FIN 521 Chapter Notes - Chapter 3: High-Yield Debt, Call Option, Commercial Paper

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Published on 10 Oct 2012
School
Ryerson University
Department
Finance
Course
FIN 521
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Chapter 3: Selecting Investments in the Global Market
Your goal should be to build a balanced portfolio of investments with a relatively stable return
This chapter is divided into three sections:
1. Because investors can choose securities from around the world, we initially look at a combination of reasons why
investors should include both foreign and domestic securities in their portfolios
2. Describe the main features and cash flow patterns of securities in domestic and global markets
3. Examine the historical risk and returns performance of several investments from around the world and the
relationship among the returns for many of these securities
Three interrelated reasons investors should think of constructing global investment portfolios can be summarized as
follows:
1. When investors compare the absolute and relative sizes of foreign markets for stocks and bonds, they see that
ignoring foreign markets reduces their choices of available investment opportunities. Because more investment
opportunities broaden the range of risk-return choices, it makes sense to evaluate foreign when selecting
investments and building a portfolio.
2. The returns available on foreign securities often have substantially exceeded those for Canadian-only securities.
The higher returns on these foreign equities can be justified by the higher growth rates for the countries where
they are issued.
3. A major tenet of investment theory is that investors should diversify their portfolios. Because the relevant factor
when diversifying a portfolio is low correlation between assets returns over time, diversification with foreign
securities that have very low correlation with Canadian securities can substantially reduce portfolio risk.
To measure whether two investments will contribute to diversifying a portfolio, we compute the correlation coefficient
between their return over time
- Correlation coefficient can range from +1.00 to -1.00
- Combining investments that are perfectly positively correlated would not help diversify the portfolio because they
have identical rate-of-return patterns over time
- Combining two investments with large negative correlation in a portfolio would be ideal for diversification
because it would stabilize the return over time, reducing the standard deviation of the portfolio returns and hence
the risk of the portfolio
- 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
- Although the correlation of returns between a single pair of countries changes over time because of the factors
influencing the correlations, such as international trade, economic growth, fiscal policy, and monetary policy,
change over time
As you increase the number of randomly selected securities in a portfolio, the standard deviation will decline due to the
benefits of diversification within your own country (this is referred to as domestic diversification)
After a certain number of securities (30 to 40), the curve will flatten out at a risk level that reflects the basic market risk
for the domestic economy
Financial Assets: payoffs are in money
Real Assets: such as real estate, art, antiques, coins, stamps, and precious gems
Fixed-income investments: promise specific payments at predetermined times, although the legal force behind the
promise varies, which affects their risks and required returns
- If the issuing firm does not make its payment as agreed, creditors can declare the issuing firm in default
- In other cases (ex: income bonds), the issuing firm makes payments only if it earns profits
- In yet other instances (ex: preferred stock), the issuing firm does not have to make payments unless its board of
directors votes to do so
Investors purchasing fixed-income securities (except preferred stock) are really lenders to the issuers
You lend some amount of money, the principal, to the borrower and in return, the borrower typically promises to make
periodic interest payments and to repay the principal at the loan’s maturity
Savings Accounts: an individual depositing funds in a financial institution is really lending money to the institution and,
as a result, earning a fixed payment
- Provide lower returns as compared with other alternatives
- Investors with larger sums of money ($10,000 or more) consequently provide lower returns as compared with
other alternatives
Capital Market Instruments: these are fixed income obligations that trade in the secondary market and there are two
general categories: government and corporate
Government Securities: all government securities, whether issued by the federal government, the various provincial and
territorial governments, by municipalities and the various agencies of the governments, are fixed-income instruments
- May be bills, notes, or bonds depending on their times to maturity
- Bills mature in one year or less, notes in over one to 10 years, and bonds in more than 10 years from time of issue
Agency Securities: sold by various agencies or Crown corporations of the various governments to support specific
programs, but they are not direct obligations of the issuing government
Corporate Bonds: these fixed- income securities issued by corporations can be broken down by issuer (industrial or
utility), in terms of credit quality (measured by the ratings assigned by an agency on the basis of probability of default), in
terms of maturity (short, intermediate, or long term), or based on some component of the indenture (sinking fund or call
feature)
- Indenture: legal agreement listing the obligations of the issuer to the bondholder, including the payment schedule
and features such as call provisions and sinking funds
- Call Provisions: specify when a firm can issue a call for the bonds prior to their maturity, at which time current
bondholders must submit the bonds to the issuing firm, which redeems them (i.e. pays back the principal and a
small premium)
- Sinking Fund: provision specifies payments the issuer must make to redeem a given percentage of the
outstanding issue prior to maturity
Preferred Stock: classified as a fixed-income security because its yearly payment is stipulated as either a coupon (ex: 5%
of the face value) or a stated dollar amount (ex: $5 preferred)
- Differ from bonds because its payment is a dividend and therefore not legally binding
- For each period, the firm’s board of directors must vote to pay it, similar to a common stock dividend
- Even if the firm earned enough money to pay the preferred stock dividend, the board of directors could
theoretically vote to withhold it
- Considered practically binding because of the credit implications of a missed dividend
