Introduction to Investment Investment analysis encompasses a methodology for accommodating the fundamental uncertainty of the financial world.

It provides the tools that an investor can employ to evaluate the implications of their portfolio decisions and gives guidance on the factors that should be taken into account when choosing a portfolio. Financial Investment A standard definition of investment is that it is the sacrifice of current consumption in order to obtain increased consumption at a later date. Two different forms of investment can be identified. Real investment is the purchase of physical capital such as land and machinery to employ in a production process and earn increased profit. In contrast, financial investment is the purchase of paper securities such as stocks and bonds. Investment analysis is the study of financial securities for the purpose of successful investing. This definition contains within it a number of important points. Firstly, there are the institutional facts about financial securities: how to trade and what assets there are to trade. Secondly, there are analytical issues involved in studying these securities: the calculation of risks and returns, and the relationship between the two. Then there is the question of what success means for an investor, and the investment strategies that ensure the choices made are successful. Finally, there are the financial theories that are necessary to try to understand how the markets work and how the prices of assets are determined. Securities A security can be defined as: A legal contract representing the right to receive future benefits under a stated set of conditions. The piece of paper (e.g. the share certificate or the bond) defining the property rights is the physical form of the security. From an investors perspective, the two most crucial characteristics of a security are the return it promises and the risk inherent in the return. The return can be defined as the percentage increase in the value of the investment, so Return = [(final value of investment initial value of investment) 100] /(initial value of investment) The return is determined by the payments made during the lifetime of the security plus the increase in the securitys value. The importance of risk comes from the fact that the return on most securities (if not all) is not known with certainty when the security is purchased. This is because the future value of security is unknown and its flow of payments may not be certain. The risk of a security is a measure of the size of the variability or uncertainty of its return. It is a fundamental assumption of investment analysis that investors wish to have more return but do not like risk. Therefore to be encouraged to invest in assets with higher risks they must be compensated with greater return. This fact, that increased return and increased risk go together, is one of the fundamental features of assets.

A further important feature of a security is its liquidity. This is the ease with which it can be traded and turned into cash. Non-Marketable Securities savings account, government savings bonds, non-negotiable certificates of deposit (CDs) etc MARKETABLE SECURITIES They are classified into money market securities which have short maturities and capital market securities which have long maturities. The third group are derivatives whose values are determined by the values of other assets. The final group are classified as indirect investments and represent the purchase of assets via an investment company. Money Market Securities Call Money Deals in loans with very short maturity 1 day to 14 days Highly liquid repayable on demand at the option of either lender or borrower o The call loans are given : to the bill market For inter bank uses For dealing in stock exchanges and bullion markets and Individuals for trade purposes to save interest in cash credits and overdrafts Treasury Bills (T-Bills) Short-term financial instruments issued by the Central Bank of the country. o It is one of the safest money market instruments as it is void of market risks, though the return is less. o Treasury bills are circulated by the primary as well as the secondary markets. o The maturity periods for treasury bills are respectively 3-month, 6-month and 1-year. o T-bills are purchased for a price that is less than their par (face) value; when they mature, the government pays the holder the full par value. Effectively, the interest is the difference between the purchase price of the security and what you get at maturity. o To be specific, the buy value is determined by a bidding process, that too in auctions. o Treasury bills were first issued by the Indian government in 1917. Certificate of Deposit It is a borrowing note just similar to that of a promissory note. o The bearer of a certificate of deposit receives interest. o The maturity date, fixed rate of interest and a fixed value - are the three components of a certificate of deposit. o The term is generally between 3 months to 5 years. o The funds cannot be withdrawn instantaneously on demand, but has the facility of being liquidated, if a certain amount of penalty is paid. o The risk associated with certificate of deposit is higher and so is the return (compared to T-bills). o It was in 1989 that the certificate of deposit was first brought into the Indian money market. Commercial Papers

