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FIN 521 (6)
Chapter 3

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Ryerson University
FIN 521
Eric Terry

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: - Com
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