JFP463E Investment & Portfolio Management

Webex #4 @ 11 Feb 2023

Secondary Markets (cont’d)

&
Mutual Funds & Other
Investment Companies

Course Manager:
Dr Zarina Md Nor
School of Distance Education
USM

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 Trading mechanisms
Dealer markets
A financial market mechanism wherein multiple dealers post
prices at which they will buy or sell a specific security of
instrument.

A dealer is a person or firm in the business of buying and

selling securities for their own account, whether through a
broker or otherwise. A dealer is defined by the fact that it acts
as principal in trading for its own account whereby buying and
selling securities is part of its regular business.

A dealer also makes markets in securities, underwrites

securities and provides investment services to investors.

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A broker is an individual or firm that charges a fee or
commission for executing buy and sell orders submitted by an
investor.

Full-service brokers offer a variety of services, including market

research, investment advice, and retirement planning, on top
of a full range of investment products. For that, investors can
expect to pay higher commissions for their trades.

Brokers are compensated by the brokerage firm based on their

trading volume as well as for the sale of investment products.

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Discount brokers are able to execute any type of trade on behalf
of a client, for which they charge a reduced commission.

Their low fee structured is based on volume and lower costs.

They don’t offer investment advice and brokers are usually paid
on salary rather than commission.

Most discount brokers offer an online trading platform which

attracts a growing number of self-directed investors.

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Trading mechanisms

Electronic Communication Networks (ECNs)

• An automated system that matches buy and sell orders for

securities.
• An ECN connects major brokerages and individual traders
so that they can trade directly between themselves without
going through a middleman.
• The ECN makes money by charging a fee for each
transaction.
• ECNs make it possible for investors in different geographic
locations to quickly and easily trade with each other.
• The Securities and Exchange Commission requires ECNs to
register as broker-dealers.

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Specialist markets
• Market in a stock made solely by the specialist, as no
public orders, and henceforth no depth, exist in the
market
• A member of an exchange who acts as the market maker
to facilitate the trading of a given stock.
• The specialist holds an inventory of the stock, posts the
bid and ask prices, manages limit orders and executes
trades.

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 Trading Costs
• Commission: fee paid to broker for making the transaction

• Spread: cost of trading with dealer

Bid price: price dealer will buy from you
Ask price: price dealer will sell to you

 Bid ask spread - The amount by which the ask price exceeds the
bid.
This is essentially the difference in price between the highest price
that a buyer is willing to pay for an asset and the lowest price for
which a seller is willing to sell

Specialists try to maintain a narrow bid-ask spread because:

• The exchange requires specialists to maintain price continuity.
• If the spread is too large, they will not participate in as many
trades, losing commission income.
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Example

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 Example
Given: Bid RM33.900; Offer RM33.910
1. What is the bid-ask spread on these shares?
Answer: Bid-ask spread = ask – bid
= RM33.91 – RM33.90
= RM0.01

2. What is the best estimate of the 'true price' of these shares?

Answer: midpoint = (ask + bid)/2 = (33.91 + 33.9)/2
= 33.905

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3. What is the best price that you
could buy one share when placing
a market order?

Answer: We execute our market

buy order against the limit sell
orders. The lowest price that we
can buy from these sellers is at
$33.91, which is the best ‘ask’ or
‘offer’.

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4. How much money could you sell
10,000 shares for, using a market
order? (Note that in this question you
are selling, in the previous question,
you are buying).

Answer: We can only sell to the buyers,

and they are prepared to sell 7,000
shares at $33.90,
and then we’ll have to sell the
remaining 3,000 shares at the slightly
worse price of $33.89.
So altogether that’s:
Sales = (7,000*33.90) + (3,000*33.89)
=$338,970

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5. What is the implicit cost of selling these 10,000 shares,
given your 'true price' answered above?

Answer: The actual sale price less the ‘true’ midpoint price
summed across all stocks will give the total implicit cost.

Implicit Cost
= 7,000*($33.90-$33.905)+ 3,000*($33.89- $33.905)
= 80

An implicit cost is any cost that has already occurred but not necessarily
shown or reported as a separate expense. It represents an opportunity
cost

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 Buying on margin
• Securities purchased with money borrowed in part
from a broker. The margin is the net worth of the
investor’s account i.e. the portion of the purchase
price contributed by the investor

Why?
- Investors wish to invest an amount greater than
their own money allows.

• Securities purchased on margin must be

maintained in street name as the securities are
collateral for the loan.

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Maintenance margin is set to guard against
insufficient collateral to cover the loan.
• Maintenance margin: minimum amount equity in
trading can be before additional funds must be put into
the account

If the percentage of margin falls below the

maintenance level, margin call will be issued
which requires the investor to add new cash or
securities to the margin account.

• Margin call: notification from broker that you must put

up additional funds

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 Example
The margin requirement on a stock purchase is 25%. You fully
use the margin allowed to purchase 100 shares of JB5 Synergy
at RM45. If the price drops to RM42, what is your percentage
loss?

Calculation:
Loss from price drop = (RM42-RM45)*100 shares
=-RM300
Amount invested = (25% x RM45)*100 shares
= RM1125
Percentage Loss = (-RM300/RM1125) * 100
= - 26.7%

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 Short Sales
• the sale of shares not owned by the investor but
borrowed through a broker and later purchased
to replace the loan.

• allows investors to profit from a decline in a

security prices however the short sellers must
repay any dividends paid during the short sale to
the lender.

• Short sellers must be concerned about margin

calls and maintenance margins.

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 Short sale
Purpose: to profit from a decline in the price of a stock or
security

Short sellers are betting that the stock they sell will drop in
price. If the stock does drop after selling, the short seller
buys it back at a lower price and returns it to the lender.
The difference between the sell price and the buy price is
the profit.

Mechanics
• Borrow stock through a dealer
• Sell it and deposit proceeds and margin in an account
• Closing out the position: buy the stock and return to the
party from which is was borrowed
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 Example of short sale
An investor thinks that Tesla stock is overvalued at $625
per share and is going to drop in price. The investor may
"borrow" 10 shares of TSLA from their broker, who then
sells it for the current market price of $625.

If the stock goes down to $500, the investor could buy the
10 shares back at this price, return the shares to their
broker, and net a profit of $1,250 ($6,250 - $5,000).

However, if the TSLA price rises to $700, the investor

would lose $750 ($6,250 - $7,000).

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 Short sale: what are the risks?
Short selling involves amplified risk. When an investor buys a stock (or
goes long), they stand to lose only the money that they have invested.

Thus, if the investor bought one TSLA share at $625, the maximum
they could lose is $625 because the stock cannot drop to less than $0.
In other words, the maximum value that any stock can fall to is $0.

However, when an investor short sells, they can theoretically lose an

infinite amount of money because a stock's price can keep rising
forever.

As in the example above, if an investor had a short position in TSLA (or

short sold it), and the price rose to $2,000 before the investor exited,
the investor would lose $1,325 per share (i.e. $2000-$625).
Total lost = $1325 x 10 = $13250

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 Why Do Investors Go for Short Sale?

For Speculation or Hedging

Speculators use short selling to capitalize on a potential decline
in a specific security or across the market as a whole.

Hedgers use the strategy to protect gains or mitigate losses in a

security or portfolio.

Institutional investors and savvy individuals frequently engage in

short-selling strategies simultaneously for both speculation and
hedging.

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Mutual Funds & Other Investment
Companies

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 Investment Companies
Investment companies are business entities, both
privately and publicly owned, that manage, sell
and market funds to the public.
The main business of an investment company is to
hold and manage securities for investment
purposes, but they typically offer investors a
variety of funds and investment services.
Investment companies come in different forms:
exchange-traded funds, mutual funds, money-
market funds, and index funds.
 What do they do?
 Collect Investments
Investment companies collect funds by issuing and
selling shares to investors.
 Invest in Financial Instruments
Investment companies invest in financial
instruments according to the strategy of which
that they made investors aware.
 Pay Out the Profits
The profits and losses that an investment company
makes are shared among its shareholders.
Put simply, investment management firms invest
their clients’ money.
 Functions of Investment Companies
• Administration & record keeping
-Keep track of the position and any income of the portfolio
as well as each shareholder
-Send periodic status reports to shareholders
-Reinvest dividend and interest income on behalf of
shareholders

• Diversification & divisibility

By polling individual investors’ money, the investment
companies can act as large investors, that is, they can
invest in a well-diversified portfolio and avoid the
indivisible problem of the stock share
• Reduce transaction costs
Due to block trading of securities, investment companies
could save substantial brokerage fees or bid-asked spreads

• Professional management
- Hire security analysts and fund managers to achieve
superior investment results for their investors
- Find undervalued securities and/or design asset allocation
strategies
- Share research and management costs
 Net Asset Value (NAV)
- a quantity to measure the share value or net worth per share
of an investment fund. Investment companies need to divide
claim to assets among investors.
- NAV represents the value of each share hold by investor or
market value of assets minus liabilities divided by shares
outstanding
- represents the per share/unit price of the fund on a specific
date or time.
Formula:
NAV = Market Value of Assets - Liabilities
Shares Outstanding

NAV = Assets - Liabilities

Shares Outstanding

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 Example 1
Assume that you have recently purchased 100
shares in an investment company. Upon examining
the balance sheet, you note that the firm is
reporting RM120 million in assets, RM5 million in
liabilities and 5 million shares outstanding. What is
the net asset value (NAV) of these shares?