International Bond Investing:
- Eurobond: international bond denominated in a currency not native to the country where it is issued,
denominated in US dollars and sold outside the US to non-US investors
- Maple Bonds: Canadian dollar-denominated bonds sold in Canada by foreign corporation or governments, this
allows a Canadian to buy the bond of a foreign firm or government but receive all payments in Canadian dollars,
eliminating exchange risk
- International Domestic Bonds: sold by an issuer within its own country in that country’s currency
Equity Instruments:
- Common Stock: represents ownership of a firm, owners of the common stock share in the company’s successes
and problems
o If the company prospers, the investor receives high returns and can become wealthy
o The investor can lose money if the firm does not do well or even goes bankrupt as did the once
formidable Nortel and Enron
- Buying foreign equities: a couple of different ways to buy foreign common stock:
1. Direct purchase or sale of foreign shares listed on a foreign stock exchange
2. Purchase or sale of international or global mutual funds or exchange-traded funds (ETFs)
a. Through the American Depository Receipts (ADRs): certificates of ownership issued by a US bank
or the firms themselves that represent indirect ownership of a certain number of shares of a specific
foreign firm on deposit in a bank in the firm’s home country
- International funds can:
1. Diversify across many countries
2. Concentrate in a segment of the world
3. Concentrate in a specific country
4. Concentrate in types of markets (ex: emerging markets, which would include stocks from countries such as
Thailand, India and China)
Special Equity Instruments: Options
- Options: rights to buy or sell common stock at a specified price for a stated period of time
- There are two types of options instruments:
1. Warrants: options issued by a corporation that gives the holder the right to purchase a firm’s common stock
from the company at a specified price within a designated time period. The warrant does not constitute stock
ownership, but only the option to buy the stock.
2. Puts and Calls:
a. Call Option: similar to a warrant because it allows the holder to buy the common stock of a company
within a certain period at a specified price called the striking price
i. 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
ii. Options are generally valid for less than one year, whereas a warrant’s life often exceeds 5
years
b. Put Option: has the right to sell a given stock at a specified price during a designated time period
i. Useful to investors who expect a stock price to decline during the specified period or to
investors who own the stock and want hedge protection from a price decline
Futures Contracts: agreement provides for the future exchange of a particular asset at a specified delivery date (usually
within 9 months) in exchange for a specified payment at the time of delivery
- Margin: made to protect the seller (a good faith deposit typically 10% of the value of the contract)
- Typically expire in less than a year
Investment Companies (or a mutual fund): owns a portfolio of individual stocks, bonds, or a combination of the two
- An investment company sells shares or units in itself and uses these proceeds to purchase bonds, stocks, or other
investments
- An investment company investor is partial owner of the investment company’s portfolio of stocks or bonds
- Money Market Funds: investment companies that purchase high-quality, short-term investments (money market
instruments), such as T-bills and high-grade commercial paper (public short-term loans) from various
corporations
o Typically the minimum initial investment in a money market fund is $1000, there are no sales
commissions, and minimum additions are allowed
o You can easily withdraw funds from your money market fund without penalty by writing a cheque on the
account, and you receive interest up to the day of withdrawal
o Individuals tend to use money market funds as alternatives to savings accounts because they are generally
quite safe (although not insured, they typically limit their investments to high-quality, short-term
investments), they provide yields above what are available on most savings accounts, and the funds are
readily available
- Bond Funds: generally invest in various long-term government or corporate bonds. They differ by the type and
quality of the bonds included in the portfolio as assessed by various rating services
o High-yield bonds (or junk bonds): lower rated corporate bonds
- Common Stock Funds: numerous common stock funds invest to achieve stated investment objectives, which can
include aggressive growth, income, precious metal investments, and international stocks
o Offer smaller investors the benefits of diversification and professional management
o Include different investment styles, such as growth or value, and concentrate in alternative-sized firms,
including small-cap, mid-cap, and large- capitalization stocks
- Balanced Funds: invest in a combination of bonds and stocks of various sorts depending on their stated
objectives
- Index Funds: are mutual funds created to equal (track) the performance of a market index like the S&P/TSX
Composite.
o Such funds appeal to passive investors who want to simply experience returns equal to some market
index either because they do not want to try to “beat the market” or they believe in efficient markets and
do not think it is possible to do better than the market in the long run
- Exchange-Trade Funds (ETFs): could be traded continuously like a share because the prices for the underlying
35 stocks were updated continuously

Document Summary

Chapter 3: selecting investments in the global market. Your goal should be to build a balanced portfolio of investments with a relatively stable return. Because more investment opportunities broaden the range of risk-return choices, it makes sense to evaluate foreign when selecting investments and building a portfolio: the returns available on foreign securities often have substantially exceeded those for canadian-only securities. The higher returns on these foreign equities can be justified by the higher growth rates for the countries where they are issued: a major tenet of investment theory is that investors should diversify their portfolios. Because the relevant factor when diversifying a portfolio is low correlation between assets returns over time, diversification with foreign securities that have very low correlation with canadian securities can substantially reduce portfolio risk. To measure whether two investments will contribute to diversifying a portfolio, we compute the correlation coefficient between their return over time. Correlation coefficient can range from +1. 00 to -1. 00.