Rift Valley University

Foreign Trade Management

Investment Management

By Dawit Haileyesus
PhD Candidate
INVESTMENTS | BODIE, KANE, MARCUS
McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
 Chapter One
Introduction
INVESTMENTS | BODIE, KANE, MARCUS
McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
 1-3

Definition of investment
• Investment is the current commitment of money or other
resources in the expectation of earning future benefits.
• The time you will spend studying a Degree also is an
investment. You are forgoing either current leisure or the
income you could be earning at a job in the expectation that
your future career will be sufficiently enhanced to justify this
commitment of time and effort.
• You sacrifice something of value now, expecting to benefit
from that sacrifice later.
INVESTMENTS | BODIE, KANE, MARCUS
 1-4

Real Assets Versus Financial Assets

• Real Assets
– Assets used to produce goods and services.
.

– Examples: Land, buildings, machines, knowledge used to produce goods and

services
• Financial Assets
– are no more than sheets of paper or, more likely, computer entries and
do not directly contribute to the productive capacity of the economy.
– If we cannot own our own auto plant (a real asset), we can still buy
shares in Hyundai or Toyota (financial assets) and, thereby, share in
the income derived from the production of automobiles.

INVESTMENTS | BODIE, KANE, MARCUS

 1-5

Financial Assets

• Three types:
1. Fixed income or debt
2. Common stock or equity
3. Derivative securities

INVESTMENTS | BODIE, KANE, MARCUS

 1-6

Fixed Income/ Debt securities

• Payments either a fixed stream of income or a stream
of income that is determined according to a specified
formula.
• Short term, highly marketable, and generally of very
low risk. Examples of securities are Treasury bills or
bank certificates of deposit (CDs). And
• Treasury bonds, as well as bonds issued by federal
agencies, state and local municipalities, and
corporations.
INVESTMENTS | BODIE, KANE, MARCUS
 1-7

Common Stock and Derivatives

• Common Stock is equity or ownership in a corporation.
– Payments to stockholders are not fixed, but depend on the success of
the firm.
– Dividends
– If the firm is successful, the value of equity will increase; if not, it will
decrease.
• Derivatives
– Value derives from prices of other securities, such as stocks and bonds
– Used to transfer risk

INVESTMENTS | BODIE, KANE, MARCUS

 1-8

The Players

• Business Firms– net borrowers

• Households – net savers

• Governments – can be both borrowers

and savers

INVESTMENTS | BODIE, KANE, MARCUS

 1-9

The Players (Ctd.)

• Financial Intermediaries: Pool and invest funds
– Investment Companies
– Banks
– Insurance companies
– Microfinance
– Pension funds

INVESTMENTS | BODIE, KANE, MARCUS

 1-10

Universal Bank Activities

Investment Banking Commercial Banking
• Underwrite new stock
and bond issues • Take deposits and
• Sell newly issued make loans
securities to public in
the primary market
• Investors trade
previously issued
securities among
themselves in the
secondary markets
INVESTMENTS | BODIE, KANE, MARCUS
 2-11

Money Market Securities

• Treasury bills: Short-term debt of government
– Bid and asked price
– 28 days or 91 days or 120 days
• Certificates of Deposit: Time deposit with a bank
• Commercial Paper: Short-term, debt of a company

INVESTMENTS | BODIE, KANE, MARCUS

 2-12

Money Market Securities

• Bankers’ Acceptances: An order to a bank by a bank’s
customer to pay a sum of money on a future date
• Eurodollars: dollar-denominated time deposits in banks.
• Repos and Reverses: Short-term loan backed by government
securities.
• Bank loans: Very short-term loans between banks

INVESTMENTS | BODIE, KANE, MARCUS

 1-13

Return and Risk from Investment

• Investors invest for anticipated future returns, but those
returns rarely can be predicted precisely.
• There will almost always be risk associated with investments.
• Actual or realized returns will almost always deviate from the
expected return anticipated at the start of the investment
period.
• Naturally, if all else could be held equal, investors would
prefer investments with the highest expected return.

INVESTMENTS | BODIE, KANE, MARCUS

 1-14

Return and Risk from Investment

• However, the no-free-lunch rule tells us that all else cannot
be held equal.
• If you want higher expected returns, you will have to pay a
price in terms of accepting higher investment risk.
• If higher expected return can be achieved without bearing
extra risk, there will be a rush to buy the high-return assets,
with the result that their prices will be driven up.

INVESTMENTS | BODIE, KANE, MARCUS

 1-15

Return and Risk

• Individuals considering investing in the asset at the now-
higher price will find the investment less attractive: If you buy
at a higher price, your expected rate of return (that is, profit
per dollar invested) is lower.
• The asset will be considered attractive and its price will
continue to rise until its expected return is no more than
commensurate with risk. At this point, investors can anticipate
a “fair” return relative to the asset’s risk, but no more.

INVESTMENTS | BODIE, KANE, MARCUS

 1-16

Return and Risk

• Similarly, if returns were independent of risk, there would be a rush to
sell high-risk assets. Their prices would fall until they eventually were
attractive enough to be included again in investor portfolios.
• We conclude that there should be a risk-return trade-off in the
securities markets, with higher-risk assets priced to offer higher
expected returns than lower-risk assets.
• When we mix assets into diversified portfolios, we need to
consider the interplay among assets and the effect of
diversification on the risk of the entire portfolio.
INVESTMENTS | BODIE, KANE, MARCUS
 1-17

Return and Risk (Ctd.)