usually known as promissory notes o unsecured and are generally issued by companies and financial institutions, at a discounted rate from their face value. o The fixed maturity for it is 1 to 270 days. o The purposes with which they are issued are: for financing of inventories, accounts receivables, and settling short-term liabilities or loans. o The return on commercial papers is always higher than that of T-bills. o Companies which have a strong credit rating, usually issue CPs as they are not backed by collateral securities. o It was in 1990 that Commercial papers were first issued in the Indian money market. Banker's Acceptance It is a short-term investment plan that comes from a company backed by a guarantee from a bank o This guarantee states that the buyer will pay the seller at a future date. o One who draws the bill should have a sound credit rating. o 90 days is the usual term for these instruments. The term for these instruments can also vary between 30 and 180 days. o It is used as time draft to finance imports, exports. Eurodollars Contrary to the name, euro-dollars have very little to do with the euro or European countries. o Eurodollars are U.S.-dollar denominated deposits at banks outside of the United States. o This market evolved in Europe (specifically London), hence the name, but eurodollars can be held anywhere outside the United States. o The average eurodollar deposit is very large (in the millions) and has a maturity of less than six months. o A variation on the eurodollar time deposit is the eurodollar certificate of deposit. A eurodollar CD is basically the same as a domestic CD, except that it's the liability of a non-U.S. bank. o Because eurodollar CDs are typically less liquid, they tend to offer higher yields. o the eurodollar market is obviously out of reach for all but the largest institutions. The only way for individuals to invest in this market is indirectly through a money market fund. Capital Market Securities Fixed Income Securities Bonds are fixed income securities. Payments will be made at specified time intervals Common Stock (Equity) Preferred Stock Derivatives Indirect Investments Mutual Funds Securities and Risk Several factors can be isolated as affecting the riskiness of a security and these are: Maturity The longer the period until the maturity of a security the more risky it is.

Creditworthiness: Corporations vary more in their creditworthiness. Some are so lacking in creditworthiness that an active junk bond market exists for high return, high risk corporate bonds that are judged very likely to default. Priority Bond holders have the first claim on the assets of a liquidated firm. Only after bond holders and other creditors have been paid will stockholders receive any residual. Liquidity relates to how easy it is to sell an asset. Underlying Activities The economic activities of the issuer of the security can affect its riskiness. The Investment Process The investment process is description of the steps that an investor should take to construct and manage their portfolio. The steps in this process are: 1. Determine Objectives. The purpose will vary between investors. Some may be concerned only with preserving their current wealth. Others may see investment as a means of enhancing wealth. What primarily drives objectives is the attitude towards taking on risk. Some investors may wish to eliminate risk as much as is possible, while others may be focussed almost entirely on return and be willing to accept significant risks. 2. Choose Value. The second decision concerns the amount to be invested. 3. Conduct Security Analysis. Security analysis is the study of the returns and risks of securities. This is undertaken to determine in which classes of assets investments will be placed and to determine which particular securities should be purchased within a class. Many investors find it simpler to remain with the more basic assets such as stocks and fixed income securities rather than venture into complex instruments such as derivatives. Once the class of assets has been determined, the next step is to analyze the chosen set of securities to identify relevant characteristics of the assets such as their expected returns and risks. This information will be required for any informed attempt at portfolio construction. Another reason for analyzing securities is to attempt to find those that are currently mispriced. For example, a security that is under-priced for the returns it seems to offer is an attractive asset to purchase. Similarly, one that is overpriced should be sold. Such analysis can be undertaken using two alternative approaches: Technical analysis. This is the examination of past prices for predictable trends. Technical analysis employs a variety of methods in an attempt to find patterns of price behavior that repeat through time. If there is such repetition, then the most beneficial times to buy or sell can be identified. Fundamental analysis. The basis of fundamental analysis is that the true value of a security has to be based on the future returns it will yield. The analysis allows for temporary movements away from this relationship but requires it to hold in the long-rum. Fundamental analysts study the details of company activities to makes predictions of future profitability since this determines dividends and hence returns.

4. Portfolio Construction. It is the determination of the precise quantity to purchase of each of the chosen securities. A factor that is important to consider is the extent of diversification. Diversifying a portfolio across many assets may reduce risk but it involves increased transactions costs and increases the effort required to manage the portfolio. 5. Evaluation. Portfolio evaluation involves the assessment of the performance of the chosen portfolio. To do this it is necessary to have some yardstick for comparison since a meaningful comparison is only achieved by comparing the return on the portfolio with that on other portfolios with similar risk characteristics. 6. Revision. Portfolio revision involves the application of all the previous steps. Objectives may change, as may the level of funds available for investment. Further analysis of assets may alter the assessment of risks and returns and new assets may become available. Portfolio revision is therefore the continuing reapplication of the steps in the investment process. Mutual Funds A mutual fund is an investment vehicle that comprises a pool of funds collected from a large number of investors who invest in securities such as stocks, bonds, and short term money market instruments. The portfolio of a mutual fund is structured and maintained by fund managers. Features of a Mutual Fund Trading in mutual funds is carried out under strict government regulations. Disclosure of information about relevant details and the acquired securities are also legally essential. Specific features of mutual funds include liquidity, transfer of money, purchase of units and high competition. Investment in mutual funds is highly liquid as funds are required to redeem shares daily. It permits transfer of money from one type of fund to another, but the exchange takes place within the same fund family. Units of mutual funds can either be purchased directly or through an investment professional, such as a broker or a financial planner. Types of Mutual Funds Mutual funds are classified on the basis of maturity period or investment objective. On the basis of maturity period, mutual funds include open ended funds and close ended funds. Mutual funds based on investment objectives include growth/equity-oriented funds, income/debt-oriented funds, balanced funds, gilt funds and index funds. Open ended mutual funds: Open ended funds is the most common type

