Revision Notes for Investments , Ninth Canadian Edition

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Bodie et al.Investments9th Canadian EditionInstructor’s Manual1-1CHAPTER ONETHE INVESTMENT ENVIRONMENTCHAPTER OVERVIEWThestudent is introduced to the general concept of investing—to forego spending cash today in the hopesof increasing wealth in the future.Real assets are differentiated from financialassets, and the majorcategories of financial assets are defined.The risk/return tradeoff and the reality that most assets areefficiently priced most of the time are introduced. The role of financial intermediaries is discussed.Thechapter concludes with a presentation of the financial crisis of 2008, itscauses and its implications, as wellas regulatory attempts to address those consequences.LEARNING OBJECTIVESAfter studying this chapter, students should have an understanding of the overall investment processknowsomeof thekey elements involved in the investment process.Students should understand differences infinancial and real assets and be able to identify the major components of the investment process. Studentsshould be able to describe a derivative security and understand how it isused.Finally, students shouldunderstand the causes and effects of the financial crisis of 2008.PRESENTATION OFCHAPTERMATERIAL1.1 RealAssetsversus Financial AssetsThemainelements of the chapter are presentedhere. The concept of giving up current consumption toinvest in assets that allow greater consumption in the future is the key notion to start discussion of thechapter material. The discussion of real and financial assets can be used to discuss key differences in theassets and their appropriateness as investment vehicles.The instructor might want to elucidate the materialusing updatedbalance sheets and net worth forCanadian households from the Statistics Canada website:https://www150.statcan.gc.ca/t1/tbl1/en/tv.action?pid=3610058001&pickMembers%5B0%5D=2.4&pickMembers%5B1%5D=3.11.2Financial AssetsFixed income securities include both long-termand short-term instruments. The essential element of debtsecurities and the other classes of financial assets is the fixed or fixed formula payments that are associatedwith these securities. Common stock that features residual payments to the owners can be contrasted withthe relatively certain debt claims. A derivative security is a security whose performance is based on or tiedto another asset or financial security. The discussion of derivative securities presentedhereshould be briefand used to highlight the discussion of innovation in our markets.Students may find interest inkeyelements of each derivative andhow theyrelate the properties to debt and equity securities.1.3Financial Markets and the EconomyFinancial assets (and hence markets where they are traded) play a big role in developed economies byallowing to make the most of the economy's real assets.Markets encourage allocation of capital to firmsthat have the best prospects in the view of the market participants.Markets allow participants to adjustconsumption and to choose levels of risk that are appropriate. Financial markets also allow for separation

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Bodie et al.Investments9th Canadian EditionInstructor’s Manual1-2of management and ownership.Current issues related tocorporate governance and ethicsissuesarepresented here, which provides students a great opportunity for discussion.Be sure to mention:Consumption TimingThe role of information infinancialmarketsand the allocation of riskSeparation of ownership and management and corporate governance1.4 The Investment ProcessSection 1.4 describes the major components of the investment process. Two of the major elements in theinvestment process, asset allocation and security selection,can be used to discuss the content and coveragein the course.Previewing the concept of risk-return trade-off is important for the development of portfoliotheory and many other concepts developed in the course. The discussion of active and passive managementstyles is related to the concept of market efficiency.1.5 Markets are CompetitiveThe two major elements of a competitive market are the risk-return trade-off and market efficiency. Hereefficiency can be introduced in broad terms. Also, contrast passive management with active management,which combinessecurity selection and timing.Material in later chapters can be previewed in terms ofemphasis on elements of active management.On the other hand the essential element related to passivemanagement is holding an efficient portfolio.Here, efficiencymeans not only diversification,butalsoappropriate risk levels, cash flow characteristics and administration costs.1.6The PlayersThe major participants in the financial markets arediscussedhere,Governments, households andbusinesses can be issuers and investors in securities.Financial intermediaries include manygroups whobring issuers and investors together.Investment bankers perform many specializedservices for businesses and operate in the primary market.Venture capital provides financial forstart-up firms.The instructor can obtain updated aggregate balance sheetsfor Canadianchartered banksfromhttps://www150.statcan.gc.ca/t1/tbl1/en/tv.action?pid=3610058001&pickMembers%5B0%5D=2.13&pickMembers%5B1%5D=3.1Canadian 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=3.1.1.7The Financial Crisis of 2008Section 1.7 presents the Financial Crisis of 2008, with emphasis on its antecedents and its significance inthe future of the financial world. It begins with events leading up to the crisis and introducesthe importantCase-Shiller Index of U.S. housing prices (of which the students should be familiar). The discussion turnsto the mechanics of the mortgage pass-through security (instructors will note that the generalized idea ofsecuritization is presented here as well). The cash flowfor these securitiesisdepicted graphically in Figure

