Portfolio Management

Dr. Himanshu Joshi FORE School of Management New Delhi

Utility Functions

The Client
Risk Tolerance/Aversion Investment Horizon Tax Status

Tax Code

The Portfolio Managers Job

Views on Markets

Asset Allocation

Asset Classes Countries

Stocks
Domestic

Bonds

Real Estates
International

Views on Inflation Rates and Growth

Risk and Return

Valuations based on: Cash Flows Comparables Technicals

Security Selection Which Stock? Which Bond? Which Real Estate?

Private Information

Market Efficiency

Trading Codes Commissions Bid/Ask Spreads Price Impacts

Execution How Often Do you Trade? How large are your Trades? Do you use derivatives to manage or enhance risk

Trading Speed

Trading Systems

Market Timings

Performance Evaluation How much Risk the Portfolio Manager take? What Return did the portfolio managers make? Did it underperform or over perform?

Stock Selection

Risk Models: CAPM APT, Multi factor

Structure of the Course

Section1. Fixed Income Securities Section2. Equity Section3. Portfolio Management Concepts. Related Concepts: 1. Efficient Market Hypothesis 2. Asset Pricing Models: CAPM, Multifactor Models.

Section 1.

Fixed Income: Basic Concepts

Session 1. Features of Debt Securities

learning Outcomes: a. Explain the purposes of a bonds indenture and describe affirmative and negative covenants; b. Describe the basic features of a bond, the various coupon rate structures, and the structure of floating rate securities. c. Define accrued interest, full price and clean price; d. Explain the provisions for redemption and retirement of bonds; e. Identify common options embedded in a bond issue, explain the importance of embedded options, and identify whether an option benefits the issuer or the bondholder.

Major Assets Classes

Equity Fixed Income Securities Alternative Asset Classes: Real Estate, Private Equity, Hedge Funds, and Commodities

Fixed Income Securities

While many people are intrigued by the exciting stories sometimes found with equities, we will find in our study of fixed income securities that the multitude of possible structures opens a fascinating filed of study. While frequently overshadowed by the media prominence of equity market, fixed income securities plays a critical role in the portfolios of individuals and institutional investors.

Definition
In its simplest form, a fixed income security is a financial obligation of an entity that promises to pay a specified sum of money at specified future dates. The entity that promises to make payments is called the issuer of the security. US Treasury, RBI, Multinationals like CocaCola, and supranational governments such as World Bank and IMF.

Fixed Income Securities

Debt Obligations Issuer: Borrower Investor: Creditors Preferred Stocks Ownership interest in a corporation. Fixed dividend and preference in dividend payment and liquidation over equity shareholders.

 Prior to 1080s, fixed income securities were simple investment products. Holding aside default by the issuer, the investor knew how long interest would be received and when the amount borrowed would be repaid. Moreover most investors purchased these securities with the intent of holding them to their maturities date.

 Beginning in 1980s, the fixed income world changed. 1. Fixed income securities became more complex. These are many features in many fixed income securities (like embedded options) that make it difficult to determine when the amount borrowed will be repaid and for how long interest will be received. 2. The hold-to-maturity investors have been replaced by institutional investors who actively trade fixed income securities.

Indenture and Covenants

The promises of the issuer and the rights of the bondholders are set forth in great detail in a bonds indenture. As part of the indenture, there are affirmative covenants and negative covenants. Affirmative covenants set forth activities that the borrower promises to do: 1. To pay interest and principal on timely basis, 2. To pay all taxes and other claims when due; 3. To maintain all properties used and useful in the borrowers business in good condition and working order. 4. To submit periodic reports to a trustee stating that borrower is in compliance with the loan agreement.

Negative Covenants
Negative covenants set forth certain limitations and restrictions on the borrowers activities. The most common restrictive covenants are those that impose limitations on the borrowers ability to incur additional debt unless certain tests are satisfied.

