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This summary was written in the year 2013-2014. Full summary available in PDF.

## 4. Mutual funds and other investment companies

*Investment companies*

Investment companies collect funds from investors, pool them and reinvest these funds in a potentially wide range of other assets. These companies function as financial intermediaries. They perform several important functions:

1. Record keeping and administration

2. Diversification and divisibility

3. Professional management

4. Lower transaction costs

Investors buy shares in such an investment company and the value of each share is called the **net asset value (NAV)**:

There are various kinds of investment companies.

**Unit investment trusts **invest their funds in a portfolio that is fixed for the lifetime of the fund. The shares sold are called redeemable trust certificates*. *There is little management involved since the portfolio composition is fixed.

**Managed investment companies **are able to manage the portfolios they have. There is a difference between open-end funds and closed-end funds. The former enables investors to sell their shares back to the fund. The latter does not and obliges the investor who wants to sell his shares on the market. Consequently there exists a market for such shares, often traded by brokers. The price often diverges widely from the net asset value, but this remains a great puzzle.

Other investment organizations are for example commingled funds, similar to open-end mutual funds, or Real Estate Investment Trusts (REITs), similar to a closed-end fund with loans secured by real estate. Of the latter (REITs) there exist two kinds: equity trusts and mortgage trusts. Hedge funds are vehicles that allow private investors to pool assets. They are constructed as private partnerships and therefore are subject to minimal regulation. They often request lock-ups that allow them to invest in illiquid assets without worrying about the demands for redemption of funds.

*Mutual funds*

Mutual funds are the common name for open-end investment companies. Each mutual fund has its own investment policy, described in the prospectus. Management companies manage a family, or complex, of mutual funds. The following groups exist:

· Money market funds

· Equity funds

· Sector funds

· Bond funds

· International funds (global, regional or emerging market for example)

· Balanced funds (covering an individual’s entire investment portfolio

· Asset allocation and flexible funds (holding both stocks and bonds)

· Index funds (trying to match the performance of a market index.

Mutual funds are either directly sold either through brokers acting on behalf of. It is important to realize that brokers have a conflict of interest due to revenue sharing. This might lead them to recommend mutual funds on the basis of criteria other than the best interest of their clients.

*Costs of mutual funds*

Investors in mutual funds often have to bear several costs, such as management fees. Operating expenses include administrative expenses, advisory fees, but also marketing and distribution costs. A front-end load is charged when shares are purchased by the investor. Back-end loads are similar but charged when the investor wants to sell the shares. Another category of costs is 12b-1 charges, used to pay for distribution costs.

East investor must choose the best combination of fees. Knowledgeable investors might not need these services, but many investors are willing to pay for advice.

The rate of return on an investment in a mutual fund is the following:

*Rate of return = (NAV _{1 }- NAV_{0 }+ Income and capital gain distributions) / NAV_{0}*

Fees can have a big effect on performance, but it is often difficult to measure the true expenses accurately. This is due to the use of so-called soft dollars, being a kind of credit with a brokerage firm on the basis of which the broker can pay for other expenses.

Late trading refers to the practice of accepting to trade in orders after the market closes and the NAV is determined. This enables investors to buy them and redeem them the next day.

In the US only the investor is asked to pay taxes, not the fund itself. When you invest through a fund, you however lose the ability to engage in tax management. A fund with a high portfolio turnover rate can be particularly tax inefficient. The turnover is the ratio of the trading activity of a portfolio to the assets of the portfolio.

*Exchange traded funds*

These ETFs are offshoots of mutual funds that allow investors to trade index portfolios just as they do with shares of stock. These ETFs offer various advantages over normal mutual funds. Firstly the price of an ETFs is continuously known, instead of published once a day. Secondly they can be sold short or purchased on margin. They can moreover provide tax advantages over mutual funds. ETFs are also cheaper than mutual funds.

*Performance*

Because investors delegate portfolio management to investment professionals, they can only choose the percentages of the portfolio that should be invested in equity, bonds or other assets. A good performance measure for mutual funds is needed. But what should be the proper benchmark against which the investment performance ought to be evaluated.

Many studies are done to find out if superior performance in a particular year is due to luck, and therefore random, or due to skill, and therefore consistent. Empirical data show that at least part of a fund’s performance is determined by skill.

Information on mutual funds is first and foremost to be found in its prospectus. The Statement of Additional Information of the prospectus includes a list of the securities in the portfolio at the end of the fiscal year, audited financial statements, a list of the directors etc. The SAI is however not often used. Other comparative sources are the Wiesenberger *Investment Companies*, and Morningstar’s *Mutual Fund Sourcebook*.

## 5. History of interest rates and risk premiums

In this chapter we will discuss the historical performance of the major asset classes. We will use a risk free asset as a benchmark to evaluate that performance. The risk free asset is the Treasury Bill or T-Bill because it is regarded as the safest asset, the main reason for this is that the US government issues these bills and maintains its credit worthiness via the tax payers money. We will start with a review of the determinants of the risk free rate, the rate available on T-bills and we will focus on the important distinction between real and nominal returns. Second we will discuss the measurement of the expected returns and volatility of risky assets, and show how historical data can be used to construct such estimates. The purpose of this is that we will construct on optimal investment portfolio and in order to construct it we need some idea how risk can be measured. Finally we will review the historical record of several portfolios of interest to provide some insight how different portfolios have performed over time.

**Determinants of the level of interest rates**

Forecasting interest rates is very difficult, But we do however have a good understanding of the fundamental determinants of the level of interest rates:

1. The supply of finds from savers, primary households

2. The demand for funds from businesses to be used to finance investments in plant, equipment and inventories.

3. The government’s net supply of or demand for funds as modified by actions of the Federal Reserve Bank.

**Real versus Nominal risk**

Now we will focus on the important distinction between real and nominal returns. The real rate of interest is the nominal rate of interest minus the expected rate of inflation. In general, we can observe only the nominal interest rates. From these nominal interest rates we can derive expected real rates using inflation forecasts. The equilibrium expected rate of return on any security is the sum of the equilibrium real rate of interest, the expected rate of inflation and a security-specific risk premium.

*Real versus nominal interest rates an example:*

General

Fisher effect: Approximation

nominal rate = real rate + inflation premium

R = r + i or r = R – i

Example

r = 3%, i = 6%

R = 9% = 3% + 6% or 3% = 9% - 6%

Fisher effect: Exact

r = (R - i) / (1 + i)

2.83% = (9%-6%) / (1.06)

The empirical relationship is that inflation and interest rates move closely together.

**The holding period return:**

HPR = Holding Period Return

P0 = Beginning price

P1 = Ending price

D1 = Dividend during period

This holding period return is always uncertain. The expected rate of return is a probability weighted average of the rates of return in each scenario. P(s) is the probability of each scenario, and r(s) is the HPR in each scenario:

To quantify the volatility of this HPR, the risk, the standard deviation (square root of the variance) is used as a measure:

An investment decision first of all depends on the expected reward, which is the difference between the expected HPR (E(r)) and the risk free rate, which is the rate of return on a risk free asset, such as Treasury bills. This difference is called the **risk premium**.

