ECB3BL

International Investment Management

Welcome!
Course introduction
1
Who are we?
 Dr. Dirk F. Gerritsen (d.f.gerritsen@uu.nl)
 In addition to this course: Investment Management in MSc. program
 Program director MSc. in Banking and Finance
 Research interests: Financial markets; ESG; behavior of financial
consumers
 External experience, member of:
 AEX Indices Steering Committee
 Editorial board VBA Journaal

2
Who are we?
 Dr. Labrini Zarpala (l.zarpala@uu.nl)
 In addition to this course: Financial Markets and Institutions
(ECB3FMI)
 Research interests: Market design; Corporate Finance; Blockchain
Economics
 Industry experience: 11 years in consulting and banking industry
 Deloitte
 Société Générale
 Piraeus Bank Group

3
What are we going to do?
 Investment Management: managing assets in such a way that expected return
and risk are balanced
 What is return and risk?
 How can we use these to construct a portfolio?
 How can we use these to price a stock? And a bond?
 Which other factors drive bond returns?
 How can we use derivatives in hedging our risks?
 Market efficiency is assumed in most models; how efficient are markets?

4
What are we not going to do?
 Source: Cartoonstock.com

5
What are we going to do? (cont’d)
 Topics part I (tested on midterm exam)
 Introduction to investing
 Investments environment, trading securities, concepts of risk & return
 Composing a portfolio
 Capital allocation, optimal risky portfolio, and index model
 Equity valuation
 Macro- & industry analysis, financial statement analysis, and CAPM
 Bonds I:Valuation
 Price, yield, and term structure of interest rates
 Topics part II (tested on the final exam)
 Bonds II
 International aspects, and interest rate risk
 Derivatives I & Derivatives II
 Futures, forwards, and options
 Market efficiency
 Efficient market hypothesis and Behavioral finance
6
How are you going to do that?
 Weekly lectures on Wednesday on 15:15
 Tutorial on Fridays
 ± 1-2 minutes discussion of investment game
 In four course weeks, a case and related academic articles are to be discussed in the
tutorial:
 ± 15 minutes case presentation
 ± 10 minutes presentation corresponding article
 Remainder of session devoted to exercises from the handbook
 Carefully study the study schedule in the course manual!

7
How are you going to do that? (cont’d)
 Practical assignments in teams: 8 project teams per tutorial
 Group composition prior to this week’s tutorial session: see signup sheet on Blackboard
 Cases
 See next slide
 Hand-in during case weeks
 Investment game
 Investopedia Stock Simulator
 League name: USE Investment Competition 2023
 Password: ECB3BL23
 Have your portfolio ready next Wednesday at the latest!
 Hand in one-pager with motivation on initial portfolio: November 24
 Winners get prize during last lecture

8
How are you going to do that? (cont’d)
 Tutorials
 See course manual for homework per week, exercises can be found on Blackboard
 During four weeks: Case study
 Everyone: submit your presentation (Powerpoint sheets, convert to pdf!) via Blackboard in case weeks
12 hours before the start of the tutorial
 One teams presents case findings, another teams discusses them + present findings from academic
papers
 In your presentation, deal with the questions/remarks in “Discussion”-field of case
 Use all figures from the assignment for your solution.
 Structure the presentation as follows:
 Summarize the question, link to relevant key concepts and background information
 Analyze the problem and show your numerical solutions step by step
 Adding updated numbers for an appendix with current numbers is appreciated
 Compare alternative approaches (optional); give some food for thought (optional)
 Presentation takes around 15-20 minutes; discussion around 10 minutes
 Selection from exercises discussed in class (‘Tutorial exercises’)
 Self-study exercises also important, solutions are posted on Blackboard
9
How are you going to do that? (cont’d)
 Theory
 Handbook
 Investments (Bodie, Kane, Marcus, 13th edition)
 Course manual (see Blackboard)
 Theory and practice
 Case studies (published in Course manual), using Excel (to be found on Blackboard)
 Practice
 Manage investment portfolio

10
How are you going to do that? (cont’d)
 Examination
 Written midterm exam, multiple choice (40%)
 Written final exam, both open and multiple choice (35%)
 Cases (25%)
 Presented case (10%); Randomly selected case (7.5%); Hand in all cases more or less correctly
(7.5%)
 Effort requirements
 Presence in 6 out of 7 tutorials
 Set up portfolio for investment game and hand in one-pager with motivation for
purchases

11
Recent course evaluations
 In general postive about the course…

 …but they came with warnings:

12
Position in curriculum
Mathematics for Econometrics Corporate Finance
Economists (year 1) and Behaviour

Chapter 5, 6, 7: Chapter 8,9,10,11: Chapter 5,9,11,12,14,17,18,19,21:

