Institutions, Investment, and Growth - Assignment Example

Investments 1. (a) Investment institutions are establishments that aid in the facilitation of financial resources from the source to users using different means as represented in three categories (Dawson, 1998, P. 603). The foregoing represents depository institutions, contractual savings institutions, and investment intermediaries. Depository institutions get a significant percentage of their funds from the deposits of customers, as represented by banks, building societies, credit unions, mortgage loan companies and trust companies (De Larosiere, 1997, Pp. 16-18). Contractual savings institutions representing a type of investment institution that receives their funds on a periodic basis via contracted arrangements. They consist of two principal types, insurance companies and pension funds that are heavy investors in that they are entrusted with large pools of funds on which they seek to earn interest in meeting their return obligations and payout expectations (Tallman, 2003, P. 748). The third category is investment intermediaries as represented by underwriters, brokers and investment funds that are primarily intermediates in the process, but also have substantial holdings (Goodchild and Callow, 2000, P. 163). (b) Depositary institutions have a responsibility to protect the funds they are entrusted with, thus their investment strategies are low on the risk-taking scale as they have to maintain liquidity on call. They are overseen by an appropriate regulatory body that oversees and restricts the types of investments and the associated risks they can undertake (Gup, 2003, Pp. 37-39). Contractual savings institutions have more defined payouts, thus their liquidity requirements are lower and more predictable. This classification has the capability of investing a higher percentage of their funds into securities, bonds, and equities that are of a longer-term duration (Chorafas, 2000, Pp. 59). Financial intermediaries are comprised of mutual funds, unit trusts, investment trusts, and hedge funds, all of which have differing strategies. Mutual funds represent the pooling of cash from a diverse group of people and companies that utilise these funds in a broad range of asset classes such as bonds, property, and equities. Unit trusts have limitations with respect to their exposure levels and thus are more conservative in their approach to investment strategy. Investment trusts seek rates if returns that are higher than the preceding as this is the rationale for their existence with investors made aware in the prospectus of the potential of losing all or part of their funds (Liaw, 1999, P. 14-15). The high-risk class of the group is found in hedge funds that engage in a broad array of investments that can range from low risk to high risk depending on the preferences of the investors and the purpose of funds (Liaw, 1999, P. 14-15). (c) Objectives in investment management represent the return level that is expected, and the tolerance for risk associated. These factors can range from high growth, high return, moderate growth, income, stability, and all manner of combinations as can the time period involved. High return entails higher risk, with these usually measured against government bonds that have high safety and low yield (Boes and Bezil, 2004, P. 32). Constraints in investment management are liquidity, the time horizon involved, tax considerations, regulations, and legal factors, along with ethical principles as defined by the investment parameters. 2. (a) The fund manager is responsible for devising the structuring the portfolio that optimises the client’s funds, Through analysis, the fund manager then looks at the return and risk factors to optimise them. Ongoing management of the portfolio another part of the fund manger’s function that adjusts the investments as circumstances warrant. Differing styles are employed by fund managers that is based on the preferences of the manner the fund was designed in terms of approach, and those of the client that includes the size of their investment capabilities (Murphy, 2000, P. 123). The differing styles of fund managers represent balanced, that seek to spread their investments across a broad plane of possibilities that leave them open to being in markets they might not have proficiency at. Specialist managers are proficient in certain classes, and what is termed as split funding manager’s use a selection of multiple balanced managers to gain a broad range of expert input. (b) Portfolios can generally be managed based upon one of the following key classes of objectives. Matching projected liabilities and through achieving or surpassing a benchmark return. Assets that are cash or near cash assets have the requirement to cover their day to day operating expenses through payments out of the fund, along with responding to unanticipated changes in those needs investments that are fixed income such as short term government