Anda di halaman 1dari 13

Investment: Investment is a current commitment of an amount for a period of

time in order to derive future earnings that will compensate the investor for: 1. the
time for which the funds are committed. 2. The expected rate of inflation. 3.
Uncertainty of future flows of funds.

Why do we need investment: By saving and investing money; investors trade-off


current consumption for a larger future consumption. There are some specific
objectives of investment: 1. Capital preservation. 2. Capital appreciation. 3. Current
income. 4. Total return.

1. Capital preservation: Investors want to minimize the risk of loss of investment


amount. They seek to maintain the purchasing power of their investments. The rate
of return from the investment need to be no less than the rate of inflation.

2. Capital appreciation: The investors want to grow the investment amount in


real terms over time to meet the future demand and this growth occurs through the
capital gains.

3. Current income: The investors want the investment amount to concentrate on


generating income rather than capital gains.

4. Total return: Investors seek to increase the portfolio value by both capital gains
and re-invest in current income.

Investment Constraints: Some constraints are considered by investors while


making investment: 1. Liquidity needs. 2. Time horizon. 3. Tax concerns

1. Liquidity needs: Investors may have liquidity needs that must be considered
while making investment plan they may require liquidity to make various current
obligations without hampering the investment plan.

2. Time horizon: There is a close relationship between time horizon, liquidity


needs and the ability to handle risk. Investors with long term investment generally
require less liquidity because funds are not usually needed for many years.
Investors can tolerate long term risk because any short fall on losses can be
overcome by returns/ by earning in subsequent years. Investors with short term
investment generally favor more liquid and less risk because losses are harder to
overcome during short time frame.

3. Tax concerns: Investment planning is complicated by the tax code of the govt.
For example: if the tax is calculated before paying dividends, investors require to
pay more tax. If it is calculated tax after paying dividend, they require to pay less
tax.

If more tax is imposed on a particular investment, investors will be inclined to invest


which require to pay less or no tax.
Rate of return: It is the exchange rate between future consumption and current
consumption. If the value of future earnings decreases due to inflations, the
investor will demand higher rate of return to cover the expected inflation effect. If
the future return from the investment is not certain, the investor will demand a rate
of return to cover the investment risk that will provide the risk premium.

Holding period: The period for which the investment is made.

Holding period return: The return from the investment for the period for which
the investment is made

HPR= ending value of investment ÷ beginning value of investment

Holding Period Yield (HPY) = HPR – 1

If an investor invests 200 at the beginning of the year and gets back 220 at the end
of the year, the holding period return= 220 ÷ 200 = 1.1, HPY= 1.1-1= .10
(1/n)
Annual Holding Period Return (AHPR): HPR (n= number of years)

If the investor invests 1000 and gets back 2500 after 3 years, what is the annual
HPR? HPR= 2500/1000=2.5, AHPR= 2.5 (1/3) = 1.36

Annual HPY: Annual HPR – 1

Arithmetic mean of HPY: ∑ all HPY ÷ no. of period

Growth percentage/ geometric mean of HPR: (HPR1 × HPR2 × HPR3 × …….


HPRn) (1/n)
(1/n)
Return: (HPR1 × HPR2 × HPR3 × ……. HPRn) –1

……………………………………………………………………………………………………….

Factors Considered by investor in selecting securities:

There are some factors that must be considered by an investor in selecting


securities: 1. Time value of money of cash flows. 2. Expected rate of inflation. 3.
Involved risk. These 3 components constitute required rate of return.

1. Time value of money of cash flows: It is the minimum rate of return that an
investor should accept from an investment to compensate for deferring
consumptions. Since the required returns from investments change over time,
investors should be aware of these components to determine the required rate of
return. These returns vary due to riskiness of investment so the investor must
consider risk factor that affect the required rate of return.

Real risk free rate of return: It is the basic interest rate assuming no inflation
and no uncertainty about the future cash flows. RRFR (Real Risk Free Rate) is
influenced by 2 factors: 1. Time preference for consumption of income. 2.
Investment opportunities in the economy.

i) Time preference for consumption of income: Where individuals give up/


consume an amount this year, how much does he want a year from now to
compensate for that sacrifice and the strength of desire for current consumption
influence the rate of compensation required in the form of real risk free rate.

ii) Investment opportunity in the economy: A rapid growing economy provides


more and better opportunities to invest funds and to have positive rates of return.
Investors supplying the funds demand higher rate of return when economy growth
is higher. Investors looking for funds are willing to pay higher rate of return to use
funds for investments because of higher growth rate. So there is a positive
relationship between investment opportunities and the real risk free rate.