Return, standard deviation Estimating realized Risk and return
Correlation and covariance and expected CAPM
rates of return Bond-, stock- and option valuation
Financial Statement Analysis

International International
Chapter 20, 21, 25:
Financial Investment
Using options
Management International hedging Management

MSc. Program in Banking and Finance

Investment
Management
And now on to this week’s topics!
 Financial assets
 The market for financial assets
 Stock market
 Initital Public Offering
 Trading of stocks
 Long and short positions
 Risk and return when investing in stocks
 Different ways of computing returns
 How do we measure risk?
 Sharpe ratio to combine risk and return

14
ECB3BL
International Investment Management

The investment
environment
15
Real assets vs. Financial assets
Real assets Financial assets
Determine the productive capacity and net income of Claims on real assets, do not contribute directly to the
the economy productive capacity of the economy
Examples: Land, buildings, machines, knowledge used to Examples: Stocks, bonds
produce goods and services

 Financial assets
 Fixed income (debt)
 Common stock (equity)
 Derivative securities

16
Role of financial markets in economy
 The informational role
 Capital flows to companies with best prospects
 Allocation of risk
 Real assets involve risk, redistribution possible
 Investors can select securities consistent with their tastes for risk, which benefits the
firms that need to raise capital as security can be sold for the best possible price
 Consumption timing
 Use securities to store wealth and transfer consumption to the future

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Financial assets
Investment process
 Portfolio
 Collection of investment assets
 Basically, two decisions
 Asset allocation (course week 2)
 Security selection (security analysis in course week 3)
 Different approaches
 Top-down
 Bottom-up

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Remember: financial markets are competitive
 Efficient markets
 In fully efficient markets when prices quickly adjust to all relevant information, there
should be neither underpriced nor overpriced securities (more on this in course week 8)
 Risk-return trade-off
 Higher-risk assets are priced to offer higher expected returns than lower-risk assets

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Players on the financial market
 Main players
 Governments as either lender or borrower
 Firms as demander of capital
 Households as suppliers
 Different institutions assist in this process
 Financial intermediaries
 Investment banks
 Newer players
 Algorithmic trading / High-frequency trading

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ECB3BL
International Investment Management

How securities are

traded
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How firms issue securities
IPO
 Private vs. public companies
 Initial public offering (IPO) [why?]
 Primary market
 Prospectus (example on next page)
 Roadshow and bookbuilding
 Underpricing in general
 Average first-day returns

22
How firms issue securities
IPO: Prospectus Adyen N.V. in 2018

23
How firms issue securities
IPO returns in Netherlands
 Average 1st day return for 8062 US IPOs: 17.9%
 Average 3 year buy-and-hold return for 7855 US IPOs
 Market-adjusted: -18.4%; Style-adjusted: -6.7%
 Evidence for the Netherlands
Period 1st day 1st week 6 months 1 year 2 year 3 year
Frederikslust et al. 1947 – 1996 5.0% 1.2% -0.5% -1.3%
(2002)
Bronckers et al. 1982 – 1992 11.7% 4.3%
(1993)
Bosveld et al. 1983 – 1990 -0.4% -5.7% -5.4% 0.4%
(1996)
Huygen et al. 1987 – 1992 2.7% -2.6%
(1993)
Munsters et al. 1984 – 1993 4.1% 3.2% -7.0% -6.7% -5.2%
(1996)
Doeswijk (2007) 1977 – 2001 17.6% 2.9% -8.7% -10.0%

24
How firms issue securities
IPO returns in Netherlands
 Own experience
 I signed up for most IPOs, such as: NIBC, Alfen, B&S Group, Takeaway.com, ASR
Nederland, Basic Fit, etc.
 Average return: 2.4% for IPOs during the past 15 years
 Winner’s curse?

25
The marketplace
 Types of markets
 Brokered markets
 Brokers search out buyers and sellers, for example: IPO
 Dealer markets
 Dealers have inventories of assets from which they buy and sell
 Most bonds trade over-the-counter (OTC)
 Auction markets
 Traders converge at one place to trade
 Most stocks trade on such an exchange
 Buyers and sellers post bid and ask prices (see next page)
 And also: direct search
 Buyers and sellers seek each other

26
Buying and selling on the marketplace
Order book
 Bid price, ask price, bid-ask spread, and depth
 Bid-ask spread is implicit cost to investor, in addition to commission as explicit costs
 See next page for example for Adyen at platform of Saxoinvestor

27
 Bid Ask Current price Difference
International Securities Identification Number
Used across different platforms, including Datastream