**Excess return **is the actual difference between the risk free rate of return and the actual rate of return of a risky asset. The risk premium is therefore the expected value of the excess return.

Investors are said to be risk averse, which means that they always want to be compensated by a premium for taking risk.

**A single period example**

Ending Price = 48

Beginning Price = 40

Dividend = 2

HPR = (48 - 40 + 2 )/ (40) = 25%

**Time series**

The probability distributions of these rates of return must be inferred from the data at hand, historical data. The average rate of return can be calculated in two ways:

1. The Arithmetic average of rates of return, giving an unbiased estimate of the expected rate of return:

2. The geometric average (g) is a time-weighted average return:

An estimate of the variance is usually based on the estimate of the expected return, the arithmetic average (). Using historical data the estimated variance looks like this:

This estimate needs to be compensated for the degrees of freedom bias, which is the result of the estimation error resulting from using . It is resolved by multiplying it with n/(n-1):

which is the standard deviation.

The trade off between reward and risk is important and represented by the **sharpe ratio:**

Assuming that expectations are rational, the actual rates of return should be normally distributed around the expectations. Because the normal distribution is symmetric, stable and binary, this assumption is very practical in investment and portfolio management.

Deviations from normality are so common, that we cannot leave it undiscussed. Skew is a measure of symmetry:

Cubing these deviations ensures that the sign is maintained.

Kurtosis is a measure of fat tails:

Historical returns on stock have more frequent large negative deviations from the mean than would be predicted from a normal distribution.

The lower partial standard deviation (LPSD) of the actual distribution quantify the deviation from normality. The LPSD, instead of the standard deviation, is sometimes used by professionals as a measurement of risk. A more widely used measurement of risk is value at risk (VaR). VaR measures the loss that will be exceeded with a specified probability such as 5%. The VaR does not add new information when returns are normally distributed. When negative deviations from the average are larger and more frequent than the normal distribution, the 5% VaR will be more than 1.65 standard deviations below the average return.

**A global view of the historical record**

Historical rates of return over the twentieth century in developed capital markets suggest the US history of stock returns is not an outlier compared to other countries. The arithmetic average of the risk premiums on stocks over the period 1926-2002 is arguably too optimistic as a forecast for the long term as we can see on page 155 of BKM figures 5.8 and 5.9. Some evidence suggests returns over the later half of the twentieth century were unexpected high, and hence the full-century average is upward biased. Another argument is that the arithmetic average returns may five upward biased estimates of long-term cumulative return. Long-term forecasts require compounding at an average of the geometric and arithmetic historical means, which reduces the forecast.

**Long term investments**

A compounding portfolio with a terminal value has a strong positive skew. It converges to a lognormal rather than a normal distribution. In a lognormal distribution the logarithms of a variable are normally distributed. For example, if an investment has low rates of returnmm the expected rate of return of the continuously compounded investment is close to the normal rate:

This changes however if it concerns longer periods or hinger r’s.

## 6. Risk and Risk Aversion

In this chapter we will discuss three themes in portfolio theory, all of them centering around risk. The first theme is that investors avoid risk and demand a reward for engaging in a risky investment. The reward is taken as a risk premium, the difference between the expected rate of return and that rate of return on a risk free investment. The second theme allows us to quantify investor’s personal trade-offs between portfolio risk and expected return. To do this we introduce the utility function which assumes that investors can assign a welfare/benefit or “utility” score to any investment portfolio depending on its risk and return. Finally, the third theme is that we cannot evaluate the risk of an asset separate from the portfolio of which it is a part; that is the proper way to measure the risk of an individual asset is to assess its impact on the volatility of the entire portfolio of investments. Taking this approach, we find that seemingly risky securities may be portfolio stabilizers and actually low risk assets. In appendix A of this chapter we will describe the theory and practice of measuring portfolio risk by variance or standard deviations of returns. In Appendix B we will discuss the classical theory of risk aversion.

**Risk and Risk aversion**

One definition of speculation is: the assumption of considerable business risk obtaining commensurate gain. With commensurate gain we mean a positive risk premium, that is, an expected profit greater than the risk-free alternative.

By considerable risk we mean that risk is sufficient to affect the decision. Gambling is to bet with an uncertain outcome. If you compare this definition to that of speculation, you will see that the central difference is the lack of commensurate gain. Economically speaking, a gamble is the assumption of risk for no purpose but enjoyment of risk itself, whereas speculation is undertaken in spite of risk involved because one perceives a favourable risk return trade off. Hence, risk aversion and speculation are not necessarily inconsistent.

A prospect that has a zero risk premium is called a fair game. Investors who are risk averse reject investment portfolios that are fair games or worse. Risk averse investors are willing to consider only risk free or speculative prospects with a positive risk premium. In a certain way risk-averse investors penalizes the expected rate of return of a risky portfolio to account for the risk involved. We can formalize the notion of a risk penalty system. In order to do so, we will assume that each investor can assign a welfare or utility, score to competing investment portfolios based on the expected return and risk of those portfolios.

We can formulate this concept into a formula:

Utility Function

where A is the index of the investor’s risk aversion

Investors can have three different views of risk:

· risk averse: investor will consider risky portfolios only if they provide compensation for risk via a risk premium.

· risk neutral: investor finds the level of risk irrelevant and considers only the expected return of risk prospects.

· risk seeking: is willing to accept lower expected returns on prospects with higher amounts of risk.

The utility function weighs the return and the risk, taking the risk aversion of the investor into account. Based on comparing the utility values of different scenarios an investor can make a profound decision. Simply said, portfolio A dominated B if its expected return is higher and if the risk is lower. Using this utility function, indifference curves can be drawn, comparing all possible portfolios.

Because we can compare utility values to the rate offered on risk-free investments when choosing between a risky portfolio and a safe one, we may interpret a portfolio’s utility value as its “certainty equivalent ”rate of return to an investor. That is, the certainty equivalent rate of a portfolio is the rate that risk-free investments would need to offer with certainty to be considered equally attractive as the risky portfolio.

Figure 6.1. on page 193 describes the trade-off between risk and return of a potential investment portfolio. We can see expected return E(r) on the y-axis and risk represented as variance on the x-axis). We say that this is the mean variance criterion. When we plot different mean variance combinations we can draw a line which results into the indifference curve as graphed in figure 6.2. on page 173.

**Capital allocation across risky and risk-free portfolios**

Shifting funds from the risky portfolio to the risk-free asset is the simplest way to reduce risk. Other methods involve diversification of the risky portfolio and hedging. In allocating capital across risky and risk free portfolios we consider T-bills the risk free asset and stocks as the risky asset. Issues we need to examine are risk versus return trade-off. We will demonstrate how different degrees of risk aversion affect allocation between risk free and risky assets.

**The risk free asset**

T-bills provide a perfectly risk free asset in nominal terms only. Nevertheless, the standard deviation of real rates on short-term T-bills is small compared to that of other assets such as long-term bonds and common stocks, so for the purpose of our analysis we consider T-bills as the risk-free asset. Money market funds hold, in addition to T-bills, relatively safe obligations such as CP and CDs. These entail some default risk, but again, the additional risk is small relative to most other risky assets. For convenience, we often refer to money market funds as risk-free assets.