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Bodie et al.Investments9th Canadian EditionInstructor’s Manual1-31.4. The authors also discuss in detail the role government sponsored entities Fannie Mae and Freddie Macplayed in the crisis.Thetextintroducesmortgage 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 ofsystemic risk (where problems in one financial sector spillover to othersectors). Students will need to tietogether several disparate concepts herefora strong understanding of how this crisis occurred.This section then describes the sub-primehousingmeltdown, the subsequent credit freeze and the impactthese events had on the real economy. The government’s response ispresented. Students canhavegreatdiscussions 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.1.8Outline of the TextIn this section, the authors divide the text into seven independent learningparts, with several chapters ineach Ppart. This can be useful for instructors when developing the course syllabus.

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1Bodie et al. Investments 9thCanadian Edition Instructor’s ManualCHAPTER TWOASSET CLASSES AND FINANCIAL INSTRUMENTSCHAPTER OVERVIEWThis chapter describes the financial instruments traded in the primary and secondary markets.The chapterprovides an overview ofoverview discussion of moneymarket, capital market instruments and derivativesecurities. The various market indices that are used as indicators of "the market" are also described. Thechapter concludes with a discussion of options and futures marketsLEARNING OBJECTIVESUpon completion of this chapter the student should have a thorough understanding of the variousfinancial instruments available to the potential investor.The student should have an insight as to theinterpretation, composition, and calculation process involved in the various market indexes presented onthe evening news.The student should have some understanding of the basics of options and futurescontracts.PRESENTATION OF MATERIAL2.1The Money MarketThe major money market instruments arepresentedhere.Indescribing the individual instruments,it ishelpful for the students’understanding of the market to integrate discussion of institutional characteristicsof the instruments.For example, commercial banks are the major participants for many of theinstruments.The text presents a thorough discussion of the calculation of money market instrumentyields.If students have adequate backgrounds from prerequisite classes, discussion of characteristics ofmarketability, liquidity,and default risk may be appropriate.Discussion of the concepts should bedelayed to later chapters if students’backgrounds are not adequate.2.2The Bond MarketDebt instruments are issued by both public and private entities. Thetreasury issues have the direct orimplied guarantee of the federal government. Provincial and municipal entities also issue bonds, butperformance on these bonds does not have the same degree of safety.The Treasury and Agency issueshave the direct or implied guaranty of the federal government.Since state and local entities issuemunicipal bonds, performance on these bonds does not have the same degree of safety.Since the interestincome on municipal bonds is not subject to federal taxes, the taxable equivalent yield is used forcomparison.Key characteristicsofGovernmentofCanada.Notesand Bonds are describedhere.Debt ofprovincialgovernmentl agencies hasalsobecome a significant component of the debt market.Major issuers ofagency debt aredescribed.Municipal bonds issued bycities, municipalities, or countiesto finance localcapital expenditures such as the construction of bridges, highways, airports, or schools.They represent asmaller component of the Canadian fixed income market than the US marketThis is in part due to thedifferential tax treatment: in the US, interest income on most municipal bonds is not subject to taxes.Inthe US,tocomparethe yield on municipals with other taxable securitiesthe taxable equivalent yield isused.In Canada, municipalbond interest is fully taxable, and this “comparative’ yield adjustment is notnecessary.Municipalbondscan be general obligation bonds or revenue bonds.General obligation bonds

