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Revision Notes for Investments , Ninth Canadian Edition

Revision Notes for Investments, Ninth Canadian Edition highlights essential lecture points, providing you with clear and easy-to-digest summaries.

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    Bodie et al. Investments 9th Canadian Edition Instructor’s Manual 1 - 1 CHAPTER ONE THE INVESTMENT ENVIRONMENT CHAPTER OVERVIEW The student is introduced to the general concept of investing — to forego spending cash today in the hopes of increasing wealth in the future. Real assets are differentiated from financial assets, and the major categories of financial assets are defined. The risk/return tradeoff and the reality that most assets are efficiently priced most of the time are introduced. The role of financial intermediaries is discussed. The chapter concludes with a presentation of the financial crisis of 2008, its cause s and its implications, as well as regulatory attempts to address those consequences. LEARNING OBJECTIVES After studying this chapter, students should have an understanding of the overall investment process know some of the key elements involved in the investment process. Students should understand differences in financial and real assets and be able to identify the major components of the investment process. Students should be able to describe a derivati ve security and understand how it is used. Finally, students should understand the causes and effects of the financial crisis of 2008. PRESENTATION OF CHAPTER MATERIAL 1. 1 Real Assets versus Financial Assets The main elements of th e chapter are presented here . The concept of giving up current consumption to invest in assets that allow greater consumption in the future is the key notion to start discussion of the chapter material. The discussion of real and financial assets can be used to discuss key differen ces in the assets and their appropriateness as investment vehicles. The instructor might want to elucidate the material using updated bal ance sheets and net worth for Canadian households from the Statistics Canada website: https://www150.statcan.gc.ca/t1/tbl1/en/tv.action?pid=3610058001&pickMembers%5B0%5D=2.4&pick Members%5B1%5D=3.1 1. 2 Financial Assets Fixed income s ecurities include both long - term and short - term instruments. The essential element of debt securities and the other classes of financial assets is the fixed or fixed formula payments that are associated with these securities. Common stock that features residual payments to the owners c an be contrasted with the relatively certain debt claims. A derivative security is a security whose performance is based on or tied to another asset or financial security. The discussion of derivative securiti es presented here should be brief and used to highlight the discussion of innovation in our markets. Students may find interest in key elements of each derivative and how they relate the properties to debt and equity securities. 1.3 Financial Markets and the Economy Financial assets (and hence markets where they are traded) play a big role in developed economies by allowing to make the most of the economy's real assets. Markets encourage allocation of capital to firms that have the best prospects in the view of the market participants. Markets allow participants to adjust consumption and to choose levels of risk that are appropriate. Financial markets also allow for separation

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    Bodie et al. Investments 9th Canadian Edition Instructor’s Manual 1 - 2 of management and ownership. Current issues related to corporate governance and ethics issues are presented here, which provides students a great opportunity for discussion. Be sure to mention:  Consumption Timing  The role of information in f inancial m arkets and the allocation of risk  Separation of ownership and management and corporate governance 1. 4 The Investment Process Section 1.4 describes the m ajor components of the investment process. Two of the major elements in the investment process, asset allocation and security selection , can be used to discuss the content and coverage in the course. Previewing the concept of risk - return trade - off is important for the development of portfolio theory and many other concepts developed in the course. The discussion of active and passive ma nagement styles is related to the concept of market efficiency. 1. 5 Markets are Competitive The two major elements of a competitive market are the risk - return trade - off and market efficiency. Here efficiency can be introduced in broad terms. Also, contrast passive management with active management, which combines security selection and timing. Material in later chapters can be previewed in terms of emphasis on elements of active management. On the other hand t he essential element related to passive management is holding an efficient portfolio. Here, e fficiency means not only diversification, but also appropriate risk level s , cash flow characteristics and administration costs. 1.6 The Players The major participants in the financial markets are discussed here , Governments, households and businesses can be issuers and investors in securities. Financial intermediaries include many groups who bring issuers and investors together. Investment bankers perform many specialized services for businesses and operate in the primary market. Venture capital provides financial for start - up firms. The instructor can obtain updated aggregate balance sheets for Canadian chartered banks from https://www150.statcan.gc.ca/t1/tbl1/en/tv.action?pid=3610058001&pickMembers%5B0%5D=2 .13&pickMembers%5B1%5D=3.1 Canadian nonfinancial corporations balance sheets can be obtained from: https://www150.statcan.gc.ca/t1/tbl1/en/tv.action?pid=3610058001&pickMembers%5B0%5D=2 .7&pickMembers%5B1%5D=3.1 . 1. 7 The Financial Crisis of 2008 Section 1.7 presents the Financial Crisis of 2008, with emphasis on its antecedents and its significance in the future of the financial world. It begins with events leadi ng up to the crisis and introduces the important Case - Shiller Index of U.S. housing prices (of which the students should be familiar) . The discussion turns to the mechanics of the mortgage pass - through security (instructors will note that the generalized idea of securitization is presente d here as well). The cash flow for these securitie s is depicted graphically in Figure

