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BONDS VS. STOCKS.   Term Paper ID:28433 Click to get this paper

Essay Subject: Examines stocks & bonds in relation to a portfolio for a private or individual investor. Characteristics of asset demand, measures of interest ratea, bond valuation, stock valuation models.... More...

11 Pages / 2475 Words 7 sources, 12 Citations, APA Format $44.00 Return to List of Papers

Paper Abstract: Examines stocks & bonds in relation to a portfolio for a private or individual investor. Characteristics of asset demand, measures of interest ratea, bond valuation, stock valuation models. Paper Introduction: ASSET DEMAND AND PORTFOLIO THEORY: BONDS VERSUS STOCKS Introduction The contemporary economic literature is replete with discussions about the centuries-old apparent schism between stocks and bonds and the impact that they can have on the concept of asset demand and portfolio theory. This statement emphasizes that there are four main concept areas to be analyzed: a) Stocks, b) Bonds, c) Portfolio Theory, and d) Asset demand ratios. These four concepts will be the subject of the first part of the next section. At this point in the paper, suffice it to say that the following simplistic definitions will be amplified in the theoretical sections. A. Stock -- As it will be used in this paper, a “stock” will Text of the Paper: The entire text of the paper is shown below. However, the text is somewhat scrambled. We want to give you as much information as we possibly can about our papers and essays, but we cannot give them away for free. In the text below you will find that while disordered, many of the phrases are essentially intact. From this text you will be able to get a solid sense of the writing style, the concepts addressed, and the sources used in the research paper. Or he could invest the entire amount in a stock that iscurrently generating a 1 percent return that would give growth but lessfixed security. (1999, Oct. Butmanagers pick stocks and then buy relatively similar amounts of each,tending much closer to equal weighting of their different positions. The single European currency - in which we may find ourselves in due course - also makes a difference and, indeed, could result in the absorption of our domestic indices into wider, European benchmarks. (2 , Jan. This lack of agreement that is apparent among the investment analystscan be baffling to the average investor who is trying to determine thecomplete portfolio risk (the mean average of all beta in a portfolio). .If you are having your money managed it is worth asking whoever looks after it on your behalf what, if any, benchmark is being used to assess performance. At the same time, the companies issuing the stocks or bonds areconcerned about interest rates in terms of how much they will have to payto use the investor's money. References Baytas, A; Cakici, N. That the assumption was not correct soonbecame evident and there arose in the literature (both academic and generalinterest) numerous articles and books about "understanding" the stockmarket. Private lenders set their interest rates by law, and theseare usually determined by reliance on the prime interest rate, which is theamount of money that the Federal Reserve Board charges its best customersfor the use of money. 1 ), Soaring US bond dives in "worst-ever"auction, Reuters Business Report. 2), short-term shakeout but long term looks goodfor stock market, money managers say, Denver Rocky Mountain News, 7. At this point in the paper, suffice it to say that the followingsimplistic definitions will be amplified in the theoretical sections. Shilling, A.G. One of theeasiest variables to consider in determining risk is the interest (Baytas &Cakici, 1999, 9 ). If weassume that a bond is issued at Par ($1 ) the CIR would reflect interestrates at time of issuance. (1999, Oct. He could invest in fixed interest instruments(CDs, treasury notes, Government or Commercial Bonds) and obtain somethingthat pays him 5 percent annually for a certain period. . That relationship depends on the bond's par. Although it does simplify the calculations, this convention assumesthat all the coupons from a bond can be reinvested at the same rate (whichis unlikely). Portfolio -- As it will be used in this paper, "portfolio" willalways mean a combination of both bonds and stocks. One conventionused to simplify the calculation procedure is to assume a single rate forall cash flows (YTM). Risk-return ratios apply to stocks, bonds or any other kind ofinvestment and is best understood as a calculated gamble, in which theinvestor is "betting" that an investment will increase in value (Priest,2 ). A further distinction must be made between the bond's price andthe interest rates. But it is more common to find afund - or a segregated portfolio - run to beat a familiar index, such asthe FTSE 1 . Ageneral (and fairly safe) rule of thumb is that the higher the risk, thegreater the return, and the lower the risk, the lower the return. This is a mathematical model that attempts to explain howsecurities should be priced, based on their relative riskiness incombination with the return on risk-free assets. "Value" of abond is a relative concept determined by interest rates during the periodof that maturity. Nawrocki, D.N. Corporations and governments sell bonds, which are interest-bearing certificates, for the purpose of raising money for expansion, fordebt payment, or for construction. Yield to maturity (YTM) is theaverage rate of return on a bond if it is held to maturity. The Theory of Bond Valuation As emphasized in the introduction to this analysis, a bond is a debtinstrument. Characteristics of Asset Demand To understand "asset demand" it is helpful to use an analogy.Consider the "portfolio" in human terms, as a muscle. Fisher, who is also a staunch advocate of CAPM (inarticles prior to Oct. This combined desire leads directly to the concept of portfoliotheory, (or rather portfolio theories) which attempt to answer the veryvital question: "What is the optimum balance between