „employ“ their funds for specific
periods of time, hence a preference for long or short term bonds which is

105

Investment Analysis and Portfolio Management

reflected in the shape of the yield curve
...
The profile of
terms structure will depend not on the market expectations or risk Premium but
most often because of the changes in the direction of cash flows (similar to
swing effect)
...

Analyzing the changes in yield curves over the time provides the investors with
information about future interest rate movements and how they an affect price
behavior and comparative returns
...
In this case investors can expect that interest rates will rise also
...

Another example could be steep yield curves
...
For aggressive investors in bonds this profile of the yield curve can be
a signal to start moving into long-term bonds segment
...

5
...


Decision making of investment in bonds
...


Selection of bond types relevant for investor and bond analysis are the
important components of overall investment in bonds decision making process
...
Selection of bond’s type according to the investor’s goals (expected
income and risk)
...
Bond analysis (quantitative and qualitative)
...
Bond valuation
...
Investment decision making
...

In the bond market investment decisions are made more on the bond’s yield
than its price basis
...
The interpretation
of this measure to investor: current yield indicates the amount of current income a
bond provides relative to its market price
...
5)

I - annual interest of the bond;
Pm - current market price of the bond
Yield- to- Maturity (YTM) is the most important and widely used measure of

the bonds returns and key measure in bond valuation process
...
YTM is also known as the promisedyield-to- maturity
...
Then YTM of the bond is calculated from
this equation:
n

P =

Σ

Ct / (1 + YTM) t + Pn / (1 + YTM)ⁿ ,

(5
...


As the callable bond gives the issuer the right to retire the bond prematurely,
so the issue may or may not remain outstanding to maturity
...
Instead, the effect of the bond called away
prior to maturity must be estimated
...
YTC measures the yield on the bond if the issue remains outstanding not to
maturity, but rather until its specified call date
...
Then
YTC of the bond is calculated from this equation:

107

Investment Analysis and Portfolio Management

m

Σ Ct / (1 + YTC) t + Pc / (1 + YTC) m,

P=

(5
...


But the result from the estimation of the yields using the current market price
could be a relevant measure for investment decision making only for those investors
who believe that the bond market is efficient (see chapter 3
...
For the others who do
not believe that market is efficient, an important question is if the bond in the market is
over valuated or under valuated? To answer this question the investor need to estimate
the intrinsic value of the bond and then try to compare this value with the current
market value
...
8)

t=1

here:

YTM* - appropriate yield-to-maturity for the bond, which depends on the
investor’s analysis – what yield could be appropriate to him/ her on this
particular bond;
n -

number of periods until maturity of the bond;

Ct -

coupon payment each period;

Pn -

face value of the bond
...
Both approaches are
based on the capitalization of income method of valuation
...

(2) approach:

If P > V - decision to buy or to keep the bond as it is under valuated;

If P < V - decision to sell the bond as it is over valuated;

If P = V - bond is valuated at the same range as in the market and its
current market price shows the intrinsic value
...
4
...
Immunization

Two types of strategies investing in bonds:



Passive management strategies;




Active management strategies
...
The
main features of the passive management strategies:
•

They are the expression of the little volatile in the investor’s forecasts
regarding interest rate and/ or bond price;

•

Have a lower expected return and risk than do active strategies;

•

The small transaction costs
...

Buy and hold strategy is the most passive from all passive strategies
...

An important part of this strategy is to choose the most promising bonds that meet the
investor’s requirements
...
An investor forms the
diversified portfolio of bonds and does not attempt to trade them in search for the
higher return
...


109

Investment Analysis and Portfolio Management

Using Indexing strategy the investor forms such a bond portfolio which is
identical to the well diversified bond market index
...

Each of the broad bond indexes contains thousands of individual bonds
...

Information and transaction costs make it practically impossible to purchase each bond
in proportion to the index
...
The bond market is stratified into
several subcategories based on maturity, industry or credit quality
...
The investor then constructs a bond portfolio with the
similar distribution across the subcategories
...
But for all indexing strategies the specific feature is that the return on bond
portfolio formed following this strategy is close to the average bond market return
...

There are many different active bond management (speculative) strategies
...


The essentiality of the active reaction to the anticipated changes of interest rate
strategy: if the investor anticipates the decreasing in interest rates, he / she is
attempting to prolong the maturity of the bond portfolio or duration, because long-term
bonds’ prices influenced by decrease in interest rates will increase more than shortterm bonds’ prices; if the increase in interest rates is anticipated, investor attempts to
shorten the maturity of the bond portfolio or duration, by including more bonds with
the shorter maturity of the portfolio
...

The aim of such replacement - to increase the return on the bond portfolio based on the
assumptions about the tendencies of changes in interest rates
...
The bond
swaps can be:
•

Substitution swap;

•

Interest rate anticipation swap;

•

Swaps when various bond market segments are used
...
The risk of substitution
swap can be determined by the incorrect rating of the bonds and the exchange of the
unequal bonds causing the loss of the investor
...
The investor using this strategy bases on his steady belief about the anticipated
changes of interest rates and attempts to change frequently the structure of his/ her
bond portfolio seeking to receive the abnormal return from the changes in bonds’
prices
...

Swaps when various bond market segments are used are based on the
assessment of differences of yield for the bonds in the segregated bond market
segments
...
);

•

The terms to maturity of the bonds (2 years, 5 years, etc
...


111

Investment Analysis and Portfolio Management

The immunization is the strategy of immunizing (protecting) a bond portfolio
against interest rate risk (i
...
, changes in the general level of interest rates)
...

Duration is the present value weighted average of the number of years over
which investors receive cash flow from the bond
...

Such concept, called duration (or Macaulay's duration) was developed by Frederick
Macaulay
...
9)

DR - duration (or Macaulay’s duration);
n - term to maturity, years;
Ct -

interest rate of the bond during period t;

Pn - face value of the bond;
YTM -

yield-to-maturity of the bond;

P - current market price of the bond
...
5) a weighted
average of the number of years is calculated
...
For the zero coupon bonds the duration
will be equal to the term to maturity
...
A portfolio is
said to be immunized if the duration of the portfolio is made equal to a selected
investment horizon for the portfolio
...
The duration of the portfolio consisting of
several bonds can be calculated using the technique of weighted average, similar to
calculation of portfolio expected rate of return:
n

DRp = Σ wi DRi = w1 DR1 + w2 DR2 +…+ wn DRn,

(5
...


Summary
1
...
A
major disadvantage of bonds is that potential profit from investment in bonds is
limited
...
Currently in the financial markets there are a lot of various types of bonds and
investor must understand their differences and features before deciding what bonds
would be suitable for his/ her investment portfolio
...

3
...