• Diversification means that many assets are held in the portfolio
so that the exposure to any particular asset is limited. The
effect of diversification on portfolio risk, the implications for the
proper measurement of risk, and the risk-return relationship.
• These topics are the subject of what has come to be known as
modern portfolio theory.

INVESTMENTS | BODIE, KANE, MARCUS

 1-18

Return and Risk (Ctd.)

“Don’t put your Eggs

in one basket”
INVESTMENTS | BODIE, KANE, MARCUS
 CHAPTER 2
Securities Markets
INVESTMENTS | BODIE, KANE, MARCUS
McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
 2-20

Securities Markets

• Firms regularly need to raise new capital to help pay for their
many investment projects.
• Broadly speaking, they can raise funds either by borrowing
money or by selling shares in the firm.
• Investment bankers are generally hired to manage the sale of
these securities in what is called a primary market for newly
issued securities.

INVESTMENTS | BODIE, KANE, MARCUS

 2-21

Securities Markets
• Once these securities are issued, however, investors
might well wish to trade them among themselves.
• For example, you may decide to raise cash by selling
some of your shares in Apple to another investor.
• This transaction would have no impact on the total
outstanding number of Apple shares. Trades in existing
securities take place in the secondary market.

INVESTMENTS | BODIE, KANE, MARCUS

 2-22

Securities Markets
• There, any investor can choose to buy shares for his or her
portfolio. These companies are also called publicly traded,
publicly owned, or just public companies.
• Other firms, however, are private corporations, whose shares
are held by small numbers of managers and investors.

INVESTMENTS | BODIE, KANE, MARCUS

 2-23

Securities Markets
• Privately Held Firms
• A privately held company is owned by a relatively small
number of shareholders.
• When private firms wish to raise funds, they sell shares
directly to a small number of institutional or wealthy investors
in a private placement.
• private placement Primary offerings in which shares are sold
directly to a small group of institutional or wealthy investors.

INVESTMENTS | BODIE, KANE, MARCUS

 2-24

Securities Markets
• Publicly Traded Companies
• When a private firm decides that it wishes to raise capital
from a wide range of investors, it may decide to go public.
• This means that it will sell its securities to the general
public and allow those investors to freely trade those
shares in established securities markets.
• The first issue of shares to the general public is called the
firm’s initial public offering, or IPO.
INVESTMENTS | BODIE, KANE, MARCUS
 2-25

Securities Markets
• Later, the firm may go back to the public and issue
additional shares.
• A seasoned equity offering is the sale of additional
shares in firms that already are publicly traded. For
example, a sale by Apple of new shares of stock would
be considered a seasoned new issue.
• Initial public offering (IPO) First sale of stock by a
formerly private company.
INVESTMENTS | BODIE, KANE, MARCUS
 2-26

Securities Markets
• Public offerings of both stocks and bonds typically are
marketed by investment bankers who in this role are called
underwriters.
• Underwriters purchase securities from the issuing company
and resell them to the public.
• More than one investment banker usually markets the
securities. A lead firm forms an underwriting syndicate of other
investment bankers to share the responsibility for the stock
issue.
INVESTMENTS | BODIE, KANE, MARCUS
 2-27

Securities Markets
• Investment bankers advise the firm regarding the terms on which it
should attempt to sell the securities.
• A preliminary registration statement must be filed with the Securities
and Exchange Commission (SEC), describing the issue and the
prospects of the company.
• When the statement is in final form, and approved by the SEC, it is
called the prospectus. At this point, the price at which the securities
will be offered to the public is announced.
• Prospectus A description of the firm and the security it is issuing.

INVESTMENTS | BODIE, KANE, MARCUS

 2-28

Securities Markets
•

INVESTMENTS | BODIE, KANE, MARCUS

 2-29

HOW SECURITIES ARE TRADED

• Financial markets develop to meet the needs of particular traders.
• Consider what would happen if organized markets did not exist.
• Any household wishing to invest in some type of financial asset would have to
find others wishing to sell.
• Soon, venues where interested traders could meet would become popular.
Eventually, financial markets would emerge from these meeting places.
• Thus, a pub in old London called Lloyd’s launched the maritime insurance
industry. A Manhattan curb on Wall Street became synonymous with the
financial world.

INVESTMENTS | BODIE, KANE, MARCUS

 2-30

Types of Markets
• Direct search markets,
• Brokered markets,
• Dealer Markets, and
• Auction markets.

INVESTMENTS | BODIE, KANE, MARCUS

 2-31

Types of Markets
• Direct search markets
• A direct search market is the least organized market. Buyers and
sellers must seek each other out directly. An example of a transaction
in such a market is the sale of a used TV where the seller advertises
for buyers on website.
• Such markets are characterized by irregular participation and low-
priced and nonstandard goods. It would not pay for most people or
firms to specialize in such markets.

INVESTMENTS | BODIE, KANE, MARCUS

 2-32

Types of Markets
• Brokered markets In markets where trading in a good is active,
brokers find it profitable to offer search services to buyers and sellers. A
good example is the real estate market, where economies of scale in
searches for available homes and for prospective buyers make it
worthwhile for participants to pay brokers to conduct the searches.
• Brokers in particular markets develop specialized knowledge on valuing
assets traded in that market. In the primary market, investment bankers
who market a firm’s securities to the public act as brokers; they seek
investors to purchase securities directly from the issuing corporation.

