Chapter 3

Presented by
Muhammad Khalid Sohail

Reasons for the expansion of

investment opportunities

As an investor in the 21st century, you have an

array of investment choices, Together, the
dynamism of financial markets, technological
advances, and new regulations have resulted in
numerous new investment instruments and
expanded trading opportunities.
Telecommunications networks enable brokers to
reach security exchanges in London, Tokyo, and
other European and Asian cities as easily as those
in New York, Chicago, and other U.S. cities.

Reasons for the expansion of

investment opportunities
1. Growth and development of foreign
financial markets
2. Advances in telecommunications
technology
3. Mergers of firms and security exchanges

The Case for Constructing

Global Investment Portfolios
1. Ignoring foreign markets can substantially
reduce the investment choices for U.S.
investors
2. The rates of return on non-U.S. securities
often have substantially exceeded those for
U.S.-only securities
3. The low correlation between U.S. stock
markets and many foreign markets can
help to substantially reduce portfolio risk

Relative Size of U.S. Financial

Markets
Overall value of the securities available in
world capital market has increased from $2.3
Trillion in 1969 to $113.6 Trillion in 2010 and
the U.S. portion has declined to less than half.
The share of the U.S. in world stock and bond
markets has dropped from about 65 percent of
the total in 1969 to about 47 percent in 2010.
The growing importance of foreign securities
in world capital markets is likely to continue.
See Exhibit 3.1

Relative Size of
U.S. Financial Markets

The Case for Global Investments

Rates of return available on non-U.S. securities often
exceed U.S. Securities due to higher growth rates in
foreign countries, especially the emerging markets.
Global Bond-Market Return:
From 19862010, the return performance of the U.S. bond
market ranked sixth out of the six countries when the
returns are measured in U.S. dollar.
The better performance of the non-U.S. markets is partly
due to the weakened dollar in this time frame
See Exhibit 3.2

Global Equity-Market Return

From 2007 through 2010, the United States average rank
in annual return measured in U.S. dollar was 17.5 out of
34 countries.

The Case for Global

Investments
Diversification with foreign securities can
help reduce portfolio risk because foreign
markets have low correlation with U.S. capital
markets

 A correlation of +1.00 means that the rates of

return for these two investments move exactly
together. Combining investments that move
together in a portfolio would not help diversify
the portfolio because they have identical rateof-return patterns over time.
In contrast, a correlation coefficient of 1.00
means that the rates of return for two
investments move exactly opposite to each
other. When one investment is experiencing
above-average rates of return, the other is
suffering through similar below-average rturn.

 Combining two investments with large negative

correlation in a portfolio would contribute much
to diversification because it would stabilize the
rates of return over time, reducing the standard
deviation of the portfolio rates of return and
hence the risk of the portfolio.
Therefore, if you want to diversify your
portfolio and reduce your risk, you want an
investment that has either low positive
correlation, zero correlation, or, ideally,
negative correlation with the other investments
in your portfolio.

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

 Why do these correlation coefficients for returns

between U.S. bonds and those of various foreign
countries differ?
For a U.S. investor, the average correlation between foreign
bond return and U.S. bond return in U.S. dollars is about 0.58
from 1986 to 2010.
The U.S.Canada correlation is 0.75, whereas the U.S.Japan
correlation is only 0.34.

The answer is because the international trade

patterns, economic growth, fiscal policies, and
monetary policies of the countries differ.
We do not have an integrated world economy but,
rather, a collection of economies that are related to
one another in different ways

Risk of Combined Country

Investments

Diversified portfolios reduce variability of

returns over time
Correlation coefficients measure
diversification contribution
Compare correlation of return among U.S.
bonds and stocks with returns on foreign
bonds and stocks

Global Bond Portfolio Risk

Low positive correlation
Opportunities for U.S. investors to reduce
risk
Correlation changes over time
Adding 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

Low positive correlation
Opportunities to reduce risk of stock
portfolio by including foreign stocks

Summary on Global Investing

Relatively high rates of return
combined with low correlation
coefficients indicate that adding
foreign stocks and bonds to a U.S.
portfolio will reduce risk and may
increase its average return

Global Investment Choices

Fixed-income investments
bonds and preferred stocks

Equity investments
Special equity instruments
warrants and options

Futures contracts
Investment companies
Real assets

Fixed-Income Investments
Contractual payment schedule
Recourse varies by instrument
Bonds

investors are lenders

expect interest payment and return of
principal

Preferred stocks

dividends require board of directors

approval

Savings Accounts

Fixed earnings
Convenient
Liquid
Low risk
Low rates
Certificates of Deposit (CDs)
- instruments that require minimum deposits
for specified terms, and pay higher rates of
interest than savings accounts. Penalty
imposed for early withdrawal