4
...
Since the bonds are debt instruments and the investor in bonds
really becomes the creditor the most important during analysis is the assessment of
the credibility of the firm – issuer of the bonds
...

5
...
The main groups of
qualitative indicators/ dimensions are: economic fundamentals (the current
economic climate – overall economic and industry-wide factors); market position
(market dominance and overall firm size: the larger firm – the stronger is its credit
rating); management capability (quality of the firm’s management team); bond
market factors (term of maturity, financial sector, bond quality, supply and demand
for credit); bond ratings (relationship between bond yields and bond quality)
...
The role of the bond ratings as the integrated indicator for the investor is important
in the evaluation of yield and prices for the bonds
...

7
...

8
...
The resulting curve
allows an interest rate pattern to be determined, which can then be used to explain
the movements and to forecast interest rates
...

9
...
There are three widely used measures of the yield: Current Yield;
Yield-to-Maturity; Yield- to- Call
...
Yield- to- Maturity is the fully
compounded rate of return earned by an investor in bond over the life of the
security, including interest income and price appreciation
...
Yield-to-Call measures the yield on the bond if the issue
remains outstanding not to maturity, but rather until its specified call date
...
The decision for investment in bond can be made on the bases of two alternative
approaches: (1) using the comparison of yield-to-maturity and appropriate yield-tomaturity or (2) using the comparison of current market price and intrinsic value of
the bond (similar to decisions when investing in stocks)
...

11
...

12
...
Passive bond management strategies are based on
the proposition that bond prices are determined rationally, leaving risk as the
portfolio variable to control
...

13
...
“Buy and hold” is strategy for any investor interested
in non active investing and trading in the market
...
Using Indexing strategy the investor forms such a bond portfolio
which is identical to the well diversified bond market index
...
The active reaction to the anticipated changes of interest rate is based on the
investor’s decision making in his/ her portfolio as reaction to the anticipated
changes in interest rates
...
The essentiality of bond swaps strategies is the replacement of the bond which is in
the portfolio by the other bond which was not in the portfolio for the meantime
...
The bond
swaps can be: Substitution swaps; Interest rate anticipation swap; Swaps when
various bond market segments are used
...
The immunization is the strategy of immunizing (protecting) a bond portfolio
against interest rate risk (i
...
, changes in the general level of interest rates)
...

17
...


115

Investment Analysis and Portfolio Management

Key-terms
•

Active management strategies

•

Internal bonds

•

Asset-Backed Securities (ABS)

•

Intrinsic value of the bond

•

Bond ratings

•

Junior bonds

•

Bonds swaps

•

Junk bonds

•

Buy and hold strategy

•

Liquidity preference theory

•

Callable (redeemable) bonds

•

Market expectations theory

•

Cash flow / Debt service ratio

•

Market segmentation theory

•

Convertible bonds

•

Mortgage bonds

•

Corporate bonds

•

Municipal bonds

•

Coupon bonds

•

Noncallable (irredeemable)

•

Current Yield

•

Debenture bonds

•

Noninteresting bearing bonds

•

Debt / Equity ratio

•

Optional payment bonds

•

Debt / Cash flow ratio

•

Passive management strategies

•

Debt coverage ratio

•

Participating bonds

•

Deferred –interest bonds

•

Public utility bonds

•

Duration (Macaulay duration )

•

Regular serial bonds

•

Full coupon bonds

•

Revenue bonds

•

Floating-rate bonds

•

External bonds

•

Eurobonds

•

General obligation bonds

•

Gilt-edged bonds

•

Guaranteed bonds

•

Immunization

•

Income bonds

•

Industrial bonds

•

Indexing strategy

•

Indexed bonds

•

Interchangeable bonds

bonds

• Quantitative indicators
• Qualitative indicators
•

Secured bonds

•

Senior bonds

•

Sinking fund bonds

•

Term structure of interest rates

•

Treasury (government) bonds

•

Unsecured bonds

•

Voting bonds

•

Yield-to-Call

•

Yield-to-Maturity

•

Zero-coupon bonds

116

Investment Analysis and Portfolio Management

Questions and problems
1
...
Is any mortgage bond or asset backed security necessarily a more secure
investment than any debenture? Comment
...
What features of the Eurobond market make Eurobonds attractive both for issuers
and investors?
4
...
How would you expect interest rates to respond to the following economic events
(what would be the direction of the interest rates changes)? Explain why
...

6
...

7
...
Distinquish between yield-to-call and yield-to-maturity
...
What is the difference between the market expectation theory and the liquidity
preference theory?
10
...

a) Calculate the price of the bond
...
The callable bond has a par value of 100 LT, 8% coupon rate and five years to
maturity
...
Investor purchased this bond
for 90 LT when it was issued in May 2008
...
Investor plans his investments for the period of four years and selects for his
portfolio two different bonds with the same face values:
• Bond A has 4 years time to maturity, 8% coupon rate, and 960 LT current market
price
...

How should be bonds A and B allocated in the portfolio if the investor is using
the immunization strategy?
13
...
The bond has four years to maturity, a 1000 EURO face value and a 7%
coupon rate
...
The
appropriate discount rate for the securities of similar risk is10%
...
Based on the result of this
estimation, should Ann purchase the bond? Explain
...
Based on the result of this
estimation, should Ann purchase the bond? Explain
...
Using the resources available in your domestic investment environment select any
4 bonds issued by Government and corporations relevant to you
...

b) Assuming that you put an equal amount of money into each of 4
bonds selected, estimate the duration for the 4 bonds portfolio
...

References and further readings
1
...
Investing: the definitive companion to investment and the
financial markets
...
Financial Times/ Prentice Hall
...
Bode, Zvi, Alex Kane, Alan J
...
Investments
...
McGraw Hill
...
Encyclopedia of Alternative Investments/ ed
...
Gregoriou
...

4
...
(1999)
...
2nd ed
...


118

Investment Analysis and Portfolio Management

5
...
, Roger Ibbotson (2002)
...

Prentice Hall Inc
...
Gitman, Lawrence J
...
Joehnk (2008)
...

Pearson / Addison Wesley
...
Haugen, Robert A
...
Modern Investment Theory
...
Prentice Hall
...
Jones, Charles P
...
Investments Principles and Concepts
...

9
...
(1999)
...
Capstone
...
Nicolaou, Michael A
...
The Theory and Practice of Security Analysis
...

