Selecting Investments in a Global Market & Organization and Functioning of Securities Markets nInvestor of the 21st century qAn array of investment opportunities not available several decades ago nDynamism of financial markets nTechnological advantages nNew regulations qNew financial instruments, expanded trading opportunities qImprovements in communication and relaxation of international regulation have made it easier for investor to trade in both domestic and global markets Reasons for the expansion of investment opportunities n 1.Growth and development of foreign financial markets n2. Advances in telecommunications technology n3. Mergers of firms and security exchanges n The Case for Constructing Global Investment Portfolios •Growth and development of numerous foreign financial markets •Japan, UK. Germany and emerging markets as well •Accessible and viable for investor all around the world •Major advances in telecommunications technology • that made it possible to maintain contact with officer and financial markets around the world •The afford of investors and firms undertook counterbalancing initiatives •Significant merges of firms and exchanges to trade securities worldwide •Investor alternatives are available from security markets around the world n n nWhen investor compare absolute and relative size of U.S. and foreign markets qReduce their choices to less than 50 percentage of available investment opportunities nThe rate of return available on non U.S. securities often have exceeded those for U.S. only securities qHigher growth rates for countries where they were issued nThesis of investment theory that investor should diversify their portfolios qLow correlation with asset returns qForeign securities have low correlation with domestic securities Relative Size of U.S. Financial Markets 1.The share of the U.S. in world capital markets has dropped from about 65 percent of the total in 1969 to about 48 percent in 2000 •Investor selection securities strictly from U.S. markets had a complete set of investments available 2.The growing importance of foreign securities in world capital markets is likely to continue Rates of Return on U.S. and Foreign Securities nMany non-U.S. securities provide superior rate of return but also show the impact of the exchange rate of risk n Global Bond Market Return Global Equity Market Return Individual Country Risk and Return nA question qAre these superior rates of return attributable to higher levels of risk for securities in these countries? q nU.S. stocks look very strong relative to other countries n Risk of Combined Country Investments nThe way to measure whether two investments will contribute to diversifying a portfolio id to compute qThe correlation coefficient between their rates of return over time nRange from -1 to + 1 nA correlation +1 means qThe rate of return for two instruments move exactly together nA correlation - 1 means qThe rate of return for two instruments move exactly opposite to each other qIf one investment is experiencing above average return, the other is suffering by similar below average rates of return n nCombining two investments with large negative correlation in a portfolio would contribute much to diversification qIt would stabilize the rates of return over time qReduces standard deviation of the portfolio returns qReduces risk of portfolio nIf you want to diversify portfolio qLow positive correlation qZero correlation qNegative correlation - ideally Global Bond Portfolio Risk 1.Macroeconomic differences cause the correlation of bond returns between the United States and foreign countries to differ 2.The correlation of returns between a single pair of countries changes over time because the factors influencing the correlation change over time •International trade, economic growth, fiscal and monetary policy, • changes in how economies are related and in the relations between returns of bond Global Bond Portfolio Risk nLow positive correlation nOpportunities for U.S. investors to reduce risk nCorrelation changes over time nAdding non-correlated foreign bonds to a portfolio of U.S. bonds increases the rate of return and reduces the risk of the portfolio Global Equity Portfolio Risk nLow positive correlation nOpportunities to reduce risk of stock portfolio by including foreign stocks Summary of Global Investing nThe relative size of the markets for non-U.S. bonds and stocks has growth in size and importance qToo big to ignore nRates of return for foreign bond and stocks per unit were superior to those in the U.S. market qReturn of dollar were typically lower during the 1990s because the strength of the dollar and the risk was always higher nTo successful diversification, an investor should combine investments with low positive or negative correlation between rates of return Global Investment Choices nFixed-income investments qbonds and preferred stocks nEquity investments nSpecial equity instruments qwarrants and options nFutures contracts nInvestment companies nReal assets Fixed-Income Investments nContractual payment schedule qSpecific payment at predetermined times nRecourse varies by instrument qCreditors can declare the issuing firm bankrupt qIssuing firm must make payments only if it earns profits - income bonds nBonds qinvestors are lenders qexpect interest payment and return of principal Savings Accounts nFixed earnings nConvenient nLiquid nLow risk – almost all are insured nLow rates qPassbook saving account qCertificates of Deposit (CDs) n - instruments that require minimum deposits for specified terms, and pay higher rates of interest than savings accounts. Penalty imposed for early withdrawal n- Limited liquidity n Money Market Certificates nCompete against Treasury bills (T-bills) nMinimum $10,000 nMinimum maturity of six months nRedeemable only at bank of issue nPenalty if withdrawn before maturity Capital Market Instruments nFixed income obligations that trade