stocks and bonds in aportfolio to guarantee risk free growth and income and long-termstability?" What is considered Modern Portfolio Theory began in the 195 s,at about the same time that the average individual investor began puttingdiscretionary savings into investment instruments (Nawrocki, 1999, 9). The standard formulato achieve CIR is to multiply the coupon rate by the principal of the bondto achieve the dollar amount of the coupon. Priest, A. The primary system fordetermining this was the introduction of the CAPM, or Capital Asset PricingModel. He has several options. Tora (1999) strongly alludes to this problem. Oneassumption that most scholars made about this investor was that he (or inrare cases, she) was assumed to understand the economy and the processesfor determining asset prices. Although bonds seldomuse coupons (attachments to the original certificates that the holder wouldcut off and submit for payment) the term still is in existence to refer tothe interest that the issuer agrees to pay each year. On the other hand, if the investor has morelong-term goals in mind, usually accompanied by lower returns butpotentially offset by stability, then the portfolio muscle does not have tobe so energetic. B. 1), A brief history of downside riskmeasures, Journal of Investing, 9. When private investors decide to addbonds to his or her portfolio, they are, essentially, loaning money to thebond's issuer in return for interest. Nonetheless, CAPM is still a primary method for analyzing a specificinvestment. 16), Benchmarks have a place, but it may beunwise to follow them, Independent London, 7. 13), Wall Street tailors, Forbes Magazine,123. This model states that: R(eturn)= Risk- Free Return (91-Day TBill for example ) + Risk Premium. Journal of Investing, 89. Interpretation The question still remains concerning what is the optimum mix ofstocks and bonds in a portfolio. Tora, B. For example, if a bond is issued in 2 and in2 1 , the coupons on these bonds could range between 6% and 12%, reflectingthe interest rates at their respective time of issue. This important concept isdealt with next. A bond'sprincipal, or face value, represents the amount of the original loan thatis to be repaid on the bond's maturity date. Recognizethis nonsense for what it is, and try on the suit before you buy it"(Shilling, 2 , 81). Such an investmentcould be safe, but would not give growth flexibility and the investment isnon-liquid. Conversely, given theYTM, a price can be calculated since YTM increasing causes the pricecalculated to decrease, while a fall in the YTM will cause the price torise. But growing globalization means these indices may no longerbe relevant" (Tora, 1999,4)Along with lacking relevancy, these funds might even be dangerous. When the investment climate reached the point wherepeople who had never ventured into the market began appearing, a moreconcise method of determining risk was needed. (1999, Dec. (2 , Feb. But you can be sure the pace of change is accelerating. With this rapidly changing environment, the assumption can be drawnfrom reading "between the lines" of most current writings that theinvestment analysts are beginning to weigh in on the side of standarddeviation theory and fundamentalism (Kelly, 2 , 7). Bond -- As it will be used in this paper, "bond" will refer toany debt instrument used as an investment security. The characteristics of asset demands, in general, were these: 1. Kelly, G. Post Modern Portfolio Theory calls for determining the amount of abond's value by finding the relationship among multiple dependent variables-- the size of its coupon payments, the length of time remaining until thebond matures and the current level of interest rates(Baytas & Cakici, 1999,92). Fisher, K.L. This, in turn, led to a great deal ofdiscussion and debate by and between adherents of portfolio theory. Bloomberg, who has been steadily leaning toward an8 -2 portfolio with 5 percent of the 8 going to foreign securitiesbelieves that DCF has a greater functionality when comparing the stockreturns of similar companies with similar investments, enabling theinvestor to estimate how sensitive the investment will be to marketmovements. This model yields a riskdeterminant called "beta" which has been subject to a number of criticismsyet is still considered a very important element of modern investment andportfolio theory.Shilling (2 ) in an insightful article alludes to both the power andweakness of beta "to make outlandish stock prices seem reasonable by usingcleverly tailored valuation methods. It is too early to say, precisely, what will happen. The asset must be readily identifiable and tangible (Baytas &Cakici, 1999, 89). You may be surprised at the answer. Various Measures of Interest Rates One element of risk that needed to be determined was the risksattendant to interest rates. Within that framework, the"portfolio" will be considered an "asset" of the Private Investor (API) and"demand" will refer to the expected reward or loss that is required of theasset, in other words, how hard it must work. The asset must grow, and yet be risk free. In this situation, YTM equates the present value of all the cashflows from a bond to the price of a bond. If, however,someone invests in a high technology company that's only been around for ayear (any of the Internet stocks, for example), then the risk is higherbecause the rate of return could also be so much higher. (1999, Oct. If, for instance, an investor purchases a Blue Chip stock (Bank ofBoston, for instance) that has been doing business for some time, then therisk factor is low, and usually the rate of return is low. The primary definitions that concern the individualinvestor are those concerning "interest rate deviation" and "interest ratevaluation." For instance, assume an investor is trying to decide where toplace $1 , in discretionary investment income. If it decreases, he loses. In portfolio theory, there are several typesof interest involved. This plethora of advice led to the growth of an investor who placedmany demands on the assets, many of which are still in existence today. 