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INVESTMENT AND PORTFOLIO MANAGEMENT COURSE ASSESSMENT 1 Submission deadline without penalties is 12 October 2017. Please refer to the Programme Handbook under Section Three: Teaching Learning and Assessment for the Late Penalty Scheme and Word Count Limit. This course is being delivered through the Manchester Blackboard virtual learning environment. Therefore, all assessments must be submitted through Blackboard. If you have any technical difficulties in using Blackboard, please visit the University's support page at: http://www.studentnet.manchester.ac.uk/blackboard Submitting your Assignment 1. For the main text, double or 1.5 spacing with a minimum font size of 12 must be used (Arial or other sans serif font) and be left-justified to aid accessibility and reading. 2. Please set the page size to UK A4. All pages must be numbered. 3. Please ensure to state the final word count on the front page of your work. 4. Assignments should be submitted in either Microsoft Office and/or PDF format (.doc, .docx, .pdf etc.). 5. File names should be kept simple and only contain alphanumeric characters (a-z0-9), spaces and underscores (e.g. Valid_filename_1.doc). Files with other characters such as apostrophes, brackets or commas may not be accessible by markers. 6. Please ensure you include your student number and the assignment reference (IPM/Student Number/Jul17/1) in all submitted assignments. Failure to do this may lead either to a grade not being assigned or being wrongly assigned. 7. Assignments may be uploaded only once; substitutions are not permitted and students should therefore ensure that the version uploaded is their final submission. If you are experiencing any difficulty in uploading your assignment to Blackboard, please email a copy of the assignment and a screenshot of the error message immediately to your local centre/Student Adviser. IMPORTANT: ALWAYS RETAIN A COPY OF YOUR ASSIGNMENT 1 INVESTMENT AND PORTFOLIO MANAGEMENT COURSE ASSESSMENT 1 The word limit for this assignment is 1,200. Please keep to it. In addition, we now have electronic submission of all assignments, so it is necessary for you to use one file only. The file can be Excel, Word or a pdf. Q.1 Jonathan is considering investing in security A that has offered average annual return of 14% and standard deviation of 18% and security B which has offered average annual returns of 11% and standard deviation of 14% in the recent past. (a) If the correlation between A and B is 0.35, what is the least risky combination of these two assets? (10 marks) (b) Jonathan is not happy with the portfolio risk and would like to reduce this further. Jonathan does not mind taking excess risk provided he can earn an average return of 10% from the portfolio. The returns on 90-day T-bills are around 2.50% per annum. Assuming that Jonathan can borrow and lend at the risk free rate of return, advise how much Jonathan should invest in the portfolio (comprising of security A and security B) and the risk free asset so that the combination of risky portfolio and risk free asset provides 10% return. How much would be invested in security A, security B, and the risk free asset and what would be the risk of the new portfolio? (15 marks) (Total 25 marks) Q.2 Read the enclosed article and answer (word limit maximum: 500 words) the following questions: a) Why did Tesco's price fall so significantly and which important finance theory the case relates to and why? (7 marks) b) The CEO of Tesco made the decision to announce the accounting irregularity. Should he have withheld this information since it would have a clear negative effect on share price and he had an obligation to maximize the value of these shares? (8 marks) c) What has happened to Tesco's shares since this episode? If you had invested 30% of your portfolio in food retail stocks that included Tesco's shares in 2004, how would you have reacted to this event? (10 marks) (25 marks in total) 2 Q.3. What is the price of a 365-day Treasury Bill with a face value of 1,000,000 and which has 69 days to maturity if it trades at a discount rate of 6.75% (Total 10 marks) Q.4 You own the following portfolio, which is a significant part of your wealth: My portfolio Security Yield Face Market Term Coupon Value Value (years) paid Annually US Treasury Bill $40,000 $38,384 1 0% Corporate Bond Rated Aa $135,000 $120,718.42 8 10% 12.14% Corporate Bond rated B $225,000 $179,937.8 10 12% 16.17% Corporate Bond rated Baa $75,000 $79,506.4 5 15% 13.28% Cash $15,000 to maturity a) What is the yield to maturity for the T Bill? (2 marks) b) Calculate the Macaulay duration of each of the securities, and the Macaulay duration of the portfolio? (14 marks) c) If your friend has an investment horizon of 3 years and wants to sell the portfolio at that time to use the principal + interest, what recommendations would you make regarding the composition of the portfolio? (4 marks) d) Using Excel Solver show how much would need to be invested in each instrument to obtain a portfolio Macaulay duration of 3.25 years. There are the following constraints. 1 The total investment should not change. 2 The same amount needs to be held in cash 3 A total of $200,000 market value needs to be invested in the T Bill and $40,000 in the Aa Bond. 4 Yield is maximized. (8 marks) NB Work on numbers in the above table. 