NAV = Market Value of Assets - Liabilities

Shares Outstanding

= (RM120 m - RM5m)/ 5m shares

= RM23 per share

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 Example 2
You have been provided with the following assets and liabilities details of
Mutual Fund X as on February 10, 2021. Calculate its net asset value as on
that date.

Investments in various securities 200 000

Cash and cash equivalents 5000
Total Receivables 20 000
Short term liabilities 7000
Long term liabilities 17 000
Accrued expenses 1000
Number of outstanding shares 1000

Total Assets=200 000 + 5000 + 20 000 = 225 000

Total Liabilities=7000 + 17 000 + 1000 = 25 000

NAV = 225 000 – 25 000

1000
= 200
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 Types of Investment Companies

1. Unit Investment Trust (Unit Trust)

2. Managed investment companies

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Unit Investment Trust (Unit Trust)
- Pools of money invested in a portfolio that is fixed for the
life of the fund.

- Called ‘unmanaged’ because of little active management

involved. Money pooled from investors is invested in a fixed
(unmanaged) portfolio with relatively uniform types of
assets, e.g., municipal bonds, for the life of the fund

- Investors liquidate their investments by selling back the unit

to the trustee for net asset value.

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Managed investment companies
Managed investment companies are so named since
securities in their portfolios are continuously bought
and sold, i.e. the portfolios are managed
Managed investment company hires a management
company to manage the portfolio for an annual fee
ranging from 0.2% to 1.5% of assets.
In most cases, the management company is the firm
that initiated the fund. One management company
can have contracts to manage several funds.

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Types of managed investment companies
1.Open-end fund
A fund that issues or redeems its shares at net asset value (NAV)
and the investment company guarantees the liquidity of shares.

The number of outstanding shares changes when new shares are

sold or old shares are redeemed (funds are easy to grow)

2. Closed-end fund
Shares may not be redeemed but the shares have to be sold to
other investors in an organized exchanges.

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 Types of managed investment companies
The primary differences lie in how they are organized, and how investors buy
and sell them.
Type of Fund Open-end Mutual Fund Closed-end Mutual Fund
Management Actively/Passively managed Actively managed

Fees Management fees Management fees

Fund Structure Unlimited share purchases and Fixed number of shares
share redemptions from fund from an IPO
manager
Fund Price Net asset value per share Premium or discount to net
asset value per share
Pricing Priced daily (end of day) Priced continually (trades
on an exchange)
Liquidity With cash requirements to Little to no cash
account for future share requirements
redemptions
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 Mutual Fund
• Made up of a pool of funds collected from many investors
for the purpose of investing in securities such as stocks,
bonds, money market instruments and similar assets.
• The greatest percentage of mutual fund assets is invested
in equity fund.
• Operated by money managers – they attempt to produce
capital gains and income for the fund's investors.
• An official description of a particular mutual fund's
planned investment policy can be found in the fund’s
prospectus.
• Fund's portfolio is structured and maintained to match the
investment objectives stated in its prospectus.
• The greatest percentage of mutual fund assets is invested
in equity funds.

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35
JFP463E Investment & Portfolio Management
Intensive Week Class @ 8 March 2023

Topics
Macroeconomics,
Industry Analysis &
Globalization
Course Manager
Dr Zarina Md. Nor
 Learning Objectives

Upon completion of this class, the students are able to:

 Understand and explain the domestic and international

macroeconomics variables that have impacts on investment
environment
 Understand and explain the business cycles and investment
decisions related to each phases of the business cycle
 Understand the impact of globalization on investment
environment and investment decision

2
 The Domestic Macroeconomy
The macroeconomy is the environment in which all
firms operate.

Key economic statistics used to describe the state of the

economy:
• Gross domestic product
• Employment
• Inflation
• Interest rates
• Budget deficit
• Sentiment
• Foreign exchange (Global Economy)

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 The Domestic Macroeconomy

Gross Domestic Product (GDP)

 The measure of the economy’s total production of
goods and services.
 Rapid growth in GDP indicates an expanding economy
and higher sales for the firms.
 Industrial production (IP): another measure of total
output. It focuses on the manufacturing side of the
economy.
• Economic growth is found to be positively associated
with domestic investment.

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Employment
 Measures the extent to which the economy is operating
at full capacity.

 Unemployment rate = number of those who are not

working/total labour force

(Total labour force - people who are either working or actively

seeking employment)

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 The Domestic Macroeconomy

Inflation
 The rate at which the general level of prices rise.
 High rates of inflation are associated with overheated
economies.
 There is a trade-off between inflation and
unemployment (the relationship is shown by Phillips
Curve)

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 Budget Deficit
• A budget deficit occurs when expenses exceed revenue and
indicate the financial health of a country.
• Certain unanticipated events and policies may cause budget
deficits.
• Countries can counter budget deficits by raising taxes and
cutting spending.
• Budget deficits, reflected as a percentage of GDP, may
decrease in times of economic prosperity, as increased tax
revenue, lower unemployment rates, and increased economic
growth reduce the need for government-funded programs

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 Sentiment
 Consumer sentiment is a statistical measurement of the overall health of
the economy as determined by consumer opinion. It takes into account
people's feelings toward their current financial health, the health of the
economy in the short-term, and the prospects for longer-term economic
growth, and is widely considered to be a useful economic indicator.
 If people are confident about the future they are likely to shop more,
boosting the economy. In contrast, when consumers are uncertain about
what lies ahead, they tend to save money and make fewer discretionary
purchases.
 Gloomy sentiment weakens demand for goods and services, impacting
corporate investment, the stock market, and employment opportunities
etc.
 Very bullish consumer sentiment can also be bad for the economy. When
people buy lots of goods and services prices can rise significantly, leading
to an unwelcome rise in inflation.
 To stamp out inflation, central banks hike interest rates, which leads to an
increase in borrowing costs for both consumers and businesses. This tends
to slow economic growth and weigh on exports—higher interest rates
strengthen the value of currencies.

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 Interest Rates
 Determinant for business investment expenditures.

As interest rates increases:

• investment decreases – bad news for stock market
• economic growth decreases

 Forecast of interest rates directly affect the forecast of

returns in the fixed income market.
- The factors that go into forecasting rates are very difficult to predict.

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Fundamental factors that determine the level of
interest rates:

1. The supply of funds from savers i.e. households

2. The demand for funds from businesses to be used to
finance physical investments in plant, equipment and
inventories.
3. The government’s net supply and/or demand for
funds (actions of Bank Negara)
4. The expected rate of inflation

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 How Do Interest Rates Affect the
Stock Market?

• https://www.investopedia.com/investing/how
-interest-rates-affect-stock-market/

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 Article

https://www.thestar.com.my/business/business-news/2023/03/07/malaysia-central-
bank-to-hold-rates-at-275-in-march-reach-peak-at-3-or-higher-in-q2

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 SS-DD Curve
• The supply curve slopes up from left to
right because the higher the real interest
rate, the greater the supply of household
savings.

• The assumption is that at higher real

interest rates household will choose to
postpone some current consumption and
set aside or invest more of their
disposable income for future use.

• The demand curve slopes down from

right to left because the lower the real
interest rate, the more businesses will
want to invest in physical capital.

• Assuming that businesses rank projects by

the expected real return on invested
capital, firms will undertake more
projects the lower the real interest rate
on the funds to finance those projects.

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 The Global Economy
Exchange rate
 The rate at which domestic currency can be converted
into foreign currency.

 Affects the international competitiveness of the

country.

 The depreciation of domestic currency makes the

domestic products cheaper in foreign countries and
increases the exports and hence the GDP growth.

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 Demand and Supply Shocks
Demand shock
• An event that affects the demand for goods and services in
the economy.
• Examples for positive demand shocks:
- reduction in tax rates
- increase in money supply
- increases in government spending
- increases in foreign exports.
• Usually characterized by aggregate output moving in the
same direction as interest rates and inflation.

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 Demand and Supply Shocks

Supply shock
• An event that influences production capacity and costs.
• Examples of supply shocks:
- changes in prices of intermediate goods such as oil
- changes in the wage rate.
- Natural disasters e.g. war, Covid-19 pandemic, floods, droughts

• Supply shocks cause the aggregate output move in the

opposite direction of inflation and interest rates.