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    Bodie et al. Investments 9th Canadian Edition Instructor’s Manual 1 - 3 1.4. The authors also discuss in detail the role government sponsored entities Fannie Mae and Freddie Mac played in the crisis. The text introduce s mortgage derivatives in this section, focusing on collateralized debt obligations (CDOs) and credit default swaps (CDS). This section ties these derivatives with the all important concept of systemic risk (where problem s in one financial sector spill over to other sectors ). Students will need to tie together several disparate concepts here for a strong understanding of how this crisis occurred. This section then describes the sub - prime housing meltdown, the subsequent credit freeze and the impact these events had on the real economy. The government’s response is presented . Students can have great discussions on the effectiveness of the various fiscal and monetary actions during this time. A brief summary of the Canadian experience over the Financial Crisis is also provided. 1.8 Outline of the Text In this section, the authors divide the text into seven independent learning p arts, with several chapters in each P p art. This can be useful for instructors when developing the course syllabus.

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    1 Bodie et al. Investments 9 th Canadian Edition Instructor’s Manual CHAPTER TWO ASSET CLASSES AND FINANCIAL INSTRUMENTS CHAPTER OVERVIEW This chapter describes the financial instruments traded in the primary and secondary markets. The chapter provides an overview of overview discussion of money market, capital market instruments and derivative securities. The various market indices that are used as indicators of "the market" are also described. The chapter concludes with a di scussion of options and futures markets LEARNING OBJECTIVES Upon completion of this chapter the student should have a thorough understanding of the various financial instruments available to the potential investor. The student should have an insight as to the interpretation, composition, and calculation process involved in the various market indexes presented on the evening news. T he student should have some understanding of the basics of options and futures contracts. PRESENTATION OF MATERIAL 2 . 1 The Money Market The majo r money market instruments are presented here . In describing the individual instruments , it is helpful for the student s’ understanding of the market to integrate discussion of institutional characteristics of the instruments. For example, commercial banks are the major participants for many of the instruments. The text presents a thorough discussion of the calculation of money market instrument yields. If students have adequate backgrounds from prerequisite classes, discussion of characteristics of marketab ility, liquidity , and default risk may be appropriate. Discussion of the concepts should be delay ed to later chapters if student s ’ backgrounds are not adequate. 2.2 The Bond Market Debt instruments are issued by both public and private entities. The treasury issues have the direct or implied guarantee of the federal government. Provincial and municipal entities also issue bonds, but performance on these bonds does not have the same degree of safety. The Treasury and Agency issues have the direct or implied guaranty of the federal government. Since state and local entities issue municipal bonds, performance on these bonds does not have the same degree of safety. Since the interest income on municipal bonds is not subject to federal taxes, the taxable eq uivalent yield is used for comparison. Key characteristics of Government of Canada. Notes and Bonds are described here . Debt of provincial government l agencies has also become a significant component of the debt market. Major issuers of agency debt are described . Municipal bonds issued by cities, municipalities, or counties to finance local capital expenditures such as the construction of bridges, highways, airports, or schools. They represent a smaller component of the Canadian fixed income market than the US market This is in part due to the differential tax treatment: in the US, interest income on most municipal bonds is not subject to taxes. In the US, t o compare the yield on municipals with other taxable securities the taxable equivalent yield is used. In Canada, municipal bond interest is fully taxable, and this “comparative’ yield adjustment is not necessary. Municipal bonds can be general obligation bonds or revenue bonds. General obligation bonds