**Portfolio’s**

So investors compose complete portfolios containing both risky investments and low-risk, even risk-free, assets. Only the government can issue default-free bonds. Although such treasury bills are in fact not entirely risk-free, it is common sense to use the rates of return of treasury bills as the risk-free rate.

The rate of return of a complete portfolio is calculated as follows:

You can take expectations of this portfolio rate of return.

It can be rearranged to:

Concerning the volatility, only the standard deviation of the risky asset is relevant, and its weight:

Using that y is the division of both standard deviations, the relationship between the expected rate of return of the complete portfolio and the risk is as follows:

S is the slope of the **capital asset allocation line** (CAL). (see page 200, figure 6.4) This line represents all the risk-return combinations available to the investor. The slope (S) is called the **reward-to-volatility ratio**. Other things equal, an investor would prefer a steeper-sloping CAL, because that means higher expected return for any level of risk. If the borrowing rate is greater than the lending rate, the CAL will be 'kinked' at the point of the risky asset.

**Risk tolerance and asset allocation**

The investor's degree of risk aversion is characterized by the slope of his or her indifference curve. Indifference curves show, at any level of expected return and risk, the required risk premium for taking on one additional percentage of standard deviation. More risk-averse investors have steeper indifference curves; that is, they require a greater risk premium for taking on more risk.

The optimal position, y*, in the risky asset, is proportional to the risk premium and inversely proportional to the variance and degree of risk aversion:

In other words, when we look at the optimal position of the risky asset shown as y* we can see that this is also strongly depended on A or in other words the level of risk averseness of the investor. Recall that A = 0 means a risk neutral investor and A > 0 are risk averse investors. The next step is to look for the optimal portfolio for a given level of risk aversion. To fully understand the level of risk aversion we need to construct a indifference curve to graphically plot the indifference curve for the level of risk aversion. An example of how an indifference curve can be plotted can be seen on page 208 in table 7.2. and figure 7.5, where we can see several indifference curves for a given several given levels of risk aversion. The next step is to find the optimal complete portfolio by using indifference curves. This can be graphically seen in figure 7.6 on page 209 where the tangent line of the indifference curve and the CAL depicts the optimal complete portfolio, this is also shown in table 7.3.

**Passive strategies: the capital market line**

A passive investment strategy disregards security analysis, targeting instead the risk-free asset and a broad portfolio of risky assets such as the S&P 500 stock portfolio. We call it a passive strategy because it describes a portfolio decision that avoids any direct or indirect security This can also be conceptually be drawn, this line is comprised by a 1-month T-bills and a broad index of common stocks and is called the capital market line (CML). There are several reasons why an investor would choose a passive strategy. The first reason is that an active strategy is not free, in involves for example research costs, analysing the different securities and buying or selling these securities, transaction costs. The second reason is the free-rider benefit. If markets work perfectly there is no need to try to outperform the market, better to hold a well diversified portfolio that represents the market, in other words if you can beat them, join them. The box on page 213 describes that passive strategies outperform active strategies.

## 7. Optimal risky portfolios

In this chapter we explain how to construct that optimal risky portfolio. We begin with a discussion of how diversification can reduce the variability of portfolio returns. After establishing this basic point we examine efficient diversification strategies at the asset allocation and security selection levels. We start a simple example of asset allocation that excludes the risk-free asset. To that effect we use two risky mutual funds: a long-term bond fund and a stock fund. With this example we investigate the relationship between investment proportions and the resulting portfolio expected return and standard deviation. We then add a risk-free asset to the menu and determine the optimal asset allocation. We do so by combining the principals of optimal allocation between risky assets and risk-free assets with the risky portfolio construction methodology. Moving from asset allocation to security selection, we first generalize asset allocation to a universe of many risky securities. We show how the best attainable capital allocation line emerges from the efficient portfolio algorithm, so that portfolio optimalization can be conducted in two stages, asset allocation and security selection. We examine in two appendixes common fallacies relating the power of diversification to the insurance principal and to investing for the long run.

**Diversification and portfolio risk**

The reduction of risk to very low levels in the case of independent risk sources is sometimes called the insurance principal, because of the notion that an insurance company depends on the risk reduction achieved through diversification when it writes insurance policies insuring against many independent sources of risk, each policy being a small part of the company’s overall portfolio.

The risk that remains even after extensive diversification is called **market risk**, risk that is attributable to market-wide risk sources. Such risk is also called **systematic risk**, or **non-diversifiable risk**. In contrast, the risk that can be eliminated by diversification is called unique risk, firm-specific risk, non-systemic risk or diversifiable risk.

**Portfolios of two risky assets**

We will now move on and study efficient diversification, whereby we construct risky portfolios to provide for the lowest possible risk for any given level of expected return. We will start with considering a portfolio of two risky assets because they are relatively easy to analyze and illustrate the principal and considerations that apply to portfolios of many assets.

*Return*

We will consider a portfolio of two risky assets. We can formalize this as:

this is the return on such a portfolio.

Wd = Proportion of funds in Security 1

We = Proportion of funds in Security 2

rd = Expected return on Security 1

re = Expected return on Security

and the weights need to add up to 1:

*Risk*

The risk of the portfolio with two risky assets can also be formalized as:

= Variance of Security 1

= Variance of Security 2

= Covariance of returns for Security 1 and Security 2

This covariance is calculated by using the correlation between security 1 and 2:

= Correlation coefficient of returns

= Standard deviation of returns for Security 1

= Standard deviation of returns for Security 2

The correlation between the two risky assets is important. Because it tells us in what way these two risky assets move together. When the securities are positively correlated they will move together. When they are negatively correlated they will move the opposite way of each other.

Portfolios of less than perfectly correlated assets always offer better risk-return opportunities than the components on their own. This is because the standard deviation is less than the weighted average of both components, as the expected return actually is. Here the diversification opportunities arise. A minimum-variance portfolio has a standard deviation that is smaller than that of either of the individual component assets. This is the effect of diversification. . In the extreme case of perfect negative correlation, there is a perfect hedging opportunity and it would be possible to construct a zero-variance portfolio.

*Portfolios with different correlations:*

We use assets with different correlations to reduce the risk of the overall portfolio. The correlation effects can b summarized as:

The relationship depends on correlation coefficient.

-1.0 __<__ __<__ +1.0

The smaller the correlation, the greater the risk reduction potential.

If r = +1.0, no risk reduction is possible

Range of values for 1,2

+ 1.0 __>__ r __>__ -1.0

If r= 1.0, the securities would be perfectly positively correlated

If r= - 1.0, the securities would be perfectly negatively correlated

The relationship of expected return and standard deviation in relation to different levels of correlation can be seen in the graph below. This graph is also called the portfolio opportunity set. Here we can clearly see the different levels of expected return associated with different levels of correlation between the two risky assets. A correlation of r = 1 achieves a lower expected return than a r = -1.