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 How can government affect the demand and
supply of goods and services?

Through:
Fiscal and Monetary Policy

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 Fiscal and Monetary Policy
1. Fiscal Policy
Fiscal policy is probably the most direct way to stimulate or to
slow the economy.
It is about the government’s spending and tax actions.
• Decrease in government spending decrease the demand for
goods and services.
• Increase in tax rates decrease the income of consumers
(households) and rapidly decreases consumption.
Ironically the implementation of this is policy is painfully slow.

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 The Domestic Macroeconomy

Budget Deficit
The difference between government spending and
revenues i.e. government spends more than it earns
(via tax)
The deficit should be closed by borrowing
The government borrowing can increase interest rates
and crowd-out the private borrowing and decrease
investment and affect economic growth negatively.

Budget Surplus
Government earns more than it spends

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 Fiscal and Monetary Policy

2. Monetary Policy
The change in money supply to affect the macro economy in
particular, its impact on interest rates.

• Increase in money supply will decrease short-term interest

rates and cause an increase in investment and consumption
demand in the short run.
• Over the longer period expansionary money supply leads to
higher price.

Monetary policy is easily formulated and implemented but has

a less immediate impact.

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Implementation of Monetary policy
 Changing monetary base (consists of currency and banks’
deposits in the central bank) by open market operations.
(Open market operation: central bank buys securities to increase money
supply; sells securities to decrease money supply)
 Changing the discount rate (i.e. the interest rate the central
bank charges banks on short-term loans).
 Changing the reserve requirement (i.e. the fraction of
deposits banks have to keep in the central bank).
 Changing the federal funds rate - the rate at which banks
make short term/overnight loans to each other.
- Not controlled by central bank
- Based on supply and demand

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 Implications
• If the quantity of money in the economy increases, investors
will find that their portfolios of assets include too much
money.

• Investors will rebalance their portfolios by buying securities

such as bonds, forcing bond prices up and interest rates
down.

• In the longer run investors may increase their holding of

stocks and ultimately buy real assets.

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 Business Cycles
Business cycles are dated according to when the direction of
economic activity changes and is measured by the time it
takes for an economy to go from one peak to another – i.e.
the recurring pattern of recession and recovery
o The economy recurrently experiences periods of expansion
and contraction, but the length and depth of those cycles
can be different.

o The transition points across cycles are called peaks and

troughs

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 Business Cycle

Portfolio is adjusted by selecting companies that should perform well for the
stage of the business cycle.
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 Business Cycle

Peaks
A peak is the transition from the end of an expansion to the start
of a contraction
The peak of the cycle refers to the last month before several key
economic indicators, such as employment and new housing
starts, begin to fall. It is at this point that real GDP spending in
an economy is its highest level.
–the economy might be overheated with high inflation and
interest rates

Time to invest in natural resource extraction firms, minerals and

petroleum
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 Contraction (recession)
 A phase of the business cycle in which the economy as a
whole is in decline.
 Occurs after the business cycle peaks, but before it becomes
a trough.
 According to most economists, a contraction is said to occur
when a country's real GDP has declined for two or more
consecutive quarters.

–Time to invest in defensive industries such as pharmaceuticals

and food

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 Trough
• A trough occurs at the bottom of a recession just as the
economy enters a recovery

• The economy is ready to recover and then expand.

–Time to invest in capital goods industries, such as equipment,

transportation or construction.

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 Expansion
 Also known as economic recovery. The economy is growing
where business activity surges and gross domestic product
expands.

 Expansions last on average about three to four years but have

been known to last anywhere from 12 months to more than
10 years.

–Time to invest in cyclical industries such as consumer durable

and luxury items

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 Business Cycle

Cyclical vs Defensive Industries

Cyclical Industry
 A type of industry that is sensitive to the business cycle, such
that revenues are generally higher in periods of economic
prosperity and expansion, and lower in periods of economic
downturn and contraction.
 Companies in cyclical industries can deal with this type of
volatility by implementing cuts to compensations and layoffs
during bad times, and paying bonuses and hiring en masse in
good times.

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 Cyclical Industry

• Cyclical industries include those that produce durable

goods such as raw materials and heavy equipment.

Example: The airline industry.

In good economic times, people have more disposable income and,
therefore, they are more willing to take vacations and make use of air
travel.

• Firms in cyclical industries will tend to have high beta

stocks.

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 Cyclical vs Defensive Industries

Defensive Industry
 Defensive industries are the ones that show little sensitivity
to the business cycle.

 Industries that produce necessary and often relatively cheap

products that consumers cannot go without.

Example: The utility, food and oil industries

 Firms in defensive industry will generally have a beta below

1.0 i.e. their statistical volatility does not coordinate strongly
with the overall volatility of the market.
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 Economic Indicators
Set of cyclical indicators helps to forecast, measure, and interpret
short-term fluctuations in economic activity.
These indicators can be divided into 3 general groups as leading,
coincident and lagging.

a. Leading indicators tend to rise and fall in advance of the

economy.
e.g. average weekly hours of production/manufacturing workers; stock
prices
b. Coincident indicators tend to change directly with the economy
e.g. industrial production, manufacturing and trade sales
c. Lagging indicators tend to follow the lag economic performance.
e.g. ratio of trade inventories to sales

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 Sensitivity of a firm’s earnings to the
Business Cycle
3 factors decide the sensitivity of a firm’s earnings to the
business cycle: sensitivity of sales of the firm’s product to the
business cycles, operating leverage, financial leverage.

1. Sensitivity of sales
• Necessities such as foods, drugs, and medical services will
show little sensitivity to business conditions.

• Firms in the industries such as steel, auto, and transportation

are highly sensitive to the state of the economy.

Business Cycle
http://www.investopedia.com/terms/b/businesscycle.asp
33
 Sensitivity to the Business Cycle

2. Operating Leverage
• Division between variable and fixed costs.
• Firms with high fixed costs are said to have high operating
leverage because small changes in business conditions may
have large impacts on profitability.
(measures the sensitivity of profits to changes in sales revenues)

3. Financial Leverage
• The use of borrowings
FL = Total debt/total equity

• The interest payments on debt is a fixed costs and increase

the sensitivity of the firms to the changes in the business
cycle
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 Investment & Globalization
Upon completion of this topic, the students are able to:

• Understand the impact of globalization on investment environment

• Differentiate between FDI and FBI and its importance in
investment decision making
 Globalization
• When people think about globalization, they often first think
of the increasing volume of trade in goods and services.
• Trade flows are indeed one of the most visible aspects of
globalization. But many analysts argue that international
investment is a much more powerful force in propelling the
world toward closer economic integration.
• Investment can alter entire methods of production through
transfers of knowledge, technology, and management
techniques, and thereby can initiate much more change than
the simple trading of goods.

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Foreign Direct Investment & Foreign
Portfolio Investment
• Capital is a vital ingredient for economic growth, but since
most nations cannot meet their total capital
requirements from internal resources alone, they turn to
foreign investors. Foreign direct investment (FDI)
and foreign portfolio investment (FPI) are two of the most
common routes for investors to invest in an overseas
economy.

• As retail investors increasingly invest overseas, they should

be clearly aware of the differences between FDI and FPI,
since nations with a high level of FPI can encounter
heightened market volatility and currency turmoil during
times of uncertainty.
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 FDI & FPI
 FDI implies investment by foreign investors directly in the
productive assets of another nation.
 FDI is generally restricted to large players who can afford to invest
directly overseas
Example: Malaysian investor acquiring a company that makes industrial machinery in Vietnam

 FPI means investing in financial assets, such as stocks and bonds of

entities located in another country.
Example: Malaysian investor buying a large stake in a company that makes industrial machinery in
Vietnam
Every time investors buy foreign stocks or bonds, either directly or through mutual funds or exchange-
traded funds, they are engaged in FPI.

 FDI and FPI are similar in some respects but very different
in others.

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 Malaysia: FDI & FPI
Key information about Malaysia Foreign Portfolio Investment

• Malaysia Foreign Portfolio Investment increased by $2.132 bn in Dec 2021,

compared with an increase of $224.023 mn in the previous quarter.
• The data reached an all-time high of 17.134 USD bn in Jun 2011 and a
record low of -$15.311 bn in Sep 2008.
• In the latest reports of Malaysia, Current Account recorded a surplus of
$3.624 bn in Dec 2021.
• Foreign Direct Investment (FDI) increased by $1.326 bn in Dec 2020.
• Malaysia Direct Investment Abroad expanded by $4.260 bn in Dec 2021.
• The country's Nominal GDP was reported at $92.104 bn in Dec 2020.
• Malaysia Foreign Portfolio Investment: USD mn data is updated quarterly,
available from Mar 2005 to Dec 2021.

https://www.ceicdata.com/en/indicator/malaysia/foreign-portfolio-investment

39
Malaysia Foreign Portfolio Investment

40
Malaysia Foreign Direct Investment

Malaysia Foreign Direct Investment, 2005 – 2021 | CEIC Data

41
 FDI vs FPI
FDI and FPI are similar in that they both involve foreign
investment, there are some very fundamental differences
between the two:

1. The degree of control exercised by the foreign investor. FDI

investors typically take controlling positions in domestic firms or
joint ventures and are actively involved in their management. FPI
investors, on the other hand, are generally passive investors who
are not actively involved in the day-to-day operations and
strategic plans of domestic companies, even if they have a
controlling interest in them.

