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Investment Analysis and Portfolio Management LEONARDO DA VINCI Transfer of Innovation Kristina Levišauskait÷ Investment Analysis and Portfolio Management Leonardo da Vinci programme project „Development and Approbation of Applied Courses Based on the Transfer of Teaching Innovations in Finance and Management for Further Education of Entrepreneurs and Specialists in Latvia, Lithuania and Bulgaria ” Vytautas Magnus University Kaunas, Lithuania 2010 Investment Analysis and Portfolio Management Table of Contents Introduction …………………………………………………………………………...4 1. Investment environment and investment management process…………………...7 1.1 Investing versus financing……………………………………………………7 1.2. Direct versus indirect investment …………………………………………….9 1.3. Investment environment……………………………………………………..11 1.3.1. Investment vehicles …………………………………………………..11 1.3.2. Financial markets……………………………………………………...19 1.4. Investment management process…………………………………………….23 Summary…………………………………………………………………………..26 Key-terms…………………………………………………………………………28 Questions and problems…………………………………………………………...29 References and further readings…………………………………………………..30 Relevant websites…………………………………………………………………31 2. Quantitative methods of investment analysis……………………………………...32 2.1. Investment income and risk………………………………………………….32 2.1.1. Return on investment and expected rate of return…………………...32 2.1.2. Investment risk. Variance and standard deviation…………………...35 2.2. Relationship between risk and return………………………………………..36 2.2.1. Covariance……………………………………………………………36 2.2.2. Correlation and Coefficient of determination………………………...40 2.3. Relationship between the returns on stock and market portfolio……………42 2.3.1. Characteristic line and Beta factor…………………………………….43 2.3.2. Residual variance……………………………………………………...44 Summary…………………………………………………………………………...45 Key-terms………………………………………………………………………….48 Questions and problems…………………………………………………………...48 References and further readings…………………………………………………...50 3. Theory for investment portfolio formation………………………………………...51 3.1. Portfolio theory………………………………………………………………51 3.1.1. Markowitz portfolio theory…………………………………………...51 3.1.2. The expected rate of return and risk of portfolio……………………..54 3.2. Capital Asset Pricing Model…………………………………………………56 3.3. Arbitrage Price Theory………………………………………………………59 3.4. Market Efficiency Theory……………………………………………………62 Summary…………………………………………………………………………...64 Key-terms………………………………………………………………………….66 Questions and problems……………………………………………………………67 References and further readings…………………………………………………...70 4. Investment in stocks………………….....................................................................71 4.1. Stock as specific investment……………………………………………….....71 4.2. Stock analysis for investment decision making………………………………72 4.2.1. E-I-C analysis……………………………………………………….73 4.2.2. Fundamental analysis………………………………………………..75 4.3. Decision making of investment in stocks. Stock valuation…………………..77 4.4. Formation of stock portfolios………………………………………………...82 4.5. Strategies for investing in stocks……………………………………………..84 Summary…………………………………………………………………………..87 Key-terms…………………………………………………………………………90 2 Investment Analysis and Portfolio Management Questions and problems…………………………………………………………..90 References and further readings…………………………………………………..93 Relevant websites………………………………………………………………....93 5. Investment in bonds……………………………………………………………….94 5.1. Identification and classification of bonds……………………………………94 5.2. Bond analysis: structure and contents………………………………………..98 5.2.1. Quantitative analysis…………………………………………………..98 5.2.2. Qualitative analysis…………………………………………………..101 5.2.3. Market interest rates analysis………………………………………...103 5.3. Decision making for investment in bonds. Bond valuation………………...106 5.4. Strategies for investing in bonds. Immunization…………………………...109 Summary…………………………………………………………………………113 Key-terms………………………………………………………………………..116 Questions and problems………………………………………………………….117 References and further readings………………………………………………... 118 Relevant websites………………………………………………………………..119 6. Psychological aspects in investment decision making…………………………..120 6.1. Overconfidence……………………………………………………………..120 6.2. Disposition effect…………………………………………………………...123 6.3. Perceptions of investment risk……………………………………………...124 6.4. Mental accounting and investing…………………………………………...126 6.5. Emotions and investment decisions………………………………………...128 Summary………………………………………………………………………....130 Key-terms………………………………………………………………………..132 Questions and problems………………………………………………………….132 References and further readings…………………………………………………133 7. Using options as investments……………………………………………………..135 7.1. Essentials of options………………………………………………………..135 7.2. Options pricing……………………………………………………………..136 7.3. Using options. Profit and loss on options…………………………………..138 