In open ended MFs, the fund house continuously buys and sells units from investors. New units are created and issued if there is demand, and old units are eliminated if there is redemption pressure. There is no fixed date on which the units would be permanently redeemed or terminated. If you want to invest in an open ended fund, you buy units from the fund house. Similarly, when you redeem your units, the fund house directly pays you the value of the units. funds are evaluated by the mutual fund company and also by external evaluating agents. NAV of units will be declared by the fund company NAV of the funds are to be evaluated as per "fair market" price. "Fair market" price is the ultimate or the closing valuation in the market of the public listed securities. The purchase of units as well as the selling of units will take place according to the calculated NAV. Closed Ended Funds The units of a close-ended mutual fund are very similar to individual shares. The units of a close ended scheme are issued only at the time of the New Fund Offer (NFO). These units are issued with a fixed tenure or duration, for example, 5 years. New units are not issued on an ongoing basis, and existing units are not eliminated before the term of the fund ends. At the time of an NFO, you can buy the units from the fund house, and at the time of the closure of the scheme (and at some other pre-defined intervals, like once every six months), you can redeem the units with the fund house. But if you want to buy or sell the units of a close ended scheme during the lifetime of the units, you have to do that on a stock exchange. The units of such schemes are listed on the stock exchanges just like ordinary shares, and can be bought and sold through a broker. Prices of the shares are determined by the demand of the individuals investing. Share prices are not ascertained by NAV or Net asset value. Growth / Equity Oriented Scheme The aim of growth funds is to provide capital appreciation over the medium to long- term. Such schemes normally invest a major part of their corpus in equities. Such funds have comparatively high risks. These schemes provide different options to the investors like dividend option, capital appreciation, etc. and the investors may choose an option depending on their preferences. The investors must indicate the option in the application form. The mutual funds also allow the investors to change the options at a later date. Growth schemes are good for investors having a long-term outlook seeking appreciation over a period of time. Income / Debt Oriented Scheme The aim of income funds is to provide regular and steady income to investors. Such schemes generally invest in fixed income securities such as bonds, corporate debentures, Government securities and money market instruments. Such funds are less risky compared to equity schemes. These funds are not affected because of fluctuations in equity markets. However, opportunities of capital appreciation are also limited in such funds. The NAVs of such funds are affected because of change in interest rates in the country. If the interest rates fall, NAVs of such funds are likely to increase in the short run and vice versa. However, long term investors may not bother about these fluctuations.

Balanced Fund The aim of balanced funds is to provide both growth and regular income as such schemes invest both in equities and fixed income securities in the proportion indicated in their offer documents. These are appropriate for investors looking for moderate growth. They generally invest 40-60% in equity and debt instruments. These funds are also affected because of fluctuations in share prices in the stock markets. However, NAVs of such funds are likely to be less volatile compared to pure equity funds. Money Market or Liquid Fund These funds are also income funds and their aim is to provide easy liquidity, preservation of capital and moderate income. These schemes invest exclusively in safer short-term instruments such as treasury bills, certificates of deposit, commercial paper and inter-bank call money, government securities, etc. Returns on these schemes fluctuate much less compared to other funds. These funds are appropriate for corporate and individual investors as a means to park their surplus funds for short periods. Gilt Fund These funds invest exclusively in government securities. Government securities have no default risk. NAVs of these schemes also fluctuate due to change in interest rates and other economic factors as is the case with income or debt oriented schemes. Index Funds Index Funds replicate the portfolio of a particular index such as the BSE Sensitive index, S&P NSE 50 index (Nifty), etc These schemes invest in the securities in the same weightage comprising of an index. NAVs of such schemes would rise or fall in accordance with the rise or fall in the index, though not exactly by the same percentage due to some factors known as "tracking error" in technical terms. Necessary disclosures in this regard are made in the offer document of the mutual fund scheme. There are also exchange traded index funds launched by the mutual funds which are traded on the stock exchanges. Derivative Instruments The Derivatives Market is meant as the market where exchange of derivatives takes place. Derivatives are one type of securities whose price is derived from the underlying assets. And value of these derivatives is determined by the fluctuations in the underlying assets. These underlying assets are most commonly stocks, bonds, currencies, interest rates, commodities and market indices. As Derivatives are merely contracts between two or more parties, anything like weather data or amount of rain can be used as underlying assets. The Derivatives can be classified as Future Contracts, Forward Contracts, Options, Swaps and Credit Derivatives. Futures Futures or futures contracts are derivatives bought or sold on a futures exchange Futures are contracts to buy or sell a particular commodity at a specified price on a certain date in the future.