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    2 Bodie et al. Investments 9 th Canadian Edition Instructor’s Manual are considered less risky since they are backed by the full taxing power of the government entity. Revenue from specific project s is dedicated to revenue bonds. Bonds issued by private corporations are subject to greater default risk than bonds issued by government entities. Corporate bonds often contain imbedded options such as the call feature which allows an existing corporation to repurchase the bond from issuers when rates have fallen. Bonds backed by mortgages have grown to compose a major element of the bond market . Such bonds can represent proportional shares of a pool of mortgages or specific portion of a pool of mortgages. The mortgage backed market has grown rapidly in recent years . 2. 3. Equity Securities Two key points are relevant in the discussion of equity instruments. First, it should be emphasized that with the issue of common stock owners having a residual claim to the earnings of the firm. The priorities of debt holders and preferred stockholders are contrasted with common shareholders. Second, the differences in preferred stock and common stock dividends should be emphasized. Preferred shareholders have a priority claim to income in the form of dividends. P referred stockholders are limited to the fixed dividend while common shareholders do not have limits. The partial tax exemption on dividends of one corporation being received by another corporation is important in discussing preferred stock. A brief discussion on depository receipts can introduce international investing to the students. 2. 4 Stock and Bond Market Indexes The uses of stock indexes provide a good starting point for the discussion of the structure and construction of stock indexes. Motivational factors include tracking average returns, making comparisons of managers’ performance to average performance and, in creasingly, indexes are used as a base for derivative instruments. Discussion of the factors in constructing or using an index focuse s the students' attention on key differences in the indexes. The samples of indexes fits well with discussion of uses of th e index. If the index were going to be used to assess the performance of a manager that invests in Small - Cap firms, the TSX 60 would not be as appropriate of benchmark as the TSX Small Cap Index. A key US benchmark, the DJIA which captures the returns from the bluest of blue chips , is also introduced. . Table s Examples 2.2 and 2.4 provides a useful way s to introduce the construction of an index . . Example 2.2 shows the basics in the construction of a price - weighted index. Example 2 .4 shows the contrast bet ween a market - value - weighted index vs. a pri ce - weighted average index. The examples of market - value indexes used in the text shows their diversity. Many important broad based indexes, such as the S&P/TSX Composite Index and the S&P 500 are value - weighted. A third possibility is equal weighting. While this method is not too commonly observed in published indexes, it is commonly used in research , especially for tests that want to provide more weight to smaller firms. The international indexes represent the most popular indexes used by investors . They include only a small example of what it available but they are representative of the major types of indexes and major countries. The text has several examples of greater detail in several exhibits. 2. 5 Derivative Markets Basic positions and terms for options and futures are described here . The basic positions and terms are used to contrast the differences in futures and options. The essential difference is that while an option confers the right but not the requirement to exercise, a futures contract represents a firm commitment to buy or sell for future delivery. The text provides discussion of options for individual stocks and on agricultural futures contracts. The extension to discussion of other assets enhances understan ding of the uses and differences of options and futures.

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    1 Bodie et al. Investments 9 th Canadian Edition Instructor’s Manual CHAPTER THREE HOW SECURITIES ARE TRADED CHAPTER OVERVIEW This chapter discusses how securities are traded in Canadian and international venues on both the primary and secondary markets, with detailed coverage of both organized exchange and over the counter activities. Margin trading and short selling are discussed along with detailed examples of margin arrangements. The chapter discusses elements of regulation and ethics issues associated with security transactions. LEARNING OBJECTIVES After studying this chapter the student should have considerable insight as to how securities are traded on both the primary and secondary markets. The student should understand the mechanics, risk, and calculations involved in both margin and short trading. The student should begin to understand some of the implications, ambiguities, and complexities of the regulation of securities markets in Canada and the U.S. PRESENTATION OF MATERIAL 3.1 How Firms Issue Securities Chapter 3 begins with a presentation on k ey characteristics of primary and secondary sales of securities. The relationship between the primary market terms and subsequent activity in the secondary market presents a good opportunity for class discussion and relating the material in the investment class to principles of finance. Investment banking involves the sale of new issues of securities to investors ; Figure 3.1 shows the relationship between parties involved in an underwritten offering. Shelf registrations allow a fi rm that is regularly reporting to sell a limited amount of new stock without going through a registered public offering. This allows a firm more flexibility in selling additional shares. Private placements allow a firm to sell securities without going through a registered public offering. While most stock offerings employ public offerings, many issues of debt are completed using private placements. It is useful to discuss differences in the markets for equity and bond when discussing this material. Bond markets are dominated by financial institutions and many of the special characteristics of bond issues lend themselves to private placements. In some years the volume of private placements exceed s public offerings of corporate bond issues.