INVESTMENTS | BODIE, KANE, MARCUS

 2-33

Types of Markets
• Dealer markets When trading activity in a particular type of asset
increases, dealer markets arise. Dealers specialize in various assets,
purchase these assets for their own accounts, and later sell them for a
profit from their inventory.
• The spreads between buy prices and sell prices are a source of profit.
Dealer markets save traders on search costs because market participants
can easily look up the prices at which they can buy from or sell to dealers.
• A fair amount of market activity is required before dealing in a market is an
attractive source of income. Most bonds trade in over-the-counter dealer
markets.
INVESTMENTS | BODIE, KANE, MARCUS
 2-34

Types of Markets
• Auction markets The most integrated market is an auction
market, in which all traders converge at one place (either
physically or “electronically”) to buy or sell an asset. The New
York Stock Exchange (NYSE) is an example of an auction
market.
• An advantage of auction markets over dealer markets is that
one need not search across dealers to find the best price for a
good. If all participants converge, they can arrive at mutually
agreeable prices and save the bid–ask spread.
INVESTMENTS | BODIE, KANE, MARCUS
 2-35

Types of Orders
• Market orders are buy or sell orders that are to be executed
immediately at current market prices.
• bid price The price at which a dealer or other trader is willing
to purchase a security.
• ask price The price at which a dealer or other trader will sell
a security.
• bid–ask spread The difference between the bid and asked
prices.
INVESTMENTS | BODIE, KANE, MARCUS
 2-36

Price-contingent orders
• Investors also may place orders specifying prices at which they
are willing to buy or sell a security.
• limit buy (sell) order An order specifying a price at which an
investor is willing to buy or sell a security.
• A limit buy order for Intel may instruct the broker to buy some
number of shares if and when they may be obtained at or below
a stipulated price. Conversely, a limit sell instructs the broker
to sell if and when the stock price rises above a specified limit.

INVESTMENTS | BODIE, KANE, MARCUS

 2-37

Trading Mechanisms
• An investor who wishes to buy or sell shares will place an order
with a brokerage firm. The broker charges a commission for
arranging the trade on the client’s behalf.
• Brokers have several avenues by which they can execute that
trade, that is, find a buyer or seller and arrange for the shares to
be exchanged.
• Broadly speaking, there are three trading systems employed in
the markets: over-the counter dealer markets, electronic
communication networks, and specialist markets.
INVESTMENTS | BODIE, KANE, MARCUS
 2-38

Dealer markets
• Roughly 35,000 securities trade on the over-the-counter or
OTC market. Thousands of brokers register with the Security
Exchange Commission as security dealers.
• Dealers quote prices at which they are willing to buy or sell
securities. A broker then executes a trade by contacting a
dealer listing an attractive quote.
• Before 1971, all OTC quotations were recorded manually and
published daily on so-called pink sheets.

INVESTMENTS | BODIE, KANE, MARCUS

 2-39

Over The Counter/OTC/

• In 1971, the National Association of Securities Dealers
introduced its Automatic Quotations System, or NASDAQ, to
link brokers and dealers in a computer network where price
quotes could be displayed and revised.
• While brokers could survey bid and ask prices across the
network of dealers in the search for the best trading
opportunity, actual trades required direct negotiation (often
over the phone) between the investor’s broker and the dealer
in the security.
INVESTMENTS | BODIE, KANE, MARCUS
 2-40

Electronic communication networks

(ECNs)
• Electronic communication networks allow participants to
post market and limit orders over computer networks. The limit
order book is available to all participants.
• ECNs offer several attractions. Direct crossing of trades
without using a broker-dealer system eliminates the bid–ask
spread that otherwise would be incurred.
• Instead, trades are automatically crossed at a modest cost.
ECNs are attractive as well because of the speed with which a
trade can be executed.
INVESTMENTS | BODIE, KANE, MARCUS
 2-41

Specialist markets
• Specialist systems have been largely replaced by electronic
communication networks, but as recently as a decade ago, they
were still a dominant form of market organization for trading in
stocks.
• In these systems, exchanges such as the NYSE assign
responsibility for managing the trading in each security to a
specialist.

INVESTMENTS | BODIE, KANE, MARCUS

 2-42

Specialist markets
• The specialist firm would be expected to offer to buy and sell
shares from its own inventory at a narrower bid–ask spread.
• In this role, the specialist serves as a dealer in the stock and
provides liquidity to other traders.
• In this context, liquidity providers are those who stand willing to
buy securities from or sell securities to other traders.

INVESTMENTS | BODIE, KANE, MARCUS

 2-43

REGULATION OF SECURITIES MARKETS

• Trading in securities markets in the United States is regulated
by a many of laws. The major governing legislation includes the
Securities Act of 1933 and the Securities Exchange Act of 1934.
• The 1933 act requires full disclosure of relevant information
relating to the issue of new securities. This is the act that
requires registration of new securities and issuance of a
prospectus that details the financial prospects of the firm.

INVESTMENTS | BODIE, KANE, MARCUS

 2-44

Regulation
• SEC approval of a prospectus or financial report is not an
endorsement of the security as a good investment. The SEC
cares only that the relevant facts are disclosed; investors must
make their own evaluation of the security’s value.
• One of the most contentious issues in regulation has to do with
“rules” versus “principles.” Rules based regulation attempts to
lay out specifically what practices are or are not allowed.

