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1、Francis&IbbotsonChapter 1:The Investment SettingThe Investment SettingFrancis&IbbotsonChapter 1:The Investment SettingCriteria used to determine whether an investment of money is investing or something else,including:Is it short-term or long-term?Is it productive or unproductive?Is it legal or illeg

2、al?Is it rational or irrational?Francis&IbbotsonChapter 1:The Investment SettingGambling occurs when Outcome is determined very quickly(a roll of the dice,for instance)A source of entertainment Outcome is not based on an economic endeavor,but,rather,random outcomes Creates risk without expectation o

3、f economic benefitSpeculation occurs when An asset is purchased with hope that price will rise rapidly,leading to quick profit Not based on random outcomes Example:Buying an IPO of a stock on the first day hoping to sell it in several days at a higher priceFrancis&IbbotsonChapter 1:The Investment Se

4、ttingMajor asset classes include Primary securities such as common and preferred stock,government bonds,corporate bonds,Treasury bills,commercial paper Derived instruments such as mutual funds,put and call options,forward and futures contracts Physical assets such as houses,land,buildings,diamonds,g

5、oldFrancis&IbbotsonChapter 1:The Investment SettingLarge international corporations have their securities traded somewhere in the world 24 hours a dayWhile other areassuch as China and Africa have a larger population than the U.S.,the U.S.has the highest Gross National Product(GNP)a measure of a nat

6、ions income However,when allocating a countrys GNP across the countrys population,the U.S.ranks 6th But after adjusting for each countrys cost of living,the U.S.ranks 2nd behind LuxembourgFrancis&IbbotsonChapter 1:The Investment SettingGlobal Stock Market CapitalizationNasdaq15%NYSE32%Europe,Africa,

7、M.East29%Asia,Pacific ex.Tokyo7%Tokyo13%South America1%Rest of N.America3%Worlds equity capital is concentrated in North America,western and central Europe and the Pacific Rim(mostly Japan)Because market prices are rather volatile,this situation can change rapidly.For instance,from 1989-1990 Japans

8、stock market was worth more than the U.S.stock market.Francis&IbbotsonChapter 1:The Investment SettingThe World Bond Market,Measured by the Issuing SectorsPrivate Placement5%Central Government35%Central Govt.Agency14%State&Local Govt.6%Corporate15%Other Domestic12%International13%Francis&IbbotsonCha

9、pter 1:The Investment SettingThe World Bond Market,By Regions of the Major IssuersU.S.Dollar50%Japanese Yen15%Euroland26%U.K.Sterling3%All other markets6%Francis&IbbotsonChapter 1:The Investment SettingValue of worlds real assets financial assetsWorlds human capital greatly exceeds combined worlds r

10、eal and financial capital Income from human capital is 80%of the worlds income Human capital represents the stock of ideas and information possessed by humans For instance,the capital contained within a tool doesnt come from the tool itself,but from the knowledge of how to build and use the toolFran

11、cis&IbbotsonChapter 1:The Investment SettingInvestable Wealth in the U.S.,$49.3 Trillion in 1998Common Stock(equities)31%Bonds25%Residential Real Estate19%Farm Real Estate6%Commercial Real Estate9%Cash+Near Cash8%Precious Metals2%Residential real estate is one of the larger investments made by U.S.c

12、itizens.However,this may change in the future.Francis&IbbotsonChapter 1:The Investment SettingIndividual investors Over 50 million in the U.S.Typically own only a few stocks with aggregate value of$15,000 Have a small impact on U.S.equities market Mostly amateurs who play the marketInstitutional inv

13、estors Include pension funds,mutual funds,life insurance companies,commercial bank trust departments,etc.In 2019 controlled 60%of market value of U.S.equities with individual investors controlling remainder Households own much of the money managed by institutional investors Frequently buy shares in

14、blocks of 10,000 or more Block trades account for 51%of volume on NYSEFrancis&IbbotsonChapter 1:The Investment SettingSectors of the U.S.Bond MarketFederal Govt.21%Govt.Agency27%Municipals9%Corporates24%Other5%International14%Francis&IbbotsonChapter 1:The Investment SettingIn determining whether a g

15、amble,a speculation or an investment has occurred,it is useful to examine the length of the holding periodEven though there are millions of individual investors,their impact on the U.S.equities market is smallInstitutional investors(such as pension funds,insurance companies,mutual funds)have a much

16、greater impact on the U.S.marketsFrancis&IbbotsonChapter 1:The Investment SettingInvestment Counsel.FirmBankSecurity Broker/DealerInsurance CompanyMutual Fund Mgmt.Co.Plan Sponsor/Endow./Foundat.Pension Consult.Firm2019 Median Salary$113,150$90,000$90,000$107,000$110,000$92,750$80,0002019 Median Bon

17、us$50,000$30,000$85,000$35,000$70,000$11,000$12,5002019 Median Non-Cash Compensation$9,000$10,000$8,000$5,000$20,000$200$2,000Median Total Compensation$185,000$128,000$185,000$150,000$196,000$104,200$95,00090th Percentile$682,265$365,111$757,108$430,769$814,603$294,412$256,250Francis&IbbotsonChapter

