INVESTMENT ANALYSIS & PORTFOLIO THEORY

Background Reasons for improvements in standards of living Major elements of businesses Human Capital Financial Capital Legal structure of a business Sole proprietorship Partnership Limited Liability and Corporations LLC Separation of Ownership and Management

Real Assets vs Financial Assets Real Assets generate goods and service Financial Assets are claims on the Real Assets and their income & allocation of income to investors Performance of Financial Assets ultimately depend on the performance of Real Assets, i.e., the economy National Wealth consists of factories, equipments, inventories i.e. Real Assets of the economy

Participants in Financial Markets Companies Individuals Governments Pension funds Investment companies Hedge Funds Venture Capital and Private Equit Financial Intermediaries Assets Liabilities

Investment Investment is current commitment of money and resources with expectation of future benefit Timing of Saving and Consumption Allocation of Risk Separation of Ownership and Management Investment Process Top-Down Bottom up

Investment Criteria Return Investment Horizon Risk Uncertainty Risk Adjusted Return Risk Premium Investor risk appetite Individual Pension fund Venture capital ………..

Capital Structure Claim on assets and cash flow of company Debt Equity Hybrid Convertible bond Preferred share Derivatives Capital Structure

Asset Classes Debt Treasury Corporate Bond Fixed Floater Convertible … Equity Share A share B Preferred Shares

Asset Classes Currency OECD Emerging Market Commodities Precious Metals Base Metals Soft Energy Timber

Frequency and Day Count Following is some common frequency of interest payment Annual Semi Annual Quarterly Monthly Day Count convention Money market = no. of days/360 Bond Market 30/360 Actual/360 Actual/Actual

Credit Spread Consider a one year loan to a risky counterparty at L + ∆ Alternatively lender can lend to another bank (riskless) at L Let probability of default be p and recovery in the case of default be R Spread ∆ should be at least such that the expected return of the two alternatives are the same: 1+ L = (1-p) (1+ L + ∆) + p(1+ L + ∆) R or (1-R)p 1-p) (1+ L + ∆) = ∆ if (1+ L + ∆) ≈ 1 then ∆ ≈(1-R)p Spread ∆ should be at least expected loss i.e. (1-Recovery)*probability of loss

Forward Rate Agreement (FRA ) & Arbitrage Pricing Suppose 6 Months rate is 2% and one year rate is 6% What should be 6x12 FRA ? Arbitrage is the process of making a profit without risking any money One way to price an asset is to determine the level at which arbitrage is not possible. For example neither 3% nor 10% are the “right” i.e., “arbitrage free” level for the FRA In both cases it is possible to make a profit without spending any money of our own

Arbitrage Process if FRA is 3% Today: Borrow $1000 at 2% for six months Invest this $1000 for 12 months at 4% In six months we owe $1000 (1+2% /2) = $1010 Borrow $1010 at 3% (FRA rate) and payoff this debt In month12 we owe $1010 (1+3%/2) = $ Our initial investment has grown to $1000 (1+4%) = $1040 Net profit without investing any of our own money = $1040-$ = $14.85

Arbitrage Process if FRA is 10% Today: Borrow $1000 at 4% for 12 months Invest this $1000 for 6 months at 2% In six months our investment becomes $1000 (1+2% /2) = $1010 Lend $1010 at 10% (FRA rate) for six months In month12 we owe $1010 (1+4%) = $1040 Our second investment has grown to $1010 (1+10%) = $ Net profit without investing any of our own money = $ $1040 = $20.5

Foreign Exchange Market Base Currency Term Currency Forward Exchange Rate Spot f = ABC/XYZ Cash Settle vs Physical Settle ABCABC(1+i) fXYZf(XYZ)(1+j)