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2Bodie et al. Investments 9thCanadian Edition Instructor’s Manualare considered less risky since they are backed by the full taxing power of the government entity.Revenue from specific projects isdedicated to revenue bonds.Bonds issued by private corporations aresubject to greater default risk than bonds issued by government entities.Corporate bonds often containimbedded options such as the call feature which allows an existing corporation to repurchase the bondfrom issuers when rates have fallen.Bonds backed by mortgages have grown to compose a major elementofthe bond market. Such bonds can represent proportional shares of a pool of mortgages or specificportion of a pool of mortgages. The mortgage backed market has grown rapidly in recent years.2.3. Equity SecuritiesTwo key points are relevant in the discussion of equity instruments.First,it should be emphasized thatwiththe issue of common stock owners having a residual claim to the earnings of the firm.The prioritiesof debt holders and preferred stockholders are contrasted with common shareholders.Second, thedifferences in preferred stock and common stock dividends should be emphasized.Preferred shareholdershave a priority claim to income in the form of dividends.Preferred stockholders are limited to the fixeddividend while common shareholders do not have limits.The partial tax exemption on dividends of onecorporation being received by another corporation is important in discussing preferred stock.A briefdiscussion on depository receipts can introduce international investing to the students.2.4 Stockand BondMarketIndexesThe uses of stock indexes provide a good starting point for the discussion of the structure andconstruction of stock indexes. Motivational factors include tracking average returns, making comparisonsof managers’ performance to average performance and, increasingly, indexes are used as a base forderivative instruments.Discussion of the factors in constructing or using an index focusesthe students'attentiononkey differences in the indexes.The samples of indexes fitswell with discussion of uses of theindex. 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 keyUS benchmark,theDJIAwhichcapturesthe returns from the bluest of blue chips, is also introduced..TablesExamples 2.2 and2.4providesa useful waystointroduce the construction of an index..Example2.2 shows the basics in the construction of a price-weighted index. Example 2.4 shows the contrastbetweena market-value-weighted index vs. aprice-weighted average index.The examples of market-value indexes used in the text shows their diversity.Many important broad basedindexes, such as theS&P/TSX Composite Index and the S&P 500 are value-weighted. Athird 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 representthe most popular indexes used by investors.They include only a smallexample 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 MarketsBasic positions and terms for options and futures are describedhere.The basic positions and terms areused to contrast the differences in futures and options.The essential difference isthat while an optionconfersthe right butnot the requirement to exercise, afutures contract represents a firm commitment tobuy or sell for future delivery.The text provides discussion of options for individual stocks and onagricultural futures contracts.The extension to discussion of other assets enhances understanding of theuses and differences of options and futures.

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1Bodie et al.Investments 9thCanadian Edition Instructor’s ManualCHAPTER THREEHOWSECURITIESARE TRADEDCHAPTER OVERVIEWThis chapter discusses how securities are tradedin Canadian and internationalvenueson both the primaryand secondary markets, with detailed coverage of both organized exchange and over thecounteractivities.Margin trading and short selling are discussed along with detailed examples of marginarrangements.The chapter discusses elements of regulation and ethics issues associated with securitytransactions.LEARNING OBJECTIVESAfter studying this chapter the student should have considerable insight as to how securities are traded onboth the primary and secondary markets.The student should understand the mechanics, risk, andcalculations involved in both margin and short trading.The student should begin to understand some ofthe implications, ambiguities, and complexities ofthe regulation of securities marketsin Canada and theU.S.PRESENTATION OF MATERIAL3.1How Firms Issue SecuritiesChapter 3 begins with a presentation on key characteristics of primary and secondary sales of securities.The relationship between the primary market terms andsubsequentactivity in the secondary marketpresents a good opportunity for class discussion and relating the material in the investment class toprinciples of finance.Investment banking involves the sale of new issues ofsecurities to investors;Figure 3.1shows therelationship between parties involved in an underwritten offering.Shelf registrations allow a firm that isregularly reportingto sell a limited amount of new stock without going through a registered publicoffering. 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 privateplacements.It is useful to discuss differences in the markets for equity and bond when discussing thismaterial. Bond markets are dominated by financial institutions and many of the special characteristics ofbond issues lend themselves to private placements. In some years the volume of private placementsexceedspublic offerings of corporate bond issues.