The underlying asset could be commodities, energy, currencies, government bonds or other financial instruments. The future date on which the contract is executed is known as the final settlement date or the delivery date. The predetermined price is known as the settlement price. The mechanism for settlement is provided by the clearinghouse of the futures exchange forward contract a forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed today. This is in contrast to a spot contract , which is an agreement to buy or sell an asset today. It costs nothing to enter a forward contract. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price, which is equal to the forward price at the time the contract is entered into. The price of the underlying instrument, in whatever form, is paid before control of the instrument changes. The forward price of such a contract is commonly contrasted with the spot price, which is the price at which the asset changes hands on the spot date. The difference between the spot and the forward price is the forward premium or forward discount, generally considered in the form of a profit, or loss, by the purchasing party. Options an option is a derivative financial instrument that establishes a contract between two parties concerning the buying or selling of an asset at a reference price during a specified time frame. During this time frame, the buyer of the option gains the right, but not the obligation, to engage in some specific transaction on the asset, while the seller incurs the obligation to fulfill the transaction if so requested by the buyer. The price of an option derives from the value of an underlying asset (commonly a stock, a bond, a currency or a futures contract) plus a premium based on the time remaining until the expiration of the option. An option which conveys the right to buy something is called a call; an option which conveys the right to sell is called a put. The price specified at which the underlying may be traded is called the strike price or exercise price. The process of activating an option and thereby trading the underlying at the agreed-upon price is referred to as exercising it. Most options have an expiration date. If the option is not exercised by the expiration date, it becomes void and worthless. In return for granting the option, called writing the option, the originator of the option collects a payment, the premium, from the buyer. The writer of an option must make good on delivering (or receiving) the underlying asset or its cash equivalent, if the option is exercised. Swaps Swaps are contracts to exchange cash (flows) on or before a specified future date based on the underlying value of currencies/exchange rates, bonds/interest rates, commodities, stocks or other assets.

A currency swap is an agreement between two parties to exchange the principal loan amount and interest applicable on it in one currency with the principal and interest payments on an equal loan in another currency. These contracts are valid for a specific period, which could range up to ten years, and are typically used to exchange fixed-rate interest payments for floating-rate payments on dates specified by the two parties. Since the exchange of payment takes place in two different currencies, the prevailing spot rate is used to calculate the payment amount. This financial instrument is used to hedge interest rate risks. Hedge fund A hedge fund is an investment fund that can undertake a wider range of investment and trading activities than other funds, but which is only open for investment from particular types of investors specified by regulators. These investors are typically institutions, such as pension funds, university endowments and foundations, or high net worth individuals. As a class, hedge funds invest in a diverse range of assets, but they most commonly trade liquid securities on public markets. They also employ a wide variety of investment strategies, and make use of techniques such as short selling and leverage. Hedge funds are typically open-ended, meaning that investors can invest and withdraw money at regular, specified intervals. The value of an investment in a hedge fund is calculated as a share of the fund's net asset value, meaning that increases and decreases in the value of the fund's assets (and fund expenses) are directly reflected in the amount an investor can later withdraw. Key Characteristics of Hedge Funds Hedge funds utilize a variety of financial instruments to reduce risk, enhance returns and minimize the correlation with equity and bond markets. Many hedge funds are flexible in their investment options (can use short selling, leverage, derivatives such as puts, calls, options, futures, etc.). Hedge funds vary enormously in terms of investment returns, volatility and risk. Many, but not all, hedge fund strategies tend to hedge against downturns in the markets being traded. Many hedge funds have the ability to deliver non-market correlated returns. Many hedge funds have as an objective consistency of returns and capital preservation rather than magnitude of returns. Most hedge funds are managed by experienced investment professionals who are generally disciplined and diligent. Pension funds, endowments, insurance companies, private banks and high net worth individuals and families invest in hedge funds to minimize overall portfolio volatility and enhance returns. Most hedge fund managers are highly specialized and trade only within their area of expertise and competitive advantage.

