Financial Markets Assignment - Essay Example

Financial Markets Paper Assignment Introduction A large number of different assets exist into which a saver can invest cash not currently needed, and investors must choose what combination best suits their needs. Because more money is considered to bring more happiness or utility, investors generally seek to maximize the return on their investments. Although maximizing investor returns and wealth is usually assumed to increase an individual's happiness or utility, the marginal utility of wealth and consumption is normally found to decline with increases in the level of wealth and consumption. For instance, if an individual has no money, the receipt of one dollar can be used to buy a loaf of bread that might prevent death by starvation. Thus, this first dollar brings a great deal of happiness, although the individual might still be a little hungry. If the individual receives another dollar, she or he could buy a second loaf of bread and eliminate all feelings of hunger. Where will the monies be invested Although the goal of all investment is to act directly or indirectly in the best interests of some specified individual or individuals, financial institutions and other organizations often play an important part in the investment process. Institutions can assist in conducting investment transactions and in making investment decisions, as well as in making investments of their own. Investment Category Weightings And Returns Investments are frequently divided into four categories: fixed-income investments (or bonds), equities (or stocks), real assets (including real estate and commodities), and foreign assets (including foreign stocks and bonds). By 1998, however, the large increase in the market value of stocks worldwide (as well as increased privatization of state companies) had caused the market portfolio to be much more heavily weighted in equities (nearly 2-1 compared to bonds whose market value had not risen nearly as much). Data on historical average returns and return standard deviations are obtainable from various sources on the Internet (such as at ftp.jpmorgan.com). Although many of the parameter estimates for security returns may provide a meaningful perspective on the risk and return of different types of investments, it should be noted that past returns are no guarantee of future performance, especially with respect to expected returns, even over time intervals as long as several decades. However, past returns over very long time horizons can be informative. For instance, a 1987 study by Jones and Wilson indicated that $1 invested in 1870 Would have grown over the next century (by 1985) to $13,264 if invested in U.S. stocks, $340 if invested in U.S. long-term bonds, and $260 if invested in U.S. short-term money market debt (in the meantime, consumer prices had risen so that it took $8.40 to buy what $1.00 bought in 1870). Although equity returns have greatly exceeded debt returns over the entire time interval, bond returns matched those of stocks over time intervals as long as 60 years (e.g., 1872 to 1932). In another study (by Siegel in 1992), it was found that bond returns exceeded those of stock returns over another 50+ year period, from 1802 to 1861, although a dollar invested into stocks in 1802 would have grown in value to $955,000 by 1990 compared to only $5770 for long-term bonds, $2680 for short-term bonds, and $15.80 for gold (it should be mentioned that it took $11.10 in 1990 to buy what $1.00 bought in 1802). Thus, although stocks tend to average higher returns than bonds over the very long term, there is substantial risk of stocks underperforming bonds even over fairly long time horizons. On the other hand, commodity investments like gold tend to be very poor investments over long time horizons (even though they do tend to keep up with inflation) Although the return to real estate was not measured in these studies, most believe that average real estate returns have been close to that for stocks. However, many analysts feel that special valuation estimation problems for less liquid investments such as real estate cause the true volatility of real estate returns to be substantially understated in most analysis of historical data (e.g., many analysts estimate that, despite a very low standard deviation of return based on past recorded prices, real estate investments actually have volatility close to that of stocks). Different Investment Vehicles For any given investment asset, there are generally four different vehicles through which an investor can take a position. In particular, an investor can buy an asset spot or directly, buy a forward or futures contract for delivery of the asset in the future, buy an option giving the investor the right to trade the asset at a fixed price (to buy for a call option and to sell for a put option), or buy a share of an investment company that owns the asset. The latter three types of positions are commonly called derivatives. In addition to buying investment vehicles (which result in long positions), it is also possible to sell them without owning them (resulting in short positions). Investment