11
...
(1993)
...
John Wiley &Sons Inc
...
Sharpe, William, F
...
Alexander, Jeffery V
...
(1999) Investments
...
Prentice –Hall International
...
fitchratings
...
bondmarketprices
...
standardpoors
...
ft
...
riskgrades
...
moodys
...
bloomberg
...
investopedia
...
Psychological aspects in investment decision making
Mini-contents
6
...
Overconfidence
6
...
Disposition effect
6
...
Perceptions of investment risk
6
...
Mental accounting and investing
6
...
Emotions and investing
Summary
Key terms
Questions and problems
References and further readings

The finance and investment decisions for some decades in the past are based on
the assumptions that people make rational decisions and are unbiased in their
predictions about the future
...
But we all know that sometimes people act in obvious irrational way and
they do the mistakes in their forecasts for the future
...
For example, people usually are risk averse, but the investors will
take the risk if the expected return is sufficient
...
Today not only psychologists but the economists as well
agree that investors can be irrational
...
So it is very important to understand actual investors’ behavior
and psychological biases that affect their decision making
...

6
...
Overconfidence
Overconfidence causes people to overestimate their knowledge, risks, and their
ability to control events
...
This perception occurs in investing as well
...
However,
ownership of a stock only gives the illusion of having control of the performance of
the stock
...


120

Investment Analysis and Portfolio Management

Investing is a difficult process
...
However, overconfidence
causes us to misinterpret the accuracy of the information and overestimate our skills in
analyzing it
...
The self-attribution bias
leads people to believe that successes are attributed to skill while failure is caused by
bad luck
...

Overconfidence can lead investors to poor trading decisions which often
manifest themselves as excessive trading, risk taking and ultimately portfolio losses
...
Investors’ opinions derive from their beliefs regarding
accuracy of the information they have obtained and their ability to interpret it
...

Consider an investor who receives accurate information and is highly capable
of interpreting it
...
In fact, these returns
should be high enough to beat a simple buy-and-hold strategy while covering the costs
of trading
...

Overconfidence–based trading is hazardous when it comes to accumulating
wealth
...

It has been observed that overconfidence leads to trading too frequently as well as to
purchase the wrong stocks
...

If many investors suffer from overconfidence at the sane time, then signs might
be found within the stock market
...
This will lead to greater trading by a large group of investors and may
impact overall trading volume on the stock exchanges
...
Investors appear to attribute the success of the good period

121

Investment Analysis and Portfolio Management

to their own skill and begin trading more
...

Overconfidence also affects investors’ risk-taking behavior
...
However,
overconfident investors misinterpret the level of risk they take
...
First is the
tendency to purchase higher risk stocks
...
The second reason is a tendency to under diversify their portfolio
...
Portfolio volatility measures the degree of ups and downs
the portfolio experiences
...
A higher beta of the portfolio indicates that
the security has higher risk and will exhibit more volatility than the stock market in
general
...
This refers to
the tendency for people to believe that the accuracy of their forecasts increases with
more information; that is, more information increases one’s knowledge about
something and improves one’s decisions
...
This information includes historical data,
such as past prices, returns, the firms’ operational performance as well as current
information, such as real-time news, prices, etc
...
That is, this information does not give them as much
knowledge about the situation as they think because they do not have training to
interpret it properly
...
Investors can get
analyst recommendations, subscribe to expert services, join news groups, etc
...
However if investors perceive the messages
as having increased their knowledge, they might be overconfident about their
investment decisions
...

People often believe they have influence over the outcome of uncontrollable events
...
When a greater amount of information is obtained by investor, illusion of
control is greater as well
...
The more successes
the investors experience, the more they will attribute it to their own ability, even when
much luck is involved
...

6
...
Disposition effect
People usually avoid actions that create regret and seek actions that cause
pride
...
Pride is the emotional joy of realizing that a decision turned
out well
...
Shefrin and Statman (1985) were the first economists
who showed that fearing regret and seeking pride causes the investors to be
predisposed to selling winners (potential stocks with growing market prices) to early
and riding losers (stocks with the negative tendencies in market prices) too long
...

Do the investors behave in a rational manner by more often selling losers or are
investors affected by their psychology and have a tendency to sell their best stocks?
Several empirical studies provide evidence that that investors behave in a manner more
consistent with the disposition effect
...
They found that the more
recently the stock gains or losses occurred, the stronger the propensity was to sell
winners and hold losers
...

The disposition effect not only predicts selling of winners but also suggests that
the winners are sold too soon and the losers are held too long
...
The fear of

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Investment Analysis and Portfolio Management

regret and the seeking of pride can affect investors’ wealth in two ways: first, investors
are paying more in taxes because of the disposition to sell winner instead of losers;
second, investors earn a lower return on their portfolio because they sell the winners
too early and hold poorly performing stocks that continue with decreasing market
results
...
Good news about the company that increases the stock price induces
investors to sell stock (selling winners)
...
This is consistent with avoiding
regret and seeking pride
...
Investors are less likely than usual to sell winners after good economic news
and these results are not consistent with the disposition effect
...
In the case of
economic news, investors have a weaker feeling of regret because the outcome is
considered beyond their control
...

6
...
Perceptions of investment risk
People’s perception of risk appears to vary
...

After experiencing a gain or profit, people are willing to take more risk
...
So, when they are taking additional risk they act as if they gamble with
opponent’s money (casino money)
...
The
“house-money” effect predicts that investors are more likely to purchase higher-risk
stocks after locking in gain by selling stocks at a profit
...

This effect is recognized as “snakebite” effect - the people remember this for a long
time and become cautious
...
For example, picking new stocks to the portfolio can give better

124

Investment Analysis and Portfolio Management

diversification of investors’ portfolio, but if the newly purchased stocks quickly
decline in price, the investor might feel snakebite effect and be afraid of picking stocks
in his portfolio in the future
...
Then losers use the
chance to make up their losses
...

People without significant gains or losses prefer not to take the risk
...
The endowment effect is when people demand much more to sell thing than they
would be willing to pay to buy it
...
How can endowment or status quo bias affect investors? People have
tendency to hold the investments they already have
...
That means, the more complicated the
investment decision that was needed becomes, the more likely the person is to choose
to do nothing
...
All these possibilities may affect
the investors, and as a result they often choose to avoid making a change
...
We can observe such a
behavior of the investors during last years
...
Memory can be understood as a perception of the physical and emotional
experience
...
Memory has a
feature of adaptively and can determine whether a situation experienced in the past
should be desired or avoided in the future
...
And the memory of the large loss at the end
of the period is associated with a higher degree of emotional pain
...
As a consequence, making decisions
about these stocks for the following period the investor might be to optimistic about
the stock with good short term results and to pessimistic about constantly growing
stock
...
Cognitive dissonance is based on evidence that people are
struggling with two opposite ideas in their brains: “I am nice, but I am not nice”
...
The avoidance of cognitive dissonance can
affect the investor’s decision-making process in two ways
...