18、 2:Rates of ReturnRates of ReturnFrancis&IbbotsonChapter 2:Rates of ReturnInvestors want to maximize their returns(or wealth)Chapter discusses The calculation of a return Historical returns offered by different types of investmentsFrancis&IbbotsonChapter 2:Rates of ReturnGoal is to maximize what is

19、earned relative to the amount put into an investment Maximize either the Rate of returnInvestment of ValuePresent Funds Invested of Value Terminal return of rate 1 Investments terminal valuereturn of rate 1 ValuePresent Value TerminalEquivalentFrancis&IbbotsonChapter 2:Rates of ReturnSome claim weal

20、th-maximizing investors are performing harmful greedy activities Law abiding wealth maximization is beneficial to both investor and general population Seek out securities issued by firms producing high quality goods and services Capital is used to benefit general population Investors can request man

21、agement actions at stockholder meetings Helps nation compete internationally Creates new job opportunitiesFrancis&IbbotsonChapter 2:Rates of ReturnSome level of ethics is necessaryEthics concerned with standards of right and wrong Concepts of trust and fairness are relevant to investments Investors

22、trust investment firms to act in their best interest and to safeguard their assets Fairness means a level playing field and the absence of fraud Decreasing information asymmetry increases efficiency and fairnessAn investment professional should Be loyal Act with due care Keep information confidentia

23、l Avoid conflicts of interestFrancis&IbbotsonChapter 2:Rates of ReturnRate of return measures change in an investors wealth over time Measures the success or failure of the investment Measures holding period return Defined asValuePresent Income Period Holding ValuePresent ValuePresent -Value Termina

24、l r Francis&IbbotsonChapter 2:Rates of ReturnYou purchased one share of Coca-Cola one year ago for$54.You sold it today for$64,and you received dividends of$0.80 during the year Your income from dividends=80 Your capital gain is$10($64-$54)Your return is$10.80$54=20%Francis&IbbotsonChapter 2:Rates o

25、f ReturnYou purchased a U.S.T-bond for$900.One year later you sold the bond for$910.You received$35 in interest during the year.Your rate of return is5%$900$900-$35 910$You bought a six-month T-bill for$9,800 with a maturity value of$10,000.After the bond matures your six-month return is2.04%$9,800$

26、9,800-000,10$-Since there are two six-month periods in one year,your annual return is1.02042 1=1.0412 1=4.12%Francis&IbbotsonChapter 2:Rates of ReturnIf you had invested$1 on December 31,1925 in each of the following,you would haveIn some years inflation exceeds T-bill returnsleading to a drop in pu

27、rchasing power for T-bill investors.Small company stocks are the most risky,but offer the highest return.T-bills are the least riskysmoothest growth path,but lowest return.Francis&IbbotsonChapter 2:Rates of ReturnNoticeable tendency for higher risk assets to offer the higher return.Francis&IbbotsonC

28、hapter 2:Rates of ReturnWe can calculate one period rates of change for the indexes Indexincome CashflowIndexIndexr1-tt1-tttany if -Includes dividends,coupon interest on bondsFrancis&IbbotsonChapter 2:Rates of ReturnArithmetic mean return(AMR)measures average historical one-period rates of returnT1t

29、trT1 AMRCompound average rate of return,or geometric mean return(GMR)isIndexIndexGMR 1GMR 10TTTT321T321T or 1 -r 1 r 1r 1r 1 GMRor r 1 r 1r 1r 1 AMR GMR because compound interest grows more rapidly than simple interestFrancis&IbbotsonChapter 2:Rates of ReturnA three-year investment earned the follow

30、ing annual returns:YearRt120%2-10%35%5%15%31 5%10%-20%31 AMR.28%4 1 -%51%10120%1 GMR3-If you placed$100 in this investment at the beginning of year 1,at the end of the third year it would be worth-$100(1.0428)3=$113.40Francis&IbbotsonChapter 2:Rates of ReturnAn asset is riskier if Its one-period rat

31、es of return fluctuate over a wide range Such as small company stocksMeasures of risk include Variancethe average of squared deviations from AMR T1t22AMR-rtT1 rVAR -Standard deviationsquare root of variance rVAR Both measure total riskFrancis&IbbotsonChapter 2:Rates of ReturnCalculate the variance a

32、nd standard deviation of the previous example 22221 VAR r 31 0.045 0.01530.20 0.050.10 0.050.05 0.05-12.247%0.12247 0.015 SD Francis&IbbotsonChapter 2:Rates of ReturnBoth standard deviation and variance result in the same risk rankingsAdvantages of standard deviation Considers every outcome Unlike r

33、ange which only considers high and low values Well known by statisticians Programmed into calculators and software Measures the wideness of probability distributions Measure of dispersion around arithmetic mean Also widely used in mathematics,econometrics,etc.Francis&IbbotsonChapter 2:Rates of Retur

34、nExamining the historical returns and risk leads to the following observations:Large company common stocks Earn higher returns than bonds If a firm is declared bankrupt,all creditors are paid in full before common stockholders receive any proceeds Common stockholders usually receive nothing which ma

