BFIN 3020 CH 15

cash flow

any income derived from an investment (interest or dividend)

capital gain

selling a security for more than its purchase price

capital loss

selling a security for less than its purchase price

holding period return

a rate of return for any time period other than one year

annual rate of return

a rate of return based on a trading period of 1 year.

ex-ante

a projection of expected returns

ex-post

actual historical return that was realized

How are expected (ex-ante) returns estimated?

T-bill rate (risk free rate) plus a performance percentage based on the risk of the investment.

risk-free rate of return

the rate of return an investor would receive if they invested in a risk-free investment (e.g. t-bill).

How is the yield paid on a t-bill determined

estimating the short term inflation rate and adding a real return

inflation rate risk

the risk that inflation will reduce future purchasing power and the real return on investments

business risk

the risk that a company’s earnings will be reduced as a result of a labour strike, a new product in the market, or outperformance by a competitor.

political risk

the risk of unfavourable changes in government policies. E.g. foreign direct investment policy, or a war torn-country.

liquidity risk

the risk that an investor will not be able buy or sell a security at a fair price quickly.

interest rate risk

the risk that changing interest rates will adversely affect an investment. E.g. a rise in interest rates will reduce the value of bonds held.

foreign exchange rate risk

the risk of unexpected loss resulting from unfavourable change in exchange rates.

foreign investment risks

a drop-off of liquidity for international small cap issuers, larger bid-ask spreads of international small cap issuers.

foreign investment risks

varying legal rights of shareholders and bond investors, poor shareholder communication in terms of reliability, quality, level of detail, and frequency of reporting.

default risk

the risk that a company will not make timely payments on interest or principal on its debt obligations.

systematic risk/market risk

risk that always exists and cannot be reduced from diversification

non-systematic risk/specific risk

risk that the price of a security will change differently from the market as a whole. Can be reduced through diversification.

standard deviation

a measure of risk that uses historical data to derive a range of future possibilities. A greater standard deviation % indicates more possible outcomes and more risk.

beta

a measure of volatility of a stock to movements in the overall market. A beta of 1 means the stock moves with the market, while a beta greater than 1 indicates greater volatility.

a beta >1 indicates

the stock is more volatile than the market

a beta <1 indicates

the stock is less volatile than the market

a beta of 1 indicates that

the stock mirrors the overall market

correlation

measures how the returns on two securities move together, and how a change to the value of one predicts another.

Correlation of +1 indicates

the securities have perfect positive correlation, meaning they’re similar enough to where prices move in the same direction.

what does not reduce the overall risk of a portfolio

adding stocks with perfect positive correlation (+1)

perfect negative correlation (-1)

when the stocks interact such that when one rises, the other one falls. This effectively diversifies the risk in a portfolio.

what type of correlation is the most desirable for achieving the maximum gain from diversification?

perfect negative correlation (-1)

if an equity portfolio has a beta of 1.30, and the S&P/TSX Composite rose 10%, how much would the equity portfolio be expected to rise?

13%

what industries have high betas

cyclical

what industries have low betas

defensive

alpha

the excess returns that outperform the market, due to the skills of a fund manager/ advisor.

active investment strategy

the fund manager actively selects securities with the intention of outperforming a benchmark on a risk-adjusted basis.

2 types of active equity investment strategies

bottom up analysis and top down analysis

bottom up analysis

analysis starts with individual stocks, and then builds a portfolio based on their risk characteristics.

top down analysis

analysis starts with broad macroeconomic factors, and is narrowed to industry and individual stocks after.

passive investment strategy

fund manager attempts to replicate the performance of an index without trying to outperform it.

2 types of passive investment strategy

indexing, and buy-and-hold

indexing

involves holding securities that replicate the composition of the benchmark index.

buy-and-hold

is an investment strategy where an investor buys securities and holds them for a long period, because it’s believed that securities markets are efficient.

Growth managers

focus on momentum in current and future EPS. Stocks in these portfolios do not focus on dividends and have a higher turnover.

risks associated with growth managers

If EPS falters, it can cause large percentage price declines. Additionally, growth stocks can stray from expectations or underperform during market downturns.

Growth portfolios have what valuation characteristics?

High P/E ratios, High price-to-book value, High price-to-cash flow

What impact does a higher portfolio turnover have on the investor?

investors in taxable accounts may be liable for increased amounts of capital gains tax every year.

Value managers

the focus is on finding undervalued stocks. These managers have lower turnover. The holding period is longer than growth investors because they wait for a stock’s intrinsic value to be realized.

risk characteristics associated with value managers

Lower standard deviation, Lower beta, stock prices are low can could remain low for a long time.

Value portfolios have what valuation characteristics?

Low P/E ratios, Low price-to-book ratios, Low price-to-cash flow ratios, higher dividend yield

What type of client is best for a value manager?

Low-medium tolerance for market risk and long-term investment horizons.

Between Growth management and Value management, which style has lower volatility?

Value Management

What is a drawback of value investing?

In an efficient market, the price of securities already tends to reflect everything known about them.

What management style is bottom-up?

value managers, growth managers.

Which management style is top-down?

Sector Rotation

Sector Rotation management

focus is on assessing the overall economy and identifying what industries will outperform others. The securities they choose are large cap stocks to represent those industries. Turnover is high

risk features of sector rotation strategy

higher volatility due to concentration of certain industries. Good individual stocks may be overlooked due to a focus on sector leaders.

What investment manager styles have a high turnover?

Growth and Sector Rotation.

What management style focuses the most on liquidity in their stock selection?

Sector Rotation

In a bullish market, a sector rotation manager will focus on what industries?

cyclical industries

In a bearish market, a sector rotation manager will focus on what industries?

defensive industries

Short term fixed-income managers

focus on T-bills and short term bonds with maturities less than 5 years.

Medium term fixed-income managers

focus on terms to maturities between 5 to 10 years, e.g. mortgage funds.

Long-term fixed-income managers

focus on long term bonds with maturities >10 years.

what is the grading range for investment quality bonds?

Aaa to Baa3

How can managers mitigate the risk of bonds with high yield but high credit risk?

Opting for bonds that mature in less than 3 years.

When managers anticipate an increase in interest rates, what do they do with their bonds?

shorten the average term on their bonds, because longer durations are more sensitive to interest rate changes.

When managers anticipate a decrease in interest rates, what do they do with their bonds?

extend the average term on their bonds

when is interest rate anticipation (duration switching) not advantageous?

when the yield curve is flat