INVESTMENTS | BODIE, KANE, MARCUS

 2-45

Regulation
• In contrast, principles-based regulation relies on a less explicitly
defined set of understandings about risk taking, the goals of
regulation, and the sorts of financial practices considered
allowable.
• This has been the dominant approach in the U.K. and seems to
be the more popular model for regulators throughout the world.

INVESTMENTS | BODIE, KANE, MARCUS

 1-46

Chapter Three

Bond Fundamentals

INVESTMENTS | BODIE, KANE, MARCUS

 2-47

Bond Market
• Bond A security that obligates the issuer to make specified
payments to the holder over a period of time.
• A bond is a security that is issued in connection with a
borrowing arrangement. The borrower issues (i.e., sells) a bond
to the lender for some amount of cash; the bond is in essence
the “IOU” of the borrower.
• face value/ par value/ The payment to the bondholder at the
maturity of the bond.

INVESTMENTS | BODIE, KANE, MARCUS

 2-48

Bond Market
• coupon rate A bond’s annual interest payment per Birr of par
value. In pre-computer days, most bonds had coupons that
investors would clip off and present to the issuer of the bond to
claim the interest payment.
• zero-coupon bond A bond paying no coupons that sells at a
discount and provides only a payment of par value at maturity.
• These bonds are issued at prices considerably below par value,
and the investor’s return comes solely from the difference
between issue price and the payment of par value at maturity.
INVESTMENTS | BODIE, KANE, MARCUS
 2-49

Example
• To illustrate, a bond with a par value of Birr1,000 and a coupon
rate of 7.5% might be sold to a buyer for Birr1,000. The issuer
then pays the bondholder 7.5% of Birr1,000, or Birr75 per year,
for the stated life of the bond, say, 5 years.
• The Birr75 payment typically comes in two semiannual
installments of Birr38.50 each. At the end of the 5-year life of
the bond, the issuer also pays the Birr1,000 par value to the
bondholder.

INVESTMENTS | BODIE, KANE, MARCUS

 2-50

Treasury Bonds and Notes

• Treasury notes are issued with original maturities between 1
and 10 years, while Treasury bonds are issued with maturities
ranging from 10 to 30 years.
• TYPES OF TREASURY BILLS in Ethiopia:-
• 28 DAYS Birr 1,000,000,000.- December 7, 2011
• 91 DAYS Birr 955,000,000.- February 8, 2012
• 182 DAYS Birr 100,000,000.- May 9, 2012
• 364 Days Birr 100,000,000.- November 7, 2012

INVESTMENTS | BODIE, KANE, MARCUS

 2-51

Corporate Bonds
• Like the government, corporations borrow money by issuing
bonds. Most bonds are traded over the counter in a network of
bond dealers linked by a computer quotation system.
• “Rating” is the estimation of bond safety given by the three
major bond rating agencies, Moody’s, Standard & Poor’s, and
Fitch. Bonds with A ratings are safer than those rated B or
below.

INVESTMENTS | BODIE, KANE, MARCUS

 2-52

Types of corporate bonds

• Call provisions
• Some corporate bonds are issued with call provisions, allowing
the issuer to repurchase the bond at a specified call price before
the maturity date.
• Holders of called bonds forfeit their bonds for the call price,
thereby giving up the prospect of an attractive rate of interest on
their original investment. To compensate investors for this risk,
callable bonds are issued with higher coupons and promised
yields to maturity than non-callable bonds.
INVESTMENTS | BODIE, KANE, MARCUS
 2-53

Convertible bonds
• give bondholders an option to exchange each bond for a
specified number of shares of common stock of the firm. The
conversion ratio gives the number of shares for which each
bond may be exchanged.
• Convertible bonds offer lower coupon rates and stated or
promised yields to maturity than nonconvertible bonds.

INVESTMENTS | BODIE, KANE, MARCUS

 2-54

Put/Puttable bond
• A bond that the holder may choose either to exchange for par
value at some date or to extend for a given number of years.
• If the bond’s coupon rate exceeds current market yields, for
instance, the bondholder will choose to extend the bond’s life.
• If the bond’s coupon rate is too low, it will be optimal not to
extend; the bondholder instead reclaims principal, which can be
invested at current yields.

INVESTMENTS | BODIE, KANE, MARCUS

 2-55

floating-rate bonds
• Bonds with coupon rates periodically reset according to a
specified market rate.
• For example, the rate might be adjusted annually to the current
saving rate plus 0.5%. If the one-year saving rate at the
adjustment date is 7%, the bond’s coupon rate over the next
year would then be 7.5%. This arrangement means that the
bond always pays approximately current market rates.

INVESTMENTS | BODIE, KANE, MARCUS

 2-56

Other Bond issuers

• There are, of course, several issuers of bonds in addition to the
Treasury and private corporations. For example, state and local
governments issue municipal bonds. The outstanding feature of
these is that interest payments are tax-free.
• GERAD bond

INVESTMENTS | BODIE, KANE, MARCUS

 2-57

International bonds
• are commonly divided into two categories: foreign bonds and
Eurobonds.
• Foreign bonds are issued by a borrower from a country other
than the one in which the bond is sold. The bond is
denominated in the currency of the country in which it is
marketed.
• For example, if a German firm sells a dollar-denominated bond
in the U.S., the bond is considered a foreign bond.

INVESTMENTS | BODIE, KANE, MARCUS

 2-58

International Bonds
• These bonds are given colorful names based on the countries in
which they are marketed. Foreign bonds sold in the U.S. are
called Yankee bonds. Like other bonds sold in the U.S., they are
registered with the Securities and Exchange Commission.
• Yen-denominated bonds sold in Japan by non-Japanese issuers
are called Samurai bonds.
• British-pound-denominated foreign bonds sold in the U.K. are
called bulldog bonds.