42
2. FDI investors need to take a long-term approach to their
investments since it can take years from the planning stage
to project implementation. On the other hand, FPI
investors may profess to be in for the long haul but often
have a much shorter investment horizon, especially when
the local economy encounters some turbulence.

3. FDI investors cannot easily liquidate their assets and

depart from a nation, since such assets may be very large
and quite illiquid. FPI investors can exit a nation literally
with a few mouse clicks, as financial assets are highly liquid
and widely traded.

43
 Evaluating Attractiveness
Capital is always in short supply and is highly mobile.
Therefore, foreign investors have standard criteria when
evaluating the desirability of an overseas destination for FDI
and FPI, which include:
 Economic factors: the strength of the economy, GDP growth trends,
infrastructure, inflation, currency risk, foreign exchange controls
 Political factors: political stability, government’s business philosophy,
track record
 Incentives for foreign investors: taxation levels, tax incentives, property
rights
 Other factors: education and skills of the labor force, business
opportunities, local competition

44
 FDI/FPI – Pros and Cons
• FDI and FPI are both important sources of funding for most
economies. Foreign capital can be used to develop infrastructure,
set up manufacturing facilities and service hubs, and invest in other
productive assets such as machinery and equipment, which
contributes to economic growth and stimulates employment.

• However, FDI is obviously the route preferred by most nations

for attracting foreign investment, since it is much more stable than
FPI and signals long-lasting commitment.

• For an economy that is just opening up, meaningful amounts of FDI

may only result once overseas investors have confidence in its long-
term prospects and the ability of the local government.

45
 FDI and FPI – Pros and Cons

 Though FPI is desirable as a source of investment capital, it tends to

have a much higher degree of volatility than FPI. In fact, FPI is often
referred to as “hot money” because of its tendency to flee at the
first signs of trouble in an economy.

 These massive portfolio flows can exacerbate economic problems

during periods of uncertainty.

 Because capital flows can also affect the exchange rate of a nation's
currency, a quick withdrawal of investment can lead to rapid decline
in the purchasing power of a currency, rapidly rising prices
(inflation) and then panic buying to avoid still higher prices.

 In short, such quick withdrawals can produce widespread economic

crisis.

46
 Cautionary Signs for Investors
• Investors should be cautious about investing heavily in
nations with high levels of FPI and deteriorating
economic fundamentals.
• Financial uncertainty can cause foreign investors to head
for the exits, with this capital flight putting downward
pressure on the domestic currency and leading to
economic instability.
(Capital flight is a large-scale exodus of financial assets and capital from a nation due to
events such as political or economic instability, currency devaluation or the imposition of
capital controls)

47
 The Asian Financial Crisis of 1997
• The Asian Financial Crisis of 1997 remains the textbook example of such a
situation. The plunge in currencies like the Indian rupee and Indonesian
rupiah in the summer of 2013 is another recent example of the havoc
caused by “hot money” outflows.
• In May 2013, after Federal Reserve chairman Ben Bernanke hinted at the
possibility of winding down the Fed’s massive bond-buying program,
foreign investors began closing out their positions in emerging markets,
since the era of near-zero interest rates (the source of cheap money)
appeared to be coming to an end.
• Foreign portfolio managers first focused on nations like India and
Indonesia, which were perceived to be more vulnerable because of their
widening current account deficits and high inflation.
• As this hot money flowed out, the rupee sank to record lows against the
U.S. dollar, forcing the Reserve Bank of India to step in and defend the
currency. Although the rupee had recovered to some extent by year-end,
its steep depreciation in 2013 substantially eroded returns for foreign
investors who had invested in Indian financial assets.
48
 The Bottom Line
• While FDI and FPI can be sources of much-needed capital for
an economy, FPI is much more volatile, and this volatility can
aggravate economic problems during uncertain times. Since
this volatility can have a significant negative impact on their
investment portfolios, retail investors should familiarize
themselves with the differences between these two key
sources of foreign investment.

(Volatility is a statistical measure of the dispersion of returns for a given security or market index.
In most cases, the higher the volatility, the riskier the security. Volatility is often measured as
either the standard deviation or variance between returns from that same security or market
index)

49
 Article

https://www.thestar.com.my/business/business-news/2023/03/07/oppstar-ipo-
oversubscribed-by-7705-times

50
Be humble, be kind &
help others

51
 JFP463E Investment & Portfolio Management
Webex #5 @ 1 April 2023

Chapter 5: Risk & Return

Course Manager
Dr Zarina Md Nor

1
 Learning outcomes
Upon completion of this chapter the students should
be able:
• to calculate risk and return statistical measures, such as holding
period returns, average returns, expected returns, and standard
deviations, ex post and ex ante.
• to construct portfolios of different risk levels, given information
about risk free rates and returns on risky assets.
• to calculate the expected return and standard deviation of these
portfolios.
• to realize that higher returns are possible, but that increased risk
must be assumed, that theoretically one can easily construct
portfolios of varying degrees of risk by altering the composition of
the portfolio between risk free securities and mutual funds.

2
 Risk & Return
• Investors use data on the past performance of stocks and
bonds to characterize the risk and return features of
investments.

• They determine the expected return and risk of portfolios that

are constructed by combining risky assets with risk-free
investments in T-bills.

• An important measure of investors’ success is the rate of

return at which their funds have grown during the investment
period.

3
 Holding period return (HPR)
HPR depends on the increase or decrease in the price of shares
and their dividend income. Therefore HPR assesses an
investment return that include capital gain and dividend
income.

The rate of HPR is defined as dollars earned over the investment

period per dollar invested. In other words it measures the
growth of investment funds.

HPR is a key measure of investor’s investment performance. It is

also called the return on investment (ROI).

4
 Formula
−P +D
HPR = P 1 0 1

P 0

P 0 = Beginning Price
P1 = Ending Price
D1 = Cash Dividend

HPR = capital gains yield + dividend yield

P1-P0 D1
P0 P0

5
Example
You put up RM100 at the beginning of the year for an
investment. The value of the investment grows 4% and
you earn a dividend of RM3.50. Your HPR
was __________

Beginning price = RM100

Ending price: 1.04 x RM100= RM104
HPR = (104 – 100 + 3.50)
100
= 0.075@ 7.5%

6
 Measuring Investment Returns over
Multiple Periods
1. Arithmetic average (AV)
AV = sums of returns in each period
number of periods

AV assumes that at the start of each period the initial

investment amount is maintained.
Limitation: Ignores compounding
Strength: Best forecast of performance in future quarters

7
Example

The arithmetic average (AV) for HPR of -12%,

15%, 30% and 20% is _________.

Answer:
AV = (-12 + 15 + 30 + 20) / 4
= 13.25%

8
2. Geometric average (rG)
(1+i1) x (1+i2) x (1+i3) x … x (1+in) = (1+ rG)n

rG = {[(1+r1) (1+r2) .... (1+rn)]} 1/n - 1

where n= the number of period returns

 Compounding the actual period-by-period returns and then

finding the equivalent single per period return
 Also called time-weighted average return
 Data on past returns earned by mutual funds actually are required
to be time-weighted returns. The rationale for this practice is that
since the fund manager does not have full control over the
amount of assets under management we should not weight
returns in one period more heavily than those in other periods
when assessing ‘typical’ past performance
 - Assumes reinvestment of gains and losses
 - Lower than arithmetic average
9
 Example
The geometric average (rG) of -12%, 20% and 25% is
__________.

[(1-0.12) x (1+0.20) x (1+0.25)] = (1+rG)3

rG = [(1-0.12) x (1+0.20) x (1+0.25)]1/3 – 1
= 3√1.32
= 1.097 – 1
=0.97 @ 9.7%

https://www.calculator.net/
10
3. Dollar-weighted return @ (IRR)
- To account for the varying amount of an investment
project.
- Dollar-weighted average return is the internal rate of
return (IRR) of the project.
- Used in capital budgeting
Example YEAR
Net CF (RM million) 0 1 2 3 4
-1.0 -0.1 -0.5 0.8 .96

IRR = 3.38%
[IRR is the interest rate that sets the present value of the cash flows realized on
the portfolio equal to the initial cost of establishing the portfolio]
https://www.calculatestuff.com/financial/irr-calculator

11
12
 Internal rate of return (IRR)
IRR Considers changes in investment
• Initial Investment is an outflow
• Ending value is considered as an inflow
• Additional investment is a negative flow
• Reduced investment is a positive flow

Read more: http://www.investopedia.com/terms/i/irr.asp

13
 Convention for Quoting Rates of Return

Returns on assets with regular cash flows usually

are quoted as annual percentage rate (APRs)
which annualized per-period rates using simple
interest approach.