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    2 Bodie et al. Investments 9 th Canadian Edition Instructor’s Manual When a company sells securities to the general investing public for the first time, the transaction is referred to as an Initial Public Offering (IPO) and uses a prospectus, which is a written registration statement filed with the SEC that describes the issue and its prospects . The underwriting firms commonly underprice IP Os leading to significant short - term performance for some investors often with massive first - day returns, as expressed in Figure 3.2 for many countries. The “underpricing” as measured by first day returns is less severe in Canada, however, relative to its international cohorts. 3. 2 How Securities Are Traded This section presents t he maj or types of secondary markets including direct search, brokered, dealer and auction markets. The discussion of secondary markets should be focused on services rather than institutional characteristics of our markets. Discussion of different demands for services by different types of investors can h elp students understand the recent developments in our markets. Figure 3.3 demonstrates the average market depth for S&P 500 size companies, though o rders for transactions in securities in auction markets have different priorities. Market orders are to be executed immediately at current market prices . Price - Contingent Orders place price as the first priority. Once a target price is reached, a price - contingent order becomes a market order. Figure 3.4 shows a portion of the lim it order book for shares in a stock trading on the CNQ exchange (an electronic Canadian exchange now called the Canadian National Stock Exchange or CSNX). Students should be familiar with Figure 3. 4 and understand the uses of each of these price - contingent orders. The section continues with a discussion on the o rganization of markets that facilitat e trade . In specialists markets, a dealer is charged to make an orderly market. The specialist is granted a monopoly position and is highly regulated. Many securities are traded in over the counter markets which utilize dealers and brokers A dealer market features competition among dealers to make the market efficient. Electronic Communication Networks ( ECNs ) allow electronic interface among traders that bypasses the traditional dealership function and have mostly replaced specialist systems . 3.3 The Rise of Electronic Trading This section discusses how the interaction of new technologies and new regulations lead to electronic trading. In 1 975 , the NYSE eliminated fixed commissions and National Market System was created in the attempt to centralize trading across exchange and enhance competition . The new order - handling rules in 1994 on NASDAQ lead to narrower bid - ask spreads ; 1 997 and 2001 introduced the drop in the minimum tick size from one - eighth to one - sixteenth, and to 1 cent, respectively . Figure 3. 5 illustrated the effect of minimum tick size on the effective spread. In Canada, o n April 23, 1997, the TSX’s trading floor closed, making it the second - largest stock exchange in North America to choose a floorless, electronic (or virtual trading) environment. Canadian derivatives markets were soon to follow suit: on Janu ary 29, 2001, the Montreal Exchange completed its automation process with the transfer of s tock options on SAM (Montre al Automated System). All derivatives were traded on SAM and the trading floor was closed. The results to date for Canada seem favourable: screen trading mitigates the extent of pricing errors in the markets and decreases expected volatility. Since 2004, CNSX (originally CNQ) has offered an ECN for Canadian listings in competition with the TSX and the TSXV. In 2006 NYSE was renamed to NYSE Arca after acquiring the electronic Archipelago Exchange . 2007 marked the creation of National Market