Money Market Certificates

Compete against Treasury bills (T-bills)
Minimum $10,000
Minimum maturity of six months
Redeemable only at bank of issue
Penalty if withdrawn before maturity

Capital Market Instruments

Fixed income obligations that trade in
secondary market
U.S. Treasury securities
U.S. Government agency securities
Municipal bonds
Corporate bonds

U.S. Treasury Securities

Bills, notes, or bonds - depending on
maturity
Bills mature in less than 1 year
Notes mature in 1 - 10 years
Bonds mature in over 10 years

Highly liquid
Backed by the full faith and credit of the
U.S. Government

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 state and local governments
usually to finance infrastructural projects.
Exempt from taxation by the federal
government and by the state that issued the
bond, provided the investor is a resident of
that state
Two types:
General obligation bonds (GOs)
Revenue bonds

 General obligation bonds (GOs) are backed

by the full taxing power of the municipality,
whereas
revenue bonds pay the interest from revenue
generated by specific projects (e.g., the
revenue to pay the interest on sewer bonds
comes from water taxes).

Corporate Bonds
Issued by a corporation
Fixed income
Credit quality measured by ratings
Maturity
Features
Indenture (which is the legal agreement that lists the
obligations of the issuer to the bondholder)
Call provision (when a firm can issue a call for the bonds
prior to their maturity)
Sinking fund (specifies payments the issuer must make to
redeem a given percentage of the outstanding issue prior
to maturity.

Corporate Bonds

Senior secured bonds

most senior bonds in capital structure and have

the lowest risk of default

Mortgage bonds
secured by liens on specific assets

Collateral trust bonds

secured by financial assets

Equipment trust certificates

secured by transportation equipment

Corporate Bonds
Debentures

Unsecured promises to pay interest and

principal
In case of default, debenture owner can force
bankruptcy and claim any unpledged assets to
pay off the bonds

Subordinated bonds

Unsecured like debentures, but holders of these

bonds may claim assets after senior secured and
debenture holders claims have been satisfied

Corporate
Bonds
Income bonds

Interest payment contingent upon earning

sufficient income.
An income bond is not considered as safe as a
debenture or a mortgage bond, so income bonds
offer higher returns to compensate investors for the
added risk.
There are a limited number of corporate income
bonds. In contrast, income bonds are fairly popular
with municipalities because municipal revenue
bonds are basically income bonds.

Corporate Bonds
Convertible bonds

Usually have lower interest rates

Corporate Bonds
Warrants

Allows bondholder to purchase the firms

common stock at a fixed price for a given time
period
Interest rates usually lower on bonds with
warrants attached

Zero coupon bond

Offered at a deep discount from the face value

No interest during the life of the bond, only the
principal payment at maturity

Preferred Stock
Hybrid security
Fixed dividends
Dividend obligations are not legally
binding, but must be voted on by the board
of directors to be paid
Most preferred stock is cumulative
Credit implications of missing dividends
Corporations may exclude 80% of dividend
income from taxable income

 For example, a corporation that owns preferred

stock of another firm and receives $100 in
dividends can exclude 80 percent of this amount
and pay taxes on only 20 percent of it ($20).
Assuming a 40 percent tax rate, the tax would
only be $8 or 8 percent versus 40 percent on other
investment income.
Due to this tax benefit, the yield on high-grade
preferred stock is typically lower than that on
high-grade bonds.

International Bond Investing

Investors should be aware that there is a very
substantial fixed income market outside the
United States that offers additional opportunity
for diversification

International Bond Investing

Bond identification characteristics

Country of origin
Location of primary trading market
Home country of the major buyers
Currency of the security denomination

Eurobond
An international bond denominated in a
currency not native to the country where it is
issued

Eurobonds

Specific kinds of Eurobonds include Eurodollar

bonds, Euroyen bonds, Eurodeutschemark bonds,
and Eurosterling bonds.
A Eurodollar bond is denominated in U.S. dollars
and sold outside the United States to non-U.S.
investors.
A specific example would be a U.S. dollar bond
issued by General Motors and sold in London.
Eurobonds are typically issued in Europe, with the
major concentration in London.

 Eurobonds can also be denominated in yen.

For example, Nippon Steel can issue
Euroyen bonds for sale in London. Also, if
it appears that investors are looking for
foreign currency bonds, a U.S. corporation
can issue a Euroyen bond in London.