Second, the filtering of new information limits the ability to evaluate and monitor
investor’s decisions
...
For example, if the investor
made a decision to buy N company’s stocks and over time information about the
results of this company were good and validate the past decision, investor feels as “I
am nice”, but if the results of the picked-up company were not good (“I am not
nice”), the investor tries to reduce the cognitive dissonance
...
Investor remembers that he/she has done well regardless of the
actual performance
...

6
...
Mental accounting and investing
People use financial budgets to control their spending
...

Mental budgeting matches the emotional pain to the emotional joy
...
Similarly, the benefits (joy) of financial gains is like the joy (or
benefits) of consuming goods and services
...
For example, financing the vacation by debt is undesirable because it
causes a long-term cost on a shot-term benefit
...

Economic theories predict that people will consider the present and future costs
and benefits when determining a course of action
...
This behavior
is called the “sunk-cost” effect
...
The sunk costs could be characterized by size and timing
...
The timing in investment decision making is
important too: pain of closing a mental account without a benefit decreases with time –
negative impact of sunk cost depreciates over time
...

Each investment is treated separately, and interactions are overlooked
...
As time passes, the purchase of
the stock becomes a sunk cost
...
When investors decide to sell a
losing stock, they have a tendency to bundle more than one sale on the same day
...
Alternatively, investors like to separate the sale of the
winning stocks over several trading sessions to prolong the feeling of joy (Lim, 2006)
...
The
tendency to overlook the interaction between investments causes investors to
misperceive the risk of adding a security to an existing portfolio
...
Investors evaluate each potential
investment as if it were the only one investment they will have
...

Therefore, the most important consideration for the evaluation is how the expected risk
and return of the portfolio will change when a new investment is added
...

Standard deviation (see chapter 2
...

However, standard deviation measures the riskiness of the investment, but not how the
risk of the investment portfolio would change if the investment were added
...
Mental accounting sets the bases
for segregating different investments in separate accounts and each of them consider as
alone, evaluating their gains or losses
...
Investments are
selected for each mental account by finding assets that match the expected risk and
return of the mental account
...
As a result, investor portfolio diversification comes from the
investment goals diversification rather than from a purposeful asset diversification
according to Markowitz portfolio theory
...

This mental accounting leads to other psychological biases, like the disposition
effect
...
5
...
In recent years the
psychologists as well as economists have examined the role of emotions in decision
making
...
As some researchers conclude the more complex and uncertain a
situation is, the more emotions influence a decision
...

The mood affects the predictions of the people about the future
...
This is called
misattribution bias
...
Translating to the behavior of investors it means
that investors who are in good mood give a higher probability of good events/ positive
changes happening and a lower probability of bad changes happening
...


Even those investors who use quantitative

methods such as fundamental analysis must use some assumptions estimating fair
value of the stock
...
An investor who is in good mood may overestimate the growth rate
and this would cause the investor to believe the stock is worth more than the believe of

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Investment Analysis and Portfolio Management

unbiased investor
...
Similar, the investor who is in bad mood may underestimate growth
rate and stock value based on his calculations shows the stock is overestimated, when
it is not in reality
...

Investors who are in a good mood can also suffer from too optimistic decisions
...
This is why the price of the stock is
frequently set up by the optimistic investors
...
For firms with the high degree of uncertainty
optimistic investors tend to set the stock price until that uncertainty is resolved
...
(Nofsinger, 2008)
...

Sunshine usually is associated with good mood and optimistic thinking and without
sun people feel bad
...
The
researchers found that the daily returns for sunny days are higher than the daily returns
for non sunny days
...
Than this tendency prevails in the market the stock prices are growing
...
Sport is investigated as one of such factors)
...
And the stock market
reaction was stronger in countries which have positive historical results in soccer
...
as Nofsinger (2005) showed in his investigation
...
This fluctuating social mood is defined as market sentiment
...

A market bubble could be explained by the situation when high prices seem to
be generated more by investors (traders in the market) optimism then by economic
fundamentals
...

Summary
1
...
This perception occurs in investing as well
...
Typically, investors expect to earn an above -average return
...
Overconfidence can lead investors to poor trading decisions which often manifest
themselves as excessive trading, risk taking and ultimately portfolio losses
...

3
...
Rational investors try to
maximize returns while minimizing the amount of risk taken
...

4
...
Fearing regret and seeking pride causes the investors to be
predisposed to selling winners (potential stocks with growing market prices) to
early and riding losers (stocks with the negative tendencies in market prices) too
long
...

5
...
The investors are more likely to purchase higher-risk
stocks after locking in gain by selling stocks at a profit
...
The “snakebite” effect predicts that after experiencing a financial loss, people
avoid to take risk in their investment decisions
...
The endowment effect is when people demand much more to sell thing than they
would be willing to pay to buy it
...
The status quo bias increases as the number of investment
options increases
...

8
...
Memory has a feature of adaptivity and can determine whether a
situation experienced in the past should be desired or avoided in the future
...
And the
memory of the large loss at the end of the period is associated with a higher degree
of emotional pain
...
Cognitive dissonance is based on evidence that people are struggling with two
opposite ideas in their brains: “I am nice, but I am not nice”
...
The avoidance of cognitive dissonance can affect the
investor’s decision-making process
...

10
...
The pain of the
financial losses could be considered as similar to the costs (pain) associated with
the purchase of goods and services
...

11
...
The sunk cost effect might be defined as
an escalation of commitment – to continue an endeavor once an investment in
money or time has been made
...

12
...
Investments are selected for
each mental account by finding assets that match the expected risk and return of

131

Investment Analysis and Portfolio Management

the mental account
...
As a result, investor’s portfolio diversification comes from the
investment goals diversification rather than from a purposeful asset diversification
according to the portfolio theory
...
The mood affects the predictions of the people about the future
...

People who are in bad mood are more pessimistic about the future than people who
are in a good mood
...

14
...

Investors tend to bee most optimistic when the market reaches the top and they are
most pessimistic when market is at the bottom
...

15
...

Key-terms
•

Cognitive dissonance

•

Memory

•

Disposition effect

•

Mental accounting

•

Emotions

•

Misattribution bias

•

Endowment effect

•

Overconfidence

•

“House-money” effect

•

“Snakebite” effect

•

Market bubble

•

“Sunk-cost” effect

•

Market sentiment

Questions and problems
1
...

2
...

3
...
Explain how mental accounting is related with the disposition effect
...
How do you understand the disposition effect?
6
...

7
...

8
...

9
...

10
...
Ackert, Lucy F
...
Behavioral Finance
...

2
...
(2007)
...

3
...
Do Behavioral Biases Affect Prices? //
Journal of Finance, 2005, 60, p
...