APR = per-period rate X periods per year

14
Example
Suppose you pay RM9,750 for a RM10,000 par T-bill
maturing in two months. What is the annual
percentage rate of return (APR) for this investment?
Rate of return for 2 months (with no dividend)
HPR = Cash income/initial price
=RM250/RM9750
= 0.0255 or 2.55% 1yr = 12mth = 6x2

APR = 2.55% x 6
= 15.3% per annum

15
 Expected Return

The reward from the investment is its expected

return which is also called as the mean of the
distribution or mean return.

Expected return is given as,

S
E (r ) = ∑ p( s)r ( s)
s =1

16
 Risk measurements
Variance
S
Var ( r ) ≡ σ 2 = ∑
s =1
p ( s )[r ( s ) − E ( r )] 2

o Variance is a measurement of the spread between numbers in a data set.

o Investors use variance to see how much risk an investment carries and whether
it will be profitable.
o Variance is also used to compare the relative performance of each asset in a
portfolio to achieve the best asset allocation.

Standard Deviation (SD) is the square root of the variance

SD = σ 2 In order to determine the SD, variance

needs to be calculated first!

The SD is adequate to measure risk when the distribution of return is

approximately normal.
17
18
 Normal Distribution

Symmetric distribution
s.d. s.d.

r
Standard deviation is used as an indicator of market volatility and therefore of
risk. The more unpredictable the price action and the wider the range, the
greater the risk. The underlying assumption is that the majority of price activity
follows the pattern of a normal distribution

http://www.investopedia.com/ask/answers/021915/how-standard-deviation-used-determine-
risk.asp#ixzz4TSFcP75P
19
Skewed Distribution: Large Negative Returns Possible

Median

Negative r Positive

20
Skewed Distribution: Large Positive Returns Possible

Median

Negative r Positive

21
 Scenario Analysis
A process of devising a list of economic scenarios and specifying
the likelihood of each one, including the HPR that will be
realized in each case.

Scenario analysis commonly focuses on estimating what a

portfolio's value would decrease to if an unfavorable event, or
the "worst-case scenario", were realized.

22
 Example
State of Economy Scenario, s Probability, p(s) HPR
Boom 1 0.25 44%
Normal growth 2 0.50 14
Recession 3 0.25 -16

Expected return:
E(r) = 0.25(0.44) + 0.50(0.14) + 0.25(-0.16)
= 0.14 @ 14%

Variance:
σ2 = 0.25(44-14)2 + 0.50(14-14) 2 + 0.25(-16-14)2
= 450

SD = √450
= 21.21%

23
 e.g. Calculations for a Portfolio
Carol manages a risky portfolio with an expected rate of return of 18% and a
standard deviation of 28%. The T-bill rate is 8%.
Carol’s client chooses to invest 80% of a portfolio in her fund and 20% in a T-bill
money market fund.
Calculate the expected return and standard deviation of the client’s portfolio.
Expected return:
E(rP) = (0.2 x 8%) + (0.8 x 18%)
= 1.6 + 14.4
= 16% per year
Standards deviation:
σP = 0.8 x 28%
= 22.4% per year

24
Carol’s risky portfolio includes the following investments in the
given proportion:

Stock A 27%
Stock B 33%
Stock C 40%

Calculate the investment proportions of her client’s overall

portfolio.

25
Calculation: Investment proportions
Security Calculations Investment Proportions

T-Bills 20.0%

Stock A 0.8 × 27% 21.6%

Stock B 0.8 × 33% 26.4%

Stock C 0.8 × 40% 32.0%

26
 Risk Premiums and Risk Aversion
 Risk premium: is the return in excess of the risk-free
rate of return that an investment is expected to yield.

 An asset's risk premium is a form of compensation for

investors who tolerate the extra risk in excess of risk
free rate in a given investment.

- Risk averse investors will require greater risk premium for their
investments.

27
The risk premium that an investor demands to hold a risky
portfolio (P) is proportional to investor’s risk aversion (A)
and the variance of the portfolio returns.
1
E (rP ) − r f = Aσ P
2

2
The equation shows that investors would not demand a
risk premium to hold a risk free portfolio,
(σ P2 = 0)
For any positive variance, the risk premium is positive.

28
The average degree of risk aversion for market portfolio
(M) is given by

E (rM ) − r f
A=
σ 2
M

The higher market risk premium per unit of risk, the

higher level of investors’ risk averse.

Studies conclude that investors’ risk aversion is in the

range of 2-4.

29
 Example
Treasury bills are paying a 5% rate of return. A risk
averse investor with a risk aversion of A = 4 should
invest in a risky portfolio with a standard deviation
of 22% only if the risky portfolio's expected return
is at least _______.

1
E (rP ) = Aσ P + rf
2

2
1
E (rP ) = (4)(0.22) 2 + 0.05 = 0.1468 = 14.68%
2

30
The Sharpe Ratio
(reward-to-volatility)

The Sharpe ratio (S) is used as a valid

statistic for ranking portfolios in
terms of risk return trade-off (not for
individual assets)

It measures the incremental return for

every 1% increment in the std
deviation of a portfolio.

A higher measure means a better return

for the associated risk.

31
32
 Asset allocation across risky and risk free
portfolios

Asset allocation: refers to the choice made among

investment classes in an investment portfolio formation.

Portfolio: a collection of investments all owned by the same

individual or organization.

What is the best combination of risk-free investment and risky

investment to be allocated in a portfolio?

33
 Risk free assets
o In real term, there is no risk-free asset because of inflation

o In general, T-bills is a risk free asset because it is a short term

investment so the price is insensitive to interest rate fluctuations. In
practice, there are a few types of risk free asset used by investors that
come under money market mutual fund holdings e.g. T-bills, bank
certificates of deposits (CDs), and commercial papers.

o The yields to maturity on CDs and commercial paper for identical

maturities are always slightly higher than those of T-bills.

o When shifting wealth from risky portfolio to the risk free assets, the
relative weight of the risky portfolio as a whole is reduced and
replaced with the risk-free assets.

34
Example:

The total market value of a portfolio is $300,000

where
$90,000 of the amount is invested in a risk-free
shares of the Ready Assets money market fund.

The balance of $210,000 is invested in risky

securities that include $113,400 in Vanguard’s
S&P 500 index fund, and $96,600 in Fidelity’s
investment Grade Bond Fund.

35
Example:
The holdings of the Vanguard (V) and Fidelity (IG) shares make up the risky
portfolio with the weight of:

wV = 113,400/210,000 = 0.54 @ 54%

wIG = 96,600/210,000 = 0.46 @ 46%

The weight of risky portfolio in a complete portfolio:

= 210,000/300,000
= 0.7 @ 70 %

The weight of risk-free portfolio in a complete portfolio:

= 90,000/300,000
= 0.3 @ 30%

[or 1 – 0.7 = 0.3 @ 30%]

36
The weight of individual assets in the complete portfolio

Total market value of a Portfolio (F+P) 300,000 1.000

Ready Asset (risk-free portfolio, F) 90,000 / 300,000 0.300

Risky Portfolio (P) 210,000 / 300,000 0.700

Shares of Risky Portfolio Proportions Weights

Vanguard 113,400 / 210,000 0.54

Fidelity 96,600 / 210,000 0.46

37
Suppose the investor wants to reduce the risky portfolio from 70% to
56%.
New total risky portfolio would be:
0.56 x $300,000 = $168,000
Difference from the previous amount:
= $210,000 – $168,000 = $42 000
(this amount is used to purchase more risk free shares of Ready Assets).
New total holdings of risk free assets:
= $90,000 + $42,000 = $132,000
It is important to remember that the proportion of each asset in the risky
portfolio is unchanged. Previous weight of Vanguard and Fidelity
shares are given as 54% and 46% respectively.
So how much is the new investment left to each of Vanguard and Fidelity
shares?
Total new amount = $168,000
Vanguard = 168,000 x 0.54 = $90,720
Fidelity = 168,000 x 0.46 = $77,288

38
 Important points:
1. Treat the collection of securities in the risky fund as a
single risky asset.

2. Risk can be reduced by changing the risky/risk free asset

mix. However, do not alter the weights of each asset
within the risky portfolio after an asset reallocation.