International Bond Investing

Yankee bonds
Sold in the United States and denominated is
U.S. dollars, but issued by foreign corporations
or governments
Eliminates exchange risk to U.S. investors

International domestic bonds

Sold by issuer within its own country in that
countrys currency

Equity Investments
Returns are not contractual and
may be better or worse than on
a bond

Equity Investments
Common Stock
Represents ownership of a firm
Investors return tied to performance of
the company and may result in loss or
gain

Classification of Common Stock

Categorized By General Business
Line
Industrial: manufacturers of automobiles,
machinery, chemicals, beverages
Utilities: electrical power companies, gas
suppliers, water industry
Transportation: airlines, truck lines,
railroads
Financial: banks, savings and loans, credit
unions

Acquiring Foreign Equities

Many investors may recognize the
desirability of investing in foreign common
stock because of the risk and return
characteristics, but they may be intimidated
by the logistics of the transaction
there are several ways to acquire foreign
common stock:

Acquiring Foreign Equities

1. Purchase of American Depository Receipts
(ADRs)
2. Purchase of American shares
3. Direct purchase of foreign shares listed on a
U.S. or foreign stock exchange
4. Purchase of international mutual funds

American Depository Receipts

(ADRs)
Easiest way to directly acquire foreign shares
Certificates 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 firms home country
Buy and sell in U.S. dollars
Dividends in U.S. dollars
May represent multiple shares
Listed on U.S. exchanges
Very popular

Purchase or Sale of American

shares
Issued in the United States by transfer
agent on behalf of a foreign firm
Higher expenses
Limited availability

Direct Purchase or Sale of

Foreign Shares
Direct investment in foreign equity marketsdifficult and complicated due to administrative,
information, taxation, and market efficiency
problems
For example, if you acquired shares of a French auto
company listed on the London Stock Exchange
(LSE), the shares would be denominated in pounds
and the transfer would be swift, assuming your
broker has a membership on the LSE
Purchase foreign stocks listed on a U.S. exchange
limited choice

mutual fund
A mutual fund is a convenient path to
global investing, particularly for a small
investor, because the purchase or sale of
one of these funds is similar to a transaction
for a comparable U.S. mutual fund

Purchase or Sale of Global Mutual

Funds
Global funds - invest in both U.S. and
foreign stocks
International funds - invest mostly outside
the U.S.
Funds can specialize

Diversification across many countries

Concentrate in a segment of the world
Concentrate in a specific country
Concentrate in types of markets

Exchange-traded funds or ETFs are a recent

innovation in the world of index products

Special Equity Instruments

Equity-derivative securities have a claim on
common stock of a firm
Options are rights to buy or sell at a stated
price for a period of time
Warrants are options to buy from the
company
Puts are options to sell to an investor
Calls are options to buy from a stockholder

call option

A call option is similar to a warrant because it is an

option to buy the common stock of a company
within a certain period at a specified price called
the striking /exercise price .
A call option differs from a warrant because it is
not issued by the company but by another investor
who is willing to assume the other side of the
transaction.
Options also are typically valid for a shorter time
period than warrants. Call options are generally
valid for less than a year.

put option
The holder of a put option has the right to
sell a given stock at a specified price during
a designated time period.
Puts are useful to investors who expect a
stock price to decline during the specified
period or to investors who own the stock
and want protection from a price decline.

Futures Contracts
Exchange of a particular asset at a specified
delivery date for a stated price paid at the
time of delivery
Deposit (10% margin) is made by buyer at
contract to protect the seller
Commodities trading is largely in futures
contracts
Current price depends on expectations

Financial Futures

Recent development of contracts on financial

instruments such as T-bills, Treasury bonds,
and Eurobonds
Traded mostly on Chicago Mercantile
Exchange (CME) and Chicago Board of Trade
(CBOT)
Allow investors and portfolio managers to
protect against volatile interest rates
Currency futures allow protection against
changes in exchange rates

Investment Companies
(mutual funds)
Rather than buy individual securities
directly from the issuer they can be acquired
indirectly through shares in an investment
company
Investment companies sell shares in itself
and uses proceeds to buy securities
Investors own part of the portfolio of
investments

Investment Companies
Money market funds
Acquire high-quality, short-term investments
Yields are higher than normal bank CDs
Typical minimum investment is $1,000
No sales commission charges
Withdrawal is by check with no penalty
Investments usually are not insured

Investment Companies
Bond funds
Invest in long-term government,
corporate, or municipal bonds
Bond funds vary in bond quality selected
for investment
Expected returns vary with risk of bonds

Investment Companies

Common stock funds

Many different funds with varying stated

investment objectives

Aggressive growth, income, precious metals,

international stocks

Offer diversification to smaller investors

Sector funds concentrate in an industry
International funds invest outside the United
States
Global funds invest in the U.S. and other
countries

