In a previous article, we introduced the
CFA Institute Investment Foundation Program (Read
more here). It is a free program
designed for anyone who wants to enter or advance within the investment
management industry, including IT, operations, accounting, administration, and
marketing. Candidates who successfully
pass the online exam earn the CFA Institute Investment Foundations Certificate.
There are total of 20 Chapters in 7
modules, covering all the essential topics in finance, economics, ethics and
regulations. This series of articles
will highlight the core knowledge of each chapter.
Chapter 10 provides an overview of equity
securities. The learning outcome of chapter 10 is as follows:
·
Describe
features of equity securities;
·
Describe
types of equity securities;
·
Compare
risk and return of equity and debt securities;
·
Describe
approaches to valuing common shares;
·
Describe
company actions that affect the company’s shares outstanding.
There are significant risk and return
differences between debt and equity securities because of differences in cash
flow, voting rights, and priority of claims.
Exhibit 1 shows the three main types of
securities and their typical cash flow and voting rights.
In the event of the company being
liquidated, assets are distributed following a priority of claims, or seniority
ranking. This priority of claims can affect the amount that an investor
will receive upon liquidation. Exhibit 2 illustrates the priority of claims.
Given the fact that equity securities
are riskier than debt securities, shareholders expect to earn higher returns on
equity securities over the long term. Because equity is riskier than debt,
risk-averse investors may prefer debt securities to equity securities. However,
although debt is safer than equity for a given entity, debt securities are not
risk-free; they are subject to many risk factors, which are discussed in the
Debt Securities chapter.
Exhibit 3 shows annualised historical
return and risk data on various equity and debt indices for the 1980–2010
period. Recall from the Quantitative Concepts chapter that the standard
deviation of returns is often used as a measure of risk. The shaded rows in
Exhibit 3 present return and risk data (based on standard deviation of returns)
for six equity indices. The non-shaded rows present return and risk data for
three bond indices.
The data are generally consistent with
the expectation that riskier investments should generate higher returns over
the long term. For the United States and Europe, annual equity returns (first
three shaded indices) were higher than annual bond returns (non-shaded
indices). Annual equity returns exhibited higher risk than annual debt returns.
Note that for the three indices that include emerging economies (the last three
shaded indices), however, annual equity returns were marginally lower than
annual bond returns but riskier.
Exhibit 4 presents annual real returns
(returns adjusted for inflation) on equity securities and government long-term
bonds for 19 countries, Europe, the world, and the world excluding the United
States (ex-US) for 1900–2010. Equity returns over the period are higher than
government bond returns within every country and region. The real return
(return adjusted for inflation) of equity securities ranged from approximately
2% to 7%. The real returns of government bonds ranged from approximately –2%
(that is, they failed to cover inflation) to +3%. On average, government bonds
have ten inflation, earning a modest positive real return per year. But in some
countries, the return to bondholders was not sufficient to cover inflation, so
bondholders lost purchasing power.
Sample question:
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