INVESTMENTS | BODIE, KANE, MARCUS

 2-59

Eurobonds
• Are denominated in one currency, usually that of the issuer, but
sold in other national markets. For example, the Eurodollar
market refers to dollar-denominated bonds sold outside the U.S.
(not just in Europe), although London is the largest market for
Eurodollar bonds.
• Similarly, Euroyen bonds are yen-denominated bonds selling
outside Japan, Eurosterling bonds are pound-denominated
Eurobonds selling outside the U.K., and so on.

INVESTMENTS | BODIE, KANE, MARCUS

 2-60

Innovation in the Bond Market

• Issuers constantly develop innovative bonds with unusual
features; these issues illustrate that bond design can be
extremely flexible. Here are examples of some novel bonds.
They should give you a sense of the potential variety in security
design.

INVESTMENTS | BODIE, KANE, MARCUS

 2-61

Inverse floaters
• These are similar to the floating-rate bonds we described
earlier, except that the coupon rate on these bonds falls when
the general level of interest rates rises. Investors in these bonds
suffer doubly when rates rise.
• Not only does the present value of each dollar of cash flow from
the bond fall as the discount rate rises but the level of those
cash flows falls as well. (Of course investors in these bonds
benefit doubly when rates fall.)

INVESTMENTS | BODIE, KANE, MARCUS

 2-62

Asset-backed bonds
• Walt Disney has issued bonds with coupon rates tied to the
financial performance of several of its films. Similarly, “David
Bowie bonds” have been issued with payments tied to royalties
on some of his albums. These are examples of asset-backed
securities.
• The income from a specified group of assets is used to service
the debt. More conventional asset-backed securities are
mortgage-backed securities or securities backed by auto or
credit card loans.
INVESTMENTS | BODIE, KANE, MARCUS
 2-63

• Pay-in-kind bonds Issuers of pay-in-kind bonds may choose to

pay interest either in cash or in additional bonds. If the issuer is
short on cash, it will likely choose to pay with new bonds rather
than scarce cash.
• Catastrophe bonds These bonds are a way to transfer
“catastrophe risk” from insurance companies to the capital
markets. Investors receive compensation in the form of higher
coupon rates for taking on the risk. But in the event of a
catastrophe, the bondholders will lose all or part of their
investments. INVESTMENTS | BODIE, KANE, MARCUS
 2-64

Indexed bonds
• Indexed bonds make payments that are tied to a general price
index or the price of a particular commodity. For example,
Mexico has issued bonds with payments that depend on the
price of oil. Some bonds are indexed to the general price level.
• By tying the par value of the bond to the general level of prices,
coupon payments, as well as the final repayment of par value,
on these bonds increase in direct proportion to the consumer
price index. Therefore, the interest rate on these bonds is a risk-
free real rate.
INVESTMENTS | BODIE, KANE, MARCUS
 2-65

DEFAULT RISK
• Although bonds generally promise a fixed flow of income, that
income stream is not riskless unless the investor can be sure
the issuer will not default on the obligation. While U.S.
government bonds may be treated as free of default risk, this is
not true of corporate bonds.
• If the company goes bankrupt, the bondholders will not receive
all the payments they have been promised. Therefore, the
actual payments on these bonds are uncertain, for they depend
to some degree on the ultimate financial status of the firm.
INVESTMENTS | BODIE, KANE, MARCUS
 2-66

Default Risk
• Bond default risk is measured by Moody’s Investor Services,
Standard & Poor’s Corporation, and Fitch Investors Service, all
of which provide financial information on firms as well as the
credit risk of large corporate and municipal bond issues.
• International sovereign bonds, which also entail default risk,
especially in emerging markets, also are commonly rated for
default risk. Each rating firm assigns letter grades to reflect its
assessment of bond safety.

INVESTMENTS | BODIE, KANE, MARCUS

 2-67

Determinants of Bond Safety

• The key ratios used to evaluate safety are:
• 1. Coverage ratios. Ratios of company earnings to fixed costs.
For example, the times-interest earned ratio is the ratio of
earnings before interest payments and taxes to interest
obligations. The fixed-charge coverage ratio includes lease
payments and sinking fund payments with interest obligations to
arrive at the ratio of earnings to all fixed cash obligations. Low
or falling coverage ratios signal possible cash flow difficulties.

INVESTMENTS | BODIE, KANE, MARCUS

 2-68

Determinants of Bond Safety

• 2. Leverage ratio. Debt-to-equity ratio. A too-high leverage ratio
indicates excessive indebtedness, signaling the possibility the
firm will be unable to earn enough to satisfy the obligations on
its bonds.
• 3. Liquidity ratios. The two common liquidity ratios are the
current ratio (current assets/current liabilities) and the quick
ratio (current assets excluding inventories/current liabilities).
These ratios measure the firm’s ability to pay bills coming due
with its most liquid assets.
INVESTMENTS | BODIE, KANE, MARCUS
 2-69

Determinants of Bond Safety

• 4. Profitability ratios. Measures of rates of return on assets or
equity. Profitability ratios are indicators of a firm’s overall
performance. The return on assets or return on equity (net
income/equity) are the most popular of these measures. Firms
with higher return on assets or equity should be better able to
raise money in security markets because they offer prospects
for better returns on the firm’s investments.
• 5. Cash flow-to-debt ratio. This is the ratio of total cash flow to
outstanding debt.
INVESTMENTS | BODIE, KANE, MARCUS
 1-70

Chapter Four

Security Analysis

INVESTMENTS | BODIE, KANE, MARCUS

 2-71

Market Analysis
• Fundamental analysis The analysis of determinants of firm
value, such as prospects for earnings and dividends.
• Because the prospects of the firm are tied to those of the
broader economy, however, valuation analyses must consider
the business environment in which the firm operates.
• The international economy might affect a firm’s export
prospects, the price competition it faces from foreign
competitors, or the profits it makes on investments abroad.