4
...
Up Close and Personal: An Individual Level Analysis
of Disposition Effect
...
726-740
...
Edmans, Alex, Diego Garcia, Oyvind Norli (2007)
...
// Journal of Finance, August 2007
...
Gervais, Simon, Terrance Odean (2001)
...
// Review
of Financial Studies, No 14, p
...

7
...
Does Past Success Lead Analysts to Become
Overconfident? // Management Science
...
489-500
...
Hirshleifer, David, Tyler Shumway (2003)
...
// Journal of Finance, 2003, 58, p
...


133

Investment Analysis and Portfolio Management

9
...
//

Management Science, p
...

10
...
Do Investors Integrate Losses and Segregate
Gains? Mental Accounting and Investor Trading Decisions
...
2539-2573
...
Nofsinger, John R
...
The Psychology of Investing
...
Pearson/Prentice
Hall
...
Nofsinger, John (2001)
...
1339-1366
...
Shapira, Zur,

Itzhak Venezia (2001)
...
// Journal of banking and Finance, 2001, 25,
p
...

14
...
The disposition to Sell Winners Too Early
and Ride Losers Too Long: Theory and Evidence
...
777-790
...
Statman, Meir, Steven Thorley, Keith Vorkink
...
Investor Overconfidence
and Trading Volume // Review of Financial Studies, No 19, p
...


134

Investment Analysis and Portfolio Management

7
...
1
...
2
...
3
...
Profit or loss on options
7
...
Portfolio protection with options
...
1
...
The most often options are used in the trading of securities
...
Option buyer must pay for this right
...

Types of option contracts:
call option
...

put option
...

Option contract specifies four main items:
1
...
The number of shares that can be bought or sold;
3
...
The date when the right to buy or to sell expires, known as expiration date
...

American options can be exercised any time during their life (defined by the
option contract)
...

The major disadvantages of investing in options:

•

the holder enjoys never interest or dividend income nor any other ownership
benefit;

•

because put and call options have limited lives, an investor have a limited time
frame in which to capture desired price behavior;

•

this investment vehicle is a bit complicated and many of its trading strategies
are to complex for the non-professional investor
...

7
...
Options pricing
The value of put or call options is closely related with the market value/ price
of the security that underlies the option
...
The relationship between the intrinsic value of
option and price of underlying stock graphically is showed in Fig
...
(a – for call
option, b – for put option)
...
In the case of call option (a), if the underlying stock price at the end of
expiration period is less than the exercise price, intrinsic value of call option will be 0,
because the investor does not use the option to buy the underlying stock at exercise
price as he/ she can buy it for more favorable price in the market
...
However it is not necessarily for the option buyer to exercise this option
...
In the case of put option (b), if the
underlying stock price at the end of expiration period is higher than the exercise price,
intrinsic value of put option will be 0, because the investor does not use the option to
sell the underlying stock at exercise price as he/ she can sell it for more favorable price
in the market
...
In both cases graphs a and b
demonstrates not only the intrinsic value of call and put options at the end of
expiration date, but at the moment when the option will be used
...
7
...
Intrinsic value of option
Exploring the same understanding of the intrinsic value of the call/ put option
as it was examined above, intrinsic value of the call/put options can be more precisely
estimated using analytical approach:

here:

IVc = max { 0, Ps - E },

(7
...
2)

IVc - intrinsic value of the call option;
IVp - intrinsic value of the put option;
Ps - the market price of the underlying stock;
E - the exercise price of the option;
max - means to use the larger of the two values in brackets
...
In table 7
...
These terms are

137

Investment Analysis and Portfolio Management

much more than only exotic terms given to options - they characterize the investment
behavior of options
...
1
...
1 and 7
...
In fact, options very rarely trade at their
intrinsic values
...
Thus, put and call options nearly always are traded at the premium
prices
...

Option premium is used to describe the market price of option
...
3)

Thus, the premium for an option can be understood as the sum of its intrinsic
value and its time value:
Pop = IVop + IVop

(7
...
3
...
Profit and loss on options
...
7
...

However, for the investor even more important is the question, what should be his/ her
profit (or loss) from using the option? In order to determine profit and loss from
buying or writing these options, the premium involved must be taken into
consideration
...
7
...
3, 7
...
Each strategy assumes that the underlying
stock is selling for the same price at the time an option is initially bought or written
...
Because the profit obtained by a buyer of
option is the writer’s loss and vice versa, each diagram in Fig
...
2, 7
...
4 has a
corresponding mirror image
...
7
...
Similarly, Fig
...
3 shows the profits and losses associated with buying and
writing a put, respectively
...
1
...
2), less the premium of the options
...
5)

Profit (or loss) on put option = IVp - Pop = max {0, E – Ps}- Pop =
= max {- Pop, E – Ps – Ppop},

(7
...


0
–

Price of
Stock at
Expiration

+

Value of
Premium

Price of
Stock at
Expiration

Profit

Profit

+

0
Value of
Premium

–

Buy a Call

Write a Call

Fig
...
2
...
7
...
Profit/ loss on the put options

139

Investment Analysis and Portfolio Management

Fig
...
4 illustrates a more complicated option strategy known as straddle
...
The graph in Fig
...
4 representing profit and loss from the strategy “Buy a put and a call” can be easily
derived by adding the profits and the losses shown in Fig
...
2 (Buy call) and 7
...
7
...
3 (Write put)
...
e
...
e
...
7
...
Profit/ loss on a straddles
For more precise valuation of options some fairly sophisticated options pricing
models have been developed
...

5 main parameters used in Black-Scholes model:
1
...
Current market price of the underlying stock;
3
...
Exercise price of the option;
5
...

Many active options traders use the complex formulas of this model (see
Annex 2) to identify and to trade over- and under valuated options
...
4
...
Hedging
...

A hedger is an individual who is unwilling to risk a serious loss in his or her
investing position and takes the actions in order to avoid or lessen loss
...
Suppose the investor currently holds the shares
of the company X in his portfolio
...
Looking to the
future the investor is not sure in what direction the price of the share will change
...
But if the price will fall, may be to 8 EURO, the investor could suffer the loss
...
The problem is that the
investor may regret this action if the fall of the price of the share does not occur and
investor has forgone the opportunity to earn a profit
...
This option will rise in value as the share price
falls
...

The hedging reduces the dispersion of possible outcomes to the investor
...
But if the price of the share stands still 8,5 EURO, however, the investor may
feel that the option premium he/ she paid to insure against an adverse movement at
0,85 EURO or 10 percent of the share price was excessive
...

Using options to reduce losses
...
The current market price of this
share is 9 EURO
...
May be the price of the share
fall to 8,5 EURO? How could the investor behave? He/ she can either exercise a direct
purchase of these shares in the market at current price or to purchase a call options
with underlying stock of company B
...


