CHAPTER ONE:

INVESTMENT AND RISK

1.1 Meaning of investment

• Investment is the current commitment of dollars for a period of time in order to

derive future payments that will compensate the investor for:-

(1) the time the funds are committed,

(2) the expected rate of inflation, and

(3) the uncertainty of the future payments.

• The “investor” can be an individual, a government, a pension fund, or a

corporation.
• Similarly, this definition includes all types of investments, including
investments by corporations in plant and equipment and investments by
individuals in stocks, bonds, commodities, or real estate. In all cases, the
investor is trading a known dollar amount today for some expected future
stream of payments that will be greater than the current outlay.

At this point, we have answered the questions about why people invest and what they
want from their investments.

• Why?
They invest to earn a return from savings due to their deferred consumption.
• What they want?
They want a rate of return that compensates them for the time, the expected rate of
inflation, and the uncertainty of the return.

Investing may be very conservative as well as aggressively speculative. Whatever

be the perspective, investment is important to improve future welfare.

• Funds to be invested may come from assets already owned, borrowed money,
savings or foregone consumptions.
• By forgoing consumption today and investing the savings, investors expect to
enhance their future consumption possibilities by increasing their wealth.
▪ Investment can be made to intangible assets like marketable securities or to real
assets like gold, real estate etc. More generally it refers to investment in
financial assets.

➢ Investments Refers to the study of the investment process, generally in

financial assets like marketable securities to maximize investor’s wealth, which
is the sum of investor’s current income and present value of future income. It has
two primary functions: analysis and management.
Investment environment

Investment environment can be defined as the existing investment instruments

in the market available for investor and the places for transactions with these
investment instruments.

1.2 Investment instruments

Investment in financial assets differs from investment in physical assets in those

important aspects:

•Financial assets are divisible, whereas most physical assets are not. An asset is
divisible if investor can buy or sell small portion of it. In case of financial assets it
means, that investor, for example, can buy or sell a small fraction of the whole
company as investment object buying or selling a number of common stocks.

• Marketability (or Liquidity) is a characteristic of financial assets that is not shared by

physical assets, which usually have low liquidity.

Marketability (or liquidity) reflects the feasibility of converting of the asset into cash
quickly and without affecting its price significantly.

• Most of financial assets are easy to buy or to sell in the financial markets.

▪ The main types of financial investment instruments are:

•Short term investment;

•Fixed-income securities;
•Common stock;
•Other investment tools.

Financial markets
- are segmented into money markets and capital markets.

1. Money market instruments

• they are called cash equivalents, or just cash for short) include short-term,
marketable, liquid, low-risk debt securities. )

Money market instruments / Short - term investment:-

Are all those which have a maturity of one year or less.

Short term investment instruments often are defined as money market
instruments, because they are traded in the money market which presents the
financial market for short term (up to one year of maturity) marketable
financial assets.
The risk as well as the return on investments of short-term investment
instruments usually is lower than for other types of investments.
 The main short term investment instruments are:

•Certificates of deposit;
•Treasury bills;
•Commercial paper;
•Bankers’ acceptances;
•Repurchase agreements
Certificate of deposit :-
▪ Is debt instrument issued by bank that indicates a specified sum of money
has be deposited at the issuing depository institution.
▪ Certificate of deposit bears a maturity date and specified interest rate and
can be issued in any denomination.
▪ Most certificates of deposit cannot be traded and they incur penalties
for early withdrawal.
▪ For large money-market investors financial institutions allow their large-
denomination certificates of deposits to be traded as negotiable certificates
of deposits.
Treasury bills (also called T-bills):-
• Are securities representing financial obligations of the government.
• Treasury bills have maturities of less than one year.
• They have the unique feature of being issued at a discount from their nominal
value and the difference between nominal value and discount price is the only
sum which is paid at the maturity for these short term securities because the
interest is not paid in cash, only accrued.
• The other important feature of T-bills is that they are treated as risk-
free securities ignoring inflation and default of a government, which was rare
in developed countries, the T-bill will pay the fixed stated yield with certainty.
But, of course, the yield on T-bills changes over time influenced by
changes in overall macroeconomic situation.
• T-bills are issued on an auction basis. The issuer accepts competitive bids and
allocates bills to those offering the highest prices.
• Noncompetitive bid is an offer to purchase the bills at a price that equals the
average of the competitive bids. Bills can be traded before the maturity, while
their market price is subject to change with changes in the rate of interest. But
because of the early maturity dates of T-bills large interest changes are
needed to move T-bills prices very far.
• Bills are thus regarded as high liquid assets.
Commercial paper:-
▪ is a name for short-term unsecured promissory notes issued by corporation.
▪ Is a means of short-term borrowing by large corporations.
▪ Large, well-established corporations have found that borrowing directly from
investors through commercial paper is cheaper than relying solely on bank loans.
▪ It is issued either directly from the firm to the investor or through an intermediary.
▪ Commercial paper, like T- bills is issued at a discount.
 ▪ The most common maturity range of commercial paper is 30 to 60 days or
less.
▪ It is riskier than T-bills, because there is a larger risk that a corporation will
default.
▪ Also, commercial paper is not easily bought and sold after it is issued, because the
issues are relatively small compared with T-bills and hence their market is not
liquid.