bonds, provide easier access to cash if such is needed. (c) Safety first investment behaviour is based in the fund manager seeking to minimise the outcome and probability that the return achieved on the asset invested is lower than the liability payout (Galer, 2002, P. 2). This is in line with the net investor who has the same concerns 3. (a) A positive alpha seeks to attain a return that is higher than the CAPM return expected. However, fund managers prefer not to attribute any outperformance to a positive by changing the realized CAPM equation to one where represents a persistent element of outperformance as a factor of skill in investing, with differs from the random (Fong et al, 2009, P. 98). (b) An active equity investment strategy that is based on security selection seeks to outperform the market using the selection of stock chosen that can consist of varied combinations of differing security selections of large, mid, small, microstock across core, value and growth approaches (Mellon Capital Management, 2009). The security selection approach asks where the heterogeneous, as well as positive alpha, come from, with one approach represented by using fundamental analysis. Some of the ways that this is accomplished the identification of securities that will either outperform or underperform is through” 1). Earnings forecasts that are more accurate than the consensus, 2). A detailed analysis of accounting policies impact on declared profits, 3). Uncovering potential takeovers, and 4). Using ratio analysis A market timing strategy is based on getting into and out of the selections at a particular time that essentially represents placing a bet on the direction the market will move in a defined time frame (Brown and Trainor, 2003, P. 100). The fund manager in accepting the overall consensus for the portfolio of the market, however, the fund manager also believes that some of the securities in that selection are miss-priced. If the fund manager does not accept the consensus, the market timing is used, which is the pessimistic view. (c) The contrarian approach is rooted in the belief that there is a negative serial correlation in the returns that is also termed as the means of reversal. The contrarian style is based on the market overreacting to news and is strongly linked to value strategies as well as tactical asset allocation (Mason and Thomas, 2008). Under the momentum style, there is a belief in the positive correlation concerning returns whereby the positive returns will follow positive returns. Within this style is the potential for overpriced assets. (d) Property investment has high transaction costs when compared to equity and bonds. It has a legal valuation that is local incorporating estate agents and lengthy processes that add to costs that are not a feature of equity and fixed income investments. In addition, property investments have management costs such as maintenance and repair that are not applicable to equity and bonds. In addition to the foregoing property investments also are subject to high regulation that many institutional investors seek to avoid. Property investment can also be subject to government intervention as a result of areas such as tax policies. 4. (a) The yield curve represents the yield to maturity that is plotted against differing maturity dates. A flat yield curve signifies yields that are constant over differing maturities. In the instance when they are sloping upward it represents current longer-dated yields that are higher than those of short-term duration. The preceding indicates that short-term rates are expected to rise in the future. The reverse is thus true for downward sloping yields. In all instances, the yield curve shape is determined by future interest rate expectations. In the instance of bonds, which offer a stream of fixed future cash flows. The valuation of a bond the present value of all future cash flows is calculated. In bonds, the measure of future bond return falls under two conditions. The first is when the bond is held to maturity. Under this scenario, if the investment horizon is shorter then the yield will only be an approximate return. The selling of the bond in advance of maturity subjects it to market conditions active at the time. The coupons received prior to maturity can be reinvested at the yield rate due to the present value calculation assume the yield curve is flat. A sloping yield curve, as well as changes in interest rates, affects the rate at which future coupon receipts can be reinvested. The yield curve in finance represents the relationship between the cost associated with borrowing (interest rate), and the maturity date of the debt (Cocheo, 2006, P. 44). The relevancy of the yield curve to bond valuation and analysis is in the theoretical fair value of the bond as represented by the cash flows expected whereby the bond’s value is arrived at through discounting those expected returns through use of the discount rate (Jeng and McLeod, 1995, P. 21). By