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2Bodie et al.Investments 9thCanadian Edition Instructor’s ManualWhen a company sells securities to the general investing public for the first time, the transaction isreferred to as an Initial Public Offering (IPO)and uses aprospectus, which is a written registrationstatement filed with the SEC that describes the issue and its prospects.The underwriting firmscommonlyunderprice IPOs leading to significant short-term performance for some investorsoften with massivefirst-day returns, as expressed in Figure 3.2for many countries. The “underpricing” as measured by firstday returns is less severe in Canada, however, relative to its international cohorts.3.2 How Securities Are TradedThis sectionpresents the major types of secondary markets including direct search, brokered, dealer andauction markets.The discussion of secondary markets should be focused onservices rather thaninstitutional characteristics of our markets.Discussion of different demands for services bydifferenttypes of investors can help students understand the recent developments in our markets.Figure 3.3 demonstrates the average market depth for S&P 500 size companies, though orders fortransactions in securitiesin auction marketshave different priorities.Market ordersare to be executedimmediately at current market prices.Price-Contingent Orders placeprice as the first priority.Once atarget price is reached, aprice-contingentorder becomes a market order.Figure 3.4 showsa portion of thelimit order book for shares in a stock trading onthe CNQ exchange (an electronic Canadian exchangenow called the Canadian National Stock Exchange or CSNX).Students should be familiar with Figure 3.4and understand the uses of each of these price-contingent orders.Thesection continues with a discussion on the organization of markets that facilitate trade. In specialistsmarkets, a dealer is charged to make an orderly market. The specialist is granted a monopoly position andis highly regulated.Many securities are traded in over the counter markets which utilize dealers andbrokersA dealer market features competition among dealers to make the market efficient.ElectronicCommunication Networks (ECNs)allow electronic interface among traders that bypasses the traditionaldealership functionand have mostly replaced specialist systems.3.3 The Rise of Electronic TradingThis sectiondiscusses how theinteraction of new technologies and new regulationslead to electronictrading. In 1975, the NYSE eliminated fixed commissionsand National Market Systemwas created in theattemptto centralize trading across exchange and enhance competition. Thenew order-handling rulesin1994 on NASDAQlead to narrower bid-ask spreads; 1997 and 2001introduced the drop in theminimumtick size from one-eighth to one-sixteenth, and to 1 cent, respectively.Figure 3.5illustrated the effect ofminimum tick size on the effective spread.In Canada,on 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 virtualtrading) environment. Canadian derivatives markets were soon to follow suit: on January 29, 2001, theMontrealExchange completed its automation process with the transfer of stock options on SAM(Montreal Automated System). All derivatives were traded on SAM and the trading floor was closed. Theresults to date for Canada seem favourable: screen trading mitigates the extent of pricing errors in themarkets and decreases expected volatility. Since 2004, CNSX (originally CNQ) has offered an ECN forCanadian listings in competition with the TSX and the TSXV.In 2006NYSEwasrenamed to NYSEArca after acquiring the electronic Archipelago Exchange. 2007 marked thecreation of National Market