141

Investment Analysis and Portfolio Management

Hedging portfolios of shares using index options
...
When
index option is exercised, settlement is made by cash payment, not delivery of shares
...

Suppose, the investor manage a well diversified portfolio of shares and
currently is concerned that the market may fall over the next 3 months
...
If the
market does fall, losses on the portfolio will be offset by gains on the value of the
index put option
...
But it is important to remember about the expenses of the insurance of
portfolio: when the options premiums are high (during periods of market volatility
caused by economic crises), hedging of the portfolio of stocks with index options over
longer period could be expensive
...
Hedge ratio is a number of stocks to buy or sell with options such that the
future portfolio value is risk-free
...

Hedge ratio (HR) can be estimated using formula:
HR = m / n,
here:

(7
...

Riskless (perfect) hedge is when for m and n are chosen such a values which

allow in each moment given to compensate the decrease in prices of the stocks by
increase in value of options
...
But perfect hedge ratio could be achieved only under following assumptions:
•

There are no transaction costs in the market;

•

There are no taxes;

•

The numbers of all traded securities is unlimited (including fractional
numbers);

142

Investment Analysis and Portfolio Management

•

All the securities are available for trading permanently (24 hours) and at
any moment
...
Thus any hedged portfolio and its hedge ratio reflects only the
particular level of the “insurance” of the investor against the market risk
...
Option is a type of contract between 2 persons where one person grants the other
person the right to buy or to sell a specific asset at a specific price within a specific
time period
...

2
...
Call option gives
the buyer the right to buy (to call away) a specific number of shares of a specific
company from the option writer at a specific purchase price at any time up to
including a specific date
...

3
...
Exercise price is the purchase or selling price for the
underlying shares
...

4
...
European options can be exercised only on their expiration
dates
...

5
...

6
...


143

Investment Analysis and Portfolio Management

7
...

8
...

9
...

10
...

11
...

12
...

13
...

Option premium is used to describe the market price of option
...
The time value reflects the option’s potential appreciation and can be calculated as
the difference between the option price (premium) and intrinsic value
...
The profit or loss of using options is defined as difference between the intrinsic
value of the option and option premium
...
Black-Scholes model is developed for estimating the fair value of the call options
...

17
...

18
...
Hedging reduces the
dispersion of possible outcomes to the investor
...

19
...
When index
option is exercised, settlement is made by cash payment, not delivery of shares
...
Using hedging strategies very important characteristic is the hedge ratio of the
portfolio
...

21
...

Key-terms
•

American options

•

Option

•

„At the money“

•

Option buyer

•

Black-Scholes model

•

Option premium

•

Call option

•

Option writer

•

European options

•

„Out of money“

•

Exercise price (strike price)

•

Riskless (perfect) hedge

•

Expiration date

•

Perfect hedge ratio

•

„In the money“

•

Put option

•

Intrinsic value of option

•

Profit or loss on option

•

Hedger

•

Straddle

•

Hedging

•

Time value

•

Hedge ratio

•

Underlying security

145

Investment Analysis and Portfolio Management

Questions and problems
1
...

2
...
Explain the following terms used with the options:
a) „In the money“
b) „Out of money“
c) „At the money“
4
...
What is the relationship between option prices and their intrinsic value?
6
...
What is an index option? What are the main differences between index option and
stock option?
8
...
What is the maximum amount the buyer of an option can lose?
10
...

11
...
(3 dol
...
The call option exercise price is 54 dol
...
Using information about several call and put options in the table below, identify,
which of these options are „in the money“, „at the money“ or „out of money“
and fulfill the last column in the table
...
Using information in the table above calculate the profit or loss for each option
contract, if they would be exercised
...
Assume you hold a well-diversified portfolio of common stocks
...

b) What happens with your hedged portfolio if the stock market will fall?
c) What happens with your hedged portfolio if the stock market will grow?
References and further readings
1
...
Investing: the definitive companion to investment and the
financial markets
...
Financial Times/ Prentice Hall
...
Black, F
...
Sholes (1973)
...
637-654
...
Fabozzi, Frank J
...
Investment Management
...
ed
...

4
...
, Michael D
...
Fundamentals of Investing
...

5
...
(2010)
...
JohnWiley&Sons
Inc
...
Levy, Haim, Thierry Post (2005)
...
FT / Prentice Hall
...
Rosenberg, Jerry M
...
Dictionary of Investing
...

8
...
Gordon J
...
Bailey
...

International edition
...

9
...
(2010)
...
2nd ed
...

Relevant websites
•

www
...
com

Futures and options world

•

http://www
...
com

ADVFN

•

www
...
com

Bloomberg

•

www
...
com

Information and learning tools from NYSE Liffe to
help the private investors

147

Investment Analysis and Portfolio Management

8
...
1
...
2
...
3
...
4
...

Summary
Key-terms
Questions and problems
References and further readings
8
...
Active versus passive portfolio management
2 types of investment portfolio management:
•

Active portfolio management

•

Passive portfolio management

The main points for the passive portfolio management:
•

holding securities in the portfolio for the relatively long periods with small
and infrequent changes;

•

investors act as if the security markets are relatively efficient
...


•

passive investors do not try outperforming their designated benchmark
...


The main points for the active portfolio management:
•

active investors believe that from time to time there are mispriced
securities or groups of securities in the market;

•

the active investors do not act as if they believe that security markets are
efficient;

148

Investment Analysis and Portfolio Management

•

the active investors use deviant predictions – their forecast of risk and
return differ from consensus opinions
...
1
Active versus passive investment management

Area of
comparisons
Aim
Strategies used and
decision making
Investor/manager
Taxes and turnover
of investment
portfolio
Performance results
before costs and
taxes
Performance results
after costs and taxes
Individual
investors*
Institutional
investors*
Supporters

Analytical methods

Active investment management
To achieve better results then
average in the market
Short term positions, the quick
and more risky decisions; keeping
the “hot” strategy
tense
High taxes, relatively high
turnover of portfolio

Passive investment
management
To achieve the average market
results
Long term positions, slow
decisions
laid-back
Low taxes, small turnover
of portfolio

In average equal to the passively
managed portfolios

In average equal to the actively
managed portfolios

In average lower than market
index after taxes

In average higher than the
results of actively managed
portfolio returns after taxes
Over 15 % from total individual
investors
Over 44% from total
institutional investors
Passively managed pension
funds, index funds

Over 85 % from total individual
investors
Over 56% from total institutional
investors
All brokerage firms, investment
funds, hedging fund, specialized
investment companies
Qualitative: avoiding risk,
forecasts, emotions, intuition,
success, speculation, gambling

Quantitative: risk management,
long term statistical analysis,
precise fundamental analysis

*Source: Statistical Data of Treasury Department USA, 2006
...
(2007);
Voicu (2008); Wellington (2002), Sharpe (1993)
...
Of course, the active versus passive investment management
decision does not have to be a strictly either/ or choice
...
Investors also combine the two
by investing part of the portfolio passively and another part actively
...
4 and 5
...