Bankers acceptances :-
▪ Are the instruments created to facilitate commercial trade transactions.
▪ Called bankers acceptances because a bank accepts the responsibility to repay a
loan to the holder of the instrument in case the debtor fails to perform.
▪ Banker’s acceptances are short-term fixed- income securities that are created by
non-financial firm whose payment is guaranteed by a bank.
▪ This short-term loan contract typically has a higher interest rate than similar
short –term securities to compensate for the default risk.
▪ Since bankers’ acceptances are not standardized, there is no active trading
of these securities.
Repurchase agreement (often referred to as a repo) :-
▪ is the sale of security with a commitment by the seller to buy the security back
from the purchaser at a specified price at a designated future date.
▪ Basically, a repo is a collectivized short-term loan, where collateral is a
security.
▪ The collateral in a repo may be a Treasury security, other money-
market security.
▪ The difference between the purchase price and the sale price is the interest
cost of the loan, from which repo rate can be calculated.
▪ Because of concern about default risk, the length of maturity of repo is
usually very short.
▪ If the agreement is for a loan of funds for one day, it is called overnight repo;
if the term of the agreement is for more than one day, it is called a term repo.
▪ Using repos helps to increase the liquidity in the money market.

A reverse repo is the opposite of a repo. In this transaction a corporation buys the
securities with an agreement to sell them at a specified price and time.

Capital markets

include longer-term and riskier securities.

We subdivide the capital market into four segments: longer-term bond markets,
equity markets, and the derivative markets for options and futures.

Fixed-income securities :- are those which return is fixed, up to some

redemption date or indefinitely. The fixed amounts may be stated in money terms or
indexed to some measure of the price level. This type of financial investments is
presented by two different groups of securities:

• Long-term debt securities

• Preferred stocks.

Long-term debt securities:-

▪ It can be described as long-term debt instruments representing the
issuer’s contractual obligation.
▪ Long term securities have maturity longer than 1 year.
▪ The buyer (investor) of these securities is lending money to the issuer, who
undertake obligation periodically to pay interest on this loan and repay the
principal at a stated maturity date.
▪ Long-term debt securities are traded in the capital markets.
▪ From the investor’s point of view these securities can be treated as a “safe”asset.
But in reality the safety of investment in fixed –income securities is strongly
related with the default risk of an issuer.
▪ The major representatives of long-term debt securities are bonds, but today
there are a big variety of different kinds of bonds, which differ not only
by the different issuers (governments, municipals, companies, agencies,
etc.), but by different schemes of interest payments which is a result
of bringing financial innovations to the long-term debt securities market.
▪ As demand for borrowing the funds from the capital markets is growing the
long-term debt securities today are prevailing in the global markets. And it is
really become the challenge for investor to pick long-term debt securities
relevant to his/ her investment expectations, including the safety of investment.
Preferred stocks :-
▪ are equity security, which has infinitive life and pay dividends.
▪ But preferred stock is attributed to the type of fixed-income securities,
because the dividend for preferred stock is fixed in amount and known in
advance.
▪ Though, this security provides for the investor the flow of income very
similar to that of the bond.
▪ The main difference between preferred stocks and bonds is that for
preferred stock the flows are forever, if the stock is not callable.
▪ The preferred stockholders are paid after the debt securities holders but
before the common stock holders in terms of priorities in payments of
income and in case of liquidation of the company.
▪ If the issuer fails to pay the dividend in any year, the unpaid dividends will
have to be paid if the issue is cumulative.
▪ If preferred stock is issued as noncumulative, dividends for the years with
losses do not have to be paid. Usually same rights to vote in general meetings
for preferred stockholders are suspended.
 ▪ Because of having the features attributed for both equity and fixed-income
securities preferred stocks is known as hybrid security.
▪ A most preferred stock is issued as noncumulative and callable. In recent
years the preferred stocks with option of convertibility to common stock are
proliferating.
The common stock:-
▪ is the other type of investment instruments which is one of most popular
among investors with long-term horizon of their investments Common
stock represents the ownership interest of corporations or the equity
of the stock holders.
▪ Holders of common stock are entitled to attend and vote at a general meeting
of shareholders, to receive declared dividends and to receive their share of the
residual assets, if any, if the corporation is bankrupt.
▪ The issuers of the common stock are the companies which seek to receive
funds in the market and though are “going public”.
▪ The issuing common stocks and selling them in the market enables
the company to raise additional equity capital more easily when using
other alternative sources. Thus many companies are issuing their common
stocks which are traded in financial markets and investors have wide
possibilities for choosing this type of securities for the investment.