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3Bodie et al.Investments 9thCanadian Edition Instructor’s ManualSystem (NMS) to link exchanges electronically. Overall, theshare of electronic tradingin the USrosefrom 16% to 80% in 2000s.3.4Securities MarketsThe domestic securities markets have undergone significant reorganization and restructuring since themid-1970s.In Canada, following its reorganization in 2000, the Toronto Stock Exchange hasseparateditself into the TSX, a platform for trading senior companies, and the Venture Exchange, for junior issues.In 2007, its parent, TSX Group, acquired the MontrealExchange. Following the merger and otheracquisitions, it is now called TMX Group.In the US,a major componentoftoday’smarket includestheNasdaqmarket system that links dealers, organized exchanges andECNs.Listing requirements on theNYSE and Nasdaq are significantly different. The NYSE requires much larger market value of shares inthe hands of the publicand considerable trading volume.3.5NewTrading StrategiesThis section presentsnew trading strategies that came into play after the development of the electronictrading. Algorithmic Tradingusescomputer programs to make trading decisions.High-FrequencyTradingemploysspecial class of algorithmic with very short order execution time.Dark Poolsare thetrading venues that preserve anonymity, mainly relevant in block trading. Special place in the OTCmarket takesBond Tradingamong bond dealers, withNYSE Bondsbeingthe largest centralizedbondmarket of any U.S. exchanges.3.6 Globalization of Stock MarketsFigure 3.7demonstrateslargeststock markets in theworld bydomesticmarketcapitalization, withNYSE-Euronext being by far the largest equity market. The TSX ranks 8thin the world in terms of overallmarket capitalization. The section discusses the widespreadtrend to form international and local alliancesand mergers. Some of the examples includeNYSE’sacquisition ofArchipelago (ECN), American StockExchange, and the mergerwith Euronext;acquisition ofInstinet/INET (ECN), Boston Stock Exchange,and mergerwith OMXbyNASDAQ to form NASDAQ OMX Group.3.7Trading CostsOn some trades only a commission is paid; on others,onlya portion of the spread is paid; and manytrades requireboth a commission and a portion of the spread are paid.This point can be made bycontrasting orders on both listed and OTC stocks.While the payment of a portion of the spread is notactually reported, the concept is important when considering the total cost of trading.3.8Buying on MarginThis section introduces margin trading.The use of actual borrowing of funds contrasts with marginarrangement in futures. While both futures and stock trading have maintenance margins and margin callswhich are similar, the costs of borrowed funds must be factored into analysis of the returns of stockmargin trading. The degree of leverage available in equities is set byIIROC in Canada and bytheFederalReserve Boardin the USand is far less than is available in futures.A sample margin trade is used to develop the concepts of margin call and maintenance margin.Thestudent’s understanding of the concept is helped by explicit treatment of the accounting for the problemusing assets = liabilities + equity. The initial position shows a60% initial margin on a 100share purchase

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4Bodie et al.Investments 9thCanadian Edition Instructor’s Manualof a stock that is selling for $100pershare.If the stock drops to $70 as depicted in theexample, theequity falls to $3,000.The margin call price is then developed.Table 3.1 illustrates some potentialreturns from buying stock on margin.3.9Short SalesWith the background developed in margin trading, the concept of short selling is then covered.A briefdescription of the mechanics of a short sale is shownhere. While stock is generally available for shortsellers, sometimes short sellers are not able to find additional stock to borrow when stock is called backfrom loan. If the short seller is not able to find other stock to borrow in that situation,he may be forced toclose out her position.A sample calculation of margin, maintenance margin and margin calls is developed for a short sale. Theshort sale involves 1000shares of a stock that has an initial price of $100with the maintenance margin of30%.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 actuallyequal to number of shares shorted time the current price.The amount owed is subtracted from theoriginal sale proceeds plus the customer’s margin to determine the equity.With a 30% maintenancemargin, the short seller will receive a margin call if the stock price rises above $115.38.Examples 3.3 and3.4 demonstrate the mechanics of short sales and margin calls on short positions.3.10Regulation of Securities MarketsInCanada,the various provincial securities acts regulate the trading of securities.There also isconsiderable self-regulation in the financial servicesindustry. It takes place via regulations governingmembership in various associations of professionals participating in the industry.The Investment IndustryRegulatory Organization of Canada (IIROC) is the national self-regulatory organization, which overseesall investment dealers and trading activity on debt and equity marketplaces in Canada.Recent scandalshave rocked the securities markets.This is an area that has received and continues to receive enormousamounts of coverage in the press.Numerous proposals for additional regulation have appeared.Thefinancial crisis of 2008launcheda new round of financial regulation legislation while insider tradingremains a major problem in the financial world.Regulatory authoritiesin Canada (e.g. Ontario Securitiescommission the AMF in Quebec, and the SEC in the UShavemultiple ways to monitorfor insider tradingand there is considerable evidence to support the idea that it occurs.Excel ApplicationsTwo Excelmodelsareprovided to allow the student to understand theimpact of marginingas well asshort salescombined with stock price volatility.These Excelmodels areavailable on the Online LearningCenter.