*Figure 1: portfolio opportunity set*

**Asset allocation with stocks, bonds and bills**

This is our next step in our refinement process of understanding portfolio selection. In the previous section we have looked at the simplest asset allocation decision. That involves the choice of how much of the portfolio to leave in risk-free money market securities versus in a risky portfolio. We will now take it a bit further by specifying the risky portfolio as comprised of a stock and bond fund. We will investigate this more refined selection of the risky part of the portfolio in this section.

*Optimal risky portfolio with two risky assets and a risk-free asset*

We will start our analysis with plotting two different capital allocation lines for two different portfolios. This can be seen in figure 7.6 on page 234 where the opportunity set of the debt and equity funds and two feasible CALs are shown. By calculating the different sharp ratios we can see which Cal dominates the other, when we calculate this we can see that portfolio B dominates portfolio A.

The next step is to think why do we stop here? We can continue to create the optimal portfolio. We do this by plotting the optimal CAL which is tangent to the opportunity set of risky assets, which is shown in figure 7.7 on page 236. P in this graph is the optimal portfolio. In practice, the process of creating an optimal risky portfolio is done with more than two risky assets we do this in a spread sheet or another computer program.

A numerical example of creating a optimal complete portfolio can be seen in examples 7.2 and 7.3 on pages 236-237 of the book. In general, we take the following steps to arrive at the complete portfolio:

1. Specify the return characteristics of all securities (expected returns, variances, covariances)

2. Establish the risk portfolio:

a. Calculate the optimal risky portfolio using the following formula:

W1 = σ1^2 - Cov(r_{1}r_{2}) / σ1^2 + σ2^2 – 2COV(r1,r2)

W2 = 1-W1

b. Calculate the properties of Portfolio P using the weights we have calculated.

3. Allocate funds between the risky portfolio and the risk-free asset:

a. Calculate the fraction of the complete portfolio allocated to Portfolio P (the risky portfolio) and to T-bills (the risk-free asset)

b. Calculate the share of the complete portfolio invested in each asset and in t-bills.

**The Markowitz portfolio selection model**

*Security selection*

In general, we can divide the security selection problem in three phases. First, we identify the risk-return combinations available from the set of risky assets. Second, we identify the optimal portfolio of risky assets by finding the portfolio weights that result in the steepest CAL. And third and finally, we choose an appropriate complete portfolio by mixing the risk-free asset with the optimal risky portfolio.

Harry Markowitz (1952), published a formal model of portfolio selection embodying diversification principals. For his work he received the nobel prize in 1990. His model is precisely step one of portfolio management: identification of the efficient set of portfolios or as we have seen and named the *efficient frontier of risky assets*. The critical idea behind the frontier set of risky portfolios is that, for any risk level, we are interested only in that portfolio with the highest expected return. An alternative we can view the frontier as asset of portfolios that minimize the variance of any target expected return.

In more detail, the first step is to determine the risk-return opportunities available to the investor. These are summarized by the minimum-variance frontier of risky assets. This is a graph of the lowest possible variance that can be attained for a given portfolio expected return. With data about expected returns, variances, and covariances we can calculate the minimum-variance portfolio for any targeted expected return. The plot of the minimum variance frontier of risky assets can be seen in the graph below (fugure 2).

*Figure 2: The minimum variance frontier of risky assets*

All the portfolios that lie on the minimum variance frontier from the global minimum variance portfolio are candidates for the optimal portfolio. The part of the frontier that lies above the global minimum-variance portfolio is therefore called the efficient frontier of risky assets. The second step of the optimization plan involves the risk-free asset. As we can see in figure 7.11 on page 240 we can see that the portfolio P is tangent with the efficient frontier. Portfolio P is clearly the optimal portfolio. The final step, is where the individual investor chooses the optimal mix between the risky portfolio P and T-bills as we can see in figure 7.8 on page 238.

**Optimal portfolios with restrictions on the risk-free asset**

In this section we briefly describe how we can create an optimal portfolio with a spread sheet program like MS excel. This we can do with a data set as shown in table 7.4 and the section describes how we can plot an efficient frontier as shown in figure 7.13 with excel with the dataset.

*Capital allocation and the separation property*

Let us assume that we now have established the efficient frontier with excel. The next step is to introduce the risk-free asset. Whatever the preference of the client, the client will always choose portfolio P, because it is the optimal risky portfolio. The assumption with this conclusion is that the risk-free asset is available and that the input lists are identical for every investor. This result is called a **separation property**.

The separation property tells us that the portfolio choice problem may be separated into two tasks.

1. determination of the optimal risky portfolio which is a purely technical part. Given the manager’s input list (list of securities), the best risky portfolio is the same for all clients, regardless of risk aversion.

2. allocation of the complete portfolio to T-bills versus risky portfolio depends on personal preferences in this part of the task the client is the decision maker.

The critical point is that the optimal portfolio P that the manager offers is the same for all clients. This result makes professional management more efficient and hence less costly. In practice however the differentiating factor of great portfolio managers and the rest is the quality of security analysis in other words the input list analysis as the universal rule also applies here garbage in is garbage out. This is the factor that makes great versus poor portfolio managers.

**Asset allocation and security selection**

We have seen that the that the theories of asset allocation and security selection are identical. So the next logical question is: Why do we make a distinction between asset allocation and security selection? There are three reasons:

1. There is a great need and ability to save (pensions, healthcare, college etc.), the demand for sophisticated investment management has increased enormously.

2. The widening spectrum of financial markets and financial instruments has put sophisticated investment beyond the capacity of many amateur investors.

3. There are strong economies of scale in investment analysis. The result is that the size of a competitive investment company has grown with the industry, and efficiency in organization has become an important issue.

**Long term risk diversification**

Risk pooling is the collection of uncorrelated assets in one portfolio. This is widely seen as the insurance principle, but it is based on the misunderstanding that adding several bets would reduce the risk. Despite the fact that risk pooling benefit from uncorrelatedness, it does not reduce risk by itself. Risk only increases less than proportionally to the number of securities. The probability of loss however does diminish.

Risk sharing is selling shares in an attractive risky portfolio to limit risk an yet maintain the profitability of the resultant position. Risk sharing combined with risk pooling is the key to the insurance industry. Adding insurance policies increases the sharpe ratio, or the profitability, and steadily reduces the risk to each shareholder.

## 8. Indexing

**Single-factor model**

This chapter introduces index models that simplify estimation of the covariances and greatly enhances analysis if risk premiums. Risk is explicitly decomposed in systematic and unsystematic risk. This simplifies the analysis because positive covariances among security returns arise from common economic forces that affect the fortunes of most firms, for example business cycles, interest rates or natural resources. Covariances and correlations are more easily estimated now.

We assume in the single factor security market that just one variable drives the normally distributed returns. Statistical implications of this normality assumption give the following model:

Where

is rate of return on security i,

is the expected rate of return on security i,

is the unexpected component of the rate of return on security i,

is a parameter measuring macroeconomic components, unanticipated macro surprises,

is the sensitivity coefficient of the specific security i (relating to a specific firm, some respond differently to m than others).