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    3 Bodie et al. Investments 9 th Canadian Edition Instructor’s Manual System (NMS) to link exchanges electronically . Overall, the share of electronic trading in the US rose from 16% to 80% in 2000s. 3.4 Securities Markets The domestic securities markets have undergone significant reorganization and restructuring since the mid - 1970s. In Canada, f ollowing its reorganization in 2000, the Toronto Stock Exchange has separated itself into the TSX, a platform for trading senior companies, and the Venture Exchange, for junior issues. In 2007, its parent, TS X Group, acquired the Montreal Exchange. Following the merger and other acquisitions, it is now called TMX Group. In the US, a m ajor component of today’s market include s the Nasdaq market system that links dealers, organized exchanges and ECNs . Listing requirements on the NYSE and Nasdaq are significantly different. The NYSE requires much larger market value of shares in the hands of the public and considerable trading volume . 3. 5 New Trading Strategies This section presents new trading strategies that came into play after the development of the electronic trading. Algorithmic Trading use s computer programs to make trading decisions . High - Frequency T rading employs special class of algorithmic with very short order execution time . Dark Pools are the t rading venues that preserve anonymity, mainly relevant in block trading . Special place in the OTC market takes Bond Trading amon g bond dealers , with NYSE Bonds being the largest centralized b ond market of any U.S. exchange s. 3.6 Globalization of Stock Markets Figure 3. 7 demonstrates largest stock m arkets in the w orld by d omestic m arket c apitalization , with NYSE - Euronext being by far the largest equity market. T he TSX ranks 8 th in the world in terms of overall market capitalization. T he section discusses the w idespread trend to form international and local alliances and mergers . Some of the examples include NYSE ’s acquisition of Archipelago (ECN), American Stock Exchange , and the merger with Euronext ; acqui sition of Instinet/INET (ECN), Boston Stock Exchange, and merge r with OMX by NASDAQ to form NASDAQ OMX Group . 3. 7 Trading Costs On some t rades only a commission is paid; on others, only a portion of the spread is paid; and many trades require both a commission and a portion of the spread are paid. This point can be made by contrasting orders on both listed and OTC stocks. While the payment of a portion of the spread is not actually reported, the concept is important when considering the total cost of trading. 3. 8 Buying on Margin This section introduces margin trading . The use of actual borrowing of funds contrasts with margin arrangement in futures. While both futures and stock trading have maintenance margins and margin calls which are similar, the costs of borrowed funds must be factored into analysis of the returns of stock margin trading. The degree of leverage available in equities is set by IIROC in Canada and by the Federal Reserve Board in the US and is far less than is available in futures. A sample margin trade is used to develop the concepts of margin call and maintenance margin. The student’s understanding of the concept is helped by explicit treatment of the accounting for the problem using assets = liabilities + equity. The initial position shows a 60% initial margin on a 100 share purchase

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    4 Bodie et al. Investments 9 th Canadian Edition Instructor’s Manual of a stock that is selling for $ 100 per share. If the stock drops to $7 0 as depicted in the example, the equity falls to $3 ,000. The margin call price is then developed. Table 3.1 illustrates some potential returns from buying stock on margin. 3. 9 Short Sales With the background developed in margin trading, the concept of short selling is then covered. A brief description of the mechanics o f a short sale is shown here . While stock is generally available for short sellers, sometimes short sellers are not able to find additional stock to borrow when stock is called back from loan. If the short seller is not able to find other stoc k to borrow in that situation, he may be f orced to close out her position. A sample calculation of margin, maintenance margin and margin calls is dev eloped for a short sale . The short sale involves 100 0 shares of a stock that has an initial price of $100 with the maintenance margin of 3 0%. The example works through calculation of the margin position when the stock price rises to $110. The amount borrowed and owed is no longer constant with a short sale. The amount owed is actually equal to number of shares shorted time the current price. The amount owed is subtracted from the original sale proceeds plus the customer’s margin to determine the equity. With a 3 0% maintenance margin, the short seller will receive a margin call if the stock price rises above $115.38. Examples 3.3 and 3.4 demonstrate the mechanics of short sales and margin calls on short positions. 3. 10 Regulation of Securities Markets In Canada, the various provincial securities acts regulate the trading of securities. T here also is considerable self - regulation in the financial services industry. It takes place via regulations governing membership in various associations of professionals par ticipating in the industry. The Investment Industry Regulatory Organization of Canada (IIROC) is the national self - regulatory organization, which oversees all investment dealers and trading activity on debt and equity marketplaces in Canada. Recent scandals have rocked the securities markets. This is an area that has received and continues to receive enormous amounts of coverage in the press. Numerous proposals for additional regulation have appeared. The financial crisis of 2008 launched a new round of financial regulation legisla tion while insider trading remains a major problem in the financial world. Regulatory authorities in Canada (e.g. Ontario Securities commission the AMF in Quebec, and the SEC in t he US ha ve multiple ways to monitor for insider trading and there is considerable evidence to support the idea that it occurs. Excel Applications Two Excel mode l s are provided to allow the student to understand the impact of margining as well as short sales combined with stock price volatility. These Excel model s are available on the Online Learning Center .