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1Bodie et al.Investments 9th Canadian Edition Instructor’s ManualCHAPTER FOURMUTUAL FUNDS AND OTHER INVESTMENT COMPANIESCHAPTER OVERVIEWThis chapter describes the various types of investment companies and mutual funds.The chapter discussesservices,expenses and loads associated withinvesting in mutual funds.It describes the investment policiesof different fundsand listssources of information on investment companies.The chapter surveys the returnsof mutual fund managers over time searching for consistency ofperformance.Finally, itpresents sourcesof information onmutual funds, andconsidersin detail theinformation provided in the most comprehensiveguide, Morningstar’s Mutual FundSourcebook.LEARNING OBJECTIVESAfter studying this chapter the students should be able to identify key differences between open-end andclosed-end investment companies.Students should be able to describe the expenses associated withinvestment in mutual funds and identify the major types of investment policies of mutual funds. Studentsshould be able to describe services provided by mutual funds and be able toidentify sources of informationon investment companies.PRESENTATION OF MATERIAL4.1 Investment CompaniesKey services provided by investment companies are presentedin this section. Theseinclude services thatare related to scale factors such as reducing transaction costs, diversification and divisibility. Mutual fundscan trade securities at lower costs because of the size of the trades and because they are trading larger dollarvolumeswith brokerage firms. Services relatedto professional management, recordkeeping,andadministration involve compensation for expertise.The concept of Net Asset Value(NAV), presented firsthere,is important for understanding pricing and performance of investment companies.4.2 Types of Investment CompaniesA unit trustis a pool of funds invested in a portfolio that is fixed for the life of the fund. Trusts are oftenset up for fixed-income securities. The trust life is dependent on the maturity of the securities.There aretwo types ofmanaged companies:closed-end and open-end.Since the shares in closed-end funds areacquired in secondary markets, prices for such shares are commonly at premiums or discounted from theunderlying net asset value.Students should understand these differences when viewingquotes forclosed-end fundsinCanada as shown inFigure 4.1.Other types of investment companies includecommingled funds, which are partnerships for investors thatpool their funds. Commingled funds are commonly used in trust accounts for which investors do not havelarge enough pools of funds to warrant individual management.