3 e) Is default risk a major concern for this portfolio? (4 marks) f) The Baa rated bond has just been re-rated by one of the rating agencies and this has the impact of increasing its yield to maturity by 7 basis points. If at the same time there is a general change in interest rates so that yields rise across the whole of the yield curve by 20 basis points (including the rerated bond), what is the new value of the portfolio? (8 marks) Total (40 marks) For question 2 Between 26 August 2014 and 1 September 2014 Tesco's share price dropped 10.0%. The company was found to have overstated it profits by 263m after revenue recognition irregularities were spotted in its half-year results, with regulators including the Financial Conduct Authority (FCA) set to decide on a suitable punishment. The supermarket originally predicted its half-year trading profit would be around 1.1bn, but this figure has now been cut back by 263m - originally 250m. Tesco has subsequently launched a review of the figures to find out why its first half profit prediction was so inflated. Tesco said it discovered the overstatement of its figures, made as part of a 29 August profit warning, during its final preparations for its latest interim results, released in late October. It asked Deloitte to undertake an 'independent and comprehensive' review, which it said involved the accelerated recognition of commercial income and delayed accrual of costs. The grocery chain's usual auditors are PwC. Deloitte has completed its investigation and found that profits were overstated by 118m in the first half of this year, by 70m in the 2013-14 financial year and by 75m before that. Dave Lewis, the newly appointed group CEO, explained in a statement: 'We uncovered a serious issue and have responded accordingly. The board, my colleagues, our customers and I expect Tesco to operate with integrity and transparency and we will take decisive action as the results of the investigation become clear.' Tesco has seen its once dominant position in the UK grocery sector come under threat from these rivals with more than 10bn wiped off its market value in 2014 after announcing last year its first annual profit drop in two decades. It is this slide that lies at the heart of the aggressive accounting scandal but, rather than fix the growing problems, Tesco pushed up its numbers to make things appear healthier than they actually were. Reports suggest Tesco booked supplier contributions that were conditional on hitting sales targets that it was not going to reach. 4 It is understood that a few employees, realising these sales targets would not be hit, struck deals with suppliers to still make these payments by offering benefits in the next financial period. These benefits were kept secret and in the worst-case scenario involved Tesco actually paying money back to the supplier in the next period. Aggressive accounting in itself is acceptable within limits of course. The practice has been around for a long time, although problems started to emerge in the dotcom era around the late 1990s. The Tesco scandal has also highlighted again the perils and pressures of being a publicly traded company with a focus fixed on the short-term. Investors demand increasing performance, irrespective of the damage this might do to long-term business, innovation or customer relationships. If increases are substantial but lower than forecast, they can also react in a way that has serious repercussions. As a result, many senior executives are now so focused on avoiding this that they are focusing on investors and analysts, and not on customers or the longer-term business requirements and direction. This can lead to the problems encountered by Tesco. The damage to Tesco's reputation is already immense and further dents in sales are to be expected. It remains to be seen what the lasting damage to the business will be and Tesco has already suspended four senior executives, including UK managing director Chris Bush, while investigations continue. It is unclear whether there are other big accounting shocks hidden away, but Tesco seems likely to receive a substantial fine from the FCA. Adapted from Tesco Scandal - the perils of aggressive accounting, ACCA Global, http://www.accaglobal.com/uk/et/student/sa/features/tesco-scandal.html 5 Investments and Portfolio Management Original Thinking Applied Manchester Business School Global MBA We regret that the authors are unable to enter directly into any correspondence relating to, or arising from this Study Guide. Any comments on this work would be welcomed and should be addressed to: THE ACADEMIC DIRECTOR Manchester Business School Worldwide The University of Manchester Booth street West Manchester M15 6PB MBS Worldwide Investments and Porfolio Management Contents UNIT 1: Investments and Portfolio Management Study Guide Introduction 1 Notes for Chapter 2 - The Asset Allocation Decision 11 Notes for Chapter 1 - An Overview of the Investment Process Notes for Chapter 6 - Efficient Capital Markets Notes for Chapter 7 - An Introduction to Portfolio Management Notes for Chapter 8 - An Introduction to Asset Pricing Models Notes for Chapter 11 - Security Valuation Principles Notes for Chapter 17 - Bond Fundamentals Notes for Chapter 18 - The Analysis and Valuation of Bonds Money Market Instruments Money Market Instruments (Self-Assessed Questions) Notes for Chapter 19 - Bond Portfolio Management Strategies Notes for Chapter 15 - Equity Portfolio Management Strategies Introduction to Options and Futures (PPT Slides) Notes for Chapter 21 - Forward and Futures Contracts Notes for Chapter 22 - Option Contracts Notes for Chapter 25 - Evaluation of Portfolio Performance UNIT 2: Investment and Portfolio Management Questions and Problems 5 15 21 29 37 43 47 53 73 77 81 85 99 105 111 Answers to Questions and Problems - Introduction 115 Answers to Chapter 2 Questions and Problems 123 Answers to Chapter 7 Questions and Problems 137 Answers to Chapter 11 Questions and Problems 151 Answers to Chapter 18 Questions and Problems 163 Answers to Chapter 19 Questions and Problems 175 Answers to Chapter 21 Questions and Problems 195 Answers to Chapter 25 Questions and Problems 207 Answers to Chapter 1 Questions and Problems 117 Answers to Chapter 6 Questions and Problems 131 Answers to Chapter 8 Questions and Problems 143 Answers to Chapter 17 Questions and Problems 159 Answers to Money Market Instruments Self-Assessed Questions 171 Answers to Chapter 15 Questions and Problems 187 Answers to Chapter 22 Questions and Problems 201 Unit 1: Investments and Portfolio Management Study Guide Introduction Introduction Study Guide We regret that the authors are unable to enter directly into any correspondence relating to, or arising from this study guide. Any comments on this work would be welcomed and should be addressed to: The Academic Director MBS Booth Street West Manchester M15 6PB United Kingdom Making the most of your studies Each study guide and workbook has been designed with the learning template in mind. Support Printed study guides have been provided to support the electronic version within Blackboard. It will help your revision to check you have attempted to understand the study element in terms of its content. Blackboard is a core part of the learning process which also contains other course material, such as: Did you work through the guided questions, including any directed to personal development? Were you able to go more deeply into recommended reading materials such as cases, articles and the textbook? Were you able to connect this with your personal experiences? Welcome letters, study plans & course outlines Assignment questions Workshop preparatory documents Discussion forums are available to discuss material content. Should your study materials be incomplete, contact: materials@mbs-worldwide.ac.uk Investments and Portfolio Management module chapters and topics Introduction When you start you should have 1) Two MBS produced books Investments and Portfolio Management Studyguide Answers to Investments and Portfolio Management Questions and Problems 2) One Textbook - Analysis of Investments and Management of Portfolios by F.K. Reilly and K.C. Brown. 3) An introductory video, explaining very briefly, how to study the module. 4) Access to Blackboard to enable you to watch the Introductory video, find and submit Excel files and assignments and gather documents for the workshop. 5) A copy of the Study Schedule (plan). How to study the module The table below shows what will be covered in the module. We have also produced a separate document with a suggested study schedule (plan). YOU MAY NEED TO ADJUST THE PLAN IF YOUR WORKSHOP IS EARLY OR LATE. ASSIGNMENT 1 CANNOT BE DONE UNTIL YOU HAVE COVERED BONDS AND MONEY MARKET INSTRUMENTS. The chapters are from \"Analysis of Investments and Management of Portfolios\" by F.K. Reilly and K.C. Brown. In the Study guides, which have been produced by Professor Sunil Poshakwale and Dr Investments and Portfolio Management 2 Nick Collett, the opening paragraph tells you whether to read the studyguide chapter notes first or the actual chapter from the textbook. After completing notes and chapter then you should do the Problems and Questions, only looking at the answer when you have attempted the question! The spreadsheet for Bond valuation has an accompanying file entitled Bond and their Valuation write-up. Also, do please make sure you download and read (twice) notes and cases for the workshop. Title Topic / Document Study Plan Study Plan Introductory video Introductory video An Overview of The Investment Process Chapter 1 The Asset Allocation Decision Chapter 2 Efficient Capital Markets Chapter 6 An introduction to Portfolio Management Chapter 7 An introduction to Asset Pricing Models Chapter 8 Security Valuation Principles Chapter 11 Bond Fundamentals Chapter 17 The Analysis and Valuation of Bonds Chapter 18 Money Market Instruments Authored by Ismail Erturk and Nick Collett Bond Portfolio Management Strategies Chapter 19 Excel Spreadsheet Bond Valuation framework + write-up Spreadsheets for yields / duration etc + Word doc. Equity Portfolio Management Strategies Chapter 15 Pre workshop case reading State of South Carolina Pre workshop case reading Yale University Investments Office Pre workshop reading Powerpoint with notes: Introduction to Futures and Options Forward and Futures Contracts Chapter 21 Option Contracts Chapter 22 Evaluation of Portfolio Performance Chapter 25 Good luck. Enjoy. We look forward to meeting you at the workshop. It is a difficult subject, and therefore it would be unwise to miss the workshop. Regards, Nick and Sunil. Investments and Portfolio Management 3 Unit 1: Investments and Portfolio Management Study Guide Notes for Chapter 1 - An Overview of the Investment Process An Overview of the Investment Process Study Guide We regret that the authors are unable to enter directly into any correspondence relating to, or arising from this study guide. Any comments on this work would be welcomed and should be addressed to: The Academic Director MBS Booth Street West Manchester M15 6PB United Kingdom Making the most of your studies Each study guide and workbook has been designed with the learning template in mind. Support Printed study guides have been provided to support the electronic version within Blackboard. It will help your revision to check you have attempted to understand the study element in terms