Best ask (or offer): 1006.80, for

this price someone wants to sell

Best bid: 1006.40, this price is

posted a prospective buyer

Bid Ask

Bid-ask spread:
1006.80 – 1006.40 = 0.40 euro

Depth: 19 as bid, 30 as ask

“Dollar depth”: (19+30)*1006.60
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= 49323.40
Buying and selling on the marketplace
Evolution of bid-ask spread

Source: Angel, Harris & Spatt (2013)

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Buying and selling on the marketplace
Market depth

Source: Angel, Harris & Spatt (2013)

30
Buying and selling on the marketplace
Order types
 Orders
 Market order
 Price-contingent order
 Limit or Stop
 Stop-Loss: sell when a threshold is met
 Stop-Buy: buy when a threshold is met

31
Buying and selling on the marketplace
Margin
 Normal trading occurs with cash account
 Another possibility is a margin account
 Buying on maring
 The investor borrows a percentage of the stock price from the broker: Why?
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣 −𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑖𝑖𝑖𝑖 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎
 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 = =
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣
 The broker sets a maintenance margin (floor percentage of investor’s investment): Why?
 Margin call
 Margin also required for short sales

32
Buying and selling on the marketplace
Short sales
 Regular investing involves buying (and then selling)
 What about selling something you don’t own?
 Short selling
 “Covering short position”, possibly with Stop-Buy order

Source: Cartoonstock.com

33
Buying and selling on the marketplace
Short sales
 European regulation: As of 2012 report net
short positions greater than 0.5% of market
value
 Dutch Authority for the Financial Markets (AFM)
register for Netherlands
 Or: http://www.shortsell.nl →
 How do short sellers perform?
 See next page for results for the Dutch stock
market

34
Buying and selling on the marketplace
Short sales
40
Source: Gerritsen & Verdoorn (2014)
35

30

25
Cumulative return (%)

20

15

10

0
Nov-12 Jan-13 Mar-13 May-13 Jul-13 Sep-13 Nov-13 Jan-14 Mar-14 May-14 Jul-14
-5

-10

-15
Market Shortportfolio (value-weighted)
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ECB3BL
International Investment Management

Risk, return, and the

historical record
36
Expected return
 Expected return when performing scenario analysis
 Here, we are looking at the future
 𝐸𝐸 𝑟𝑟 = ∑𝑠𝑠 𝑝𝑝 𝑠𝑠 𝑟𝑟(𝑠𝑠)
 𝑝𝑝(𝑠𝑠) = probability of a state
 𝑟𝑟(𝑠𝑠) = return if a state occurs
 𝑠𝑠 = state
 Next week, we consider required returns in-depth using the Capital Asset
Pricing Model

37
Expected scenario returns: example
State of the world Probability of state r in state

1 0.1 -0.05

2 0.2 0.05

3 0.4 0.15

4 0.2 0.25

5 0.1 0.35

 𝐸𝐸 𝑟𝑟 = 0.1 × −0.05 + 0.2 × 0.05 + ⋯ + 0.1 × 0.35

 𝐸𝐸 𝑟𝑟 = 0.15

38
Rate of return
Components
 Rate of return: single period
𝑃𝑃1 −𝑃𝑃0 +𝐷𝐷1
 𝐻𝐻𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑃𝑃𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝑅𝑅𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 (𝐻𝐻𝐻𝐻𝐻𝐻) =
𝑃𝑃0
 𝑃𝑃0 = Starting price
 𝑃𝑃1 = Ending price
 𝐷𝐷1 = Dividend during period 1

39
Rate of return
Example of past realized return
 Example
 Price at the start of the year = 40
 Dividend = 2
 Price at year-end = 48
48−40+2
 𝐻𝐻𝐻𝐻𝐻𝐻 = = 25%
40
 Always use total return (price + dividend)!
 In Excel files, total return index captures both price & dividend
 This series starts at 100 when a firm goes public
𝑇𝑇𝑇𝑇𝑡𝑡 −𝑇𝑇𝑇𝑇𝑡𝑡−1
 Return still needs to be computed by
𝑇𝑇𝑇𝑇𝑡𝑡−1

40
Price return vs. total return
Popular saying: Sell in May and go away…

41
Price return vs. total return
Popular saying: Sell in May and go away but remember to be back in September

42
Average realized returns for multiple periods
 What if our next year’s return equaled -25%?
 Year 1: +25%
 Year 2: -25%
 What is the average return here?
 Starting with 100, we have 100×(1+0.25)=125 after year 1, and 125×(1-0.25)=93.75
after year 2
 Let 𝑇𝑇𝑇𝑇 be Terminal value and 𝑔𝑔 be the geometric average
 𝑇𝑇𝑇𝑇𝑛𝑛 = 1 + 𝑟𝑟1 × 1 + 𝑟𝑟2 … × (1 + 𝑟𝑟𝑛𝑛 )
1
(𝑛𝑛)
 𝑔𝑔 = 𝑇𝑇𝑇𝑇 −1
1
( )
 Geometric average: (1 + 0.25) × (1 + −0.25 ) 2 − 1 = −3.18%