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2Bodie et al.Investments 9th Canadian Edition Instructor’s ManualREITs(Real Estate Investment Trusts) are investment vehicles that are similar to closed-end fundsbuttheyinvest in real estate or in loans secured by real estate. REITsoftenemploy financial leverage and offer aninvestor the possibility to invest in real estate with professional management.Like mutual funds,hedge fundsare vehicles that allow private investors to pool assets to be invested by afund manager. Unlike mutual funds, however, hedge fundsare commonly structured as private partnershipsand thus subject to only minimal governmentregulation. They typically are open only to wealthy orinstitutional investors.4.3Mutual FundsThe major types of mutual fundsclassified by investment policy are identifiedhere. For example, in theequity funds group, some funds emphasize growth while others emphasize income.Within the moneymarket group, some funds limit theirinvestment to very short-term.Government securitiessuch asTreasury billswhile others may invest in securities with longer maturities and greater risk of default. Somemoney market funds invest in derivatives.According to the Investment Funds Institute of Canada, over 4.9million households in Canada owned mutual funds in 2015. At the end of 2017, assets under managementin the Canadian mutual fund industry were almost $1.5 trillion, compared to about $460 million at the endof 2000. Mutual fund assets showed year-to-year increases throughout this period with the exception of2008, 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 oftenused by the industry and may create conflicts of interest.Mutual funds are also sold through financialsupermarkets that allow individuals to gainaccess to a wide variety of funds in one location.4.4Costs of Investing in Mutual FundsThis section discusses issues relevanttocosts associated withinvesting in mutual funds.Four classes offees are discussed.Comparative data on virtually all important aspects of mutual funds are available onMorningstar’s website atwww.morningstar.ca.Funds with a front-end load initially reduce the investmentamount. A back-end load or exit fee is charged when the shares are redeemed.It is common for an exitfee or the back-end load to become smaller with longer investment periods.Table 4.2 illustrates howdifferent free structures affect returnsover 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 IncomeUnder Canadian tax laws, investment returns of mutual funds are taxed in the hands of the investor in themutual fund and are not paid by the fund itself, provided that the income is distributed to investors. A fund’scapital gains,interest, and dividends are passed through to investors as though the investor earned theincome directly.Investor directed portfolios can take advantage of tax consequencesbut mutual fundinvestmentscannot be structured to take advantage of specific tax considerations.High turnover, or theratio of trading activity to the assets of the portfolio,leads to tax inefficiency.4.6 Exchange Traded FundsExchange Traded Funds have become popular and offer investors alternatives to traditional mutual funds.Key aspects on ETFsare discussed in this section. ETFs allow investors to trade portfolios of indexes as

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3Bodie et al.Investments 9th Canadian Edition Instructor’s Manualindividual shares of stock. A wide variety of indexes, both international and domestic can be traded. Someadvantages include lower taxes and costs as well as the ability to trade the index portfolios intra-day.Potential disadvantages include price deviation from NAV and payment of brokerage fees to trade thefunds.Table 4.2 lists majorETFsponsors in Canada.Figure 4.2demonstrates the growth of CanadianETFs over time.4.7 Mutual Fund Investment Performance: A First LookThe evidence on mutual fund performance does not show a consistent superior performance to broad marketindexes.Evidence shows a tendency for some persistence in superior performance by funds but theevidence is far from conclusive.If you look at performance against broad market indexes, most of theperformance is less than broad investment portfolios. As Figure 4.4shows, over along horizon, most fundsunderperform the broad market.Table 4.3discusses Malkiel’s study of consistency of returns amongmutualfund managers; the results make for good class discussion.4.8 Information on Mutual FundsA partial list of sources of information on mutual funds appearsin thissection. As the popularity of mutualfunds has grown in recent years, nearly all major business publications feature some reporting onperformance of mutual funds.