having the yield curve calculations, the estimation of the expected return can be projected. (b) As an investment, bonds risk is made known to the public by a rating system that provides an assessment of the creditworthiness of the issuer (Grey et al, 2006, P. 334). As an independent evaluation of the ability of a company to make payments on its debts on time, it represents the ability of the issuer to meet obligations as they come due (Grey et al, 2006, P. 334). Firms such as Moody’s Investor Service, and Standard & Poor’s are termed as being Nationally Recognised Statistical Rating Organisations that have been certified to meet the guidelines in offering ratings of issuers (Perry et al, 1991, P. 111). These ratings range from Aaa or AAA, which indicates the most creditworthy issuers, with the successive categories indicated as follows: Table 1 – Credit Rating Scale S&P Moody’s Interpretation AAA Aaa Highest quality bond AA+ / AA / AA- Aa1 / Aa2 / Aa3 High quality A+ / A / A- A1 / A2 / A3 Strong payment quality BBB+ / BBB / BBB- Baa1 / Baa2 / Baa3 Adequate capacity BB+ / BB / BB- Ba1 / Ba2 / Ba3 Likely, but uncertain B+ / B / B- B1 / B2 / B3 High Risk CCC+ / CCC / CCC- Caa1 / Caa2 / Caa3 Vulnerable to default CC / C Ca SD / D C Default. Selective As one can readily ascertain, credit ratings provide a valuable service to investors in understanding the issuer and their prospects for return. The other benefit is that issuers strive for the highest rating in order to receive favourable lending rates. (c) If interest rates rise over the next two year (using that as the duration period for the bond example), then the reinvested coupon income will be greater than expected, however, the market value of the bond will be lower than expected as a result of the bond price has fallen. In the case of interest rates falling over that two-year period, the reverse applies. Immunization represents one of four key strategies utilised in the management of bond portfolios (Viswannath, 2000). It represents the use of a strategy that matches asset and liability durations to thus minimise interest rate impact on net worth (Viswannath, 2000). It is the protection of future values, thus the uncertainty of future interest rates is an issue that immunization protects from (Viswannath, 2000). It uses the characteristics present in two of the four strategies mentioned, passive and active, which in effect hedge the position making it neutral (Viswannath, 2000). As would be expected, the upside potential is compromised for the assurance of an intended return and thus represents a safe strategy approach. 5. (a) The following three sets of bonds are calculated for their present values as indicted below: Table 2 – Present Value Calculations Bond 1 Bond 2 Bond 3 Par Value £1,000 £1,000 £1,000 Coupon 0% 7% 11% Time to Maturity 2 years 3 years 3 years Required Yield 9% 9% 9% £1,000 £816.30 £731.19 (b) The following three sets of bonds are calculated for their Macaulay Duration as indicated below: Table 2 – Macaulay Duration Calculations Bond 1 Bond 2 Bond 3 Par Value £1,000 £1,000 £1,000 Coupon 0% 7% 11% Time to Maturity 2 years 3 years 3 years Required Yield 9% 9% 9% Macaulay Duration 0.00 2.80 2.71 (c) The following three sets of bonds are calculated for their Modified Duration as indicated below: Table 2 – Modified Duration Calculations Bond 1 Bond 2 Bond 3 Par Value £1,000 £1,000 £1,000 Coupon 0% 7% 11% Time to Maturity 2 years 3 years 3 years Required Yield 9% 9% 9% 0.00 2.57 2.50 (d) In terms of the prior three bond classifications, the one that would be selected if the yield fell to 8% would be Bond 2 as the return would be the highest of the three. (e) The modified duration, as well as Macauley calculation, provides the measurement of the sensitivity of the price of a bond with respect to interest rate changes (Hovakimian and Titman, 2006, P. 357). In terms of bond prices and yields, there is an inverse relationship, whereby increases in the bond’s yield to its maturity date results in a decline in price smaller than the gains in price that are associated with a decrease in the yield of equal proportion (Hovakimian and Titman, 2006, P. 357). The longer the term, the more exposure to the potential of interest rate fluctuations. This represents the largest problem which if an investor either has to, or desires to position themselves in a long term bond arrangement can take the duration route as a means to limit the impact of interest rate changes. The foregoing represents the most foolproof strategy. References Aragones, J., Blanco, C. 2008. Incorporating Correlation Regimes in an Integrated Stressed Risk Modeling Process. 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Retrieved on 17 April 2010 from http://www.valic.com/Mutual-funds-Investment-Styles_217_14292.html Viswannath, P. 2000. Fixed Income Portfolio Management. Retrieved on 18 April 2010 from http://webpage.pace.edu/pviswanath/notes/investments/fixportf.html#Immunization Read More