149

Investment Analysis and Portfolio Management

8
...
Strategic versus tactical asset allocation
An asset allocation focuses on determining the mixture of asset classes that is
most likely to provide a combination of risk and expected return that is optimal for the
investor
...
It focus is on
investment in various asset classes
...

Asset classes here is understood as groups of securities with similar characteristics and
properties (for example, common stocks; bonds; derivatives, etc
...
These activities may be integrated in the asset allocation process
...
Asset allocation largely determines
an investor’s success or lack thereof
...
Furthermore, researchers
have found that asset allocation has a much greater impact on reducing total risk than
does selecting the best investment vehicle in any single asset category
...

Strategic asset allocation identifies asset classes and the proportions for those
asset classes that would comprise the normal asset allocation
...
The fixed-weightings approach in
strategic asset allocation is used
...
Example of asset allocation in the portfolio might be as follows:
Asset class
Common stock
Bonds
Short-term securities
Total portfolio

Allocation
40%
50%
10%___
100%

Generally, these weights are not changed over time
...


150

Investment Analysis and Portfolio Management

Tactical asset allocation produces temporary asset allocation weights that
occur in response to temporary changes in capital market conditions
...
For
example, if the investor believes some sector of the market is over- or under valuated
...

Alternative asset allocations are often related with the different approaches to
risk and return, identifying conservative, moderate and aggressive asset allocation
...
The example of these alternative asset allocations is presented in Table 8
...

Table 8
...

Comparison between the alternative asset allocations
Asset class
Common stock
Bonds
Short-term securities
Total portfolio

Conservative
20%
45%
35%
100%

Alternative asset allocation
Moderate
35%
40%
15%
100%

Aggressive
65%
20%
5%
100%

For asset allocation decisions Markowitz portfolio model as a selection
techniques can be used
...
1) was developed
for selecting portfolios of individual securities, but thinking in terms of asset classes,
this model can be applied successfully to find the optimal allocation of assets in the
portfolio
...

The correlation between asset classes is obviously a key factor in building an
optimal portfolio
...
2)
...
It is also important to note that the historical
correlation between different asset classes will vary depending on the time period
chosen, the frequency of the data and the asset class, used to estimate the correlation
...

8
...
Monitoring and revision of the portfolio
Portfolio revision is the process of selling certain issues in portfolio and
purchasing new ones to replace them
...
Individual securities
in the portfolio often change in risk-return characteristics and their
diversification effect may be lessened
...
Changes in market conditions;
2
...
Asset mix in the portfolio
...
Investment decisions
are made in dynamic investment environment, where changes occur permanently
...
Investor can monitor these changes
using various sources of information, especially specialized websites (most frequently
used are presented in relevant websites)
...
If it so investor must take an actions to
rebalance his/ her portfolio
...


Any changes identified must be assessed very carefully before usually they
generally are related with the noticeable changes in investor’s portfolio
...
Rebalancing reduces the risks of losses – in general, a
rebalanced portfolio is less volatile than one that is not rebalanced
...


Constant proportion portfolio
...
Investors should concentrate on keeping their
chosen asset allocation percentage (especially those following the requirements for
strategic asset allocation)
...
One
rule may be to rebalance portfolio when asset allocations vary by 10% or more
...
This is very difficult to do for the investor psychologically (see
Chapter 6)
...

Constant Beta portfolio
...
Over time the values of the portfolio
components and their Betas will change and this can cause the portfolio Beta to shift
...
Diluting the

stocks in portfolio with the cash will reduce portfolio Beta, because cash has
Beta of 0
...
But the investor may be is not able to
invest additional money and this way for rebalancing the portfolio can be
complicated
...
As with the first

alternative, this way reduces the equity holdings in the investor’s portfolio
which may be not appropriate
...
The stocks bought could

be new additions to the portfolio, or the investor could add to existing
positions
...
This alternatives for rebalancing the portfolio are more frequently
used by institutional investors (often mutual funds), because their portfolios tend to be
large and the strategy of matching a market index are best applicable for them
...
Investor attempts to maintain some predetermined characteristics of
the portfolio, such as Beta of 1,0
...

Revising a portfolio is not without costs for an individual investor
...
With the developing of alternative trading systems
(ATS) these costs can be decreased
...

1
...
Portfolio performance measures
Portfolio performance evaluation involves determining periodically how the
portfolio performed in terms of not only the return earned, but also the risk
experienced by the investor
...

In general, the market value of a portfolio at a point of time is determined by
adding the markets value of all the securities held at that particular time
...

The return on the portfolio (rp):

154

Investment Analysis and Portfolio Management

rp = (Ve - Vb) / Vb,
here:

(8
...

The essential idea behind performance evaluation is to compare the returns

which were obtained on portfolio with the results that could be obtained if more
appropriate alternative portfolios had been chosen for the investment
...
In selecting them
investor should be certain that they are relevant, feasible and known in advance
...

Portfolio Beta (see Chapter 3
...
It can be compared directly
with the betas of other portfolios
...
To adjust the return for risk before comparison of
performance risk adjusted measures of performance can be used:



Sharpe’s ratio;




Treynor’s ratio;




Jensen’s Alpha
...
2)

řp - the average return for portfolio p during some period of time;
řf - the average risk-free rate of return during the period;
σp - standard deviation of returns for portfolio p during the period
...
3)

βp – Beta, measure of systematic risk for the portfolio p
...
This measure of the portfolio
manager’s performance is based on the CAPM (see Chapter 3
...


155

Investment Analysis and Portfolio Management

Jensen’s Alpha = (řp– řf) – βp (řm –řf),
here:

(8
...

It is important to note, that if a portfolio is completely diversified, all of these

measures (Sharpe, Treynor’s ratios and Jensen’s alfa) will agree on the ranking of the
portfolios
...
When portfolios are not completely diversified, the
Treynor’s and Jensen’s measures can rank relatively undiversified portfolios much
higher than the Sharpe measure does
...

Summary
1
...

2
...

3
...
Strategic asset allocation
is used to derive long-term asset allocation weights
...