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    1 Bodie et al. Investments 9th Canadian Edition Instructor’s Manual CHAPTER FOUR MUTUAL FUNDS AND OTHER INVESTMENT COMPANIES CHAPTER OVERVIEW This chapter describes the various types of investment companies and mutual funds. The chapter discusses services, expenses and loads associated with investing in mutual funds . It describes the i nvestment policies of different funds and lists sources of information on investment companies. T he chapter surveys the returns of mutual fund managers over time sea rching for consistency of performance. Finally, it presents sources of information on mutual funds, and c onsider s in detail the information provided in the most comprehensive guide, Morningstar’s Mutual Fund Sourcebook. LEARNING OBJECTIVES After studying this chapter the students should be able to identify key differences between open - end and closed - end investment companies. Students should be able to describe the expenses associated with investment in mutual funds and identify the major ty pes of investment policies of mutual funds. Students should be able to describe services provided by mutual funds and be able to identify sources of information on investment companies. PRESENTATION OF MATERIAL 4. 1 Investment Companies Key services provided by investment companies are presented in this section . The se include services that are related to scale factors such as reducing transaction costs, diversification and divisibility. Mutual funds can trade securities at lower costs because of the size of the trades and because they are trading larger dollar volumes with brokerage firms. Services related to professional management , record keeping, and administration involve compensation for expertise. T he concept of Net Asset Value (NAV ) , presented first here, is important for understanding pricing and performance of investment companies. 4. 2 Types of Investment Companies A unit trust is a pool of funds invested in a portfolio that is fixed for the life of the fund. Trusts are often set up for fixed - income securities. The trust life is dependent on the maturity of the securities. There are two types of managed companies : closed - end and open - end. Since the shares in closed - end funds are acquired in secondary markets, prices for such shares are commonly at premiums or discounted from the underlying net asset value. Students should understand these differences when viewing quotes for closed - end funds in Canada as shown in Figure 4.1 . Other types of investment companies include commingled funds , which are partnerships for investors that pool their funds. Commingled funds are commonly used in trust accounts for which investors do not have large enough pools of funds to warrant individual management.

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    2 Bodie et al. Investments 9th Canadian Edition Instructor’s Manual REITs (Real Estate Investment Trusts) are investment vehicles that are similar to closed - end funds but they invest in real estate or in loans secured by real estate. REITs often employ financial leverage and offer an investor the possibility to invest in real estate with professional management. Like mutual funds, hedge funds are vehicles that allow private investors to pool assets to be invested by a fund manager. Unlike mutual funds, however, hedge funds are commonly structured as private partnerships and t hus subject to only minimal government regulation. They typically are open only to wealthy or institutional investors. 4.3 Mutual Funds The major types of mutual funds classified by investmen t policy are identified here . For example, in the equity funds group, some funds emphasize growth while others emphasize income. Within the money market group, some funds limit their investment to very short - term . Government securities such as Treasury bills while others may invest in securities with longer maturities and greater risk of default. Some money market funds invest in derivatives. According to the Investment Funds Institute of Canada, over 4.9 million households in C anada owned mutual funds in 2015. At the end of 2017, assets under management in the Canadian mutual fund industry were almost $1.5 trillion, compared to about $460 million at the end of 2000. Mutual fund assets showed year - to - year increases throughout thi s period with the exception of 2008, a decline reflecting the impact of the financial crisis. Mutual funds can be marketed directly or sold through a sales force. Revenue sharing agreements are often used by the industry and may create conflicts of interest. Mutual funds are also sold through financial supermarkets that allow individuals to gain access to a wide variety of funds in one location. 4.4 Costs of Investing in Mutual Fund s This section discusses i ssues relevant to costs associated wi th investing in mutual funds . Four classes of fees are discussed. Comparative data on virtually all important aspects of mutual funds are available on Morningstar’s website at www.morningstar.ca . Funds with a front - end load initially reduce the investment amount. A back - end load or exit fee is charged when the shares are redeemed. It is common for an exit fee or the back - end load to become smaller with longer investment periods. Table 4.2 illustrates how different free structures affect return s over time. This section also introduces the concept of soft dollars, which are not included in the fund’s expenses resulting in artificially low expense ratios. 4. 5 Taxation of Mutual Fund Income Under Canadian tax laws, investment returns of mutual funds are taxed in the hands of the investor in the mutual fund and are not paid by the fund itself, provided that the income is distributed to investors. A fund’s capital gains, interest, and dividends are passed through to investors as though the investor earned the income directly. Investor directed portfolios can take advantage of tax consequences but mutual fund investments cannot be structured to take advantage of specific tax considerations. High turnover , or the ratio of trading activity to the assets of the portfolio, leads to tax inefficiency. 4. 6 Exchange Traded Funds Exchange Traded Funds have become popular and offer investors alternatives to traditional mutual funds. Key aspects on ETFs are discussed in this section . ETFs allow investors to trade portfolios of indexes as