of its content. Blackboard is a core part of the learning process which also contains other course material, such as: Did you work through the guided questions, including any directed to personal development? Were you able to go more deeply into recommended reading materials such as cases, articles and the textbook? Were you able to connect this with your personal experiences? Welcome letters, study plans & course outlines Assignment questions Workshop preparatory documents Discussion forums are available to discuss material content. Should your study materials be incomplete, contact: materials@mbs-worldwide.ac.uk Notes for Chapter 1 - An Overview of the Investment Process Please read the notes before you read Chapter 1 of the book. Before we begin the discussion of the investment process, we need to understand, what investing actually involves. Investment is an activity undertaken by individuals and large institutional investors who seek to make gains on the initially invested amount. Simply put, if an investor invests in shares or bonds issued by a firm, he/she expects to earn a positive return. The returns on the investments could be earned in short or long time depending on how long an investor's time horizon and also on the reasons for investing. Investment involves a sacrifice as investors forgo the opportunity to use cash for immediate consumption and instead invest this with an aim to receive larger amount than the amount originally invested. The difference between the final amounts received by investors in excess of the original sum invested is the return they earn as a compensation for sacrificing immediate consumption. Chapter 1 deals with a number of issues in relation to the investment process by providing both theoretical and practical reasons for why individuals invest? It also explains how rates of returns and risks are calculated and what factors contribute to returns and risks. The chapter starts with an explanation of what is investment and then provides a formal definition of investment. The key issues are that investors require return that is commensurate with the time, inflation and the related uncertainty of future pay outs. The different measures of return and risk are then explained. Note that there a variety of ways in which return could be calculated and each measure of return has its pros and cons. The most interesting point here is that the widely used return measure involving calculation of arithmetic average may provide counter-intuitive answer if the returns are too volatile for a given period. Geometric mean is considered as a more robust measure of return calculation and no wonder most commonly used in the finance industry. Expected return, a measure of how much return investor require for a given level of risk, is yet another way of calculating return. It considers the uncertainty of payments and assigns a probability value to return received under each possible economic condition. The discussion in Section 1.2 of chapter 1 of the book then moves on to calculation of risk Investments and Portfolio Management 6 which is not difficult to understand since return the uncertainty measures in terms of different probabilities for each economic condition is simply subtracted from the average and this difference is squared so that variance is positive. The square root of variance is taken to calculate standard deviation which is most commonly used as a measure of risk. If an investor wants to compare several investment opportunities, then the risk/reward ratio can be calculated by simply dividing standard deviation by returns which provides an indication of how much return is earned for bearing one unit of risk. An investment with lower Coefficient of variation (CV) is considered better since it offers better returns for lower risk. How much return an investor would expect for mow much risk is the next issue dealt in the chapter. If once assumes that it is possible for investors to earn return, however, small, for bearing no risk, then all investors are expected to compare returns on a risky investment (e.g., stock) with those available at no risk. The difference between return earned on a risky asset is hence compared with risk free return which is defined as risk premium. Recall that risk is defined in terms of uncertainty of payment. Therefore, the chapter further discusses the sources of uncertainty which range from business risk to country level risk. The returns of each asset are depicted via a Security Market Line (SML) which shows various risk-return combinations that are available to investors at a given point in time in the capital market and investors will choose to invest in a combination that is consistent with their desired risk-return preference. The slope of the SML will change in response to changes in market conditions. If investors become risk averse, as has been shown by the current on-going economic crisis that followed the collapse of the US sub-prime market in 2007, then investor's required rate of return would increase. Also, the SML will shift from its original position with changes in the expectations about real growth and/or inflation. The discussion in the chapter lays down a good foundation for understanding advanced ideas related to pricing of risk and is therefore quite important for determination of the return required by investors on their investments. However, one critical idea that needs due consideration with respect to the risk-reward relationship is the economic concept of utility. Utility, despite difficulties of measurement, is a powerful concept for the simple reason