35、kes it more risky than debt Stockholders demand a higher average rate of returnFrancis&IbbotsonChapter 2:Rates of Return Small company stocks Earned highest returns of all other investments But,riskier than any of the other investments The percentage of small firms declared bankrupt is greater than

36、the percentage of large firms Investors require a higher rate of return for investing in a small firm Long-term corporate bonds Bonds issued by the U.S.Treasury are unlikely to be defaulted However,bonds issued by corporations are more likely to be defaultedFrancis&IbbotsonChapter 2:Rates of Return

37、Long-term U.S.Treasury bonds Mature about 20 years from initial offering date Involve no default risk Intermediate-term U.S.Treasury Bonds Mature about 5 years after issue date Experience smaller price fluctuations than long-term U.S.Treasury bonds U.S.Treasury bills Mature in less than one year No

38、horizon premium necessary U.S.Treasury is unlikely to default No default premium needed AKA risk-free assets Probably no other security in world with less riskFrancis&IbbotsonChapter 2:Rates of Return Opportunity cost What it could earn in its highest paying alternative use Example:The opportunity c

39、ost of attending college includes foregone wages Less obvious expenses than out-of-pocket expenses Example:The opportunity cost of holding cash rather than investing in large company stocks was 13.3%a yearFrancis&IbbotsonChapter 2:Rates of ReturnShould only invest if you expect to earn a return grea

40、ter than your cost of capital Interest expense paid for borrowed funds Cash dividend payment paid to stockholders Opportunity costsAKA required rate of return Minimum rate of return an investment must earn to increase investors wealth RRR r leads to a wealth decreaseFrancis&IbbotsonChapter 2:Rates o

41、f ReturnRequired Rate of Return(k)Sum ofappropriate risk premiumsFor T-bills,k=4.5%4.5%=Risk-free rate(RFR)For T-notes,k=5.5%4.5%=+1.0%=5.5%=Risk-free rate(RFR)+Intermediate Horizon PremiumTotal=Required rate of returnFor T-bonds,k=5.9%4.5%=+1.4%=5.9%=Risk-free rate(RFR)+Long Horizon premiumTotal=Re

42、quired rate of returnFor Corporate bonds,k=6.3%4.5%=+1.4%=+0.4%=6.3%=Risk-free rate(RFR)+Long Horizon Premium+Default PremiumTotal=Required rate of returnFrancis&IbbotsonChapter 2:Rates of ReturnRequired Rate of Return(k)Sum ofappropriate risk premiumsFor Large Cap Stocks,k=13.0%4.5%=+1.4%=+7.1%=13.

43、0%=Risk-free rate(RFR)+Long Horizon Premium+Equity Risk PremiumTotal=Required rate of returnFor Small Cap Stocks,k=14.5%4.5%=+1.4%=+7.1%=+1.5%=14.5%=Risk-free rate(RFR)+Long Horizon Premium+Equity Risk Premium+Size PremiumTotal=Required rate of returnFrancis&IbbotsonChapter 2:Rates of ReturnU.S.pens

44、ion funds are the largest investors in the world Hire professional money managersOwners/sponsors of largest pensionsU.S.Pension Fund SponsorAssets(in billions)California Public Employees Retirement System$155.82New York Common111.40California State Teachers98.40Florida State Board93.20General Motors

45、91.00Francis&IbbotsonChapter 2:Rates of ReturnFirms hired to manage pension assets includeInvestment Management FirmTax-exempt assets managed(in billions)State Street Global103Capital Guardian85Barclays Global Investors62.6Morgan Stanley Dean Witter56.4Putnam Investments33.5Janus31.6J.P.Morgan28.8UB

46、S Asset Management25.4Francis&IbbotsonChapter 2:Rates of ReturnManagers of defined benefit plans(guarantee fixed income in retirement)Have duty to maintain sufficient funds for future obligations Some funds become overfunded Should these funds be allowed to divest excess funds?Managers of defined co

47、ntribution plans(employee and employer contributions accumulate in individual accounts)Must offer at least three different funds Must seek to maximize risk-adjusted return Have a fiduciary duty to vote funds stock solely in beneficiaries interestsFrancis&IbbotsonChapter 2:Rates of ReturnInvestors wi

48、sh to maximize their wealth(return)over the long-runArithmetic mean is not a compounded return like the geometric mean AMR GMRRealized returns represent historical dataInvestors desire investments with an expected return greater than their required rate of return or hurdle rateFrancis&IbbotsonChapte

49、r 3:Introduction to ValuationChapter 3Francis&IbbotsonChapter 3:Introduction to ValuationDetermining current price of a security is easy Ask the seller Look in newspaper,television,InternetMuch more difficult to determine the value of an investment How much is an investment worth?Need to know so you

50、 can determine if the investment is over-or under-valuedChapter presents the discounted present value model to estimate value of an investment Demonstrates examples of valuing stock,bond and rental propertyFrancis&IbbotsonChapter 3:Introduction to ValuationSecurity price fluctuations may appear chao