Hedge funds benefit by heavily weighting hedge fund managers remuneration towards performance incentives, thus attracting the best brains in the investment business. In addition, hedge fund managers usually have their own money invested in their fund. Risk and Return An investor expects a return from investment expected return in the future Future is uncertain and so future expected return is uncertain This uncertainty associated with return from investment introduces risk into an investment There is expected return on every investment The actual return realized may not correspond to the expected return. The possibility of variation of actual return from the expected return is termed RISK Elements of Risk The factors which produce variations in return from investment constitute the elements of risk. The elements of risk affecting investment may be classified into two groups: Factors that are external to the company systematic risk Factors that are internal to the company unsystematic risk Total risk = systematic risk + unsystematic risk Systematic Risk External to the Company Capital risk: This refers to the risk of losing the capital invested. Currency risk: Risk due to change in exchange rate. If one holds assets in a foreign currency, changes in the exchange rate can cause fluctuations in the asset value. A decline in the value of the foreign currency vis--vis the investors domestic currency will result in a reduction in the value of the asset in terms of the home currency. This is known as currency risk or exchange rate risk. Liquidity risk: The risk associated with a delay in the trade of an asset is known as liquidity risk. An asset sale may be difficult due to the small size of the market or low demand, preventing the owner from converting the asset into cash. Credit risk: The risk associated with the inability of the borrower to repay the principal is known as credit risk. For instance, the owner of a corporate bond could suffer losses in case the issuing company declares bankruptcy and is unable to redeem the bond. Inflation risk (Purchasing power risk): Inflation erodes the value of a currency. The possibility of the value of an asset declining due to contraction in the purchasing power of a currency is called inflation risk. Interest rate risk: The possibility of devaluation of an interest-baring asset (such as bonds, stocks and loans) due to a change in the interest rate is known as interest rate risk. Market risk: This refers to the possibility of a decline in the value of an investment due to a change in price. Price fluctuations may be caused by changes in the interest rate, foreign exchange rate ,inflation or demand and supply situation. Legal risk: The risk associated with changes in laws and regulations is called legal risk. Counterparty risk: This refers to the risk of the other party in an agreement defaulting. For instance, the risk faced by an option owner of the other party not selling the underlying asset as agreed is called their counterparty risk. Business risk Probability of loss inherent in a firm's operations and environment (such as competition and adverse economic conditions) that may impair its ability to provide returns on investment. Business risk plus the financial risk arising from use of debt (borrowed capital and/or trade credit) equal total corporate risk.

Financial risk Financial risk is the additional risk a shareholder bears when a company uses debt in addition to equity financing. Companies that issue more debt instruments would have higher financial risk than companies financed mostly or entirely by equity. Levered firm and unlevered firm effect of operating profit on EPS As far as an investor is concerned the unsystematic risk is not very important as it can be reduced through diversification. But systematic risk is important as it is undiversifiable. Asset allocation Asset allocation is an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio according to the investors risk tolerance, goals and investment time frame A fundamental justification for asset allocation is the notion that different asset classes offer returns that are not perfectly correlated, hence diversification reduces the overall risk in terms of the variability of returns for a given level of expected return. Security Selection It is a process used to determine which securities will be included in a particular portfolio. Certain factors, such as risk and return, are taken into consideration when selecting the security. The goal of security selection is to increase one's chances of making a profit on all investments in the portfolio and to hedge against losses. Diversification is an important function in security selection In risk management, the act or strategy of adding more investments to one's portfolio to hedge against the investments already in it. Ideally, this reduces the risk inherent in any one investment, and increases the possibility of making a profit, or at least avoiding a loss. This may also reduce the expected return on a portfolio, but it depends on level and type of diversification. There are two main types of diversification. Horizontal diversification involves investing in similar investments. Examples include investing in several technology companies or in different types of bonds. Vertical diversification involves investing in very different securities; for example, one may choose to invest in securities traded in different countries, or in both winter clothing and swimsuit companies. Both types of diversification may be as broad or as narrow as the investor chooses. In general, broader diversification equates to less risk and less return.