7.4. Portfolio protection with options. Hedging………………………………...141 Summary…………………………………………………………………………143 Key-tems…………………………………………………………………………145 Questions and problems………………………………………………………….146 References and further readings…………………………………………………147 Relevant websites………………………………………………………………..147 8. Portfolio management and evaluation…………………………………………...148 8.1. Active versus passive portfolio management………………………………148 8.2. Strategic versus tactical asset allocation……………………………………150 8.3. Monitoring and revision of the portfolio…………………………………...152 8.4. Portfolio performance measures……………………………………………154 Summary…………………………………………………………………………156 Key-terms………………………………………………………………………..158 Questions and problems………………………………………………………….158 References and further readings…………………………………………………160 Relevant websites………………………………………………………………..161 Abbreviations and symbols used…………………………………………………….162 Bibliography…………………………………………………………………………164 Annexes……………………………………………………………………………...165 3 Investment Analysis and Portfolio Management Introduction Motivation for Developing the Course Research by the members of the project consortium Employers’ Confederation of Latvia and Bulgarian Chamber of Commerce and Industry indicated the need for further education courses. Innovative Content of the Course The course is developed to include the following innovative content: • Key concepts of investment analysis and portfolio management which are explained from an applied perspective emphasizing the individual investors‘decision making issues. • Applied exercises and problems, which cover major topics such as quantitative methods of investment analysis and portfolio formation, stocks and bonds analysis and valuation for investment decision making, options pricing and using as investments, asset allocation, portfolio rebalancing, and portfolio performance measures. • Summaries, Key-terms, Questions and problems are provided at the end of every chapter, which aid revision and control of knowledge acquisition during self-study; • References for further readings and relevant websites for broadening knowledge and analyzing real investment environment are presented at the end of every chapter. Innovative Teaching Methods of the Course The course is developed to utilize the following innovative teaching methods: • Availability on the electronic platform with interactive learning and interactive evaluation methods; • Active use of case studies and participant centered learning; • Availability in modular form; • Utilizing two forms of learning - self-study and tutorial consultations; • Availability in several languages simultaneously. Target Audience for the Course The target audience is: entrepreneurs, finance and management specialists from Latvia, Lithuania and Bulgaria. 4 Investment Analysis and Portfolio Management The course assumes little prior applied knowledge in the area of finance. The course is intended for 32 academic hours (2 credit points). Course Objectives Investment analysis and portfolio management course objective is to help entrepreneurs and practitioners to understand the investments field as it is currently understood and practiced for sound investment decisions making. Following this objective, key concepts are presented to provide an appreciation of the theory and practice of investments, focusing on investment portfolio formation and management issues. This course is designed to emphasize both theoretical and analytical aspects of investment decisions and deals with modern investment theoretical concepts and instruments. Both descriptive and quantitative materials on investing are presented. Upon completion of this course the entrepreneurs shall be able: • to describe and to analyze the investment environment, different types of investment vehicles; • to understand and to explain the logic of investment process and the contents of its’ each stage; • to use the quantitative methods for investment decision making – to calculate risk and expected return of various investment tools and the investment portfolio; • to distinguish concepts of portfolio theory and apply its’ principals in the process of investment portfolio formation; • to analyze and to evaluate relevance of stocks, bonds, options for the investments; • to understand the psychological issues in investment decision making; • to know active and passive investment strategies and to apply them in practice. The structure of the course The Course is structured in 8 chapters, covering both theoretical and analytical aspects of investment decisions: 1. Investment environment and investment process; 2. Quantitative methods of investment analysis; 3. Theory of investment portfolio formation; 4. Investment in stocks; 5 Investment Analysis and Portfolio Management 5. Investment in bonds; 6. Psychological
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