Financial markets

Financial markets are the other important component of investment

environment. Financial markets are designed to allow corporations and
governments to raise new funds and to allow investors to execute their buying
and selling orders. In financial markets funds are channeled from those with
the surplus, who buy securities, to those, with shortage, who issue new securities or sell
existing securities. A financial market can be seen as a set of arrangements that allows
trading among its participants.

Other investment tools:

• Various types of investment funds;

• Investment life insurance;

• Pension funds;

• Hedge funds.
1.3 INVESTMENT ALTERNATIVES:

▪ Assets: Assets are things that people own.

▪ The two kinds of assets are financial assets and real assets.
▪ The material wealth of a society is determined ultimately by the productive
capacity of its economy—the goods and services that can be provided to its
members.
▪ This productive capacity is a function of the real assets of the economy: the
land, buildings, knowledge, and machines that are used to produce goods
and the workers whose skills are necessary to use those resources.
▪ Together, physical and “human” assets generate the entire spectrum of out-
put produced and consumed by the society. In contrast to such real assets are
financial assets such as stocks or bonds. These assets,by itself, do not represent
a society’s wealth.
▪ Shares of stock are no more than sheets of paper or more likely, computer
entries, and do not directly contribute to the productive capacity of the
economy. Instead, financial assets contribute to the productive capacity of
the economy indirectly, because they allow for separation of the ownership and
management of the firm and facilitate the transfer of funds to enterprises
with attractive investment opportunities.
▪ Financial assets certainly contribute to the wealth of the individuals or firms
holding them.

This is because financial assets are claims to the income generated by real assets or
claims on income from the government.

When the real assets used by a firm ultimately generate income, the income is
allocated to investors according to their ownership of the financial assets, or
securities, issued by the firm.

Bondholders, for example, are entitled to a flow of income based on the interest rate
and par value of the bond. Equity holders or stockholders are entitled to any residual
income after bondholders and other creditors are paid. In this way the values of
financial assets are derived from and depend on the values of the underlying real
assets of the firm. Real assets produce goods and services, whereas financial assets
define the allocation of income or wealth among investors. Individuals can choose
between consuming their current endowments of wealth today and investing for the
future. When they invest for the future, they may choose to hold financial assets. The
money a firm receives when it issues securities (sells them to investors) is used
to purchase real assets. Ultimately, then, the returns on a financial asset come from the
income produced by the real assets that are financed by the issuance of the security.
In this way, it is useful to view financial assets as the means by which individuals
hold their claims on real assets in well-developed economies. Most of us cannot
personally own auto plants (a real asset), but we can hold shares of General Motors or
Ford (a financial asset), which provide us with income derived from the production
of automobiles. Real and financial assets are distinguished operationally by the
balance sheets of individuals and firms in the economy. Whereas real assets appear
only on the asset side of the balance sheet, financial assets always appear on both
sides of balance sheets. Your financial claim on a firm is an asset, but the firm’s
issuance of that claim is the firm’s liability

Securities:

A security is a legal document that shows an ownership interest. Securitie shave

historically been associated with financial assets such as stocks and bonds, but in
recent years have also been used with real assets.

Securitization is the process of converting an asset or collection of assets into a more

marketable forum.

Security Groupings:

Securities are placed in one of three categories:

• Equity securities,
• Fixed income securities, or
• Derivative assets.

1) Equity Securities:

The most important equity security is common stock. Stock represents

ownership interest in a corporation. Equity securities may pay dividends from the
company’s earnings, although the company has no legal obligation to do so.

Most companies do pay dividends, and most companies try to increase these dividends
on a regular basis.

2) Fixed Income Securities:

A fixed income security usually provides a known cash flow with no growth in the
income stream. Bonds are the most important fixed income securities.

A bond is a legal obligation to repay a loan’s principal and interest, but

carries no obligation to pay more than this. Interest is the cost of borrowing money.
Although accountants classify preferred stock as an equity security, the investment
characteristics of preferred stock are more like those of a fixed income security. Most
preferred stocks pay a fixed annual dividend that does not change overtime
consequently. An investment manager will usually lump preferred shares with bonds
rather than with common stocks.

Conversely, a convertible bond is a debt security paying a fixed interest rate. It has then
added feature of being convertible into shares of common stocks by the bond holders.
If the terms of the conversion feature are not particularly attractive at a given
moment, the bonds behave like a bond and are classified as fixed income securities.
On the other hand, rising stock prices make the bond act more like the underlying
stock, in which case the bond might be classified as an equity security. The point is that
one cannot generalize and group all stock issues as equity securities and all bonds as
fixed income securities. Their investment characteristics determine how they are
treated. For investment purposes, preferred stock is considered a fixed income security.

3) Derivative Assets:

The value of such an asset derives from the value of some other asset or the relationship
between several other assets. Future and options contracts are the most familiar
derivative assets.