International Investments

Welcome!
Wednesday, February 6

Who we are

Dirk F. Gerritsen (d.f.gerritsen@uu.nl)

Assistant Professor Finance & Financial Markets

AEX Indices Steering Committee Editorial board VBA Journaal

Research interests

Investment strategies Security analysts

Ludger Buijs (l.buijs@fm.ru.nl)

Lecturer Faculty Management Sciences

Bachelor Master

About the course

Asset valuation and asset management

Creating a portfolio Estimating required rates of return Valuation of shares and bonds Managing bond portfolios Options, futures, CDS Portfolio insurance Behavioral finance vs. efficient markets International diversification

Derivatives and the international aspects

About the course (contd)

Theory

Book, reader Weekly case studies Manage investment portfolio

Theory and practice

Practice

About the course (contd)

Practical assignments in groups

4-5 students per group (12 project groups in total) Today: group composition Cases

Hand-in on a weekly basis Have your portfolio ready this Friday! Hand-in logbook at the end of course week 7

Investment game

About the course (contd)

Lectures

Wednesday 10.45-12.45: Friday 08.45-12.45

Tutorials

5-10 minutes discussion of investment game 30-45 minutes case presentation & discussion Discussion of exercises

About the course (contd)

Tutorials

See Course Manual for homework per week

Case: see course manual for the weekly cases

Everyone: hand-in your presentation (e-mail) each week before the start of the tutorial One group presents, one group discusses In your presentation, deal with the questions/remarks in the Discussion-field of each case Use all figures from the assignment for your solution. Adding updated numbers for an appendix with current numbers would be appreciated Apart from raw presenting, please ensure a class discussion

Exercises discussed in class Investment game: make sure to know the motivation of your transactions

About the course (contd)

Study materials

Investments and Portfolio Management (Bodie, Kane, Marcus, 9th edition) Reader

Download the reader from Blackboard

About the course (contd)

Examination

Presented case (10%) Randomly selected case (10%) Hand in all cases more or less correctly (10%) Written final exam, both open and multiple choice (70%) Presence in 7 out of 8 tutorials Trade on a weekly basis in the investment game and hand-in logbook

Effort requirements

CHAPTER 5
Introduction to Risk, Return, and the Historical Record

Risk and Risk Premiums

Rate of return: single period =

1 0 +1 0

HPR = Holding Period Return P0 = Starting price P1 = Ending price D1 = Dividend during period 1

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Rate of return: single period example

Ending price = 48 Starting price = 40 Dividend = 2 =

4840+2 40

= 25%

Always use total return (price + dividend)!

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Price return vs. total return Sell in May?

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Price return vs. total return Sell in May?

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Expected Return & Standard Deviation

Expected returns

()

() = probability of a state () = return if a state occurs = state

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Scenario Returns: example

State
1 2 3 4 5

Probability of state
0.1 0.2 0.4 0.2 0.1

r in state
-0.05 0.05 0.15 0.25 0.35

= 0.1 0.05 + 0.2 0.05 + + 0.1 0.35 = 0.15

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Variance or Dispersion of Returns

Variance

2 =

()

()

Standard deviation = (Variance)

Using our example

2 = (0.1)(0.05 0.15)2 + + (0.1)(0.35 0.15)2 2 = 0.01199

= 0.01199 = 0.1095

1 2

What does it mean??

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The Normal Distribution

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Fat tails?
(Dutch stock market 1983 2012)
50 0
-.15

10

20

30

40

-.1

-.05

0 AEX_daily Density kdensity AEX_daily

.05

.1

In markets, the probability of outsized events is much higher than predicted by a normal probability distribution

Skewness: -0.2572 Kurtosis: 11.47

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Time Series Analysis of Past Returns

Expected return and the arithmetic average

=1

=1 ()

Geometric average return

TV = Terminal value = 1 + 1 1 + 2 (1 + ) g = Geometric average

()

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Geometric vs. arithmetic average return

Example:

Year 1: +60% Year 2: -40% Arithmetic:

0.60+(0.40) 2

Question: what is the average return?

= 10%
(2)
1

Geometric: (1 + 0.60) (1 + 0.40 )

1 = 2.02%

Illustration: stock starts at $100

After year 1 $160, after year 2 $96: geometric better in this case!

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Risk and return integration

Sharpe ratio (S)

S = Risk premium / Risk of excess return

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CHAPTER 6
Risk Aversion and Capital Allocation to Risky Assets

Available risky portfolios

Which portfolio do you prefer?

Risk-free rate ( ) is 5%

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Utility function

Utility formula = 2

1 2

U = Utility E(r) = Expected return on the asset or portfolio A = Coefficient of risk aversion s2 = Variance of returns

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Netherlands: Risk Profiles

Each bank has its own questionnaire

Do you sleep worse when you lose 25%? And so on. Very defensive; defensive; neutral; offensive; very offensive

Risk profile:

But not always invested accordingly

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Perpetuals

Bron: Dekritischebelegger.nl

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The indifference curves

Same utility along the line!

How does the line look a more risk averse investor?

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The indifference curve U = .05 and U = .09 with A = 2 and A = 4

Which investor has A = 4?

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The indifference curve U = .05 and U = .09 with A = 2 and A = 4

Notice: the higher the curve, the higher the utility

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Capital Allocation Across Risky and RiskFree Portfolios

Control risk

Asset allocation choice

Fraction of the portfolio invested in Treasury bills or other safe money market securities

T-bills viewed as the risk-free asset

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Portfolios of One Risky Asset and a RiskFree Asset

It is possible to split investment funds between safe and risky assets.

Risk free asset: proxy; T-bills Risky asset: stock (or a portfolio)

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Capital Allocation Line (CAL)

The investment opportunity set

Risky and risk-free asset () on vertical axis, risk on the horizontal axis

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Risk and return in complete portfolios

Return

= + 1 = +

= = % 1 = %

Risk

= + (1 )

= 0
=

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Finding the Optimal Complete Portfolio Using Indifference Curves

Where will point C of less risk averse investors be?

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Passive strategies The Capital Market Line

Avoiding any direct or indirect security analysis Well-diversified portfolio of common stocks

Mutual funds or ETF?

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Return, Risk and Sharpe ratio

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CHAPTER 7
Optimal Risky Portfolios

Diversification and portfolio risk

Market risk

Systematic or non-diversifiable Diversifiable or nonsystematic

Firm-specific risk

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Covariance and correlation

Portfolio risk depends on the correlation between the returns of the assets in the portfolio Covariance and the correlation coefficient provide a measure of the way returns of two assets vary

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Two-security portfolio: return

= + = = = = =

= + ( )

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Two-security portfolio: risk

2 =

2 =
, =

2 = 2 2 + 2 2 + 2 ( , )

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Covariance

, =

=
=

, = ,

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Portfolio E(r) as a Function of risk

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Markowitz portfolio selection model

See the 1-minute introduction on Markowitz on

http://db.tt/ibuP4XWk

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Markowitz portfolio selection model

Security Selection

First step is to determine the risk-return opportunities available All portfolios that lie on the minimum-variance frontier from the global minimum-variance portfolio and upward provide the best risk-return combinations

46

Min.Variance Frontier of Risky Assets

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Capital Allocation Lines with Various Portfolios from the Efficient Set

48

The Sharpe ratio

Maximize the slope of CAL for any possible portfolio, p

The objective function is the slope: =

49

Capital Allocation and the Separation Property

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

Determination of the optimal risky portfolio is purely technical Allocation of the complete portfolio to T-bills versus the risky portfolio depends on personal preference

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Determination of the optimal overall portfolio

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Questions?

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