that it provides a basis on which investors' preferences in terms of risk, return and growth in return can be represented. Utility is important because investor satisfaction is not a straightforward function of returns and risk! If it were, then there would be little point Investments and Portfolio Management 7 in the hundreds of fund managed investment products each designed to offer slightly different mixes of upside and downside exposure and overall return. So far as investment outcomes are concerned there are two basic assumptions. First it is generally assumed that investors prefer more return to less, (indeed their appetite for return is insatiable - they will always be made happier by more return) - and second they prefer less risk to more. Hence in Diagram XX no rational investor would be happy with investment D, which has lower returns and more risk than either investment A or B. Where an investment is better in all respects than an alternative with which it is being compared it is said to dominate the alternative. Where a dominant option exists the utility it offers is always higher than the dominated alternatives. In the diagram, C may be better than D but it certainly offers no more return and a higher level of risk than the investment represented by point B. Where an investment is superior in at least one respect and at least equal in all others again dominance occurs and C is dominated as a choice by B. Finally we can compare the investments represented by points A and B. Since B offers more return and more risk than A no situation of dominance occurs and because individuals have different appetites for risk and return, either point might rationally offer higher utility and be preferred. There is though another alternative. Perhaps an investor finds the extra return from B just compensates for the extra risk compared with A and so in this case points A and B, being of equal utility both lie on a curve, called an indifference curve, which connects up all combinations of risk and return that offer the same level of utility to a given investor. Indifference is thus a shorthand way of describing a choice situation where the alternatives offered are all equally attractive (or unattractive!) to the representative Investments and Portfolio Management 8 investor. In general indifference curves are non-linear and the slope at any point tells us the marginal rate of substitution of return for risk required to retain the same level of utility. The curvature reflects a phenomenon known as diminishing marginal utility. The more wealth an individual has the lower the utility of each additional dollar. This may explain the lavish compensation packages required to motivate chief executives of large banks (e.g., Barclays). In the same way the more return we get the less additional return is valued and the more has to be offered to persuade the investors to buy more of the asset. Between risk and return there is diminishing marginal substitutability - as we reduce risk the reduction in expected return for each additional unit of risk eliminated is falling so that even when risk becomes zero (risk free) the investor still requires a return RF. If a risk free asset such as a 3 month Treasury Bill paying RF was bought but unexpected inflation of 3% occurred the return of RF - 3% puts this investor onto a lower indifference curve which happens to include portfolio D. As a result we then know that for this investor portfolio D needs to offer 3% more return to provide the same utility as assets A or B. Understanding utility and how it affects risk-return desirability of investors is important since these ideas are used in development of portfolio theory. Below are the problems and questions which we believe will be most useful for helping your understanding of ideas discussed in chapter 1. Please see the chapter 1 folder in blackboard for suggested answers to these questions. Questions 3, 7, 10, 13, 15 Problems 3, 4, 5, 6, 9, 10, 11 Investments and Portfolio Management 9 Unit 1: Investments and Portfolio Management Study Guide Notes for Chapter 2 - The Asset Allocation Decision The Asset Allocation Decision Study Guide We regret that the authors are unable to enter directly into any correspondence relating to, or arising from this study guide. Any comments on this work would be welcomed and should be addressed to: The Academic Director MBS Booth Street West Manchester M15 6PB United Kingdom Making the most of your studies Each study guide and workbook has been designed with the learning template in mind. Support Printed study guides have been provided to support the electronic version within Blackboard. It will help your revision to check you have attempted to understand the study element in terms of its content. Blackboard is a core part of the learning process which also contains other course material, such as: Did you work through the guided questions, including any directed to personal development? Were you able to go more deeply into recommended reading materials such as cases, articles and the textbook? Were you able to connect this with your personal experiences? Welcome letters, study plans & course outlines Assignment questions Workshop preparatory documents Discussion forums are available to discuss material content. Should your study materials be incomplete, contact: materials@mbs-worldwide.ac.uk Notes for Chapter 2 - The Asset Allocation Decision Please read the notes before you read Chapter 2 of the book. According to many investment managers, asset allocation policy determines more than 90% success of the investment performance (see, Financial Planner, May 2008). It is further argued that strategic asset allocation and right combination of assets is the key to ensure good portfolio performance. Chapter 2 deals with important issues that investors need to consider while deciding on how much they should put in what type of asset. However, before asset allocation decisions can be made, investors need to carefully think about the purpose of investing. Identification and clear articulation of investment objectives is the first task since it not only aids a clear decision making in terms of security selection but also provides a way forward in terms of development of investment policy. The investment process is dynamic since the both investor needs and market conditions may change over time which would require continuous monitoring and adjustments to asset allocation to ensure that investments objectives are met. The chapter starts with a discussion about individual investor life cycle. The discussion is based on 'product life cycle' idea in the marketing literature. Here, unlike, the product is substituted by an individual investor whose preferences with regard to income and expenditure undergo changes with age. The discussion makes sense, since we know that as we grow older, we get generally more risk averse. However, risk aversion is not based purely on age alone as the income status, wealth and family may also influence how much risk an individual is prepared to take while investing their money. The other point is that the idea of investor life cycle cannot be seen in isolation of market conditions and overall macroeconomic environment. For example it will be in correct to assume that between the ages of 60 to 85, investors are necessarily in position to spend their wealth. As the current economic crisis have shown, many of the retired people in developed economies are struggling to meet their current needs as their income from pension is falling behind the increased costs of food, energy and health care. Section 2 of the chapter explains the portfolio management process where it is shown that development of a clear investment policy statement is a must before one can begin Investments and Portfolio Management 12 research on financial and economic conditions in selecting investment strategy. A clear investment policy statement also provides benchmark that would allow investors to evaluate performance of their portfolio or alternatively performance of the professional fund managers, if individuals decide to use their services. A clear articulation of investment objectives may also prevent portfolio managers from engaging in unethical behaviour. At a very basic level, investment objectives can be grouped under four main categories which are Income, Capital Appreciation, Growth of Income and Stability of the Principal amount invested. Although the investment industry often develops their own investment styles, there are mainly two goals that investors seek from investing their savings. Either they look to generate income from such investment or their aim is to achieve growth of the invested pot of money. Investors can choose among different styles, i.e., they can do so aggressively by taking more risk or moderately by taking less risk. If the overriding concern of investors is to preserve their invested savings no matter what, then they may prefer to invest conservatively. The other choice available to investors is to balance the investment objectives, income v growth and/or use a combination of investment styles aggressive v moderate. One other factor which plays a crucial role in portfolio management is the 'time'. Some securities like stocks do much better over longer time horizon than others. Hence investor's time horizon plays an important part in asset allocation decisions. Further, other investment constraints that individual investors may face, need due consideration in the asset allocation. There could be several, but the two main constraints are, need for cash (liquidity) and tax. Tax on capital gains is generally lower than tax on income in most countries and this may sway an investor's decision to invest in assets which offer good capital appreciation rather than income. Finally, in the later part of Section 2, the chapter explains how apart from taxes, inflation plays a crucial role in asset allocation decisions. History has shown that often in periods of economic and financial crisis, Gold often does better than most other assets. The current economic crisis have shown that Gold prices have sky rocketed since the onset of the crisis in 2007. We can have a long a discussion about why this is so but the long and short of this debate is that Gold represents a safety net to investors when they are uncertain about the short term future of capital markets. Regardless of the asset class, returns from investment are adversely affected by rising inflation. As an investor, you should be rightfully concerned about the impact of inflation. Therefore, it is not correct to look at nominal rates of return on your investment. What one should look at is 'real rates of returns' which are calculated after adjusting for inflation. There are, of course, inflation linked securities which would provide 'inflation Investments and Portfolio Management 13 proof' returns. However, such securities are often in short supply, particularly when in periods of rising inflation. Pension funds are one of the largest investors in capital markets. They seek both income and growth from their investments. However, investment in stock markets is less popular in some countries (e.g., Germany, Japan) and despite the overwhelming research evidence that stocks outperform most other assets over a long time periods, there is reluctance to invest in stocks. On the contrary, in countries such as the US and the UK, investing in stocks is preferred by pension funds. However, since the financial and economic crisis that started in 2007, an increasing number of pension funds have started to allocate larger proportion of their investment in bonds than in stocks. Loss of confidence about the future stock market performance and excessive volatility has dented investors' confidence. Also, both the magnitude and frequency of stock market crashes have increased in 1990's leading to a great deal of uncertainty amongst both individual and institutional investors like pension funds. Below are the problems and questions which we believe will be most useful for helping your understanding of ideas discussed in chapter 1. Please see the chapter 1 folder in blackboard for suggested answers to these questions. Questions 1, 2, 9 Problems 1, 4, 5 Investments and Portfolio Management 14 Unit 1: Investments and Portfolio Management Study Guide Notes for Chapter 6 - Efficient Capital Markets Efficient Capital Markets Study Guide We regret that the authors are unable to enter directly into any correspondence relating to, or arising from this study guide. Any comments on this work would be welcomed and should be addressed to: The Academic Director MBS Booth Street West Manchester M15 6PB United Kingdom Making the most of your studies Each study guide and workbook has been designed with the learning template in mind. Support Printed study guides have been provided to support the electronic version within Blackboard. It will help your revision to check you have attempted to understand the study element in terms of its content. Blackboard is a core part of the learning process which also contains other course material, such as: Did you work through the guided questions, including any directed to personal development? Were you able to go more deeply into recommended reading materials such as cases, articles and the textbook? Were you able to connect this with your personal experiences? Welcome letters, study plans & course outlines Assignment questions Workshop preparatory documents Discussion forums are available to discuss material content. Should your study materials be incomplete, contact: materials@mbs-worldwide.ac.uk Notes for Chapter 6 - Efficient Capital Markets Please read the notes before you read Chapter 6 of the book. Capital markets are considered efficient if the security prices reflect new information quickly and therefore the investors are able to trust the prices as the most up-to-date at which they are willing to buy or sell securities. There are important implications of the idea of efficient capital markets. One important implication of efficient market is that no investor should be able to outperform the market and earn risk-adjusted returns in excess of those implied by the prices at which securities are traded. The concept of an efficient market has stimulated both insight and controversy since its introduction to the economics and financial literature. The chapter begins by explaining why markets are expected to be efficient. The argument relies on three key points. First, there are a large number of return maximising investors who compete with each other and therefore the prices at which they trade reflect their expectations about performance of a given security. Second, information arrival process is considered random and independent. Third, buying and selling activities causes the prices to adjust to any new information that is likely to affect any security that is traded in the market. In Section 2, the chapter explain the Efficient Market hypotheses (EMH). Fama (1970) classified market efficiency into three categories namely, weak form, semi-strong form, and strong form. A market is weak form efficient if security price changes cannot be predicted based on past returns, semi-strong efficient if prices instantaneously reflect any new publicly available information, and strong form efficient if prices reflect all types of information whether available publicly or privately. The efficient market hypothesis addresses the consequences of competition in financial markets in determining the equilibrium values of financial assets. In Section 3, the chapter summarises the academic literature that has developed around testing whether stock markets are indeed efficient. One of the commonly used tests for examining whether markets are weak form efficient involves checking if stock returns are serially uncorrelated. In simple words, the subsequent price movement should be independent since information is supposed to arrive in random fashion. If the market Investments and Portfolio Management 16 comply with weak-form efficiency then no investor should be be able to develop trading strategy that would earn excess returns on the basis of past price patterns. A weaker and economically more sensible version of the hypothesis says that prices reflect information to the point where the marginal benefits of acting on the information (profits to be made) do not exceed the marginal costs (Jensen, 1978). This view led to many early tests of weak-form efficiency and has influenced the interpretations of the various anomalies in stock returns that have been documented so far (Poshakwale, 1996). Based on mixed results for and against the efficient market hypothesis Fama (1991) made changes in all the three categories. In order to cover a more general