ch03 by liaoxiuli3


									Chapter 3

 Chapter 3 Questions
Why should investors have a global
perspective regarding their investments?
What has happened to the relative size of
U.S. and foreign stock and bond markets?
How can changes in currency exchange rates
affect the returns that U.S. investors
experience on foreign securities?
What advantage is there to diversifying in
international markets?
  Chapter 3 Questions
What alternative securities are available?
What are their cash flow and risk properties?
What are the historical return and risk
characteristics of the major investment
What is the relationship among the returns for
foreign and domestic investment
instruments? What is the implication of these
relationships for portfolio diversification?
      Why have a global
The foreign market for stocks and bonds is
   U.S. markets comprise less than half of the total
    available securities
   More opportunities broaden the range of risk-
    return choices
Returns on non-U.S. securities have often
exceeded U.S. securities
   Higher returns on equities are explained by higher
    growth rates in some countries
     Why have a global
Diversification with foreign securities
can help reduce portfolio risk.
   Since foreign investments are impacted by
    somewhat different forces than domestic
    investments, risks can be reduced.
It’s easier than ever before!
   Barriers to global investing, both for
    companies and for individual investors, are
    getting smaller.
Relative Size of U.S. and
    Foreign Markets
The overall value of world financial markets
has seen explosive growth ($2.3 trillion in
1969 to $63.8 trillion in 2000)
The U.S. share of the overall world financial
markets has gone from well over half (65% in
1969) to less than half (48% in 2000).
For the equities market, the U.S. market was
about 49% of the world market in 2000.
See Exhibits 3.1 and 3.2
The Effect of Changing
   Exchange Rates
For U.S. investors, a foreign security’s return
in its domestic market is not the “bottom line.”
Exchange rates have a major impact on the
equivalent U.S. return on a foreign
The key factor is the changing strength of the
U.S. dollar vis-à-vis the foreign currency.
The Effect of Changing
   Exchange Rates
Stronger dollar: Income
from foreign
investments get
exchanged for fewer
dollars over time,
reducing net return for
the U.S. investor.
Weaker dollar: Income
from foreign
investments get
exchanged for more
dollars over time,
increasing net return for
the U.S. investor.
  Diversification in
International Markets
Can we reduce risk through international
   U.S. returns appear to give better performance on
    a risk per unit of return basis (lower Coefficient of
    Variation, see Exhibit 3.6) after considering
    exchange rate risk.
While it may seem strange that combining
apparently riskier investments with less risky
investments can reduce risk, it works!
   The key reason: Correlation
     Diversification in
   International Markets
Recall that diversification involves risk
      Correlations range from +1 (perfect positive
       correlation) to –1 (perfect negative correlation)
      By combining securities whose returns are not
       perfectly positively correlated with each other in a
       portfolio, the portfolio standard deviation
       characteristically falls.
      The lower the correlation coefficient between
       investments, the greater the benefit of
  Diversification in
International Markets
Correlations between U.S. markets and major
foreign markets are relatively low.
   In bond markets, the correlations, while positive,
    are all below +.50
   In equity markets, the correlations are a bit higher,
    but still relatively low with an average of about
The bottom line: there is considerable benefit
to international diversification.
   Portfolios that are diversified internationally tend to
    have substantially lower standard deviations.
     Diversification in
   International Markets
Several words of caution:
  Correlations vary greatly between pairs of
     As you might guess, there is a higher correlation
      between U.S. and Canadian returns than between
      U.S. and various European returns.
     Not all international diversification is created
  Correlations are increasing over time.
     As global competition and various regulatory
      barriers have fallen, correlations have increased.
       Global Investment
Focus on capital market securities (at least one
  year to original maturity)
  Fixed-Income Investments
     Bonds, Preferred Stock
     Futures, Options
  Indirect, Managed Investments
     Mutual Funds, Hedge Funds
          Fixed Income
Except for preferred stock, fixed income
securities are debts of the issuer.
Promise specified cash flows at pre-
determined times.
   Legal force behind the agreement varies
    by type of security and issuer, as does the
    corresponding risk borne by the investor.
             Fixed Income
Most fixed income instruments specify a
 number of features including the following:
     The maturity date – the date that the obligation is
      to be fully repaid, according to its provisions.
     The coupon – the income that the investor will
      receive each year.
     The par value – the principal value of the
      obligation; usually the original value and also the
      amount to be returned to the investor on the
      maturity date.
       Fixed Income
U.S. Treasury Securities
U.S. Government Agency Securities
Municipal Bonds
Corporate Bonds
Other Fixed Income Instruments
U.S. Treasury Securities
Bills, notes, or bonds - depending on
  Bills mature in less than 1 year
  Notes mature in 1 - 10 years
  Bonds mature in over 10 years