4
...
The investor’s goals
and risk- return preferences are assumed to remain unchanged as the asset weights
are occasionally revised to help attain the investor’s constant goals
...
For asset allocation decisions Markowitz portfolio model as a selection techniques
can be used
...
The
correlation between asset classes is a key factor in building such an optimal
portfolio
...
Portfolio revision is the process of selling certain issues in portfolio and
purchasing new ones to replace them
...
Three areas to monitor when implementing investor’s portfolio monitoring: (1)
Changes in market conditions; (2) Changes in investor’s circumstances; (3) Asset
mix in the portfolio
...
When monitoring the changes in the investor’s circumstances, following aspects
must be taken into account: change in wealth; change in time horizon; change in
liquidity requirements;

change

in

tax

circumstances;

change

in

legal

considerations; change in other circumstances and investor’s needs
...
Rebalancing a portfolio is the process of periodically adjusting it to maintain
certain original conditions
...

10
...
Investors should concentrate on
keeping their chosen asset allocation percentage (especially those following the
requirements for strategic asset allocation)
...
The bases for the rebalancing portfolio using constant Beta portfolio alternative is
the target portfolio Beta
...
This can cause the portfolio Beta to shift and then the
portfolio Beta should be brought back to the target
...
Using indexing method for rebalancing the portfolio the investors match a market
index best applicable for them
...

13
...
For portfolio evaluation appropriate measures of
return and risk as well as relevant standards (or “benchmarks”) are needed
...
The benchmark should reflect the objectives of the
investor
...
To adjust the return for risk before comparison of performance risk adjusted
measures of performance can be used
...
Treynor’s ratio shows an excess actual return over risk free rate, or risk
premium, by unit of systematic risk, measured by Beta
...
This measure of the portfolio manager’s performance is
based on the CAPM
...


•

Tracking error

•

Active portfolio management

•

Constant proportion portfolio method

•

Passive portfolio management

•

Constant Beta portfolio method
Questions and problems

1
...

2
...
What are the major differences between active and passive portfolio management?
4
...

5
...

6
...
Why is the asset allocation decision the most important decision made by
investors?
8
...
What changes in investor’s circumstances cause the rebalancing of the investment
portfolio? Explain why
...
Why is portfolio revision not free of cost?
11
...
Briefly describe each of the portfolio performance measures and explain how they
are used:
a) Sharpe’s ratio;
b) Treynor’s ratio;
c) Jensen’s Alpha
...
Assume that you plan to construct a portfolio aimed at achieving your stated
objectives
...

a) Identify state and comment your investment objectives
...
Explain your decision
...
An investor’s portfolio consists of 50000 EURO in stocks and 5000 EURO in
cash
...
How the investor could reduce Beta of the
portfolio to 0,95? Show and explain
...


Select four stocks which were actively traded in the local stock exchange last
calendar year, find the information about their prices at the beginning and at the
end of the year, amount of dividends paid on each stock for this year and stock
Beta at the end of the year
...
Assume that these four stocks were put to the portfolio
in equal proportions (25% in each stock)
...

a) Find the portfolio return for the given year (see chapter 3
...
2, formula 3
...

b) Calculate Sharpe’s, Treynor’s ratios and Jensen’s Alpha
...


159

Investment Analysis and Portfolio Management

References and further readings
1
...
, at al
...
versus passive investment management: putting
the debate into perspective // Journal of Financial Research, spring
...
Arnold, Glen (2010)
...
2nd ed
...

3
...
C
...

4
...
, Brown, S
...
, Gallagher, D
...
(2005) Portfolio concentration and
investment performance // Journal of Banking and Finance, spring
...
Brands, S
...
R
...
(2003) Active investment manager portfolios
and preferences for stock characteristics: Australian evidence // Securities Industry
Research Centre of Asia-Pacific
...
Cianciotto, Ph
...

7
...
(1999)
...
2nd
...
Prentice Hall Inc
...
Francis, Jack C
...
Investments: A Global Perspective
...

9
...
R
...

10
...
R
...
(2004) Top management turnover: an analysis of
active Australian investment managers // The Journal of Banking and Finance,
winter
...
Gitman, Lawrence J
...
Joehnk (2008)
...

Pearson / Addison Wesley
...
Gold, M
...

13
...
(2010)
...
John Wiley &
Sons, Inc
...
LeBarron, Dean, Romeesh Vaitilingam
...
Ultimate Investor
...

15
...
(2005) A comparison of active and passive investment strategies //
The Journal of Financial Research, spring
...
Rice, M
...
(2007) The next chapter in the active vs
...

17
...
(1993)
...
John Wiley &Sons Inc
...
Sharpe, William
...
// Financial Analysis
Journal, 1991
...
Strong, Robert A
...
Portfolio Construction, Management and Protection
...

20
...
, (2008) Passive vs
...

21
...
W
...
passive management // The Journal of
Financial Research, spring
...
morningstar
...
uk

Morningstar UK

•

www
...
ft
...
funds-sp
...
, Deaves, Richard (2010)
...
South-Western Cengage
Learning
...
Investing: the definitive companion to investment and the
financial markets
...
Financial Times/ Prentice Hall
...
Oxford Dictionary of
Economics
...
Oxford University Press Inc
...

Bode, Zvi, Alex Kane, Alan J
...
Investments
...
McGraw Hill
...
by Greg N
...
CRC Press, 2009
...
(1999)
...
2nd
...
Prentice Hall Inc
...
, Roger Ibbotson (2002)
...
Prentice
Hall Inc
...
, Michael D
...
Fundamentals of Investing
...

Haan, Jakob, Sander Oosterloo, Dirk Schoenmaker (2009)
...
Cambridge University Press
...
(2001)
...
5th ed
...

Jones, Charles P
...
Investments Principles and Concepts
...

LeBarron, Dean, Romeesh Vaitilingam
...
Ultimate Investor
...

Levy, Haim ,Thierry Post (2005)
...
FT / Prentice Hall
...
(2000)
...


MacMillan Business
...
(2008)
...
3rd ed
...

Rosenberg, Jerry M
...
Dictionary of Investing
...

Sharpe, William, F
...
Alexander, Jeffery V
...
(1999) Investments
...
Prentice –Hall International
...
(1993)
...

Wilmott, Paul (2009)
...
2nd ed
...


164

Investment Analysis and Portfolio Management

Annex 1
...
Maximum Safety
High Grade High Quality

Upper Medium Grade

Lower Medium Grade

Non-Investment Grade

Highly Speculative

In Poor Standing

Extremely Speculative
May be in Default
Default

Source: Ministry of Finance of the Republic of Lithuania
...
finmin
...

Black-Scholes formula for estimating the fair value of the call options
Vc = N(d1) * Ps - [E*R* T* N(d2)] / e,

(1)

here Ps - current market price of the underlying stock;
E - exercise price of the option;
R-

continuously compounded risk free rate of return expressed on the annual
basis;

T - time remaining before expiration, expressed as a fraction of a year
N(d1) and N(d2) denote the probabilities that outcomes of less d1 and d2
respectively
...


166



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