This beta coefficient gives the sign of the systemic risk. Cyclical firms for example respond greater to the market, resulting in a higher beta.

Total risk of security i is given by a composition of beta and standard deviations:

Also the covariance between a pair of securities is determined by its beta’s:

**Single-index model**

The single index model uses the market index to estimate the common macroeconomic factor. Since the model is linear, the beta coefficient of a security can be estimated using single-variable linear regression. The basis is regressing the excess return of a security i on the excess return of the market index using historical data (from for example the S&P500):

Where

is the excess return of a security i

is the expected excess return when the market excess return is zero,

is the security’s sensitivity to the market index,

is the excess return of the market index,

is the residual, the estimation error, with .

Taking expectations of this model results in the following:

The first term (alpha) on the right hand side is the **nonmarket risk premium**. The second part, derived from the market risk premium, is the **systemic risk premium**.

This model simplifies the analysis because less separate coefficients need to be estimated. This model also enables specialization of effort in the analysis. The model however simplifies the World of risks, dividing them into a Sharp dichotomy: market versus firm-specific risk.

**Estimating the model**

Page 283 until 289 describe the simplified estimation process of the model using six large corporations. The regressions of the rate of returns of these (six in total) corporations describe the **security characteristic line (SCL)**, drawn through a scatter diagram. (basic econometrics)

This regression is complemented by an analysis of the variance (ANOVA), the estimate of the alpha, the estimate of the beta, and the covariance and correlation matrix.

**Portfolio Construction**

In the context of portfolio Construction the alpha term is crucial. The beta’s are widely known and standardized. A sound estimation of the alpha however tells the manager if the security is good or bad. Intuitively: a positive alpha provides a premium on top of the premium that would result from following macroeconomic movements.

To optimize a portfolio, the goal is to maximize the Sharpe ratio. The procedure is summarized as follows:

1. Compute the initial position of the securities in weights:

2. Scale them:

3. Compute the alpha of the active portfolio:

4. Compute the residual variance of the active portfolio:

5. Compute the initial position of the active portfolio:

6. Compute the beta of the active portfolio:

7. Adjust the initial position in the active portfolio:

8. The optimal portfolio now has weights: and

9. Calculate the premium of the optimal portfolio from the premium of the index portfolio and the alpha of the active portfolio:

10. Compute the variance of the optimum:

**Practical aspects**

The full Markowitz model would be a better model in principle, since all necessary estimations would have to be made. However the great number of possible estimation errors cumulatively could account for a major failure. The single-index framework has a clear practical advantage.

Another practical issue is the estimation of betas. betas seem to drift toward 1 over time, meaning that estimating a beta based on past betas is usually not the best option. Forecasting models have been developed that use regression to estimate the beta’s from various variables, such as variance of earnings, market capitalization, and dividend yield or debt-to-asset ratio.

Beta capture is the procedure of constructing a **tracking portfolio** which has the same beta as the portfolio of interest. This tracking portfolio captures the systemic risk. Buying this tracking portfolio short combined with the portfolio of interest long, the systemic risk is cancelled out. This is characteristic for many hedge funds.

## 9. CAPM

The capital asset pricing model (CAPM) is the core of modern finance. It provides a prediction of the relationship between risk and expected return that should be observed. As such it is a benchmark and it provides ground for educated guesses on non-traded securities.

**The model**

The model is based on six assumptions:

1. Perfect competition: there are many investors with each a small fraction of the total endowments, which implies that they are price takers.

2. Investors show myopic behavior: they plan for one identical holding period.

3. They can only invest in publicly traded Financial assets. They may borrow at a fixed risk-free rate.

4. No taxes or transaction costs exist.

5. All investors are rational mean-variance optimizers, using the Markowitz portfolio selection model.

6. Homogeneous expectations: all investors have identical estimates of the probability distributions.

Although these assumptions are often not realistic, they provide insight in many real-world complexities.

These assumptions will result in the following equilibrium:

· All investors will choose to hold a risky portfolio in the same proportions as the market portfolio (M) is composed. M is on the efficient frontier. This results logically from the assumptions above, since if all investors have identical information and identical analytical tools, they will hold the same portfolio. Consequently this has to be M.

· The capital market line (CML) is the best capital allocation line (CAL).

· The risk premium on M will be proportional to its risk and the risk aversion of the investor: where is the average degree of risk aversion, and is the variance of the market portfolio (or in this case the systemic risk of the universe).

· The risk premium on individual assets will be proportional to the risk premium on M. Beta measures the extent to which returns on the stock and the market move together: .

So the risk premium on individual securities is: .

The **mutual fund theorem **is the result that the passive strategy of investing in a market index portfolio is efficient. If this is true, it would imply that attempts to beat the passive strategy only generates trading and research costs with no offsetting benefits. However, in the real world, investors do choose different portfolios from M.

The **market price of risk** is the extra return that investors demand to bear portfolio risk. It is represented by the following ratio:

A basic principle of equilibrium is that all investments should offer the same reward-to-risk ratio, otherwise trading a rearranging would be beneficial. That is why the reward-to-risk ratio of an individual security needs to equal the market price of risk.

Rearranging terms results in the **expected return-beta relationship:**

In which is the ratio that measures the contribution of this individual security to the variance of the market portfolio as a fraction of the total variance of the market portfolio:

If this holds for every i, this would have to hold for the entire portfolio.

This expected return-beta relationship can graphically be represented by the **security market line (SML)**, see figure 9.2 on page 317. The SML graphs the individual asset risk premiums as a function of asset risk. Relevant in this case is the contribution of the asset to the portfolio variance, measures by beta. The capital market line (CML) in contrast graphs the risk premiums of efficient portfolios as a function of portfolio standard deviation.

**Practicality of CAPM**

Testing the implication of CAPM is difficult. First of all because all traded risky assets would need to be considered, which is immense. Second, the CAPM implies relationships among expected returns and such expected values are never actually observed.

A model, consisting of assumptions, logical/mathematical manipulation of these assumptions, and predictions, can be tested normatively and positively. Normative tests test the assumptions, positive tests test the predictions. Few models can pass the normative test. In case of the CAPM the positive test implies testing the efficiency of the market portfolio and the accurateness of security market line. The principle problem with testing these, is that the market portfolio M is unobservable.

This leaves us with empirical tests of the expected return-beta relationship, but the CAPM miserably fails these tests.

Despite its empirical shortcomings, the CAPM is the accepted norm in the US and other developed countries. The first reason is that the theoretical decomposition of systematic risk from firm-specific risk is compelling. Second, there is impressive evidence that the central conclusion of CAPM, which is the efficiency of M, may be close to truth.

**Extensions of CAPM**

Greater accuracy could be gained by adding complexity to the model.

*Zero-beta model*

Efficient frontier portfolios have some interesting implications:

· A combination of two efficient frontier portfolios is in itself efficient.

· The expected return of any asset can be expressed as an exact linear function of the expected return on any two efficient-frontier portfolios P and Q:

· Every portfolio on the efficient frontier has a companion portfolio (**the zero-beta portfolio**) on the inefficient half of the frontier, which is uncorrelated. Choosing M and its zero-beta companion Z, then :

which resembles the SML of CAPM.

