FINANCE 261 LECTURE SUMMARY 1

WHAT IS AN INVESTMENT? AN INVESTMENT is a current commitment of funds to assets that will be held over some future time period in the expectation of earning a return sufficient to compensate for (i) the time resources are committed called the pure rate of interest (ii) (iii) the expected rate of inflation the risk involved.

The investment process involves deciding (a) how much current wealth should be saved (b) which assets to invest in (allocation decision)

Our main interest is in FINANCIAL ASSETS, (SECURITIES), paper or electronic records that - describe the nature of the commitment, and - provide a claim on the issuer (i) and (ii) are approx constant across all investments but risk can vary greatly selecting between investments can be viewed as choosing between different E(return) /risk trade-offs Risk averse investors require compensation for bearing risk the higher the risk, the higher the required rate of return Risk: The possibility that the realised return will differ from the expected return

INVESTMENT ALTERNATIVES: OVERVIEW Different ways of investing in financial assets

1. DIRECT INVESTMENT

THE SHORT TERM MONEY MARKET Treasury Bills Commercial Bills FIXED INCOME CAPITAL MARKET Govt/local body Stock Company Debentures (Bonds) Capital notes EQUITY MARKET Ordinary Shares DERIVATIVE MARKETS Options, Futures These instruments differ in their expected return, risk, liquidity and marketability.
2

Ex-Ante Return Risk Trade Off Expected Return

Futures Options Shares Commercial Bills

Rf 0

Government Bonds

Risk

2. INDIRECT INVESTMENT

MANAGED FUNDS
Unit Trusts/Group Investment Funds Superannuation Funds Exchange traded funds

Comprise a portfolio of shares that trades in the market as if it was a single security.

The fund usually tracks a market index i.e. the fund contains shares in the same proportions as a market index.
www.nzx.com/education/investment_products

3. GLOBAL INVESTMENT OPPORTUNITIES

- Institutional & overseas investors are important - Around the clock investment possible - The internet has revolutionised flow of investment info and lowered trading costs

THE MONEY MARKET A market for the purchase and sale of short term debt instruments; highly liquid, relatively low risk

A means of lending/borrowing temporary excess funds Maturities generally less than 12 months, typically Provides interbank liquidity and large scale corporate working capital

TREASURY BILLS Short term low risk Govt debt issued by RBNZ Maturities 7 to 240 days Traded in parcels of $1m Redeemable at par on maturity Priced on a yield basis, generally stated as a rate p.a. Sold by the Govt at a discount from face value Key role in liquidity management Example: 90 day $1000 par value T bill issued at $950
5

What is the T-Bills annual yield?

annualised yield = 1000 - 950 365 x x 100 = 21.35% p.a. 950 90

face value - market price market price

Called a pure discount security - i.e return is in the form of a discount This is the annual percentage method of calculating yields; often used when the term is less than 1 year In contrast, the effective annual rate of interest on the 90 day T bill is calculated as:
1 + 1000 950 950
r 1+ m
m

365/90

- 1

= 23.1% p.a.

r = annual percentage interest rate m = frequency of compounding p.a.

6

How do we calculate the value of a bill? A 182 day bill is yielding r=10.84% p.a. How much will it cost you to buy?
Future Value 1000 = = $948.72 182 d 1+.1084 x 1+ r x 365 365

PV =

d = number of days to maturity If we purchased the bill at $948.72 and held it the 182 days to maturity our return would be 10.84% p.a. Once purchased bills can be re-sold on the secondary market Example: Assume you bought the 182 day bill at a yield of 10.84% p.a. You then sell it after 122 days at a yield of 9% p.a. What was your return p.a?

Selling price =

Future Value 1000 = = $985.42 60 d 1+.09 x 1+ r x 365 365

Psell 365 Re alised Yield (%) = 1 x 122 x 100 Pbuy 985.42 365 = 1 x x 100 = 11.57% p.a. 948.72 122

COMMERCIAL BILLS Document comprising a promise by the borrower to repay the lender Sold at discount from face value A source of short term borrowing and lending for companies, financial institutions, local bodies Maturities: usually 90 days, may range from 30270 days
8

You wish to borrow about $500,000 for 90 days

You issue (sell) a 90 day bill at $489,593, and promise to repay face value ($500,000) on maturity

The buyer of the bill lends $489,593 to you

The holder (buyer) usually re-sells (rediscounts) the bill in the market before maturity

If repayment of the bill is accepted (guaranteed) by a registered bank it is called a

It has higher security than a non-bank bill

How do commercial bills work?

borrower (issues/sells) lender (buys) re-sells holder 2 re-sells

Borrower receives mkt price of bill holder 3 Repayt of $500,000 (face value) at maturity Holds bill to maturity

If the borrower defaults holders 1 and 2 are contingently liable to repay the face value of the bill.