Nominal risk free rate: It is the quoted rate of interest for a financial asset and it
is determined by the real rate of interest plus factors depending on: 1. Conditions in
the capital market. 2. Expected rate of inflation

i) Conditions in the capital market: A change in supply for money and demand
for money changes the nominal rate of interest.

ii) Expected rate of inflation: If investor expects the price level to increase
during the investment period, they would require the rate of return to compensate
the expected rate of inflation.

There is a relationship between nominal rate of interest and real interest rate.

NRFR (Nominal Risk Free Rate) = (1+RRFR) (1+Expected Inflation Rate) – 1

Example: assume that the nominal return of T-bill is 9% during a given year when
the rate of inflation is 5%. What is the RRFR? Ans: 9% = (1+RRFR) (1+5%) – 1. So,
RRFR= 3.8%

Security Market Line: When there are changes is one of the following factors: 1.
Expected growth rate of economy. 2. Capital market condition. 3. Expected rate of
inflation. If one of these factors changes, there is parallel upward shift of SML. If
parallel shift occurs, it occurs because, changes in these factors affect the
economy’s nominal risk free rate that impacts all investments.

………………………………………………………………………………………………………………
…………………………….

Asset Allocation:

It is the process of deciding how to distribute an investor’s wealth among asset


classes for investment purposes.
Asset class: It is composed of securities that have similar attributes,
characteristics and risk return relationships. For example: bond is an asset class.
Bond can be divided into small asset classes like corporate bonds, govt. bonds

Importance of asset allocation: Asset allocation decision is based on four types


of decisions. It is called the investment strategy. 1. What asset class to consider for
investment. 2. What weight to assign to each asset class. 3. To determine the
allowable allocation range of each class based on the weight. 4. What specific
securities to select for the portfolio. These 4 decisions make investment strategy.

Investor’s Lifecycle: There are 4 stages of investor’s lifecycle: 1. Accommodation


phase. 2. Consolidation phase. 3. Spending phase. 4. Gifting phase

1. Accommodation phase: This phase covers individual’s early to middle years of


working career. Characteristics of this phase are: 1. These individuals attempts to
accumulate assets to satisfy immediate needs such as: down-payment for a
house or a car. Another is long term goal such as: children’s college education,
expenses after retirement. 2. Their net worth is usually small. 3. They consider long
term investments for future earning ability. In doing so, they make relatively high
risk investment in the hope of earning above average return over time.

2. Consolidation Phase (35-60 years): It covers individuals in the past midpoint


of careers. They have paid off much/ all of their outstanding debts. They have
assets to pay their children’s college bills, their earnings are greater than their
expenses and the excess amount can be invested to provide for future retirement
or real estate plan. Individuals in this phase are concerned about capital
preservation. They don’t want to take high risk.

3. Spending phase (after 60 years): Spending phase usually begins after


retirement. Living expenses are covered by income from prior investments. Because
their earning has concluded, they seek greater of their capital.

4. Gifting phase: In this phase, individuals believe that they have sufficient
income and assets to cover their current and future expenses and excess income
can be used to provide financial assistance: 1. To relatives and friends. 2. To
establish charitable trust or to fund trusts.

Portfolio Management Process:

There are 4 steps of this process: 1. Developing investment policy statement. 2.


Examining current and projected financial and economic connections. 3.
Implementing the investment plan by constructing the portfolio. 4. Continual
monitoring of the investors’ needs

1. Developing investment policy statement: An investor should develop a


policy statement before making a long term policy investment decision. Policy
statement is a road map that guides the investment process because: 1. It helps
investors understand their own needs, objectives and investment constraints. 2. It
sets standards for evaluating portfolio performance. 3. It helps the investor decide
on realistic investment goals, knowing about the financial market and the risk of
investment.

All investment decisions are based on policy statement to ensure that, they
(investments) are appropriate for the investors

2. Examining current and projected financial and economic connections: It


requires to study short term and intermediate term expected financial and
economic condition and forecast future trends. The investors’ needs and
expectations from the financial market jointly determine the investment strategy of
the investors.

3. Implementing the investment plan by constructing the portfolio: With


the policy statement and financial forecast as input, the investor can implement the
investment strategy and determine how to allocate available funds across different
countries and asset classes. It involves constructing a portfolio that will minimize
the investors’ risk.

4. Continual monitoring of the investors’ needs: It is required to evaluate a


portfolio performance and compare relative results to the expectations of the
investor that are specified in the policy statement. So it requires continual
monitoring of the investors’ needs and capital market conditions. It also requires
updating policy statement when necessary. Based upon all of these, investment
strategies can be modified accordingly.