INVESTMENTS | BODIE, KANE, MARCUS

 2-72

Market Analysis
• Exchange rate The rate at which domestic currency can be
converted into foreign currency.
• Gross domestic product, or GDP, is the measure of the
economy’s total production of goods and services. Rapidly
growing GDP indicates an expanding economy with ample
opportunity for a firm to increase sales.
• The unemployment rate is the percentage of the total labor
force yet to find work. The unemployment rate measures the
extent to which the economy is operating at full capacity.
INVESTMENTS | BODIE, KANE, MARCUS
 2-73

Market Analysis
• Inflation is the rate at which the general level of prices is rising.
High rates of inflation often are associated with “overheated”
economies, that is, economies where the demand for goods and
services is outstripping productive capacity, which leads to
upward pressure on prices.
• High interest rates reduce the present value of future cash
flows, thereby reducing the attractiveness of investment
opportunities. For this reason, real interest rates are key
determinants of business investment expenditures.
INVESTMENTS | BODIE, KANE, MARCUS
 2-74

Market Analysis
• The budget deficit of the federal government is the difference
between government spending and revenues. Any budgetary
shortfall must be offset by government borrowing.
• Large amounts of government borrowing can force up interest
rates by increasing the total demand for credit in the economy.
• Sentiment Consumers’ and producers’ optimism or pessimism
concerning the economy are important determinants of
economic performance.

INVESTMENTS | BODIE, KANE, MARCUS

 2-75

Business cycle
• business cycles Recurring cycles of recession and recovery.
• Peak The transition from the end of an expansion to the start of
a contraction.
• Trough The transition point between recession and recovery.
• cyclical industries industries with above-average sensitivity to
the state of the economy.
• defensive industries industries with below-average sensitivity
to the state of the economy.

INVESTMENTS | BODIE, KANE, MARCUS

 2-76

Industry Analysis
• Industry analysis is important for the same reason that market
analysis is: Just as it is difficult for an industry to perform well
when the market is ailing, it is unusual for a firm in a troubled
industry to perform well. Similarly, just as we have seen that
economic performance can vary widely across countries,
performance also can vary widely across industries.
• While we know what we mean by an industry, it can be difficult
in practice to decide where to draw the line between one
industry and another.
INVESTMENTS | BODIE, KANE, MARCUS
 2-77

Industry analysis
• sector rotation An investment strategy that entails shifting the
portfolio into industry sectors that are expected to outperform
others based on macroeconomic forecasts.

INVESTMENTS | BODIE, KANE, MARCUS

 1-78

INVESTMENTS | BODIE, KANE, MARCUS

 2-79

Industry life cycle

• This analysis suggests that a typical industry life cycle might
be described by four stages: a start-up stage characterized by
extremely rapid growth; a consolidation stage characterized by
growth that is less rapid but still faster than that of the general
economy; a maturity stage characterized by growth no faster
than the general economy; and a stage of relative decline, in
which the industry grows less rapidly than the rest of the
economy or actually shrinks.

INVESTMENTS | BODIE, KANE, MARCUS

 2-80

Industry life cycle

• Start-up stage The early stages of an industry are often
characterized by a new technology or product, such as desktop
personal computers in the 1980s, cell phones in the 1990s, or
the new generation of 4G smart phones being introduced today.
• At this stage, it is difficult to predict which firms will emerge as
industry leaders. Some firms will turn out to be wildly
successful, and others will fail altogether.
• Therefore, there is considerable risk in selecting one particular
firm within the industry.
INVESTMENTS | BODIE, KANE, MARCUS
 2-81

Industry life cycle

• Consolidation stage After a product becomes established,
industry leaders begin to emerge. The survivors from the start-
up stage are more stable, and market share is easier to predict.
• Therefore, the performance of the surviving firms will more
closely track the performance of the overall industry.
• The industry still grows faster than the rest of the economy as
the product penetrates the marketplace and becomes more
commonly used.

INVESTMENTS | BODIE, KANE, MARCUS

 2-82

Industry life cycle

• Maturity stage At this point, the product has reached its
potential for use by consumers. Further growth might merely
track growth in the general economy. The product has become
far more standardized, and producers are forced to compete to a
greater extent on the basis of price. This leads to narrower profit
margins and further pressure on profits.
• Firms at this stage sometimes are characterized as “cash cows,”
firms with reasonably stable cash flow but offering little
opportunity for profitable expansion. The cash flow is best
“milked from” rather than reinvestedINVESTMENTS
in the company.
| BODIE, KANE, MARCUS
 2-83

Industry life cycle

• Relative decline In this stage, the industry might grow at less
than the rate of the overall economy, or it might even shrink.
• This could be due to obsolescence of the product, competition
from new products, or competition from new low-cost suppliers;
consider, for example, the steady displacement of desktops by
laptops.