*Labor income*

Two important assets are not traded, human capital and privately held businesses. Such capital is less portable across time and thus may be more difficult to hedge with using traded securities. Such facts may put pressure on security prices and results in departures from CAPM.

*Multiperiod model*

Robert C. Merton has relaxed the assumption of myopic investors. He envisions investors who optimize a lifetime consumption or investment plan and who adapt their decisions to changes. His model however predicts the same expected return-beta relationship when the only source of risk is the uncertainty about portfolio returns. Other sources of risk could be changes in the parameters such ask the risk-free rate or expected returns. Another possibility would be the prices of consumption goods, inflation risk for example. All these risks would require hedging activities, highly complicating the model.

*Consumption based CAPM*

It might be useful to center the model on consumption, assuming that an investor would try to optimally smooth maximum consumption. In a lifetime consumption plan, he must in each period balance the allocation of current wealth between today’s consumption and the savings and investment that will support future consumption. When optimized, the utility value from an additional dollar of consumption today must be equal to the utility value of the expected future consumption that can be financed by that additional dollar of wealth.

Investors will value additional income more highly during difficult economic times. An asset will therefore be viewed as riskier in terms of consumption if it has positive covariance with consumption growth. Equilibrium risk premiums will be greater for assets that exhibit higher covariance with consumption growth.

**Liquidity**

The liquidity of an asset is the ease and speed with which it can be sold at fair market value. Illiquidity is measures by the discount that a seller must accept if the asset is to be sold quickly. Liquidity is increasingly seen as an important determinant of prices. Investors are likely to act on expected liquidity constraints or changes in such constraints. Liquidity premises might change unexpectedly as well. Therefore, investors may demand compensation for their exposure to liquidity risk.

## 11. The efficient market hypothesis

**Random walk & EMH**

The efficient market hypothesis (EMH) is the notion that stocks already reflect all available information. As market participants try to anticipate on all available information, in principle stock prices should contain all information that could possibly be used to predict them. Consequently stock prices that respond to information must move unpredictably. Prices should follow a **random walk**.

The *weak-form *of the EMH asserts that stock prices already reflect all information that can be derived by examining market trading data. The *semi strong-form *states that all publicly available information regarding the prospects of a firm must be reflected already in the stock price. The *strong-form *of the hypothesis, the most extreme position, claims that all information relevant to a firm is reflected.

**Implications**

The EMH implies that technical analysis is of no merit. Technical analysis is the search for recurrent and predictable patterns in stock prices. Well-known concepts of such technical analysis are *resistance levels *and *support levels*, respectively probable upper and lower levels of stock prices.

Fundamental analysis uses earnings and dividend prospects of the firm, expectations of future interest rates, and risk evaluation of the firm to determine proper stock prices. Just as technical analysis, most fundamental analysis is useless following the reasoning of EMH. The trick is to identify firms that are better than everyone else’s estimate.

Proponents of the EMH are advocates of passive investment strategy, because the costs of active management is unlikely to be compensated by benefits. Such passive management simply aims for a well-diversified portfolio of securities. One common strategy is creating an index fund, designed to replicate the performance of a broad-based index.

Even in an efficient market there is a role for portfolio management. Optimal positions depend on such things as tax, risk aversion and employment. The role of the portfolio manager is to adjust the portfolio to these factors, not to beat the market.

**Event studies**

An event study is empirical financial research to assess the impact of a certain event on a firm’s stock price. The general approach commences with an estimate of the stock price if the event would not have occurred. The abnormal return is then the difference between the actual return and this benchmark.

Index models are widely used to estimate these abnormal returns. Rewriting the mathematical formula for stock return () gives the following equation to estimate:

Where

is the part of a security’s return resulting from firm-specific events,

is the actual rate of return of this stock,

is the return on the market portfolio,

is the sensitivity of this particular stock to market return,

is the average rate of return the stock would realize in a period with a zero market return.

This model can be easily upgraded to include all kinds of sophisticated factors. Estimation of the parameters a and b is a delicate issue. The standard estimate of abnormal return is easily complicated by leakage of information. The **cumulative abnormal return **is a better measure in such a case. Event studies are widely used nowadays.

**Efficiency**

EMH has never been widely accepted on Wall Street. Three important issues are important: the magnitude issue, the selection bias issue and the lucky event issue. With these in mind, we can discuss the empirical test of EMH.

*Weak-form tests*

One way of finding trends in stock prices is measuring the serial correlation of returns. This reflects the tendency of returns to be related to past returns. Broad market indexes only reflect very weak serial correlation. There seems to be a stronger relationship across specific sectors.

Some studies have shown the predictive power of particular easily collected variables. On the one hand this could imply the violation of the EMH. On the other hand, such variables probably account for variation in market return.

*Semi strong-form*

Fundamental analysis is always in line with the semi strong-form of the hypothesis, since fundamental analysis uses publicly available information to clarify and predict stock prices. Examples of such fundamental analysis and its findings are the small-firm effect, the neglected-firm effect, the book-to-market effects, and the post-earnings-announcement price drift.

*Strong-form*

It is very common sense that insiders are able to make superior profits trading in their own stock. This practice is regulated and limited. This however implies that the strong-form of the hypothesis is not very likely to appear.

*Anomalies*

Lots of literature has been produced on the anomalies of the financial markets. Are these markets just inefficient? Some argue that the anomaly effect named above are actually in line with efficiency and just reflect manifestations of risk premiums. The opposite interpretation is also provided, claiming that these effects are proof of inefficiency.

Prices can also lose their grounding in reality. Such bubbles show prices that depart from any semblance of intrinsic value. These bubbles are usually only acknowledged in retrospect.

**Market professionals**

Can market professionals outperform the passive index funds? This provides a short discussion of the professionals, stock market analysts and mutual fund managers.

Stock market analysts recommend investment positions based on their analysis. Only the relative performance of these analysts is really of interest. Literature suggests that they add some value, but ambiguity remains. The same accounts for mutual fund managers, who actually manage portfolios.

## 12. Behavioral finance and technical analysis

Behavioral finance is a relatively new school in finance, arguing that the literature on finance strategies has overlooked the most important point: the correctness of security prices. Conventional financial theory ignores how people really make decisions. Behavioral finance starts with the assumption that investors might not be rational. Irrationalities fall into two categories: people do not always process information correctly, and people make often inconsistent decisions.

1. Information processing: this leads to misestimating of probabilities. Four important biases have been identified.

a. Investors make forecasting errors.

b. Investors tend to overestimate their own insights and abilities.

c. Investors are slow in updating their beliefs in response to new evidence (conservatism)

d. Investors to quickly trust information inferred from relatively small samples (representativeness).

2. Behavioral biases

a. Decisions are affected by the framing of an issue.

b. Mental accounting: investors treat cases differently or separately per case.

c. Investors experience greater regret when they failed in some unconventional case.

d. Prospect theory modifies the analytic description of rational risk averse investors found in standard financial theory.

