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The Process of Portfolio Management

The Process of Portfolio Management. Determinants of Portfolio Policies. Objectives Constraints Policies Return Requirements Liquidity Asset Allocation Risk Tolerance Horizon Diversification Regulations Risk Positioning Taxes Tax Positioning Unique Needs Income Generation.

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The Process of Portfolio Management

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  1. The Process ofPortfolio Management 25-1

  2. Determinants of Portfolio Policies Objectives Constraints Policies Return Requirements Liquidity Asset Allocation Risk Tolerance Horizon Diversification Regulations Risk Positioning Taxes Tax Positioning Unique Needs Income Generation 25-2

  3. Matrix of Objectives Type of Investor Return Requirement Risk Tolerance Individual and Personal Trusts Life Cycle Life Cycle Mutual Funds Variable Variable Pension Funds Assumed actuarial rate Depends on payouts Endowment Funds Determined by income Generally needs and asset growth to conservative maintain real value 25-3

  4. Matrix of Objectives (cont’d) Type of Investor Return Requirement Risk Tolerance Life Insurance Spread over cost of Conservative funds and actuarial rates Nonlife Ins. Co. No minimum Conservative Banks Interest Spread Variable 25-4

  5. Constraints on Investment Policies • Liquidity • Ease (speed) with which an asset can be sold and created into cash • Investment horizon - planned liquidation date of the investment • Regulations • Prudent man law • Tax considerations • Unique needs 25-5

  6. InternationalDiversification 25-6

  7. Background • Global market • US Market is 40% - 45% of all markets • Improved access & technology • New instruments • Emphasis for our investigation • Risk assessment • Diversification 25-7

  8. Issues • What are the risks involved in investment in foreign securities? • How do you measure benchmark returns on foreign investments? • Are there benefits to diversification in foreign securities? 25-8

  9. Diversification Benefits Evidence shows international diversification is beneficial • Possible to expand the efficient frontier above domestic only frontier • Possible to reduce the systematic risk level below the domestic only level 25-9

  10. Int’l Return Dom * * * * * * * * Risk Efficient Frontier with International Diversification 25-10

  11. Risk Dom Int’l Securities Systematic Risk Level with International Diversification 25-11

  12. International Investment Choices • Direct stock purchases • American depository receipts • Mutual Funds • Open-end funds • Closed-end funds • WEBS 25-12

  13. Risks in International Investing Political Risks • Expropriation of assets • Restrictions on foreign exchange • Political instability 25-13

  14. Risks in International Investing Foreign Exchange Risk • Variation in return related to changes in the relative value of the domestic and foreign currency • Total return = investment return & return on foreign exchange • Not possible to completely hedge a foreign investment 25-14

  15. Returns with FX (1 + rUS) = (1 + rFM) (1 + rFX) rUS = return on the foreign investment in US Dollars rFM = return on the foreign market in local currency rFX = return on the foreign exchange 25-15

  16. Return Example: Dollar Depreciates Initial Investment : $100,000 Initial Exchange: $2.00/ Pound Sterling Final Exchange:$2.10/ Pound Sterling Return in British Security: 10% Return in US Dollars (1 + rUS) = (1.10) (1.05) = (1.155) rUS = 15.5% 25-16

  17. Return Example: Dollar Appreciates Initial Investment : $100,000 Initial Exchange: $2/ Pound Sterling Final Exchange: $1.85/ Pound Sterling Return in British Security: 10% Return in US Dollars (1 + rUS) = (1.10) (.9250) = (1.0175) rUS = 1.75% 25-17

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