1, 1999 by a few weeks) citing a belief that theasset demand and liquidity will increase proportionally with its beta.Bloomberg, on the other hand, sees CAPM's power as limited when applied tostock considerations. An understanding of the various aspects of theindividual investment profile was essential, as was the need for a systemto quantify risk. Equalweighting the S&P would reduce its average cap by 8 % , to $22 billion"(Fisher, 1999, 123). Way back, stocks were valued inrelation to their dividends, just as high-quality bonds are still pricedaccording to coupons and current interest rates..[but today] Wall Streetcan always concoct a theory to justify any insane stock price. CAPM and other Stock Valuation Models In the previous discussions, the risks were determined by fairlystandard systems. "Benchmarks aregenerally indices (of which there are more than 3, worldwide)" (Tora,1999, 4). However, theanalogy is not complete for some investors have a combined asset demand,and want both income and growth. 1), Do stocks really provide thehighest return in the long run? These characteristics, in turn, led to the growth of a wide range of"investment" counselors, agents, brokers, and advisers who developedphilosophies of investing that were utilized in their decisions of what abalanced portfolio should be. If there are stronginvestment goals demanded -- for instance reasonably risk-controlled growthor income enhancement -- then the "demand" on that portfolio, the muscle,would be intense, and it is safe to say that that portfolio would becomprised primarily of stocks. For clarity of focus, the point of view of the paper will be that ofthe private or individual investor. The portfolio enhancement is based on two major concepts -- couponinterest rate and yield to maturity (CIR and YTM). For example, a bond with an 8percent coupon rate and a principal of $1 will pay annual interest of$8 . Investment is now much more global and large institutional fund managers increasingly look outside their domestic borders when constructing portfolios. C. Investec Guinness Flight recently launched a fund based upon anindex produced by an Internet magazine. The asset must be readily liquid, and yet not lose value in thisliquidity. Kenneth Fisher, senior analyst for ForbesMagazine is a firm believer in a 6 -4 mix of stocks and bonds, with minorreliance on the 25 largest stocks on the S&P roster since those stocks "areso huge they pull up the other 475 to its average cap of $12 billion. 2. The value of a bond is the present value of its cash flows (couponsand principal) discounted at a suitable interest rate(s). The primary risk connected withthis formula is that it "trial and error" and accounts for reinvestment ofthe coupons as well as any capital gain or loss on the price of the bond(which will be redeemed by the issuer at par, $1 ). The actual return generated by a bond held until maturitydepends on the future reinvestment rates at which the coupon paymentsreceived are invested. He points out that most fund managers and many investors try tobeat the index they have selected as their benchmark. Usually the lower the credit rating the company has, the higher theinterest rate. (Tora, 1999,4). ASSET DEMAND AND PORTFOLIO THEORY: BONDS VERSUS STOCKS Introduction The contemporary economic literature is replete with discussions aboutthe centuries-old apparent schism between stocks and bonds and the impactthat they can have on the concept of asset demand and portfolio theory.This statement emphasizes that there are four main concept areas to beanalyzed: a) Stocks, b) Bonds, c) Portfolio Theory, and d) Asset demandratios. Usually Fundamentalanalysis of a stock involves determining the value of a stock by studyingelements about the company that issues the stock. Conceptually, all of the adherents agreed that an optimally performinginvestment portfolio was one that was based on a balance between the risksthe investor was willing to take measured against the returns needed toachieve the goals. If they pay 6 percent, and their cost ofcredit goes to 9 percent then they will be suffering a 3 percent loss. 13),The index sirens, Forbes, 22. Different theories, according to Nawrocki (1999) cameabout in a period known as "Post Modern Portfolio Theory", a period whichbegan reevaluating some of the dangers of portfolio theory, one of whichwas the difficulty of determining the ratios between risk and return. In the above analogy, we saw that there were primarily two long rangegoals demanded of the investment: growth and income demanded from thestocks asset, and stability demanded from the bonds assets. It is sometimes called Yield to Maturity. During the past three decades feweconomic models have done better than the CAPM in bridging the gap betweentheory and practice. But the increasing integration of world financialmarkets is forcing economists to scrutinize more closely the theory itself. "Maturity" is usually agreed to mean the amount a bond will be worthwhen a given amount of time has passed and is a fixed number. These four concepts will be the subject of the first part of thenext section. Stock -- As it will be used in this paper, a "stock" will referto a financial instrument that has profit as its goal, and consists of an"equity" share in a company. 3. Oneof the reasons for this bafflement is the lack of suitable indexingbenchmarks. (1999, Dec. A. This ratio has astrong impact on yet another variable in bond valuation, the relationshipbetween maturity and bond value. To Bloomberg, the chief benefit of CAPM appears to be theintercepting of a regression equation between an asset's returns and thereturns of systematic factors equaling the efficient market zero. The fundamentaliststudies such things as earnings, dividends, balance sheet variables andfootnotes, and the quality of management. If it increases, he gets a return. "Some can be highlyesoteric. If this paper is not what you are looking for, you can search again: Search for: or Click here to request an essay written just for you.