INVESTMENTS | BODIE, KANE, MARCUS

 1-84

INVESTMENTS | BODIE, KANE, MARCUS

 2-85

Industry life cycle

• The famous portfolio manager Peter Lynch uses an industry
classification system in a very similar spirit to the life-cycle
approach:
• Slow growers. Large and aging companies that will grow only
slightly faster than the broad economy. These firms have
matured from their earlier fast-growth phase.
• They usually have steady cash flow and pay a generous
dividend, indicating that the firm is generating more cash than
can be profitably reinvested in the firm.
INVESTMENTS | BODIE, KANE, MARCUS
 2-86

Industry life cycle

• Stalwarts. Large, well-known firms like Coca-Cola or Colgate-
Palmolive. They grow faster than the slow growers but are not
in the very rapid growth start-up stage. They also tend to be in
noncyclical industries that are relatively unaffected by
recessions.
• Fast growers. Small and aggressive new firms with annual
growth rates in the neighborhood of 20% to 25%. Company
growth can be due to broad industry growth or to an increase in
market share in a more mature industry.
INVESTMENTS | BODIE, KANE, MARCUS
 2-87

Industry life cycle

• Cyclicals. These are firms with sales and profits that regularly
expand and contract along with the business cycle. Examples
are auto companies, steel companies, or the construction
industry.
• Turnarounds. These are firms that are in bankruptcy or soon
might be. If they can recover from what might appear to be
imminent disaster, they can offer tremendous investment
returns. A good example of this type of firm would be Chrysler in
1982, when it required a government guarantee on its debt to
avoid bankruptcy. The stock price rose 15-fold in the next five
INVESTMENTS | BODIE, KANE, MARCUS
years.
 2-88

Industry life cycle

• Asset plays. These are firms that have valuable assets not
currently reflected in the stock price. For example, a company
may own or be located on valuable real estate that is worth as
much or more than the company’s business enterprises.
• Sometimes the hidden asset can be tax-loss carryforwards.
Other times the assets may be intangible. For example, a cable
company might have a valuable list of cable subscribers. These
assets do not immediately generate cash flow and so may be
more easily overlooked by other analysts attempting to value the
firm. INVESTMENTS | BODIE, KANE, MARCUS
 2-89

Industry Structure and Performance

• The maturation of an industry involves regular changes in the
firm’s competitive environment. We will examine the relationship
between industry structure, competitive strategy, and
profitability.
• Michael Porter (1980, 1985) has highlighted these five
determinants of competition: threat of entry from new
competitors, rivalry between existing competitors, price
pressure from substitute products, the bargaining power of
buyers, and the bargaining power of suppliers.
INVESTMENTS | BODIE, KANE, MARCUS
 2-90

Threat of Entry
• New entrants to an industry put pressure on price and profits.
Even if a firm has not yet entered an industry, the potential for it
to do so places pressure on prices, since high prices and profit
margins will encourage entry by new competitors.
• Therefore, barriers to entry can be a key determinant of industry
profitability. Barriers can take many forms.

INVESTMENTS | BODIE, KANE, MARCUS

 2-91

Threat of Entry
• For example, existing firms may already have secure
distribution channels for their products based on long-standing
relationships with customers or suppliers that would be costly
for a new entrant to duplicate.
• Brand loyalty also makes it difficult for new entrants to penetrate
a market and gives firms more pricing discretion. Proprietary
knowledge or patent protection also may give firms advantages
in serving a market. Finally, an existing firm’s experience in a
market may give it cost advantages due to the learning that
takes place over time. INVESTMENTS | BODIE, KANE, MARCUS
 2-92

Rivalry between existing competitors

• When there are several competitors in an industry, there will
generally be more price competition and lower profit margins as
competitors seek to expand their share of the market.
• Slow industry growth contributes to this competition since
expansion must come at the expense of a rival’s market share.

INVESTMENTS | BODIE, KANE, MARCUS

 2-93

Rivalry between existing competitors

• High fixed costs also create pressure to reduce prices since
fixed costs put greater pressure on firms to operate near full
capacity.
• Industries producing relatively homogeneous goods also are
subject to considerable price pressure since firms cannot
compete on the basis of product differentiation.

INVESTMENTS | BODIE, KANE, MARCUS

 2-94

Pressure from substitute products

• Substitute products mean that the industry faces competition
from firms in related industries. For example, sugar producers
compete with corn syrup producers.
• Wool producers compete with synthetic fiber producers. The
availability of substitutes limits the prices that can be charged to
customers.

INVESTMENTS | BODIE, KANE, MARCUS

 2-95

Bargaining power of buyers

• If a buyer purchases a large fraction of an industry’s output, it
will have considerable bargaining power and can demand price
concessions.
• For example, auto producers can put pressure on suppliers of
auto parts. This reduces the profitability of the auto parts
industry.

INVESTMENTS | BODIE, KANE, MARCUS

 2-96

Bargaining power of suppliers

• If a supplier of a key input has monopolistic control over the
product, it can demand higher prices for the good and squeeze
profits out of the industry. One special case of this issue
pertains to organized labor as a supplier of a key input to the
production process.
• The key factor determining the bargaining power of suppliers is
the availability of substitute products. If substitutes are
available, the supplier has little clout and cannot extract higher
prices.
INVESTMENTS | BODIE, KANE, MARCUS
 2-97

Company and Technical Analysis

• Book value The net worth of common equity according to a
firm’s balance sheet.
• liquidation value Net amount that can be realized by selling
the assets of a firm and paying off the debt.
• income statement A financial statement showing a firm’s
revenues and expenses during a specified period.
• economic earnings The real flow of cash that a firm could pay
out without impairing its productive capacity.