3. The above biases would not lead to inefficient markets if some rational arbitrageurs would operate. For the following reasons, such arbitrage is limited:

a. There is always a degree of fundamental risk.

b. Implementation costs limit possibilities.

c. There is always a risk in trusting on models.

d. Even the law of one price is in some cases violated (see pages 416 to 418)

Behavioral finance is not uncontroversial yet. It does make important points on the limits of rationality. It however does not provide investment opportunities based on its insights, for example. Some believe that the behavioral critique is too unstructured.

**Technical analysis**

Technical analysis attempts to exploit recurring and predictable patterns in stock prices to generate superior investment performance. This section discusses the relation between technical analysis and behavioral finance. Technical analysis reflects all kinds of behavioral biases.

Technical analysis mostly uncovers trends. **Dow theory **is one of the oldest of trend analysis. According to Dow, three major trends influence stock prices:

1. Primary trend: long term

2. Secondary or intermediate trend: short term deviations, usually corrected.

3. Tertiary or minor trend: daily fluctuation of little importance.

This model is built on the notion of predictability. EHM argues however that in this case investors would exploit these possibilities, affecting the prices and resulting in a self-destructing strategy. These trends are thus only observed after the fact.

Two other measures are (1) the moving average, and (2) the breadth, a measure of the extent to which movements in the market index are reflected widely in the price movements of all the stocks in the market.

There are three indicators of the investor’s sentiment to be named here:

1. Trin statistic: when rising prices go with rising volumes, technicians consider the market advances to be favorable. The trin statistic is such a measure:

2. Confidence index is the ratio of the average yield on 10 top-rated corporate bonds divided by the average yield on 10 intermediate-grade corporate bonds.

3. Put/call ratio is the ratio of outstanding put options to outstanding call options. Because put options do well in falling markets while for call options it’s the other way around, deviations of the ratio from historical data are considered to be a signal of market performance.

## 14. Bond Prices and Yields

We will start with analysing debt securities. A debt security is a claim on a specified periodic stream of income. Debt securities are often called fixed-income securities, because they promise a (fixed) stream of income that is determined according to a specified formula. These securities have the advantage of being relatively easy to understand because the payment formulas are specified in advance. Risk considerations are minimal as long as the issuer of the security is sufficiently creditworthy.

The bond is the basic debt security. We will start with an overview of the universe of bond markets. This includes Treasury, corporate, and international bonds. We next turn to bond pricing, showing how bond prices are set in accordance with market interest rates and why bond prices change with those rates. Given this background we compare the different measures of bond returns such as yield to maturity, yield to call, holding-period return or realized compound yield to maturity. We show how bond prices evolve over time. Finally we consider the impact of default or credit risk on bond pricing and look at the determinants of credit risk and the default premium built into bond yields.

**Bond characteristics**

A bond is a security that is issued in connection with a borrowing arrangement. The borrower issues (i.e., sells) a bond to the lender for some amount of cash; the bond is a “IOU” of the borrower. The arrangement obligates the issues to make specified payments to the bondholder on specified dates. A typical coupon bond obligates the issuer to make semiannual payments of interest to the bondholder for the life of the bond. These are called coupon payments. When the bond matures, the issuer repays the debt by paying the bondholder the bond’s par value another word for par value is face value. The coupon rate of the bond serves to determine the interest payment: the annual payment is the coupon rate times the bond’s par value. The coupon rate, maturity date, and par value of the bond are part of the bond indenture, which is the contract between the issuer and the bondholder.

Bonds are usually issued with coupon rates set high enough to induce investors to pay par value to buy the bond. Sometimes, however, zero-coupon bonds are issued that make no coupon payments. In this case, investors receive par value at the maturity date but receive no interest payment until then. The bond has a coupon of zero. This type of bond is issued at priced considerably below par value, and the investor’s return comes solely from the difference between issued price and the payment of par value at maturity.

**Treasury bonds and notes**

Figure 14.1 on page 468 is an excerpt from the listing of treasury issues of the Wall Street Journal. Aside from the differing initial maturities, the only major distinction between T-notes and T-bonds is that in the past, some T-bonds were callable for a given period. The US treasury no longer issues callable bonds, but some previously issued callable bonds still outstanding. Page 468 explains how to read a bond price quote in the Wall Street Journal (WSJ).

*Accrued interest and quoted bond prices.* The bond prices that you see quoted in the financial pages are not the actual prices that investors pay for the bond. This is because the quoted price does not include the interest that accrues between coupon payment dates.

In general, the formula for the amount of accrued interest between two dates is:

Accrued interest = (Annual coupon payment / 2 ) × (days since last coupon payment/ daysseparating coupon payments)

**Corporate bonds.** These are bonds issued by corporations. An example is given in figure 14.2 on page 451 here you can a sample from the WSJ.

· *Call provisions on Corporate bonds.* The US treasury no longer issues callable bonds, some corporate bonds are issued with call provisions allowing the issuer to repurchase the bond at a specified call price before the maturity date. The option to call the bond is valuable to the firm, allowing it to buy back the bond and refinance at lower interest rates when market rates fall

· *Convertible bonds.* These bonds give bondholders an option to exchange each bond for a specified number of shares of common stock of the firm. The conversion ratio is the number of shares for which each bond may be exchanged.

· *Puttable bonds.* While the callable bond gives the issuer the option to extend or retire the bond at the call date, the extendable or put bond gives this option to the bond holder.

· *Floating-rate bonds**. *These bonds make interest payments that are tied to some measure of current market rates.

**Preferred Stock****.** Although preferred stock strictly speaking is considered to be equity, it often is included in the fixed-income universe. This is because like bonds preferred stock promises to pay a specified stream of cash in the form of dividends.

**Other Issuers***. *There are also other issuers of bonds. For example local governments and federal agencies as discussed in chapter 2.

**International Bonds.** International bonds can be divided into two categories: foreign bonds and Eurobonds. Foreign bonds are issued by a borrower from a country other than the one in which the bond is sold. The bond is denominated in the currency of the country in which it is market. Foreign bonds sold in the US are called Yankee bonds, for example German BMW issues a bond in dollars in the US are called Yankee bonds. Foreign bonds in Japan are called Samurai bonds and foreign bonds in the UK are called bulldog bonds.

**Innovation in the bond market.** Below we will describe some innovations in the bond market:

· *Inverse floaters**. *These are similar to the floating bonds, except that the coupon rate on these bonds falls when the general level of interest rises. Investors in these bonds suffer doubly when rates rise.

· *Asset-backed Bonds***.** An example BMW has issued bonds with coupon rates tied to the financial performance of the firm. This is what is meant with asset backed bonds.

· *Catastrophe bonds***.** An example Winterthur (the insurer) has issued a bond whose payment depend on whether there has been a sever hailstorm in Switzerland. The bond is a way to transfer “catestrophe risk” from the firm to the capital markets.

· *Indexed Bonds***.** Indexed bonds make payments that are tied to a general price index or the price of a particular commodity. For example Mexico has issued 20-year bonds with payments that depend on the price of oil.