in secondary market nU.S. Treasury securities nU.S. Government agency securities nMunicipal bonds nCorporate bonds U.S. Treasury Securities nBills, notes, or bonds - depending on maturity qBills mature in less than 1 year qNotes mature in 1 - 10 years qBonds mature in over 10 years nHighly liquid nBacked by the full faith and credit of the U.S. Government Municipal Bonds nIssued by state and local governments usually to finance infrastructural projects. nExempt from taxation by the federal government and by the state that issued the bond, provided the investor is a resident of that state nTwo types: qGeneral obligation bonds (GOs) qRevenue bonds n Corporate Bonds nIssued by a corporation nFixed income nCredit quality measured by ratings nMaturity nFeatures qIndenture qCall provision qSinking fund Corporate Bonds nSenior secured bonds qmost senior bonds in capital structure and have the lowest risk of default nMortgage bonds qsecured by liens on specific assets nCollateral trust bonds qsecured by financial assets nEquipment trust certificates qsecured by transportation equipment Corporate Bonds nDebentures qUnsecured promises to pay interest and principal qIn case of default, debenture owner can force bankruptcy and claim any unpledged assets to pay off the bonds nSubordinated bonds qUnsecured like debentures, but holders of these bonds may claim assets after senior secured and debenture holders claims have been satisfied Corporate Bonds nIncome bonds qInterest payment contingent upon earning sufficient income nConvertible bonds qOffer the upside potential of common stock and the downside protection of a bond qUsually have lower interest rates q Corporate Bonds nWarrants qAllows bondholder to purchase the firm’s common stock at a fixed price for a given time period qInterest rates usually lower on bonds with warrants attached nZero coupon bond qOffered at a deep discount from the face value qNo interest during the life of the bond, only the principal payment at maturity Preferred Stock n nHybrid security nFixed dividends nDividend obligations are not legally binding, but must be voted on by the board of directors to be paid nMost preferred stock is cumulative nCredit implications of missing dividends nCorporations may exclude 80% of dividend income from taxable income International Bond Investing nMore than half of all fixed-income securities available to U.S. investors are issued by firms in countries outside the U.S. nIndentification it by different ways qCountry or city of issuer qLocation of primary trading market qHome county of major buyers qCurrncy in which are securities denominated International Bond Investing nEurobond qAn international bond denominated in a currency not native to the country where it is issued nYankee bonds qSold in the United States and denominated is U.S. dollars, but issued by foreign corporations or governments qEliminates exchange risk to U.S. investors nInternational domestic bonds qSold by issuer within its own country in that country’s currency q Equity Investments nReturns are not contractual and may be better or worse than on a bond Equity Investments nCommon Stock qRepresents ownership of a firm qInvestor’s return tied to performance of the company and may result in loss or gain Classification of Common Stock Categorized By General Business Line nIndustrial: manufacturers of automobiles, machinery, chemicals, beverages nUtilities: electrical power companies, gas suppliers, water industry nTransportation: airlines, truck lines, railroads nFinancial: banks, savings and loans, credit unions Acquiring Foreign Equities in U.S. market n1. Purchase of American Depository Receipts (ADRs) n2. Purchase of American shares n3. Direct purchase of foreign shares listed on a U.S. or foreign stock exchange n4. Purchase of international mutual funds American Depository Receipts (ADRs) nEasiest way to directly acquire foreign shares nCertificates of ownership issued by a U.S. bank that represents indirect ownership of a certain number of shares of a specific foreign firm on deposit in a U.S. bank in the firm’s home country nBuy and sell in U.S. dollars nDividends in U.S. dollars nMay represent multiple shares nListed on U.S. exchanges nVery popular Purchase or Sale of American shares nIssued in the United States by transfer agent on behalf of a foreign firm nHigher expenses nLimited availability Direct Purchase of Foreign Shares nDirect investment in foreign equity markets- difficult and complicated due to administrative, information, taxation, and market efficiency problems qPurchasing security in the domestic county nPurchase foreign stocks listed on a U.S. exchange – limited choice qIn 2000 only 96 firms nMostly Canadian Purchase International Mutual Funds nGlobal funds - invest in both U.S. and foreign stocks nInternational funds - invest mostly outside the U.S. nFunds can specialize qDiversification across many countries qConcentrate in a segment of the world nEurope, South Africa, the Pacific basis, etc. qConcentrate in a specific country nJapan fund, Germany fund, etc. qConcentrate in types of markets nEmerging markets, BRIC, etc. Special Equity Instruments nEquity-derivative securities have a claim on common stock of a firm nOptions are rights to buy or sell at a stated price for a period of time nWarrants are options to buy from the company nPuts are options to sell to an investor nCalls are options to buy from a stockholder Futures Contracts nExchange of a particular asset at a specified delivery date for a stated price paid at the time of delivery nDeposit (10% margin) is made by buyer at contract to protect the seller nCommodities trading is largely in futures contracts nCurrent price depends on expectations Financial Futures nRecent development of contracts on financial instruments such as T-bills, Treasury bonds, and Eurobonds nTraded mostly on Chicago Mercantile Exchange (CME) and Chicago Board of Trade (CBOT) nAllow investors and portfolio managers to protect against volatile interest rates nCurrency futures allow protection against changes in exchange rates Investment Companies nRather than buy individual securities directly from the issuer they can be acquired indirectly through shares in an investment company qMutual fund nInvestment companies sell shares in itself and uses proceeds to buy securities nInvestors own part of the portfolio of investments Investment Companies nMoney market funds qAcquire high-quality, short-term investments nT-Bills, commercial papers, etc. qYields are higher than normal bank CDs qTypical minimum investment is $1,000 nMinimum additions $250 to $500 qNo sales commission charges qWithdrawal is by check with no penalty qInvestments usually are not insured Investment Companies nBond funds qInvest in long-term government, corporate, or municipal bonds qBond funds vary in bond quality selected for investment qExpected returns vary with risk of bonds Investment Companies nCommon stock funds qMany different funds with varying stated investment objectives nAggressive growth, income, precious metals, international stocks qOffer diversification to smaller investors qSector funds concentrate in an industry qInternational funds invest outside the United States qGlobal funds invest in the U.S. and other countries Investment Companies nBalanced funds qInvest in a combination of stocks and bonds depending on their stated objectives nIndex Funds qCreate to equal performance of a market index qPassive investors nETFs qMutual Funds priced daily after trading day nDo not reflect event till the end of day qETFs fund traded in stock exchange Real Estate nProfitable investment alternative qAvailable only for limited number of expert with a lot of capital Real Estate Investment Trusts (REITs) nLow capital alternatives nInvestment fund that invests in a variety of real estate properties nConstruction and development trusts provide builders with construction financing nMortgage trusts provide long-term financing for properties nEquity trusts own various income-producing properties qOffice buildings, shopping centers Direct Real Estate Investment nPurchase of a home qAverage cost of a single-family house exceeds $100,000 qFinancing by mortgage requires down payment qHomeowner hopes to sell the house for cost plus a gain Direct Real Estate Investment nPurchase of raw land qIntention of selling in future for a profit qOwnership provides a negative cash flow due to mortgage payments, taxes, and property maintenance qRisk from selling for an uncertain price and low liquidity Direct Real Estate Investment nLand Development qBuy raw land qDivide into individual lots qBuild houses or a shopping mall on it qRequires capital, time, and expertise qReturns from successful development can be significant Low-Liquidity Investments nSome investments don’t trade on securities markets nLack of liquidity keeps many investors away nAuction sales create wide fluctuations in prices nWithout markets, dealers incur high transaction costs nTrading in auctions Antiques nDealers buy at estate sales, refurbish, and sell at a profit nSerious collectors may enjoy good returns nIndividuals buying a few pieces to decorate a home may have difficulty overcoming transaction costs to ever enjoy a profit Art nInvestment requires substantial knowledge of art and the art world nAcquisition of work from a well-known artist requires large capital commitments and patience nHigh transaction costs nUncertainty and illiquidity Coins and Stamps nEnjoyed by many as hobby and as an investment nMarket is more fragmented than stock market, but more liquid than art and antiques markets nPrice lists are published weekly and monthly nGrading specifications aid sales nWide spread between bid and ask prices Diamonds nCan be illiquid nGrading determines value, but is subjective nInvestment-grade gems require substantial investments nNo positive cash flow until sold nCosts of insurance, storage, and appraisal before selling Returns of Stocks, Bonds, and T-Bills nIbbotson and Sinquefield (I&S) examined nominal and real rates of return for seven major classes of assets in the United States q1. Large-company common stocks q2. Small-capitalization common stocks q3. Long-term U.S. government bonds q4. Long-term corporate bonds q5. Intermediate-term U.S. Treasury bills q6. U.S. Treasury bills q7. Consumer goods (inflation) Derived Series: Historical Highlights (1926 - 2001) nI & S computed geometric and arithmetic mean rates of return nThey derived four return premiums q1. Risk premium q2. Small-stock premium nReturn on small capitalized stock minus the return on large company stocks q3. Horizon premium nLong term government bond vs. T-Bills q4. Default premium nLong-term risky corporate bonds vs. long term risky-free government bonds Returns of Stocks, Bonds, and T-Bills nReturns and risk increase together nRates of return are generally consistent with the uncertainty of returns Art and Antiques nMarket data is limited qResults of financial securities published daily qSotheby’s a major art auction firm nIndices from 13 areas of arts nResults vary widely, and change over time, making generalization impossible, but showing a reasonably consistent relationship between risk and return nCorrelation coefficients vary widely, allowing for great diversification potential nLiquidity is still a concern Real Estate nReturns are difficult to derive due to lack of consistent data nResidential shows lower risk and return than commercial real estate nDuring some short time periods REITs have shown higher returns than stock with lower risk measures nLong term returns for real estate are lower than stocks, and have lower risk Real Estate nNegative correlation between residential and farm real estate and stocks nLow positive correlation between commercial real estate and stocks nPotential for diversification