3. Only the rate of return on complete portfolio will change

after an asset reallocation

39
 Ramadan Mubarak

Be Kind, Be Humble, Help Others

Thank you

40
JFP463E Security Investment & Portfolio Management

Webex #6 @ 13 May 2023

Topic
Equity Valuation

Course Manager
Dr Zarina Md. Nor
Upon completion of this topic, the students would be
able to:
 Assess the growth prospects of a firm and relate growth
opportunities to the P/E ratio.
 Perform calculations related to equity valuation

2
3
 The purpose of fundamental analysis is to identify
stocks that are mispriced relative to some measure of
‘true’ value that can be derived from observable
financial data.

 Fundamental analysis attempts to measure a

security's intrinsic value by examining related
economic and financial factors including the balance
sheet, strategic initiatives, microeconomic indicators,
and consumer behavior

4
 Book value
Book value is the net worth of a company as reported on its
balance sheet or the accounting value of a firm. It has two
main uses:
1. It is the total value of the company's assets that
shareholders would theoretically receive if a company were
liquidated.

Book value per share = common shareholders' equity

common shares outstanding

2. The book value can indicate whether a stock is under-

or overpriced (i.e. book value vs market value).

5
Market Value
 Market value is often different from book value because
the market takes into account future growth potential.
It is also known as market price.

 Investors determine whether or not the market value is

adequate or if it is undervalued in comparison to its
book value, net assets or some other measures.

6
Liquidation value
 Net amount that can be realized by selling the assets of a firm
and paying off the debt.

 If the market price of equity drops below this value, the firm
becomes attractive as a takeover target.

7
Replacement cost
The price that will have to be paid to replace an existing
asset with a similar asset.

Competitive pressure of other similar firms entering the

same industry would drive down the market value of all
firms until they came into equality with replacement
cost.

The ratio of market price to replacement cost is known

as Tobin-q.
8
 Intrinsic value
The value of a security which is intrinsic to or
contained in the security itself.

Intrinsic value is calculated by summing the

future income generated by the asset, and
discounting it by the required rate of return
to the present value.
The cash flows from the stock discounted at the appropriate rate, based on the perceived riskiness of the
stock, the market risk premium and the risk free rate, determine the intrinsic value of the stock.

9
Market capitalization rate, k
The market-consensus estimate of the appropriate discount rate
for a firm's cash flows
- a common term for the market consensus value of the required
return on a stock.

The market capitalization rate, which consists of the risk-free

rate, the systematic risk of the stock and the market risk
premium, is the rate at which a stock's cash flows are discounted
in order to determine intrinsic value.

10
Dividend Discount Models (DDM)

11
Dividend Discount Models (DDM)

• The dividend discount model (DDM) is a procedure

for valuing the price of a stock by using predicted
dividends and discounting them back to present
value.

• The idea is that if the value obtained from the DDM

is higher than what the shares are currently trading
at, then the stock is considered undervalued and a
good investment.

12
• The intrinsic value, V0, of the share is the
dividend to be received at the end of first
year, D1 and the expected sale price, P1.

D1 + P1
Therefore, V0 =
1+ k
Accordingly, D2 + P2
V1 =
1+ k
Where k is the market capitalization rate
13
So how to estimate the year end price, P1 ?

If we assume the stock will be selling for its

intrinsic value next year, then V1=P1 .
Therefore,
D1 D2 + P2
V0 = +
1 + k (1 + k ) 2
i.e. The intrinsic value is the present value of
dividends plus sales price for a 2-year holding
period

14
Generally, for a holding period of H years, the formula becomes

D1 D2 DH + PH
V0 = + + ........ (13.2)
1 + k (1 + k ) 2
(1 + k ) H

This leads to
DDM
D1 D2 D3
V0 = + + + ........ (13.3)
1 + k (1 + k ) (1 + k )
2 3

15
• DDM states that the stock price should equal
the present value (PV) of all expected future
dividends into perpetuity *
*a constant stream of identical cash flows with no end

• DDM asserts that stock prices are determined

ultimately by the cash flows accruing to
stockholders (i.e. dividends)

• DDM doesn't work for companies that don't pay

out dividends.

16
To make DDM practical, an assumption is made -
dividends are trending upward at a stable growth rate
called ‘g’.
D1 = D0 (1+g)
D2 = D0 (1+g)2
D3 = D0 (1+g)3 ….. etc.

17
Using equation D1 + P1 the intrinsic
V0 =
value becomes: 1+ k

D0 (1 + g ) D0 (1 + g ) 2 D 0(1 + g )3
V0 = + + + ........
1+ k (1 + k ) 2
(1 + k ) 3

And it can be simplified to:

D0 (1 + g ) D1
V0 = =
k−g k−g

This equation is known as the Constant Growth DDM

or Gordon Model. 18
Gordon Model is used to determine the current
price of a security. The Gordon model assumes
that the current price of a security will be
affected by the dividends, the growth rate of
the dividends, and the required rate of return
by shareholders.

This model is valid only when g is less than k.

If g is greater than k, then the growth rate must

be unsustainable in the long run.

Note: Gordon Model & calculator

http://www.ultimatecalculators.com/constant_growth_model_calculator.html
19
The constant growth rate DDM implies that a
stock’s value will be greater..

1. The larger it’s expected dividend per share

2. The lower the market capitalization rate, k
3. The higher the expected growth rate of
dividends

The stock price is also expected to grow at the

same rate as dividends so that
V0 = P 0
20
When the stock price is expected to grow at the same rate
as dividends, V0 = P0.
Therefore from V0 = D1 it becomes P0 = D1
k-g k-g
As the stock price is proportional to dividend, we can
generalize it as P1 = P0(1+g)

So, g = P1 – P0
P0
Substituting g into Er, the expected holding period return will be
* Er = dividend yield + Capital gains yield

Discounted
cash flow
(DCF) formula

21
This formula offers a mean to infer the market
capitalization rate of stock, k, because if the
stock is selling at it intrinsic value, then
E(r) = k

implying that
k = D1
P0 + g

22
23
The P/E ratio is the ratio for valuing a company that
measures its current share price relative to its per-share
earnings.

It indicates the dollar amount an investor can expect to

invest in a company in order to receive one dollar of that
company’s earnings. This is why the P/E is sometimes
referred to as the “multiple” because it shows how much
investors are willing to pay per dollar of earnings.
e.g. If a company were currently trading at a multiple (P/E) of 20, the
interpretation is that an investor is willing to pay RM20 for RM1 of
current earnings.

24
 Price-Earning Ratios (P/E Ratios)
The price-earnings ratio = Market Value per Share
Earnings per Share

High P/E ratios tend to indicate that a company will grow

quickly, vice versa.
Investors pay for growth; hence the high P/E ratio for growth
firms - the investor should be sure that he or she is paying
for expected growth, not historic growth.
It seems simple but that’s not usually the case as earnings
will depend on international, macroeconomics, industry and
firm specific factors.

25
 One primary limitation of using P/E ratios emerges
when comparing P/E ratios of different companies.

 Valuations and growth rates of companies may often

vary between sectors due both to the differing ways
companies earn money and to the differing timelines
during which companies earn that money.

 As such, one should only use P/E as a comparative tool

when considering companies within the same sector, as
this kind of comparison is the only kind that will yield
productive insight.

26
For most firms, P/E ratios and risk will have an
inverse relationship
**********************************************************

Dividend discount models and P/E ratios are used

by fundamental analysts to try to find mispriced
securities.

- Fundamental analysts look at the basic features

of the firm to estimate firm value.

27
https://siblisresearch.com/data/pe-ratios-by-country/
28
Computer stocks currently provide an expected rate of return of
16%. MBI, a large computer company will pay year end dividend
of RM2 per share. If the stock is selling at RM50 per share,
calculate:
a. P/E ratio
P/E = RM50/RM2 = 25

b. Market expectation of the growth rate of MBI dividends?

P0 = D1/k-g
RM50 = RM2/0.16-g
g= 0.16 – (2/50)
g = 0.12 @ 12%
29
c. If dividend growth forecasts for MBI are revised downward to 5% per year,
what will happen to the price of its stock?
Given: k = 16%; D1=RM2; new g = 5%
So, P0 = D1/k-g
= RM2/[0.16-0.05]
= RM18.18

30
Assume that Tetra Company’s dividends are trending
upwards at a stable growth rate (g).
If g = 5% and the most recently paid dividend was RM3.81.
a. Calculate the expected future dividends for the next 3
years.
D1 = D0 (1+g) = 3.81 x 1.05 = 4.00
D2 = D0 (1+g)2 = 3.81 x (1.05)2 = 4.20
D3 = D0 (1+g)3 = 3.81 x (1.05)3 = 4.41

31
b. If the market capitalization rate for Sella
Company is 12%, what is the intrinsic value
(V0) of a share of its stock?
Given: k=12% ; g = 5%; D1 = RM4
V0 = D1
k-g
= RM4 / [0.12-0.05]
= RM57.14

32
Purpletree Ltd has 200,000 4% RM1 preference shares and
600,000 RM1 ordinary shares in issue. If the company pays
an ordinary dividend 6 cent per share during the year ended
31 December 2022, calculate the total dividends payable for
that year.

