Intensive Actuarial Training for Bulgaria January 2007 Lecture 15 – Principles and Types of Investment By Michael Sze, PhD, FSA, CFA

Agenda Different types of investment Organization and functioning of securities markets Different methods of investments

Different Types of Investment Fixed income investment Stocks Derivative securities Investment companies Real estate Low liquid investments

Fixed Income Investments Contractual repayment schedule By purchasing an instrument, you are LENDING money to the issuer –This money is known as PRINCIPAL In return, the borrower promises to make periodic payments (INTEREST) At maturity, repay the principal

Fixed Income Investments Savings accounts –Convenient, liquid, low risk, low return –Two basic types: passbook, certificates of deposit Capital market instruments – Traded on stock exchanges –Three basic types: Bonds of various levels of government Corporate bonds International bonds

Stocks Basic principles of common stocks –Common stock represents ownership of a firm –Shares the companies’ successes and failures –Higher risk and return, relative to fixed income securities Classified by industry, domestic, or foreign Buying foreign equities: actual investment, ADR, mutual funds

Valuation: Two Approaches Stock Valuation Discounted Cash Flow Zero Growth in Dividends Constant Growth in Dividends 2-Stage Growth in Dividends Market Multiples P/B; P/CF; P/E; P/S

Stock Purchase Decision 1.Estimate future expected cash flows D 1 2.Estimate required rate of return (CAPM): k 3.Estimate future growth: g 4.Discount future expected cash flows Estimated price P 0 = D 1 ÷ (k e – g) Make investment decision by looking at estimated price versus market price

Price Earning Ratio P/E Multiple P/E estimate = (D 1 /E 1 ) ÷ (k e – g) (D 1 /E 1 ) = Dividend payout rate DPR Earnings per share EPS = [(per share sales estimate times EBDIT%) – D – I] times (1-T) EBDIT is earnings before depreciation, interest and taxes (more stable)

Derivative Securities Derives its value from other securities, such as stocks and bonds Options –Warrants:issued by a firm giving holder right to buy firm’s stock at specified price in a period –Call:right to buy stock of a firm in a given period at a specified price –Put:right to sell stock of a firm in a given period at a specified price –Call and put are not issued by the firm

Derivative Securities (continued) Futures –Contracts for delivery of a commodity at some future date –Price of futures is determined by belief about future price of the commodity –Difference of futures from underlying asset High leverage Maturity date –Sold on stock exchanges

Investment Companies Sell and manage mutual funds Investors buy shares of these, instead of buying shares in firms Types: –Money market funds –Stock funds –Bond funds –Balance funds Diversification, professional management, liquidity, greater flexibility

Real Estate Low correlation with stocks and bonds Easiest form of investment is purchase of shares of a REIT –Investment pools specializing in a particular type of real estate –Not directly involved with property management –Traded like other securities –More liquid than direct real estate investments

Low Liquidity Assets Investments in art, antiques, stamps, coins Low liquidity, high transaction costs, high price variability High storage costs, no dividends or cash flows

Characteristics of a well- functioning securities market Provides timely and accurate information on –Price and volume of past transactions –Supply/demand for goods and services Provides liquidity, ability to buy/sell quickly at a known price Provides internal efficiency, ability to get the lowest possible transaction cost Provides external efficiency, prices rapidly adjust to new information

Organization of Securities Markets Primary capital markets –Sale:NEW issues of bonds, preferred/common stocks –Help of underwriter Origination – design, plan, and register the issue Risk bearing – guarantees price: purchase securities Distribution – sale of the issue Secondary financial markets –Bond dealers –Stock exchanges

Short Sale Sell security seller does not own –Seller borrows securities from a broker –Inform broker that of the short sale –Return securities at request of the lender or when short sale is closed out Three rules of short selling –Uptick rule: shorted in an up market –Dividend payments: by short seller –Margin: deposit margin money to guarantee the eventual repurchase

Margin Transactions Buy securities with borrowed money Brokerage firms lend their customers money with securities as collateral Margin requirement – required equity position –Initial margin requirement – e.g. 50% –Maintenance margin – e.g. 25% Margin call –Long: [(orig. price)(1 – initial margin %)]/[1 – maintenance margin %] –Short:[(orig. price)(1 + initial margin %)]/[1 + maintenance margin %]

Special Orders Stop loss –Sell order below current market price –Used to prevent greater loss of stock the person holds Stop buy –Buy order above current market price –Used in conjunction with a short sale –Used to prevent greater loss of short sale on stock price increases