Investment Companies
Balanced funds
Invest in a combination of stocks and
bonds depending on their stated
objectives

Investment Companies
Index Funds
These are mutual funds created to equal
the performance of a market index like
the S&P 500

Investment Companies
Exchange-Traded Funds (ETFs)

These are depository receipts for a portfolio of

securities deposited at a financial institution in
a unit trust that issues a certificate of ownership
for the portfolio of stocks
The stocks in a portfolio are those in an index
like the S&P 500 and dozens of country or
industry indexes
ETFs can be bought and sold continuously on
an exchange like common stock

Real Estate Investment Trusts

(REITs)
Investment fund that invests in a variety of
real estate properties
Construction and development trusts
provide builders with construction
financing
Mortgage trusts provide long-term
financing for properties
Equity trusts own various incomeproducing properties

Direct Real Estate Investment

Purchase of a home
Average cost of a single-family house exceeds
$100,000
Financing by mortgage requires down payment
Homeowner hopes to sell the house for cost
plus a gain

Direct Real Estate Investment

Purchase of raw land
Intention of selling in future for a profit
Ownership provides a negative cash flow due to
mortgage payments, taxes, and property
maintenance
Risk from selling for an uncertain price and low
liquidity

Direct Real Estate Investment

Land Development
Buy raw land
Divide into individual lots
Build houses or a shopping mall on it
Requires capital, time, and expertise
Returns from successful development can be
significant

Direct Real Estate Investment

Rental Property
Acquire apartment buildings or houses with
low down payments
Derive enough income from the rents to pay the
expenses of the structure, including the
mortgage payments, and generate a good return
Rental property provides a cash flow and an
opportunity to profit from the sale of the
property

Low-Liquidity Investments
Some investments dont trade on securities
markets
Lack of liquidity keeps many investors
away
Auction sales create wide fluctuations in
prices
Without markets, dealers incur high
transaction costs

Antiques
Dealers buy at estate sales, refurbish, and
sell at a profit
Serious collectors may enjoy good returns
Individuals buying a few pieces to decorate
a home may have difficulty overcoming
transaction costs to ever enjoy a profit

Art
Investment requires substantial knowledge
of art and the art world
Acquisition of work from a well-known
artist requires large capital commitments
and patience
High transaction costs
Uncertainty and illiquidity

Coins and Stamps

Enjoyed by many as hobby and as an
investment
Market is more fragmented than stock
market, but more liquid than art and
antiques markets
Price lists are published weekly and
monthly
Grading specifications aid sales
Wide spread between bid and ask prices

Diamonds
Can be illiquid
Grading determines value, but is subjective
Investment-grade gems require substantial
investments
No positive cash flow until sold
Costs of insurance, storage, and appraisal

Historical Risk-Returns on
Alternative Investments
World Portfolio Performance
Reilly and Wright (2004) examined the
performance of various investment alternatives
from the United States, Canada, Europe, Japan,
and the emerging markets for the period 19802001

Reilly and Wrights 2004 Study

Asset Returns and Total Risk
The expected relationship between annual rates
of return and total risk (standard deviation) of
these securities was confirmed

Reilly and Wrights 2004 Study

Return and Systematic Risk
The systematic risk measure (beta) did a better
job of explaining the returns during the period
than did the total risk measure
The beta risk measure that used the Brinson
index as a market proxy was somewhat better
than the beta that used the S&P 500 Index

Reilly and Wrights 2004 Study

Correlations between Asset Returns
U.S. equities have a reasonably high correlation
with Canadian and U.K. stocks but low
correlation with emerging market stocks and
Japanese stocks
U.S. equities show almost zero correlation with
world government bonds, except U.S. bonds

Art and Antiques

Market data is limited
Results vary widely, and change over time,
making generalization impossible, but
showing a reasonably consistent
relationship between risk and return
Correlation coefficients vary widely,
allowing for great diversification potential
Liquidity is still a concern

Real Estate
Returns are difficult to derive due to lack of
consistent data
Residential shows lower risk and return
than commercial real estate
During some short time periods REITs have
shown higher returns than stock with lower
risk measures
Long term returns for real estate are lower
than stocks, and have lower risk

Real Estate
Negative correlation between residential
and farm real estate and stocks
Low positive correlation between
commercial real estate and stocks
Potential for diversification

Appendix Chapter 3
Covariance and Correlation

Covariance
absolute measure of the
extent to which two sets
of numbers move together
over time

Covariance
COVij

i i j j

If we define (i - i ) as i and (j - j) as j , then

COVij

i j

Correlation
relative measure of a
given relationship

Correlation
rij

COVij

i j

i i