**Bond pricing**

A bond’s coupon and principal payment all occur months or years in the future, the price an investor would be willing to pay for a claim to those payment depends on the value of dollars to be received in the future compared to dollars in hand today. This sort of present value calculation depends in turn on market interest rates. The nominal risk-free interest rate equals: 1) a real risk-free rate of return 2) a premium above the real rate to compensate for expected inflation. In addition a premium reflects bond specific characteristics such as default risk, liquidity, tax attributes, call risk etc. To value a security we discount its expected cash flows by the appropriate discount rate.

Bond value = Present value of coupons + Present value of par value

PB = price of the bond

Ct = interest or coupon payments

T = number of periods to maturity

y = semi-annual discount rate or the semi-annual yield to maturity

An example:

What is the price of the bond?

We know:

10 year bond

Face value or Par value 1000

8% Coupon

Calculations

:

Ct = 40 (SA)

P = 1000

T = 20 periods

r = 3% (SA)

An important insight is that with a higher interest rate, the present value of the payments to be received by the bondholder is lower. Therefore, the price of the bond will fall as market interest rates rise. This illustrates a crucial general rule in bond valuation. When interest rates rise, bond prices must fall because the present value of the bond’s payments are obtained by discounting at a higher interest rate.

Figure 14.3 on page 476 explains the inverse relationship between bond prices and yields. The price of an 8% coupon bond with 30-year maturity making semiannual payments. An important insight from this figure is that the shape of the curve implies that an increase in the interest rate results in a price decline that is smaller than the price gain resulting from a decrease of equal magnitude in the interest rate. This property of bond prices is called convexity because of the convex shape of the bond price curve. This curvature reflects the fact that progressive increases in the interest rate result in progressively smaller reductions in the pond price. Therefore, the price curve becomes flatter with higher interest rates. Prices and Yields (required rates of return) have an inverse relationship

We can say that when yields get very high the value of the bond will be very low. When yields approach zero, the value of the bond approaches the sum of the cash flows.

A general rule in evaluating bond price risk is that, keeping all other factors the same, the longer the maturity of the bond, the greater the sensitivity of price to fluctuations in the interest rate. This is also the reason why short-term Treasury securities such as T-bills are considered to be the safest. They are free not only of default risk but also largely of price risk attributable to interest rate volatility.

**Bond yields**

We would like a measure to rate of return that accounts for both current income and the price increase or decrease over the bond’s life. The yield to maturity is the standard measure of total rate of return. The yield to maturity is defined as the interest rate that makes the present value of a bond’s payments equal to its price.

In Formula:

An example:

10 yr Maturity Coupon Rate = 7%

Price = $950

Solve for r = semiannual rate

Answer: r = 3.8635%

The financial press reports on an annualized basis, and annualizes the bond’s semiannual yield using simple interest techniques, resulting in an annual percentage rate, or APR. Yields annualized using simple interest are also called “bond equivalent yields”. Therefore, the semiannual yield would be doubled and reported in the newspaper as a bond equivalent of 6%. The effective annual yield of the bond, however, accounts for compound interest. If one earns 3% interest every 6 months, then after 1 year, each dollar invested grows with interest to

$1 X (1,03)^2 = $ 1,0609, and the effective annual interest rate on the bond is 6,06%.

Yield to maturity is different from the current yield of a bond, which is the bond’s annual coupon payment divided by the bond price.

A general rule is that for premium bonds (bonds selling above par value), coupon rate is greater than current yield, which in turn is greater than yield to maturity. For discount bonds (bonds selling below par value), these relationships are reversed. Some numeral examples:

Bond Equivalent Yield

7.72% = 3.86% x 2

Effective Annual Yield

(1.0386)2 - 1 = 7.88%

Current Yield

Annual Interest / Market Price

$70 / $950 = 7.37 %

**Bond prices over time**

A bond sell at par value when its coupon rate equals the market interest rate. We shall now discuss the *Yield to maturity *versus* holding-period return*. The difference between yield to maturity and holding period return is that yield to maturity depends only on the bond’s coupon, current price and par value at maturity. All of these values can de observed today, so it is relatively easy to calculate. In other words we can see the yield to maturity as a measure of the average rate of return if we hold the bond until the bonds maturity. The holding-period return is the rate of return over a particular investment period and depends on changes in rates affects returns, reinvestment of coupon payments and change in price of the bond.

**Zero coupon bonds.** Original issue discount bonds are less common than coupon bonds issued at par. There are bonds that are issued intentionally with low coupon rates that cause the bond to sell at a discount from par value. An extreme example are zero-coupon bonds, which carries no coupons and provides all its return in the form of price appreciation. Zeros provide only one cash flow to their owners, on the maturity date of the bond.

**Default risk and bond pricing**

Although bonds generally promise a fixed flow of income, that income stream is not risk less unless the investor can be sure the issuer will not default on obligation. Bond default risk, is usually called credit risk, this risk is measured by rating agencies such as Moody’s, Fitch and Standard and Poor. They give a bond a rating such as in figure 1.8 on page 472.

To determine the safety of a bond we can use some ratios to analyze. We will discuss five of them briefly:

1. Coverage ratio. Ratios of company earnings and fixed costs.

2. Leverage ratios. Debt-to equity ratios

3. Liquidity ratio. Two common liquidity ratios are:

a. Current ratio (asset/current liability)

b. Quick ratio (current assets excluding inventories/current liabilities)

4. Profitability ratios. Measures of rates of return on assets or equity.

5. Cash flow to debt ratio. This is the ratio of cash flow to outstanding debt.

**Bond indentures**

A bond is issued with an indenture, which is the contract between the issuer and the bondholder. Part of the indenture is a set of restrictions that protect the rights of bondholders. To make sure the bond issuer does not come into a cash flow problem the firm agrees to establish a sinking fund to spread the payment burden over several years. The sinking fund may operate in one of two ways:

1. The firm may repurchase a fraction of outstanding bonds in the open market each year.

2. The firm may purchase a fraction of the outstanding bonds at a special call price associated with the sinking fund provision.

The firm has an option to purchase the bonds at either the market price or the sinking fund price, whichever is lower. To allocate the burden of the sinking fund call fairly among bondholders, the bonds chosen for the call are selected at random based on serial number. Other issues are subordination of further debt in case of liquidation, dividend restrictions and collateral.

Bonds with a relatively high risk of default yield lower prices and consequently its rate of return will rise. Following the same reasoning implies that collateralized bonds usually yield a lower rate of return, because the risk of losses in case of default is smaller. The default premium is the compensation that corporate bonds offer for the possibility of default. The development over time of these default premiums on these risky bonds is sometimes called the structure of interest rates.

A credit default swap (CDS) is in short an insurance on the default risk of an investment. By using such a CDS a highly risky bond can be repackaged as a very safe investment. These CDSs have widely been used to speculate, resulting in the credit boom that led to the financial crisis of 2008.

Another example of such a financial product dealing with risk mitigation is the Collateralized Debt Obligation (CDO). A separate legal financial institution would first raise funds, collect different kinds of debt obligations, pool them togehter, and resell the total in small ‘slices’ or ‘tranches’ in different priority-scales varying in the risk they would entail.

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