Bank Accepted Bill: At Maturity

issuer final holder

repays face value

issuer reimburses bank

Bank

10

Example: The NZ Herald reports 90 day bank bills are priced to yield 6.78% p.a. What is the value of the bill?
Future Value 500,000 = = $491,778.5 5 90 90 1 + .0678 x 1+ r x 365 365

PV =

If market interest rates increased to 7.5% p.a. how does this affect 90 day bill prices?

Bill prices would fall to $490,921.32 The holder would make a loss of $857.23 Why? Bond and bill prices move inversely to yields

11

THE FIXED INCOME CAPITAL MARKET

Debt securities which provide a fixed interest (coupon) rate plus repayment of principal at maturity - Maturities > 1 year - Sold by companies/Govt to raise money - Listed debt traded on NZX Debt Market See www.nzx.com/nzxmarket/nzdx Quoted on a yield to maturity basis The minimum return expected from holding the bond to maturity and re-investing all cash flows Since this is a market based return it also measures investors required return

Interest rates are quoted on a points basis

12

Example: NZ GOVERNMENT STOCK Face value: $10,000 Minimum tradable parcel of $1,000,000 Govt stock 7/09 selling to yield 6.09% p.a. Two weeks ago was yielding 6.02%

A fall of .07% or 7 basis points (.0007) One basis point is

Revision Example: Assume a bond has a 10% p.a. coupon, a nominal (par or face) value of $1,000 Interest paid annually on 4/3 Issued on 5/3/03, expires on 4/3/09 At what price should the bond sell today (assume 5/3/06) assuming investors' required rates of return are 6%?

13

Answer: the bond should sell for $1,106.92 OR 110.69% of face value Price of a debt security is stated as a % of its face value

DEBENTURES Company debt secured by charge against the companys assets

A trustee looks after the debenture holders interests which are specified in a trust deed

UNSECURED NOTES Medium long term unsecured debt issued by companies

14

Other major investment alternatives comprise: The EQUITY (SHARE) MARKET The DERIVATIVES MARKET

Derivatives are securities whose value depends on another security

Examples are: Share Options these give the right, but not the obligation, to buy/sell a parcel of shares in the future at a price specified now

Futures the obligation to buy/sell an asset in the future at a price specified now

15

Appendix: Revision Examples

Fixed Interest Investments: Assume a bond has a 10% p.a. coupon, a nominal (par or face) value of $1,000 Interest paid annually on 4/3 Issued on 5/3/04, expires on 4/3/10

At what price should it be selling on 5/3/07 if investors required rate of return is 6%?
PV2007 = Cash Flow 1( 2008 ) C F2 ( 2009 ) C F3 ( 2010 ) + + (1 + r )1 (1 + r )2 (1 + r )3

100 100 1100 + + = (1.06) 1 (1.06) 2 (1.06) 3

= $1,106.92 = 110.69% of face value Now assume a year goes by. It is now 5/3/08 and required rates of return have increased to 7%

16

VALUE THE BOND at 5/3/08 and CALCULATE THE RETURN over the year 5/3/07 to 4/3/08 Value at 5/3/08 is: 100 1100 PV = + = $1054 .24 2 1.07 (1.07) TOTAL RETURN over the year is given by
Pt Pt 1 + interest 1054.24 1106.92 + 100 Rt = = = 4.27% Pt 1 1106.92

This is called a holding period return

To calculate the RETURNS we use MARKET PRICES to measure the CHANGE in the VALUE OF THE INVESTMENT and add INTEREST INCOME This bond is priced at a premium (above par)

17

Selling price depends on market interest rates, credit rating (risk), tax status, maturity terms The investor made the investment EXPECTING a return of 6%. The ACTUAL return was 4.27%! What caused this difference?

As interest rates change the realised (actual) return will differ from the expected return.

18

19