area of testing weak form market efficiency, tests for return predictability and forecasting of returns with variables like dividend yields, interest rates, etc. were included. Also issues such as cross-sectional predictability for testing asset-pricing models and anomalies like Low Price/Earning (P/E) stocks outperforming high PE stocks (Basu, 1977), Small stock portfolio outperforming large stock portfolio known as 'size effect' (Banz, 1981), seasonality of returns like the January effect (Roll, 1983) and day of the week effect (Cross, 1973; French, 1980) have been included under the theme of return predictability. In the semi-strong form of market efficiency it is assumed that the prices of securities will change immediately and rationally in response to new information and the market neither delays nor overreacts or underreacts in response to the new information. This implies that investors should not be able to earn excess risk-adjusted returns by developing trading rules based on publicly available information. When announcements of an event can to dated to the day, daily data allow precise measurement of the speed of the stock price response which is the central issue for market efficiency. Event studies have become an important part of research in capital markets since they come closest to allowing a break between market efficiency and equilibrium pricing issues and give direct and mostly supportive evidence on efficiency. Event studies such as those of Ahrony and Swary (1980), Mandelker (1974), and Kaplan (1989) document interesting regularities in response of stock prices to dividend decisions, changes in corporate control, etc. Strong-form efficiency assumes that prices fully reflect all new information whether available publicly or privately. The tests of private information help to ascertain whether such information is fully reflected in market prices. Fama (1991) reviews tests for private information and concludes that the profitability of insider trading is well documented. Insider trading refers to the use of private information to earn abnormal profits. Although, evidence that some investment analysts have insider information (Jaffe, 1974; Ippolito, 1989) is balanced by evidence that they do not (Brinson et al., 1986; Elton et al., 1991), Investments and Portfolio Management 17 there have been many cases over the years where investors have been implicated under insider trading cases (e.g., Raja Rajratnam of Galleon Hedge Fund, 2011). Several papers document empirical evidence which suggests that stock returns contain predictable components. Keim and Stamburgh (1986) find statistically significant predictability in stock prices using forecasts based on certain predetermined variables. Fama and French (1988) show that long-holding-period returns are significantly negatively serially correlated, implying that 25 to 40 percent of the variation of longer-horizon returns is predictable from the past returns. Lo and MacKinlay (1988) reject the random walk hypothesis and show that it is inconsistent with the stochastic behavior of weekly returns, especially for smaller capitalization stocks. Empirical evidence of anomalous return behavior in the form of variables like P/E ratio, marker/book value ratio (Fama and French, 1992) has defied rational economic explanation and appears to have caused many researchers to strongly qualify their views of market efficiency. In Section 4 of the chapter, attention is given to the Behavioural Finance. The efficient market hypothesis is frequently misinterpreted to imply perfect forecasting abilities. In fact, it implies only that prices reflect all available information. When we talk of efficient markets, we mean that the market is functioning well and prices are fair. Thus in assessing the efficiency of the market on the basis of observed behaviour of stock returns, and observed predictability of returns in particular, one must judge whether the observed behaviour is rational. Given the subjectivity of judgment of rational behaviour, it is not surprising that the question of whether markets are efficient is hotly debated. Behavioural finance considers that investor behaviour is not rational and instead their investment decisions are affected by psychological traits. Academic research that supports the idea claims that a number of anomalies documented in EMH literature can be explained by investor bias based on psychological characteristics. Finally in Section 5, the chapter discusses the implications of efficient capital markets for those investors who believe in their ability to outperform the market using either technical or fundamental analysis. Perhaps the most important implication of the hypothesis is that the market prices of any security reflects the true, or rational, value of security; thus in an efficient market, investors are assured that the securities they purchase are fairly priced. A precondition for this strong version of the hypothesis is that information and trading costs, the costs of getting prices to reflect information, are zero. The fact that in practice the investors have to incur trading costs and that not all behave homogenously in response to the information has led to a huge amount of research Investments and Portfolio Management 18 producing evidence for and against the proposition that financial markets are efficient. However, in spite of these controversies the efficient market hypothesis has contributed to our understanding of how and when economic and industry information is included in security prices. 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