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    3 Bodie et al. Investments 9th Canadian Edition Instructor’s Manual individual shares of stock. A wide variety of indexes, both international and domestic can be traded. Some advantages include lower taxes and costs as well as the ability to trade the index portfolios intra - day. Potential disadvantages include price dev iation from NAV and payment of brokerage fees to trade the funds. Table 4.2 lists major ETF sponsors in Canada. Figure 4.2 demonstrates the growth of Canadian ETFs over time. 4. 7 Mutual Fund Investment Perfor mance: A First Look The evidence on mutual fund performance does not show a consistent superior performance to broad market indexes. Evidence shows a tendency for some persistence in superior performance by funds but the evidence is far from conclusive. If you look at performance against broad market indexes, most of the performance is less than broad inves tment portfolios. As Figure 4. 4 shows, over a long horizon, most funds under perform the broad market. Table 4.3 discusses Malkiel’s study of consistency of ret urns among mutual fund managers; the results make for good class discussion. 4. 8 Information on Mutual Funds A partial list of sources of information on mutual funds appears in this section . As the popularity of mutual funds has grown in recent years, nearly all major business publications feature some reporting on performance of mutual funds .

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    1 Bodie et al. Investments 9th Canadian Edition Instructor’s Manual CH APTER FIVE RISK, RETURN, AND THE HISTORICAL RECORD CHAPTER OVERVIEW This chapter includes two major sections. The first section of the chapter describes the major factors influencing the level of interest rates and discusses the Fisher Effect. The second part of the chapter investigates holding period returns for different holding periods and presents information on historical risk/return data on different types of financial assets and presents statistical calculations of risk and returns measures, both ex post and ex ante. LEARNING OBJECTIVES After covering the chapter, the students should be able to describe the major factors that influence the level of interest rates and be able to apply the Fisher effect to interest rates and inflation. Students should be able to understand and calculate risk and return statistical measures, such as holding period returns, average returns, expected returns, and standard deviations . PRESENTATION OF MATERIAL 5. 1 Determinants of the Level of Interest Rates The chapter begins with the list of the major factors that influence interest rates - supply of funds by savers, demand for funds by businesses, government’s net demand for funds and the expected rate of inflation . It introduces the important relationship between nominal rates and real rates (Equation 5. 3 ) . Figure 5.1 displays a graph of the supply and demand for loanable funds. The graph shows the impact that a greater demand for funds would have on rates given no change in the supply of funds. The e quili brium for the nominal rate of interest is presented by the Fisher equation (Equation 5.4). Please note that this may be the first time students have seen the expectations operator, so a review of its meaning an d use may be helpful. The impact of t axes on the real rate of interest is presented at the end of this section (Equation 5.5) . 5. 2 Comparing Rates of Return for Different Holding Periods The formula for developing historical rates of returns on zero - coupon is shown in equation 5.6 . The return is measured for the total number of years or periods. Example 5.2 demonstrates the calculation of the return for various holding periods. Once the holding period returns are calculated, returns can be expressed as Effective Annual Rates and Annual Percentage Rates. The formulas to calculate EARs and AP Rs are presented here as well as how the relate to one another (Equation 5.8 and Table 5.1) . It is advised that instructors discuss the different ways EAR and APR will be presented in the financial world and their implications. 5. 3 Bills and Inflation, 19 57 - 201 6 Historical analysis of real rates of return shows disparity ov er sub periods over the sixty year period from 19 57 to 201 6 , noted in Table 5.2 . The average interest rate over the more recent portion of our history, 1988 – 2017, 4.36%, was noticeably lower than in the earlier portion, 6.92%. That’s because inflation, the