………………………………………………………………………………………………………………
…………………………………………………..

Investment in Global Market:

Reasons:

1. Growth and development of the global financial market

2. Advances in the telecommunications technology

3. Mergers of firms and security markets around the globe

Advantages of diversification: Diversification reduces the variability of return


over time.

Classification of investment: Investments can be divided by asset classes: 1.


Fixes income investments. 2. Equity investments. 3. Special equity investments. 4.
Future contracts. 5. Investment companies. 6. Real estate. 7. Miscellaneous
1. Fixed Income Investment: These types of investments have contractual
payment schedule: 1. Different types of bond. 2. Preferred stock. 3. Certificate of
deposit. 4. Money market instruments (commercial paper, banker’s acceptance), 5.
Capital market instruments

5.1 Treasury securities: there are 2 types of treasury securities: treasury notes,
treasury bonds.

Treasury notes: maturity period up to 10 years. Treasury bond: over 10 years.

Advantages of treasury notes and bonds: highly liquid and are backed by govt.

5.2 Govt. agency securities: issued by govt. agencies: govt. mortgage bank,
home loan bank, national housing authorities, govt. agency securities are not direct
obligation of the treasury and they are considered default free and fairly liquid.

5.3 Corporate bonds:

Debentures: are unsecured promises to pay interest and the principal amount. In
case of default, debenture owner can claim any unpledged assets to pay off the
bonds.

Sub-ordinate bonds: are unsecured like debentures but the holders of this bonds
may claim asset after debenture holders claim

Income bonds: are issued by financially troubled company and the company
doesn’t have to pay the interest unless the company earns sufficient income to pay
the interest. Interest payment depends upon the firm’s income.

Bond with warrants: It allows bondholders to purchase common stock at a fixed


price for a given time period.

Zero-coupon bond: It is offered at a high discount from the free value and
company does not pay interest during the life of the bond and the principal amount
(face value) is re-paid after the maturity

Preferred stock: - Company pays fixed dividends.

- Most preferred stock is cumulative

- There are credit implications on missing dividends

International Bonds: These types of bonds offer fixed income outside the country
and also offer additional opportunities for diversification.

Identification characteristics of international bond: 1. Country of origin. 2.


Location of primary trading market. 3. Home market of major buyers. 4. Currency of
the security denomination
There are 3 types of international bonds:

1. Euro bond: It is an international bond denominated in currency not native to the


country where it is issued

2. Yankee bond: are sold in the US and denominated in US dollars but issued by
foreign corporations or governments. It eliminates exchange risk of the US investors

3. International Domestic Bonds: These are offered by the issuer within its own
country in that country’s currency but foreign national can also buy these bonds.

2. Equity Investment:

1. Common Stock: 1. It represents the ownership of a fund 2. Investors’ return


(dividend) depends on the performance of the company. 3. May result in loss or
gain

2. Stock of foreign companies: Investors can invest directly in foreign equity


market and it is often difficult and complicated due to administrative information,
taxation and exchange rates

3. International mutual funds: There are 2 types of international mutual funds:


1. Global funds: are invested in both home and foreign stocks. 2. International
funds: are invested mostly outside the country.

3. Special equity investments: are related to purchase and sell of equity.

1. Warrants: These are options issued by a company that gives the holders right
to buy common stock from the company at a specified price within a specified time
period. Warrant does not represent ownership of the stock but only the option to
buy the stock

2. Call option: A call option gives the right to buy the common stock of a company
within a certain period at a specified price

3. Put option: it gives the right to sell a given stock of a company within a certain
period at a specified price. It is useful to the investors when stock price declines
during the specified period

4. Future contract: is agreement on a particular asset at a specified delivery date


for a stated price at that time of delivery. Initial deposit is made by the buyer at the
contract to protect the seller.

Investment Companies: sell shares to the public and uses proceeds to buy
securities. There are different types of funds of investments companies.
1. Money market fund: invest in short term high quality money market asset
such as: treasury bill, bank certificate of deposit, banker’s acceptance, commercial
papers

2. Bond funds: invest in long term govt. and corporate bonds. Govt. bonds are
default free but the expected returns from corporate bonds vary with degree of risk
of bonds

3. Sector funds: invest in securities of a particular industry

4. International funds: These funds are invested in securities outside the country

5. Global funds: global funds are invested in the home country and other
countries

6. Balanced funds: invest in a combination of stocks and bonds depending on the


objections of funds

7. Real estate investment: invested in a variety of real estate properties.


Residential estate has lower risk and return than commercial real estate. In a short
term, real estate shows higher returns than stocks with lower risk. In long term,
returns from real estate are lower than stocks

Purchase of home: Investors hope to sell the house for cost plus gain

Purchase of raw land: It provides very high return in the future. It provides low
liquidity and there is a risk from selling for an uncertain price

Land development: Investors buy raw land and divide it to individual plots. They
build houses, shopping mall on it and returns from successful development are
significant.

