CHAPTER 3

SELECTING INVESTMENTS IN A GLOBAL MARKET

I.The Rationale for Global Investments
A.Reasons for the expansion of investment opportunities

1.Growth and development of foreign financial markets

  1. Advances in telecommunications technology
  2. Mergers of firms and security exchanges
  1. The Case for Constructing Global Investment Portfolios
  1. Ignoring foreign markets can substantially reduce the investment choices for U.S. investors
  2. The rates of return on non-U.S. securities often have substantially exceeded those for U.S.-only securities
  3. The low correlation between U.S. stock markets and many foreign markets can help to substantially reduce portfolio risk
  1. Relative Size of U.S. Financial Markets (Exhibit 3.1)
  1. The share of the U.S. in world capital markets has dropped from about 65 percent of the total in 1969 to about 48 percent in 2000
  2. The growing importance of foreign securities in world capital markets is likely to continue
D.Rates of Return on U.S. and Foreign Securities
  1. Global Capital Markets (Exhibit 3.1)
  2. Global Bond Market Returns (Exhibit 3.2)
  3. Individual Country Risk and Return (Exhibits 3.3, 3.4, 3.5, and 3.6)
E.Risk of Combined Country Investments
  1. Correlation Coefficient - a relative measure of the relationship between two series over time. A value of +1.00 (perfect positive correlation) means the rates of return for the two investments move exactly together. A value of -1.00 (perfect negative correlation) means that the rates of return for the two investments move exactly opposite to each other. A value of 0 indicates that the movement in the rate of return on one investment has no bearing or influence on the movement in the rate of return for the other investment
  2. Global Bond Portfolio Risk (Exhibits 3.7 and 3.8)
  • Macroeconomic differences cause the correlation of bond returns between the United States and foreign countries to differ
  • The correlation of returns between a single pair of countries changes over time because the factors influencing the correlation change over time
  • Global Equity Portfolio Risk (Exhibits 3.9 and 3.10)
  • Adding foreign securities to a U.S. portfolio reduces risk by more than what a domestic diversification strategy can achieve
  • Summary on Global Investing
II.Global Investment Choices
  1. Fixed Income Investments - contractually mandated payment schedules
  2. Savings Accounts – usually no minimum balance or required term
  • Certificates of Deposits - instruments that require minimum deposits for specified terms, and pay higher rates of interest than savings accounts. Penalty imposed for early withdrawal

2.Capital Market Instruments - fixed income instruments that trade in the secondary market

  1. U.S. Treasury securities
  2. Include bills, notes, and bonds
  3. Backed by the full faith and credit of the U.S. Government
  4. U.S. Government Agency Securities
  • Are not direct obligations of the Treasury
  1. Municipal Bonds
  • Are issued by state and local governments usually to finance infrastructural projects. Exempt from taxation by the federal government and by the state that issued the bond, provided the investor is a resident of that state

Two types: general obligation bonds and revenue bonds

  1. Corporate Bonds
  • Indenture
  • Call provisions
  • Sinking fund
  1. Senior Secured Bonds
  • Mortgage Bonds
  • Collateral Trust Bonds
  • Equipment Trust Certificates
  1. Debentures
  • Unsecured bond
  1. Subordinated Bonds
  • Claims subordinate to senior secured bondholders and debenture holders
  1. Income Bonds
  • Interest payment contingent upon earning sufficient income
  1. Convertible Bonds
  • Offers the upside potential of common stock and the downside protection of a bond
  1. Zero Coupon Bonds
  • Offered at a deep discount from the face value. No interest payment during the life of the bond
  • Preferred Stock
  1. Hybrid security with some features of both bonds and stocks
  1. International Bond Investing - Investors should be aware that there is a very substantial fixed income market outside the United States that offers additional opportunity for diversification.
  2. Eurobond
  1. An international bond denominated in a currency not native to the country where it is issued
  2. Yankee Bonds
  1. U.S. dollar denominated bond, issued by foreign corporations or governments, and sold in the United States
  2. International Domestic Bonds
  1. Sold by an issuer within its own country in that country’s currency
C.Equity Instruments
  1. Common stock
  1. represents ownership of a firm
  2. Common Stock Classifications
  1. Industrials
  2. Utilities
  3. Transportation
  4. Financials
  5. Acquiring Foreign Equities
  6. Purchase or sale of American Depository Receipts (ADRs)
  • Certificates of ownership issued by a U.S. bank that represents indirect ownership of a certain number of shares of a specific foreign firm on deposit in a U.S. bank in the firm’s home country
  • Purchase or sale of American Shares
  • Direct purchase or sale of foreign shares
  • Purchase or sale of international or global mutual funds
D.Special Equity Instruments: Options – the right to buy or sell common stock of a company at a specified price within a certain period of time
  1. Warrants
  2. Puts and Calls
E.Futures Contracts
  1. Commodity Futures
  2. Financial Futures
F.Investment Companies
  1. Money Market Funds
  2. Bond Funds
  3. Common Stock Funds
  4. Balanced Funds
  5. Index Funds
  6. Exchange-Traded Funds
G.Real Estate
  1. Real Estate Investment Trusts (REITS) – Investment funds that invest in various real estate properties
  2. Construction and development trusts – Lend money required by builders during the initial construction of a building
  3. Mortgage trusts – Provide long-term financing for properties
  4. Equity trusts – Own various income-producing properties
  5. Direct Real Estate Investment
  6. Raw Land
  7. Land Development
  8. Rental Properties
H.Low Liquidity Investments
  1. Antiques
  2. Art
  3. Coins and Stamps
  4. Diamonds
  1. Historical Risk/Returns on Alternative Investments
  1. Stocks, Bonds, and T-Bills (Ibbotson-Sinquefield Study)
  2. Seven major classes of assets considered:
  3. large-company common stocks
  4. small-capitalization common stocks
  5. long-term U.S. government bonds
  6. long-term corporate bonds
  7. intermediate-term U.S. government bonds
  8. U.S. Treasury bills
  9. consumer goods (a measure of inflation)
  10. Study considered (see Exhibit 3.11):
  11. real returns on stocks and other investments
  12. the difference between arithmetic mean returns and geometric mean returns

risk premium

small stock premium

horizon premium

default premium

  1. World Portfolio Performance (Reilly and Wright Study) – Study considered (see Exhibits 3.12 and 3.13):
  2. individual asset returns and absolute risk
  3. relative asset risk
  4. correlations between asset returns
  1. Art and Antiques (Reilly Study) - Study considered (see Exhibit 3.14):
  2. returns and risk of art and antiques
  3. correlation with financial assets and with the rate of inflation
  1. Real Estate (Goetzmann and Ibbotson Study) - Study found (see Exhibits 3.15 and 3.16):
  2. CREFs has lower returns and low volatility
  3. REIT index had higher returns and risk
  4. Low positive correlation between commercial real estate and stocks
  5. Negative correlation between stocks and residential real estate and farm real estate

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