Highly liquid
Very low risk of default, so essentially
no credit risk
      U.S. Government
      Agency Securities
Sold by government agencies
   Federal National Mortgage Association (FNMA or
    Fannie Mae)
   Federal Home Loan Bank (FHLB)
   Government National Mortgage Association
    (GNMA or Ginnie Mae)
   Federal Housing Administration (FHA)
Not direct obligations of the Treasury
   Still considered default-free and fairly liquid
       Municipal Bonds
Issued by local governments
 General obligation bonds (GOs)
 Revenue bonds

Exempt from federal income taxes and
often state income taxes
   Popular instrument for high tax bracket
     Corporate Bonds
Debt securities issued by corporations.
Vary by:
 Level of claim (security)
 Credit quality

 Term to maturity

 Special features
  Corporate Bonds:
Secured or Unsecured?
Secured bonds feature some sort of collateral
to protect the investor.
   Mortgage bonds: backed by land and buildings
   Collateral trust bonds: backed by financial assets
   Equipment trust certificates: backed by specific
    pieces of equipment
Unsecured bonds or debentures are backed
only by the firm’s promise to pay.
   Subordinated debentures: lower priority claim
   Income bonds: pay only if profits are earned
     Corporate Bonds:
     Special Provisions
The bond contract (the indenture) may
include several important provisions that can
influence the actual maturity of the bond.
Call provision: allows the issuer to buy back
or “call in” the bond prior to maturity at a
specified call price
   Bonds range from freely callable (can be called
    any time) to non-callable
   Most have deferred calls, which are non-callable
    for a period of time, then freely callable
     Corporate Bonds:
     Special Provisions
Sinking fund provision: requires the
issuer to retire a portion of a bond issue
prior to maturity.
   Like a call provision, the investor would
    typically receive a specified call price under
    a sinking fund provision.
Both call provisions and sinking fund
provisions can shorten the actual
maturity of a bond.
    Other Fixed Income
Convertible Bonds: Corporate bonds with the
added option to exchange them for a fixed
number of shares of common stock.
   Usually lower interest rates than if the same bond
    was not convertible
Bonds with Warrants
   Allows bondholder to purchase the firm’s common
    stock at a fixed price for a given time period
   Usually lower interest rates on bonds with
    warrants attached
    Other Fixed Income
Collateralized Mortgage Obligations (CMOs):
securities that “pass through” the payments
that borrowers make on mortgages, with
specific distribution rules that apply to
different classes of these instruments.
   Other asset-backed securities as well, such as
    certificates for automobile receivables (CARs)
Zero coupon bonds: bonds that pay low or no
coupon interest, and instead provide their
return only in the form of price appreciation.
   Sell at a discount from par, mature to par value.
     International Bond
Eurobond: an international bond that pays
cash flows in a currency not native to the
country of issue
   Eurodollar bonds are denominated in U.S. dollars,
    but sold outside of the U.S.
Yankee bond: a bond denominated in U.S.
dollars, sold in the U.S., but issued by a
foreign corporation or government
International domestic bonds: U.S. investor in
a foreign bond, subject to exchange rate risk.
           Bond Ratings
Most bonds are rated for default, or credit risk
by one or more rating agency.
   Duff and Phelps, Fitch Investors Service, Moody’s,
    Standard & Poors (S & P)
Ratings from AAA to D, some agencies give
slightly different modifiers or letters
Top four ratings (AAA down to BBB):
Investment Grade Securities
Below the top four ratings: Speculative Grade
Securities (High-yield or junk bonds)
        Preferred Stock
Classified as a fixed income security since
yearly dividends are stipulated.
Preferred dividends are not legally binding, so
preferred stock is technically not a debt.
Since corporations are loathe to miss a
dividend, they are binding in practical terms.
Much of the outstanding preferred stock is
held by other corporations.
   80% of dividends received by one corporation
    from another are excluded from taxable income
Returns are not contractual.
Instead, returns vary according to
performance, and can be much better or
much worse than fixed income investments.
Equity represents an ownership interest.
   The owner gets as much or as little as is left over
    after all fixed and higher priority claims have been
Most common equity investment: Common
         Common Stock
Represents the ownership of a corporation
Relatively risky investment compared to fixed
income securities
Investment considerations include choice of
business group or sector and at industries
within those broad groups
   Business groups: Industrial firms, Utilities,
    Transportation firms, Financial Institutions
          Foreign Equity
Several means of obtaining an equity interest in
  foreign investments:
  Through American Depository Receipts
  Through direct investment in foreign shares
  listed on a U.S. or foreign stock exchange
  Through indirect investment in international or
  global mutual funds
 American Depository
Easiest way to acquire foreign shares
Certificates issued by a U.S. bank
   Represent indirect ownership of shares of a
    foreign firm on deposit in a bank in the firm’s home
Buy and sell in U.S. dollars
Dividends in U.S. dollars
May represent multiple shares
Very popular, over 1500 ADR programs
available in 2002
 Direct Investment in
    Foreign Shares
The most difficult approach, especially
when purchasing stock in the foreign
country (in the foreign currency) and
transferring back to the investor’s home
A growing number of foreign firms do
list their stock directly on the NYSE.
International and Global
     Mutual Funds
Global funds: invest in both U.S. and foreign
International funds: invest mostly outside the
Funds can specialize
    Diversification across many countries
    Concentrate in a segment of the world
    Concentrate in a specific country
    Concentrate in types of markets
   Derivative Securities
There are many types of derivative
 investments, including financial
 derivative securities whose payoffs are
 tied to various financial assets.
   Warrants
   Puts and calls