Antiques: Serious collectors may enjoy good returns from antiques but individuals
buying a few pieces to decorate house may have difficulty to earn profit

Art: Investors require substantial knowledge on art and art world. Acquisition of
work from well known artists requires large capital investment and patience to earn
profit. Its market data is limited and has low liquidity

Coins and stamps: is enjoyed by many as hobby and as an investment and it is


more liquid than art and antique market. Market data are available because price
list are published weekly and monthly

Diamonds: grading of diamonds determines the value but it is subjective and it


requires substantial investments. No income until sold

Functioning of Security Market:


Market: It is a means which brings buyers and sellers together to aid in the transfer
of goods and services. There are some aspects of market:

1. It does not require physical location. It only requires that, buyers and sellers can
communicate with each other

2. It provides smooth transfer of goods and services

3. It provides facilities to transfer ownership

4. It provides benefits to both buyers and sellers

Characteristics of Good Market:

1. Good market provides timely and accurate information that is buyers and sellers
must have timely and accurate information on the volume and prices of past
transaction and all current outstanding offers.

2. A good market provides liquidity to the owners of goods and services

3. In a good market, transaction cost is low which makes market more efficient

4. It provides rapid adjustment of prices to new information. Prevailing market


prices reflect all available information about an asset

There are 2 broad categories of security market: 1. Primary security market 2.


Secondary security market

1. Primary market: It is the market where the new issues/ securities are sold by
the government or corporations to raise new capital. Funds go directly to the issuing
unit.

1.1 Govt. bond: Treasury bills, treasury notes, treasury bonds

1.2 Corporate bond: Corporate bonds are issued through a negotiated


assessment of an investment banking firm which works as the underwriter.
Investment banking firms compete with each other to get underwriting business.

Underwriting function: the investment banking firm purchases the entire issue
from the corporations and resells the security to the investors. Underwriting
function involves 3 services: 1. Organization 2. Risk bearing 3. Distribution

Organization: involves the design of security issues. The design includes: the
maturity period, face value, coupon rate

Risk Bearing: Underwriter acquires the total issues at a price set in a competitive
bid or negotiations.
Distribution: involves selling the issue to the investors with the help of other
investment banking firms or commercial banks

1.2.1 Corporate Stock Issues: New corporate stocks are issued into 2 issues: 1.
Seasoned new issues 2. Initial public offerings

Seasoned New Issues: are new issues offered by firms that already have stock
outstanding i.e. a firm which has stock outstanding could sell additional share to the
public at a price very close to the current price of the firm’s stock.

IPO: it involves a firm selling its common stock to public for the first time. The new
issues are usually underwritten by the company and sell the security to the
interested investors.

There are 3 forms of underwriting functions. The underwriting function takes


one of the 3 forms: 1. Negotiated. 2. Competitive bids. 3. Best efforts

a. Negotiated: This form involves the contractual arrangement between the issues
and the underwriter. The underwriter helps the issuer prepare stock issue, set the
price and has the exclusive right to sell the issue

b. Competitive bids: It involves competitive bids. The issue is sold to the bidder
who submits the bid with highest price.

c. Best effort: This is usually done with new issues. Investment banker agrees to
sell issue on a best effort basis. Investment banker acts as a broker to sell whatever
it can by giving the best effort.

2. Secondary Market: It is a market where outstanding securities are brought and


sold by investors. The issuing unit does not receive any fund from a secondary
market transaction.

Characteristics: 1. It provides liquidity to investors who acquire security in the


primary market. 2. It helps determine market price for new issues

Trading system in the secondary market: There are 2 major trading systems.
1. Pure auction market. 2. Dealer market

Pure auction market: Interested buyers and sellers submit bids and ask price for
a given stock. A broker acts as a facilitating agent. It is also called the price driven
market because shares of stock are sold to the highest bidder and bought from the
seller who offers lowest selling price

Dealer market: Dealers provide liquidity to the investors by buying and selling
shares of stock and dealers compete with each other to provide the highest bid
price to the seller and lowest ask price to the buyer. A stock exchange can use
anyone or combination of both. There are other 2 types of markets for buying and
selling auctions. 1. Call market. 2. Continuous market
1. Call market: gather all bids and ask orders at a point in time to determine a
single price to satisfy the most orders. Call markets are used during early stage of
development of an exchange in which there are few stocks listed and small number
of investors.