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1Bodie et al. Investments 9th Canadian Edition Instructor’s ManualCHAPTER FIVERISK, RETURN, AND THE HISTORICAL RECORDCHAPTER OVERVIEWThis chapter includes two major sections.The first section of the chapter describes the major factorsinfluencing the level of interest rates and discusses the Fisher Effect.Thesecond part of the chapterinvestigates holding period returns for different holding periods andpresents information on historicalrisk/return data on different types of financial assets and presents statistical calculations of risk and returnsmeasures, both ex post and ex ante.LEARNING OBJECTIVESAfter covering the chapter, the students should be able to describe the major factors that influence the levelof interest ratesandbe able to apply the Fisher effect to interest rates and inflation. Students should be abletounderstand andcalculate risk and return statistical measures, such as holding period returns, averagereturns, expected returns, and standard deviations.PRESENTATION OF MATERIAL5.1 Determinants of the Level of Interest RatesThe chapter begins with thelist 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. Itintroduces the important relationship between nominal rates and real rates (Equation 5.3).Figure 5.1displays a graphof the supply and demand for loanable funds. The graph shows the impact that a greaterdemand for funds would have on rates given no change in the supply of funds.The equilibrium for thenominal rate of interest is presentedby the Fisher equation (Equation 5.4). Please note that this may be thefirst time students have seen the expectations operator, so a review of its meaning anduse may be helpful.The impact of taxes on the real rate ofinterest is presentedat the end of this section (Equation 5.5).5.2 Comparing Rates of Return for Different Holding PeriodsThe formula for developing historical rates of returns on zero-coupon is shown inequation 5.6. The returnis measured for the total number of years or periods. Example 5.2 demonstratesthecalculation of the returnfor various holding periods.Once the holding period returns are calculated, returns can be expressed as Effective Annual Rates andAnnual Percentage Rates. The formulas to calculate EARsand APRs arepresentedhereas well as how therelate to one another (Equation 5.8 and Table 5.1). It is advised that instructors discuss the different waysEAR and APR will be presented in the financial world and their implications.5.3 Bills and Inflation, 1957-2016Historical analysis of real rates of return shows disparity over sub periodsover the sixty year periodfrom1957to 2016, 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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2Bodie et al. Investments 9th Canadian Edition Instructor’s Manualmain driver of T-bill rates, which also had a noticeably higher average value, 5.26%, in the earlier portionof the sample than in the later period, 2.26%.5.4 Risk and Risk PremiumsThe formula for calculation of a single holding period rate of return and a sample calculation are presentedat the beginning of this section (Equation 5.10).The formulas used inthecalculation of mean(Equation5.11)and variance(Equation 5.12)forascenario along with sample calculations arepresented as well.Scenario means and variances should be contrasted with historical means and variances to enhance thestudentsunderstanding of significant differences in the concepts.While historical returns are used forestimating 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 returnof the investment and the actual risk-free rate.This section also introduces the idea of risk aversion as anecessary condition for a risk premium.5.5 Time SeriesAnalysisof Past Rates of ReturnWhen working with historical data each of the observed holding period returns, they areassumed to haveequal probabilities.Average returns can be measured using a simplenumerical average or a geometricaverage(Equations 5.13 and 5.14).The text contains an excellent discussion of how the geometric andarithmetic averages differ and issues related to measuring standard deviation of returns over time.It alsopresents the difference between variance (Equation 5.15) and estimated variance (5.16/5.17).Investors measure returns in the form of excess returns or risk premiums over the risk-free asset. The ShapeRatio(Equation 5.18)measures the added risk premium or excess return on a portfolio relative to standarddeviation of excess returns.5.6 The Normal DistributionThe normal distribution is presentedin Figure 5.3. When distributions are normal they have a bell shapedcurve that allows complete description of the portfolio by examining the mean and standard deviation.5.7 Deviations From NormalityandAlternativeRisk MeasuresThe normal distribution is symmetric and has small probabilities of occurrences in the tails of thedistributions. Twodeparturesfrom normal distributions that are observed with returns are the existence ofskewed distributions(Equation 5.19)and the existence of fat-tailed distributions(Equation 5.20).Figure5.4A and 5.4B demonstrate these concepts.Variance, while the standard for risk measurement, is not without its shortcomings. This section presentsa series of alternative risk measures. Value at Risk, Expected Shortfall,Sortino Ratioand calculating therelative frequency of Large, Negative 3-Sigma returnsarefourrisk measures which can complementvariance.

Revision Notes for Investments , Ninth Canadian Edition - Page 16 preview image

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3Bodie et al. Investments 9th Canadian Edition Instructor’s Manual5.8 HistoricalReturns on Risky PortfoliosThe historical record on investments is presented inFigure 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 5.7shows a century-plus-long history (1900–2015) of average excess returns in 20 stock markets. The meanannual excess return across these countries was 7.40% and the median was 6.50%. Canada is on the lowerend of the graph, with a historical risk premium ofbelow 6%.5.9NormalityLong Term InvestmentsWhen estimating long-term risk premiums, return distributionscan beasymmetric with a significantpositive skew.When compounding returns, the distribution of returns is lognormally distributed and notnormally distributed. Figur5.8 andTable 5.5showrisk and returnover the long haul;stockscan bemorerisky and that terminal values can be less than risk-free securities.

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