43
Average realized returns for multiple investments in one
period
 Suppose that we have two investments in one year where one would earn
25% and the other -25%, what is the average return here?
 Stock 1 end value: 100×(1+0.25)=125
 Stock 2 end value: 100×(1-0.25)=75
 Portfolio starting value was 200 and final value also 200
0.25+(−0.25)
 Arithmetic average: = 0%
2

44
Average returns, a last look
Dollar-weighted
 Geometric correct method for computing average returns for investments
during multiple periods
 Drawback of geometric average is that the returns are weighted by invested amount
 Suppose you achieved 0% return in year 1 and 10% return in year 2
 But, your invested amount was much higher in year 2!
 What can you infer about your average return here?
 Dollar-weighted returns (IRR)
 Internal rate of return considering the cash flow from or to investment
 Returns are weighted by the amount invested in each stock

45
Average returns, a last look
Dollar-weighted
 Back to the basics: What is return?
 The interest rate which equals initial investment to final outcome
 Suppose you invest 100 and receive 108 after one year, you solve the equation
108 108
100 = → 1 + 𝑟𝑟 = → 𝑟𝑟 = 0.08
1+𝑟𝑟 100
 Same procedure for dollar-weighted return
 Suppose you invest in a stock of 100 and receive 4 dividend after one year
 You purchase one extra share for 106 after one year
 After two years, you sell two stocks for 108, plus 8 dividend
106 4 224
 Equate investment and payoff: 100 + = + → 𝑟𝑟 = 7.1%
1+𝑟𝑟 1+𝑟𝑟 1+𝑟𝑟 2

46
Average returns, a last look
Arithmetic, geometric, dollar-weighted
 Examining investment returns in practice
 Which multi-period investment returns are usually higher in practice?
 Those stated in geometric average, or in arithmetic average (=wrong)?
 See previous example
 Those stated in geometric average, or those stated in dollar-weighted average?
 See next slides

47
 Time-weighted computed as
geometric average

Geometric average vs. dollar-weighted average

 Some evidence from the literature
Nesbit (1995: JPM), sample: US mutual funds, 1984-
1994
“The timing of these cash flows is very uneven,
however. For example, net cash flow into domestic
stock funds totaled $1.5 billion for six months prior
to the October 1987 market crash. All that money
left in the six months following.”

48
Geometric average vs. dollar-weighted average
 More evidence Buy-and-hold return computed
as geometric average
Dichev (2007: AER) studies a longer period, 1926 – 2002

49
Risk
Variance (or dispersion) of returns
 Variance
 𝜎𝜎 2 = ∑𝑠𝑠 𝑝𝑝(𝑠𝑠) 𝑟𝑟 𝑠𝑠 − 𝐸𝐸(𝑟𝑟) 2

 Risk often denoted by standard deviation 𝜎𝜎 which equals (Variance)½

 Using our scenario example where the average 𝑟𝑟 was equal to 0.15
 𝜎𝜎 2 = (0.1)(−0.05 − 0.15)2 + ⋯ + (0.1)(0.35 − 0.15)2
 𝜎𝜎 2 = 0.01199
1
 𝜎𝜎 = 0.01199 = 0.1095
2

 What does it mean?

50
Risk
The normal distribution
 If stock returns are normally distributed with a mean return of 15% and a
standard deviation of 10.95%, then:

–17.85 –6.9 4.05 15 25.95 36.90 47.85

51
Risk
Are stock returns normally distributed?
 In markets, the probability of outsized events is much higher than predicted by
a normal probability distribution

50
 For the Netherlands, 1983 – 2012

40
 Skewness: -0.2572
Kurtosis: 11.74

30


Density
20 10
0
-.15 -.1 -.05 0 .05 .1
AEX_daily

Density
kdensity AEX_daily

52
Risk and return integrated
 Sharpe ratio (S)
 S = Risk premium / Risk of excess return
𝑟𝑟𝑝𝑝 −𝑟𝑟𝑓𝑓
 𝑆𝑆 =
𝜎𝜎𝑝𝑝
 𝑝𝑝 stands for portfolio; 𝑓𝑓 stands for risk-free asset

53
Thank you for your attention!

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