1. Preference dividend = 200,000 x RM1 x 4% = RM8,000.

2. Ordinary dividend = 600,000 x RM1 x 6% = RM36,000.
3. Total dividends = RM44,000

33
In the market…

34
Be Kind Be Humble & Help
Others

35
JFP463E Security Investment & Portfolio Management
Webex #7 @ 10 June 2023

Bond Market

Course Manager
Dr Zarina Md Nor
Learning Objectives
Upon completing the topic, the students should be able to:
 Explain the key terms associated with bonds
 Explain the advantages/disadvantages of investing in bonds.
 Calculate bond prices and yields
What is a bond?
A debt instrument whereby an investor lends money to an entity (such
as a company or a government) that borrows the funds for a defined
period of time at a fixed interest rate.
2 major issuers of bonds
• Companies
- Issuing corporate bonds

• Governments
- Issuing government bonds
Examples
Microsoft Bond Issue: Nov 2012
Sold $2.25bn of corporate
Microsoft were vague about how
bonds in Nov 2012.
the money would be spent:
It chose to sell three individual
• To purchase other companies
groups of bonds, repaying the
• To pay off other more
money at different dates and
expensive loans
paying different interest rates.

Why do you think the interest rate INCREASES as the repayment term increases?

Quantity Repayment Interest

Issued Payment
Longer dated bonds are more risky and hence
$600m 5 years 0.875% pa investors want greater returns…MS is probably
$750 10 years 2.125% pa more likely to have problems in the next 30 years
rather than the next 5 years!
$900m 30 years 3.5% pa
Total $2,250
Examples:
Government Bond Issues

UK Govt. Bond Issue: Jan 2015

When Total Receipts (taxes)
The UK government sold £1.75 are less than
billion of bonds called Total Expenditure…
Treasury Gilts in January 2015.
…the difference needs to be funded
The bonds will repay the through the issue of bonds
borrowed money in 2034 and
will pay interest of 4.5% each
year.
 Bond Features
Also known as the face value. It is the
amount that is written on the face of the
bond certificate.

When the money will be Bonds can be sold before they

returned. Also known as reach their repayment date
the redemption or
maturity date. This is Percentage paid as interest
when the bond will be and how often it is paid.
redeemed. More typically termed as
the COUPON on a bond.
Bond Market
• Bond dealers act as intermediaries between bond issuers and
investors

• Issuers sell new bonds in the primary market, dealers resell them to
investors in the secondary market

• Relatively illiquid for small investors because of high transaction cost

Key terms
 Maturity: time when bond principal and all interest will
be paid in full
 Term-to-Maturity: years remaining until maturity

 Par Value: face amount, or principle of bond

 Discount and Premium to par

 Coupon Rate: rate promised based on par value of

bond principal—determines interest paid
 Current Yield: rate based on interest paid divided by
current bond price
Bond Terminology
FLAT YIELD
• When the calculation of YIELD = COUPON/PRICE

YIELD TO MATURITY
• When the calculation includes the capital gain/or loss if the bond is held until its
maturity date.

NOMINAL VALUE
• This is the FACE value of the bond. It is the amount owed by the bond issuer, that
will be repaid on repayment date.

REPAYMENT/REDEMPTION/MATURITY DATE
• Is the date when the bond will be paid back to the investor.

TRADABLE INSTRUMENT
• A bond is a tradable instrument which means it can be bought and sold.
Bond Yields
YIELD: This is just another work for “return” and it is expressed as an ANNUAL PERCENTAGE

COUPON: This is the INTEREST RATE paid on the FACE/NOMINAL value of the bond

YIELD and COUPON are NOT the same thing.

They are only the same when the bond is bought/sold at its
FACE/NOMINAL value.

Otherwise, generally they are different.

Their relationship can be explained as follows:

Bond Prices
Bond prices respond to changes in INTEREST RATES
• This is because, for their yield (return) to be attractive to investors it
must remain competitive (when compared to the return available on
alternative investment instruments).

• If the bank increases the rate of interest, then alternative investments

may appear to have a more competitive return.

• In response to this the bond price decreases to make the bond

appear cheaper to purchase, and the yield offered needs to increase.
Callable bonds
A callable bond is a debt security that can be redeemed early by the
issuer before its maturity at the issuer's discretion.
A callable bond allows companies to pay off their debt early and
benefit from favorable interest rate drops.
A callable bond benefits the issuer, and so investors of these bonds are
compensated with a more attractive interest rate than on otherwise
similar non-callable bonds.

https://dqydj.com/bond-yield-to-call-calculator/
(also YTM calculator)
Zero-coupon bond
• A zero-coupon bond is a debt security instrument that does not pay
interest.
• Zero-coupon bonds trade at deep discounts, offering full face value
(par) profits at maturity.
• The difference between the purchase price of a zero-coupon bond
and the par value indicates the investor's return.

https://www.brandonrenfro.com/bond-price-calculator/
A case study
John purchases a bond which has a face value of £1000 with a yield of 5% per
annum, to be matured in 5 years time.
One year later, the interest rate offered by banks INCREASES from 5% to 7% thus
making alternative investments more attractive.
John is considering selling his bond, however he cannot sell it at £1000 and offer
just the 5% yield when there are better investment opportunities available.
Therefore, to make the bond seem more attractive to customers, the price of the
bond is dropped from £1000 to £800.
As the price has dropped the yield now appears to be more attractive too.
This is because they are still getting the original yield of 5% of £1000 i.e. £50. This is
a bigger percentage of the amount paid (50/800 x 100 = 6.25%)
If the new investor keeps the bond until maturity date, they will also make a gain
on their investment as they only paid £800 for the bond but will be redeemed with
£1000 (the face value of the bond)
Scenario 1
A 30 year bond is paying a 7% coupon and is currently priced at face
value. What is the current yield on the bond?

• If the price is at nominal/face value then the yield is the same as

the coupon rate.
• In this case 7%.
Scenario 2
A 30 year bond is paying a 7% coupon and is currently priced at face value.
If the bond’s price falls to $980, what happens to the yield? Does it
increase or decrease?

• When price decreases, then required yield increases beyond the coupon
rate, i.e. beyond 7%.
• The fall in price results in an increase to the percentage the investor
receives each year.
• The purchase will receive 7% of $1000 having paid only $980. This means
the purchaser receives around 7.14% of his investment each year (based on
70/980 expressed as a percentage).
• If he holds on to the bond for the 30 years, the purchaser will also benefit
from a windfall gain of a further $20 on redemption, having paid$980 and
receiving back $1000.

https://dqydj.com/bond-yield-to-maturity-calculator/
Scenario 3
A 30 year bond is paying a 7% coupon and is currently priced at
face value. If the bond’s price now increases to $1,100, what
happens to the yield?
Does it increase or decrease?

– When price increases, then required yield decreases because an

increase in a bond’s price results in a fall in the bond’s yield.
– For a buyer paying $1100, the annual yield generated by the bond
will fall to 6.36% each year (based on 70/1100 expressed as a
percentage).
– The purchaser will also suffer a further loss at redemption when the
bond will only pay back $1000 even though the purchaser paid
$1100 to buy the bond.
Bond Yields
There is an INVERSE RELATIONSHIP between BOND PRICE and BOND
YIELD

If the required yield INCREASES, price DECREASES

If the required yield DECREASES, price INCREASES
 Interest Rates & Bond Prices
• Bond prices are susceptible to movements in general
interest rates.

• For the yield offered to be attractive to investors it needs to

remain competitive with the return available on alternative
instruments.

Bank Rate of Interest DECREASES Other products may appear to

Bond Price INCREASES have a more competitive
return.
Bond Yield DECREASES

Bank Rate of Interest INCREASES Bondholders are willing to

Bond Price DECREASES accept a lower return when they
buy bonds.
Bond Yield INCREASES
What will happen to the Bond Price?
Look at the following two scenarios.
Think about whether the bonds will go up or
down in value or stay the same?

The European Central Bank

The central bank in the UK (Bank
decreases interest rates in the
of England) increases interest
Eurozone. What is likely to
rates.
happen to the bond prices of
What will happen to the price of
German and French Government
UK government bonds?
Bonds?
What will happen to the Bond Price?
Look at the following two scenarios.
Think about whether the bonds will go up or
down in value or stay the same?

The PRICE will go DOWN.

An increase in interest rates

means that bond yields need to The central bank in the UK (Bank
increase too, to keep them of England) increases interest
attractive to investors. The rates.
increase in bond yields is What will happen to the price of
generated by the prices of those UK government bonds?
bonds falling.
What will happen to the Bond Price?
Look at the following three scenarios.
Think about whether the bonds will go up or
down in value or stay the same?