2. Continuous market: In a continuous market, trading occurs at any time the


market is open where stocks are priced either by auctions or by dealers

Portfolio Theory:

Portfolio: includes all investments of an investor. There are 2 factors that affect an
investor’s choice in making investment decision: 1. Risk 2. Rate of return

An investor wants to minimize the rate of return for a given level of risk. If 2 assets
give the same rate of return, the investor will prefer the asset with lower level of
risk.

Risk: Uncertainty of future incomes. It is also the probability of adverse income.

Markwitz portfolio model: is used to calculate the expected rate of return from a
portfolio of assets and risk of the portfolio.

Markwitz portfolio theory: The model is based on a set of assumptions:

1. Investors consider each investment alternative being presented by the


probability distribution of expected returns over some holding period.

2. Investors try to maximize one period expected utility and their utility curves
demonstrate diminishingly marginal utility of wealth.

3. Investors estimate the risk of the portfolio on the basis of the variability of
expected returns from portfolio.

4. Investors base decision depends solely on the expected return and risk so their
utility curves are the function of expected return and the expected variance of
standard deviation of returns.

5. For a given level risk, investors prefer higher returns to lower returns. Similarly
for a given level of expected returns, investors prefer lower risk to higher risk.

Considering these assumptions, a single asset or a portfolio of assets is considered


to be efficient if no other asset or portfolio of asset offers higher expected rate of
return with same or lower risk.

For an individual asset, the expected return is the sum of the potential returns
multiplied by the corresponding probabilities of the return. E (R) = ∑ PiRi
How to calculate the expected return: Portfolio weight: (a 20%, b 30%, c 30%,
d 20%); return: (a 10%, B 11%, C 12%, D 13%). Expected return: (20% × 10%) +
(30% × 11%) + (30% × 12%) + (20% × 13%) = 11.5%

Measurement of risk of portfolio management: 3 measures of risk: 1.


Variance/ standard deviation of expected returns.2. Range of returns. 3. Semi
variance

Semi-variance: It is a measure that considers deviations of returns below the


expected return. It assumes that, investors want to minimize the loss from returns
below some target rate. It also assumes that, investor would welcome returns
above the target rate and the returns above the target rate are not considered in
measuring risk.

Variance: δ2= ∑(Ri – E(R))2 × pi where Ri=return from asset, E(R)= Expected return
(E (R) = ∑ PiRi), Pi=probability

Positive co-variance indicates that, rates of return from 2 investments tend to


move in the same direction relative to their individual means during the same time
period.

Observation: 1. Low correlation reduces portfolio risk but expected return is not
affected. 2. Negative correlation exactly offsets the individual risk and makes the
standard deviation of the portfolio 0 and this is the risk free portfolio

Efficient Frontier: It is the envelop curve that contains best of all possible
combinations of various weights of 2 assets. The portfolio A dominates C because it
has equal rate of return at substantially lower risk and the portfolio B dominates C
because it has higher expected return at an equal risk

Features of Efficient Frontier:

1. The efficient frontier represents the set of portfolios with the maximum rate of
return for every given level of risk or the minimum risk for every level of return

2. Every portfolio that lies on efficient frontier has either a higher rate of return for
equal risk or lower risk with equal rate of return than some portfolios below the
frontier

3. The slope of the efficient frontier curve decreases steadily as we move upward. It
implies that, adding equal increment of risk, the efficient frontier gives diminishing
increments of expected returns

4. No portfolio on the efficient frontier can dominate any other portfolio on the
frontier. That means all of the portfolios have different risk and return with expected
return that increases with higher risk.

Investor’s Utility Function:


The set A of curves labeled u1, u2, u3 are for strongly risk averse investors. These
curves indicate that, the investors will not tolerate much additional risk to obtain
additional returns and the set of curves labeled u4, u5, u6 characterize less risk
averse investors. Such investors are willing to tolerate more risk to get higher
expected returns. An investor targets a point along the efficient frontier based on
his utility function which reflect his attitude toward risk. An individual investor’s
utility curve specifies the trade-off he is willing to make between the expected rate
of return and risk. This expected return and risk determines a particular portfolio
selected by an individual investor.

Optimum portfolio is the efficient portfolio that has the highest utility for an
investor. It lies at the point of tangency between the efficient frontier and the utility
curve with the highest possible utility. A conservative investor’s highest utility is at
point M where the utility curve just touches the efficient frontier. So this point is the
highest utility for conservative investor. A less risk averse investor’s highest utility
occurs at point N where the utility curve just touches the efficient frontier which
represents a portfolio with high expected return and higher risk than the portfolio at
M.