 Futures contracts
       Option Contracts
  Give the owner the right to purchase a
  company’s common stock from the company
  at a specified price within a designated period
  of time.
Puts and calls
  Give the owner the right to sell (put) or buy
  (call) a company’s stock within a specified
  period of time at a specified price (called the
  striking price).
    Futures Contracts
Standardized contracts to make or take
delivery of some financial (or other) asset in
exchange a specified payment at a future
Payment not due until the future date, but
margin (a good faith deposit) is required.
Futures contracts are often used to manage
risk, especially the risk of changing interest
  Managed Investments
Investment companies sell shares in
  themselves and use the proceeds to invest in
  other investment instruments.
  Closed-end investment companies: offer a
  fixed number of shares.
  Open-end investment companies (Mutual
  funds): offer fluctuating number of shares
  based on purchases/sales of fund shares.
     Stock funds, Bond funds, Money market funds,
      Mixed funds
Managed Investments
Hedge Funds: typically act as a partnership
where one partner manages funds for all
other partners according to some investment
Venture capital pools: Similar to hedge funds,
these partnerships obtain an equity interest in
promising start-up or privately held firms.
Real Estate Investment Trusts (REITs):
provides investors with an indirect means of
investing in real estate.
Historic Return and Risk
Historic investment results have been studied
Ibbotson and Sinquefield (I&S) data chronicle rates of
return for major classes of assets in the United States
 1. Large-company common stocks
 2. Small-capitalization common stocks
 3. Long-term U.S. government bonds
 4. Long-term corporate bonds
 5. Intermediate-term U.S. Treasury bills
 6. U.S. Treasury bills
       Summarizing the
        Historic Data
History confirms the relationship between risk
and return.
   The higher returning classes of investments
    (common stock, especially small-cap firms) have
    experienced greater volatility.
Adjusting for inflation, thereby creating real
returns, shows a small positive real interest
rate for the lowest risk investment (T-bills:
         Summarizing the
          Historic Data
The historical data also allows for the
  calculation of average premiums earned
     Equity risk premium = Common Stock return
      minus T-bill return = 6.97%
     Small-stock premium = Small stock return minus
      Large stock return = 1.22%
     Horizon premium = Long-term T-bond return
      minus T-bill return = 1.45%
     Default premium = Long-term Corporate bond
      return minus Long-term T-bond return = .36%
          World Portfolio
Examination of historical returns largely confirm
  Riskier assets also have had higher average
  Coefficients of variation range widely, with the
  combined World Stock Index having a low
  CV, showing benefits of global diversification.
  Correlations between asset returns vary by
  global regions, also showing the potential, but
  variant advantages to global diversification.

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