Buddy Inc is an oil exploration company that has just announced a significant discovery of
easily accessible oil. What happens to the price of Buddy’s 5% coupon-paying bonds?

Anemone PLC’s sales have suffered due to a recession in its main market. Anemone has a
number of 7% coupon-paying bonds in issue – what is likely to happen in their price.

Lakeground Inc announces a substantial equity issue aimed at reducing its debt burden.
What is likely to happen to the price of Lakegound’s bonds?
What will happen to the Bond Price?
Look at the following three scenarios.
Think about whether the bonds will go up or
down in value or stay the same?

Buddy Inc is an oil exploration company that has just announced a significant discovery of
easily accessible oil. What happens to the price of Buddy’s 5% coupon-paying bonds?

The PRICE will go UP.

The increased likelihood of Buddy being able to pay the

coupons and repay the bonds should result in the yield
required by investors falling and the price of the bonds
rising.
What will happen to the Bond Price?
Look at the following three scenarios.
Think about whether the bonds will go up or
down in value or stay the same?

Anemone PLC’s sales have suffered due to a recession in its main market. Anemone has a
number of 7% coupon-paying bonds in issue – what is likely to happen in their price.

The PRICE will go DOWN.

Anemone’s credit risk has increased as its main

market is in recession.
The result is likely to be that Anemone’s bonds
will fall in price, resulting in an increase in the
yield to reflect the additional risk.
What will happen to the Bond Price?
Look at the following three scenarios.
Think about whether the bonds will go up or
down in value or stay the same?

Lakeground Inc announces a substantial equity issue aimed at reducing its debt burden.
What is likely to happen to the price of Lakegound’s bonds?

The PRICE will go UP.

A reduced amount of debt relative to the size of the issuing company will
mean there is less risk that Lakeground may fail to pay the coupons and
repay the debt.

The lower the credit risk should mean the bond’s price increase, with the
investors willing to accept a lower yield.
Example
Consider a 20-year bond paying an annual coupon of RM80 and selling
at par value of RM1000. If the yield remains at 8% over the year, the
bond price will remain at par, so the holding period return also will be
8%. BUT if the yield falls below 8%, the bond price will increase to
RM1125.
Calculate the holding period return (HPR) for the bond.

HPR = RM80 + (RM1125-RM1000) = 0.205 @ 20.5%

RM1000
Article

https://www.thestar.com.my/business/business-news/2020/09/09/lure-of-
malaysias-high-yield-bonds
Article on Sukuk

https://www.ey.com/en_my/news/2022-press-releases/01/malaysia-is-prime-issuer-of-
sustainability-sukuk-in-asean-with-uss3-9-billion-of-total-issuance
The End
Be Kind, Be Humble & Help Others
JFP463E Security Investment & Portfolio Management
Webex #8 @ 24 June 2023

Bond Rating, Capital Structure

& Revision

Course Manager
Dr Zarina Md Nor
Learning Objectives
Upon completing the topic, the students should be able to:
 Explain the role of credit rating agencies
 Explain the difference in capital structure
Credit Rating Agencies
Credit Rating Agencies will look at bond issuers and assess the risk
involved.

• There are three dominant credit rating agencies:

• Moody’s
• Standard & Poor’s
• Fitch Ratings

• All three have an alphabetical system where issuers with the

LEAST credit risk are termed “Triple A”
• SP and F use an identical scale
• M uses their own scale

• These have been depicted on the next slide…

“Triple A” means….
Standard & Poor’s / Moody’s Ratings
Fitch Ratings
AAA Aaa
AA Aa
A A
BBB Baa
Increasing
BB Ba levels of
B B credit risk
CCC Caa
CC Ca
C C
D
“Triple A” means….
Standard & Poor’s / Moody’s Ratings
Fitch Ratings
S&P: “extremely high AAA Aaa “highest quality
capacity to meet their
AA Aa with minimal
financial
credit risk”
commitments” A A
BBB Baa
FR: “exceptionally
strong capacity for BB Ba
payment of financial B B
commitments”
CCC Caa
CC Ca
C C
D
There is a dividing line between…

The bonds that are rated by agencies as having

less credit risk therefore suitable for prudent
investors

The bonds that are more risky and therefore less

appropriate for prudent investors.
The dividing line…
Standard & Poor’s / Moody’s Ratings
Fitch Ratings
Investment
AAA Aaa
Grade
AA Aa (BONDS)
A A
BBB Baa
BB Ba
B B
Non-
CCC Caa Investment
CC Ca Grade
Already in (BONDS)
C C
default and
failing to pay D
the bond
coupons
What’s the Credit Rating?

Complete the following table. You must identify which credit rating agency the score is
relevant to as well as whether the score suggests suitability for prudent investors or
not.

Credit Rating Standard & Poor’s/ Fitch Investment grade or non-

Ratings, Moody’s or all investment grade?
three?
Aaa
AA
Ba
BBB
B
Capital Structure
Bond vs Equity
Why is it better for your business to issue bonds rather
than equity?
• Issuing equity means that the influence of the
original shareholders will become diluted.

E.g. A company doubles its shares by selling new

shares to new shareholders . This means the
original shareholders’ original 100% ownership
will be diluted to just 50% after the new issue.

• Hence, this is not a popular choice for existing

shareholders.
What are the benefits and risks of
leverage in a company’s financing
structure?
Leverage
Leverage is the proportion of debt finance compared to equity finance in a company.

A business will either raise finance through debt or equity.

Scenario 1: The value of a company is $100mn at the start of the year and this goes up to
$120m by the end of the year.

The outcomes would depend on how the business is financed.

If the company is financed

PURELY by equity, then this
means ALL of the 20% gain will
be for the shareholders.

The share value will increase by

20%
Leverage
Leverage is the proportion of debt finance compared to equity finance in a company.

A business will either raise finance through debt or equity.

Scenario 1: The value of a company is $100mn at the start of the year and this goes up to
$120mn by the end of the year.

The outcomes would depend on how the business is financed.

If the company is financed by $50mn debt and $50m

equity then:

The value of the equity would go up from $50mn to

$70mn.

The debt amount would stay the same at $50mn.

Overall there is a 40% increase in equity.

(20/50 *100 = 40%)

The GAIN has been MAGNIFIED

 Leverage: Activity
What if the borrowing had been even bigger?

Assume that the Starting Value is still $100m and the Ending
Value is $120mn.

Assess the impact on the shareholders but this time with:

a) 60% debt
b) 90% debt
Leverage
Leverage is the proportion of debt finance compared to equity finance in a company.

A business will either raise finance through debt or equity.

Scenario 2: The value of a company is $100mn at the start of the year and this
goes down to $90mn by the end of the year. The company was financed through
$50mn Equity and $50 Debt.
The outcomes could be:

If the company is financed

PURELY by equity, then this
means ALL of the 10% loss
will be felt by the
shareholders.

The share value will decrease

by 10%
Leverage
Leverage is the proportion of debt finance compared to equity finance in a company.

A business will either raise finance through debt or equity.

Scenario 2: The value of a company is $100mn at the start of the year and this goes down to
$90mn by the end of the year. The company was financed through $50m Equity and $50m
Debt.
The outcomes could be:

If the company is financed by $50mn debt and $50m

equity then:

The value of the equity would go down from $50mn

to $40mn.

The debt amount would stay the same at $50mn.

Overall there is a 20% decrease in equity.

(10/50 *100 = 20%)

The LOSS has been MAGNIFIED

Leverage: Activity
What if the borrowing had been even bigger?

Assume that the Starting Value is still $100m and the

Ending Value is $90m.

Assess the impact on the shareholders but this time with:

a) 60% debt
b) 90% debt
Exercise:
The Government is expected to issue an additional RM2 billion treasury
bills for the purpose of liquidity management. Domestic borrowings
remain as the main source, constituting 99.9 per cent of the total gross
borrowings while external drawdowns remain minimal at 0.1 per cent.
The country's deep and well-developed bond market has provided
ample liquidity in the domestic financial market, enabling the
government to raise borrowing requirements in local currency. This
reduces Malaysia's direct exposure to foreign exchange and interest
rate risks.

Question: What is the importance of a well-developed bond

market?
Malaysian Government Securities (MGS)

https://financialmarkets.bnm.gov.my/types-of-securities
Final Exam (60%)
5 questions with subsections

• 4 calculations
• 1 structured/short answers

e.g. Short sales, dividend, scenario analysis, portfolio allocation, equity

evaluation, bond yield, business cycle, risk premium
Links: Video Clips
• What are bonds and how do they work?
• http://www.learningmarkets.com/what-are-bonds-and-how-do-they-work/

• Investopedia – Understanding Bonds

• http://www.investopedia.com/video/play/understanding-bonds/

• Corporate Bonds
• https://www.youtube.com/watch?v=jeRxswiPJBs
All the best for your final exam!
Be Kind, Be Humble & Help Others