Maturity
The term to maturity of a bond is the number of years the debt is outstanding or the number of years remaining prior to the final principal payment. Why it is important: 1. Term to maturity indicates the time period over which the bondholder can expect to receive interest payments and the number of years before the principal will be paid in full. 2. The yield offered on a bond depends on the term to maturity. (will discuss later) 3. The price of bond will fluctuate over its life as interest rate in the market change. (longer the maturity higher will be price volatility) (will discuss later)

Par Value
The par value of a bond is the amount that the issuer agrees to repay the bondholder at or by the maturity date. This amount is also referred to as the principal value, face value, redemption value, and maturity value. Because bonds can have a different par value, the practice is to quote the price of a bond as percentage of its par value.

Par Value
A value of 100 means 100% of par value. So for example, if the bond has a par value of $1000 and the issuer is selling for $900, this bond would be said to be selling at 90. If a bond with par value of $5000 is selling for $5500, the bond is said to be selling at ?. Notice that a bond may trade below or above its par value. Below par value : Trading at Discount Above par Value: Trading at Premium.

Par Value
Quoted Price 90 102 103 70 1/8 Price per $1 of par value (rounded) 0.9050 1.0275 Par Value ($) 1000 5000 1000 5000 Dollar Price 905.00 5137.50

 The coupon rate is called nominal rate, is the interest rate that the issuer agrees to pay each year. Coupon = Coupon Rate * Par Value Bond with $1000 of par value and 8% coupon rate will pay $1000 * 0.08 = $80 of coupon. When describing a bond of an issuer, the coupon rate is indicated along with the maturity date. 6s of 12/1/2020 means a bond with a 6% coupon rate maturing on 12/1/2020. s refers to coupon series. Coupon rate also affects the bonds price sensitivity to changes in market interest rates. Higher the coupon rate, the less the price will change in response to a change in market interest rates.

Coupon Rate

Floating Rate Securities

Coupon Rate = Reference Rate + Quoted Margin Coupon rate = 1-month LIBOR + 100 BPS. The quoted margin need not be a positive value. It can also be subtracted from the reference rate: Home Loan Interest Rate (Floating) = PLR 250 BPS.

Inverse Floaters
Inverse Floaters: these are similar to the floaters, except the coupon rate on these bonds falls when general level of interest rate rises. 14% - LIBOR

Accrued Interest and Quoted Bond Prices

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

Accrued Interest
Accrued Interest = Annual Coupon Payment Days since last coupon payment 2 Days Separating coupon payments

Example: Suppose that the coupon rate is 8% on bond of par value $1000. 30 days have been passed since the last coupon payment. If the quoted price of the bond is $990, then what should be the invoice price?
Bonds are quoted net of accrued interest in the financial pages and thus appears as &1000 at the maturity. In contrast to the bonds, stocks do not trade at flat prices with adjustments for accrued dividends. Whoever owns the stock when it goes exdividend receive the entire dividend on the ex-day. And the stock price reflect value of the upcoming dividend. The price therefore falls after the ex-dividend date.

Provisions of Bonds
Secured or unsecured Call provision Convertible provision Put provision (putable bonds) Floating rate bonds Preferred Stock

 The right to call the issue; The right of the underlying borrowers in a pool of loans to prepay principal above the scheduled principal payment; The accelerated sinking fund provision; and The cap on a floater. {The accelerated sinking fund provision is an embedded option because the issuer can call more that is necessary to meet the sinking fund requirement. (when interest rates decline below the issues coupon rate)} {The Cap of a floater can be thought of as an option requiring no action by the issuer to take advantage of a rise in the interest rate. Effectively bondholders have given the issuer the right not to pay more than Cap.)

Embedded Options Granted to Issuers

Embedded Options Granted to Bondholders..

Conversion Privilege (Convertible Debentures) It depends on market price of shares of the issuers company. Right to put the issue. Floor on Floater.