Strategy and Philosophy Although each investment may have different characteristics, all can be valued using the discounted cash-flow approach that takes the present value of expected future cash flows. To do so, future cash flows and the appropriate discount rate must be estimated For different asset types, different procedures are used to effectively estimate the future cash flows and discount rates. General Discounted Cash-Flow Model The value of any asset is a function of the cash flows expected from the asset. These cash flows can be valued by discounting them at an appropriate interest rate. The appropriate discount rate is the minimum expected return that is required on assets with similar risk (and with other relevant characteristics). Discounting the expected cash flows by the required returns yields a value, which if paid as the price for the asset, would result in an internal rate of return (IRR) equal to the minimum required return. Victor A. Canto and Arthur B. Laffer Theory and common experience postulate that general economic factors impact stock prices in the aggregate. These same factors can have substantially different effects, depending on the size, location, and the industry groups being considered.Over the past decade, research at A. B. Laffer, V. A. Canto & Associates has focused on developing a portfolio strategy that would identify differential performance based on overall economic environment, location, and size. Given our published work, a superior portfolio strategy is one that takes into account the investment implications of the following: - Capitalization. Selection of small-capitalization rather than large-capitalization stocks will take advantage of the empirically documented differential return between small and large firms. - Location. The location of plant facilities will identify companies most likely to be affected by state and local policies. - The overall economic environment. The capital assets tax sensitivity (CATS) strategy will aid in the selection of industry groups that are favored by the economic environment. - A natural question addressed in this study is whether the three independent strategies can be combined into a single strategy. In order to determine the incremental performance added by the combination of the strategies, the first step in the analysis is to review the individual strategies. Size-Related Effects: The Small Caps It has long been conventional wisdom that investments in small firms yield greater returns than investments in the largest companies listed on the New York Stock Exchange (NYSE) and the American Stock Exchange (AMEX). 1 This understanding can be applied in a systematic way to earn above-average rates of return. These are the major implications of this research: - The smaller the average capitalization of firms in a portfolio, the better that portfolio's performance. This result holds even after adjustments are made for risk differences as measured by betas. - This result differs strongly from findings of the 1960s efficient market research that indicated that active trading strategies could not beat buyand-hold strategies. The rate of return from a portfolio consisting of small-capitalization companies was outstanding. For example, $1 invested in a small-capitalization portfolio for the period 1963-84 increased to more than $115. For the same period, a portfolio consisting of companies with the largest average capitalization grew to only $6. Superior results were found to exist at each size gradation. In general, the smaller the firms in a portfolio, the better it performed. While the superior performance of the size effect is not guaranteed, it was present in 17 out of 22 years of studies. Therefore, it should be considered an important part of an overall investment strategy. Conclusion The three portfolio strategies provide three screens for separating industries and stocks that will, on average, outperform the market. Since the screens are not mutually exclusive, the possibility exists that by combining these screens one can develop a portfolio strategy that may yield a performance that will exceed that of each of the individual portfolio strategies. In the process of selecting the various screens, the location and/or industry classification of a particular stock may not be readily available. That is why one cannot aggregate the various subgroups into a combined broad category. Similarly, since there are stocks being excluded from the grand averages, it is possible for all the subgroups included to be below average or above average in a particular year. Works Cited Ibbotson and Associates. Stocks, Bonds, Bills, and Inflation: 1998 Yearbook. Chicago: Ibbotson ( 1998). Victor A. Canto, "The State Competitive Environment: 1988-89 Update," Economy in Perspective, A. B. Laffer Associates, December 15, 1988; Victor A. Canto and Arthur B. Laffer, "The State Competitive Environment: 1989-90 Update," Economic Study, A. B. Laffer, V. A. Canto & Associates, November 14, 1989; Victor A. Canto, "The State Competitive Environment: 1990-91 Update," Economic Study, A. B. Laffer, V. A. Canto & Associates, November 28, 1990. Read More