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Intensive Actuarial Training for Bulgaria January 2007

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.

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Intensive Actuarial Training for Bulgaria January 2007

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

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

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

  4. 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

  5. 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

  6. 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

  7. Valuation: Two Approaches

  8. Stock Purchase Decision • Estimate future expected cash flows D1 • Estimate required rate of return (CAPM): k • Estimate future growth: g • Discount future expected cash flows Estimated price P0 = D1÷ (ke – g) Make investment decision by looking at estimated price versus market price

  9. Price Earning Ratio P/E Multiple • P/Eestimate = (D1/E1) ÷ (ke – g) • (D1/E1) = 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)

  10. 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

  11. 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

  12. 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

  13. 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

  14. 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

  15. 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

  16. 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

  17. 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

  18. 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 %]

  19. 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

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