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    2 Bodie et al. Investments 9th Canadian Edition Instructor’s Manual main driver of T - bill rates, which also had a noticeably higher average value, 5.26%, in the earlier portion of the sample than in the later period, 2.26%. 5. 4 Risk and Risk Premiums The formula for calculation of a single holding period rate of return and a sample calcu lation are presented at the beginning of this section (Equation 5.10) . The formulas used in the calculation of mean (Equation 5.11) and variance (Equation 5.12) for a scenario along with sample ca lculations are presented as well . Scenario means and variances should be contrasted with historical means and variances to enhance the students understanding of significant differences in the concepts. While historical returns are used for estimating future returns, scenario analysis is a different process. Investors measure reward as the difference between the returns of the investment and the risk - free rate . This risk premium is also known as excess return when it displays the difference between the actual return of the investment and the actual risk - free rate. This section also introduces the idea of risk aversion as a necessary condition for a risk premi um. 5. 5 Time Series Analysis of Past Rates of Return When working with historical data each of the observed holding period returns , they are a ssumed to have equal probabilities . Average returns can be measured using a simple numerical average or a geometric average (Equations 5.13 and 5.14) . The text contains an excellent discussion of how the geometric and arithmetic averages differ and issues related to measuring standard deviation of returns over time. It also presents the difference between variance (Equation 5.15) and estimated variance (5.16/5.17). Inv estors measure returns in the form of excess returns or risk premiums over the risk - free asset. The Shape Ratio (Equation 5.18) measures the added risk premium or excess return on a portfolio relative to standard deviation of excess returns. 5. 6 The Normal Distribution The normal distr ibution is presented in Figure 5. 3 . When distributions are normal they have a bell shaped curve that allows complete description of the portfolio by examining the mean and standard deviation. 5. 7 Deviations From Normality and Alternative Risk Measures The normal distribution is symmetric and has small probabilities of occurrences in the tails of the distributions. Two departures from normal distributions that are observed with returns are the existence of skewed distributions (Equation 5.19) and the existence of fat - tailed distributions (Equation 5.20) . Figure 5.4A and 5.4B demonstrate these concepts. Variance, while the standard for risk measurement, is not without its shortcomings. This section presents a series of alternative risk measures. Value at Risk, Expected Shortfall , Sortino Ratio and calculating the relative frequency of Large, Negative 3 - Sigma returns are four risk measures which can complement variance.

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    3 Bodie et al. Investments 9th Canadian Edition Instructor’s Manual 5. 8 Historical Returns on Risky Portfolios The historical record on inve stments is presented in Figure 5. 5, Table 5.3 and Figure 5.6 and Figure 5.7. Table 5.4 show the monthly excess returns on the market index and four “style” portfolios. Figure 5.7 s hows a century - plus - long history (1900 – 2015) of average excess returns in 20 stock markets. The mean annual excess return across these countries was 7.40% and the median was 6.50%. Canada is on the lower end of the graph, with a historical risk premium of below 6%. 5. 9 Normality Long Term Investments When estimating long - term risk premiums, return distributions can be asymmetric with a significant positive skew. When compounding returns, the distribution of returns is lognormally distributed and not normally distributed. Figur 5.8 and Table 5.5 show risk and return over the long haul ; stocks can be more risky and that terminal values can be less than risk - free securities.

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