INVESTMENTS | BODIE, KANE, MARCUS

 2-98

Company and Technical Analysis

• balance sheet An accounting statement of a firm’s financial
position at a particular time.
• statement of cash flows A financial statement showing a firm’s
cash receipts and cash payments during a specified period.
• return on assets (ROA) Earnings before interest and taxes
divided by total assets.
• Return on Capital Earnings before interest and taxes divided
by long-term capital.
• return on equity (ROE) The ratio of net income/profits to
common equity. INVESTMENTS | BODIE, KANE, MARCUS
 2-99

Chapter Five
Introduction to Derivative
Market

INVESTMENTS | BODIE, KANE, MARCUS

 2-100

Futures and Forwards

• Forward contract An arrangement calling for future delivery of
an asset at an agreed-upon price.
• No money need change hands at this time. A forward contract is
simply a deferred-delivery sale of some asset with the sales
price agreed upon now.
• All that is required is that each party be willing to lock in the
ultimate price for delivery of the commodity.
• A forward contract protects each party from future price
fluctuations.
INVESTMENTS | BODIE, KANE, MARCUS
 2-101

Futures and Forwards

• Futures price The agreed-upon price to be paid on a futures
contract at maturity.
• Futures and forward contracts are traded on a wide variety of
goods in four broad categories: agricultural commodities, metals
and minerals (including energy commodities), foreign
currencies, and financial futures (fixed-income securities and
stock market indexes).

INVESTMENTS | BODIE, KANE, MARCUS

 2-102

SWAPS
• foreign exchange swap An agreement to exchange a
sequence of payments denominated in one currency for
payments in another currency at an exchange rate agreed to
today.
• interest rate swaps Contracts between two parties to trade
cash flows corresponding to different interest rates.

INVESTMENTS | BODIE, KANE, MARCUS

 2-103

Options
• Call option The right to buy an asset at a specified exercise
price on or before a specified expiration date.
• exercise or strike price Price set for calling (buying) an asset
or putting (selling) an asset.
• put option The right to sell an asset at a specified exercise
price on or before a specified expiration date.

INVESTMENTS | BODIE, KANE, MARCUS

 2-104

Option-based interest rate contracts

– Cap agreement
• a series of cash settlement interest rate options, typically based on cap interest
rate.
– Floor agreement
• makes settlement payments only when option is below the floor interest rate.

INVESTMENTS | BODIE, KANE, MARCUS

 2-105

Chapter Six
Portfolio selection,
Management and
Evaluation
INVESTMENTS | BODIE, KANE, MARCUS
 Portfolio Definition
• An investor’s portfolio is simply his/her collection of investment
assets. Once the portfolio is established, it is updated or
“rebalanced” by selling existing securities and using the proceeds to
buy new securities, by investing additional funds to increase the
overall size of the portfolio, or by selling securities to decrease the
size of the portfolio.
• Broad asset classes, such as stocks, bonds, cash, real estate,
commodities, and so on.

INVESTMENTS | BODIE, KANE, MARCUS

 Investment Alternatives
• What is stock?
– part ownership in a company
– the money you pay for shares of
stock provides equity capital for the
business

INVESTMENTS | BODIE, KANE, MARCUS

 Investment Alternatives
(continued)

• What is a bond?
– a loan to a corporation, the
federal government, or a municipality
• The interest is paid twice a
year, and the principal is
repaid at maturity (1-30 years)
• You can keep the bond until maturity or sell it
to another investor

INVESTMENTS | BODIE, KANE, MARCUS

 2-109

Investment Alternatives
• What is a mutual fund?
– investors’ money is pooled and invested by a professional fund
manager
– you buy shares in the fund
– provides diversification to reduce risk
– funds range from conservative
to extremely speculative
– match your needs with
a fund’s objective

INVESTMENTS | BODIE, KANE, MARCUS

 2-110

Portfolio management
• passive management Holding a well-diversified portfolio
without attempting to search out security mispricing.
• Cash Shorthand for virtually risk-free money market securities.
• active management Attempts to achieve returns higher than
commensurate with risk by forecasting broad markets and/or by
identifying mispriced securities.

INVESTMENTS | BODIE, KANE, MARCUS

 2-111

The Efficient Frontier

• The efficient frontier represents that set of portfolios with the
maximum rate of return for every given level of risk, or the
minimum risk for every level of return
• Frontier will be portfolios of investments rather than individual
securities
– Exceptions being the asset with the highest return and the asset with
the lowest risk

INVESTMENTS | BODIE, KANE, MARCUS

 2-112

Sources of Investment Information

• Newspapers
• Business Periodicals
• Government Publications
• Corporate Reports
• Statistical Averages
• Investor Services and newsletters
– Standard and Poor’s stock reports
– Value Line
– Moody’s investment service
INVESTMENTS | BODIE, KANE, MARCUS
Investment Philosophies

INVESTMENTS | BODIE, KANE, MARCUS

 Portfolio Evaluation
• Read your account statements
• Chart the value of your investments
• Maintain accurate and current records
• Calculate the current return %

INVESTMENTS | BODIE, KANE, MARCUS

 2-115

Thank You!
Good Luck!
INVESTMENTS | BODIE, KANE, MARCUS