CHAPTER ONE

INVESTMENT DECISION

1.1 INVESTMENT DECISION PROCESS

INTRODUCTION
An investment is the current commitment of Money 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 term “investing” could be associated with different activities, but the common target in
these activities is to “employ” the money (funds) during the time period seeking to enhance
the investor’s wealth. Funds to be invested come from assets already owned, borrowed
money and savings. By foregoing consumption today and investing their savings, investors
expect to enhance their future consumption possibilities by increasing their wealth.
But it is useful to make a distinction between real and financial investments. Real
investments generally involve some kind of tangible asset, such as land, machinery,
factories, etc. Financial investments involve contracts in paper or electronic form such as
stocks, bonds and other financial instruments. This course deals only with the financial
investments because the key theoretical investment concepts and portfolio theory are
based on financial investments. Such theories allow us to analyze the investment decision
making process and portfolio management in the substantially broader context.

INVESTING VERSUS FINANCING

One of the most important questions for the company is financing. Modern firms raise
money by issuing stocks and bonds. These securities are traded in the financial markets
and the investors have possibility to buy or to sell securities issued by the companies. Thus,
the investors and issuer companies, searching for realize their interest in the same place
(in financial markets). Financing involves the interaction between firms (security issuer)
and financial markets but Investing involves the interaction between investors and
financial markets. Both Finance and Investment decisions are built upon a common set of
financial principles, such as the present value, the future value, the cost of capital. And very
often investment analysis and financing analysis for decision making use the same tools,
but the interpretation of the results from such analyses for the investor and for the
financier would be different. For example, for financing, when for issuing securities and
selling them in the financial market the companies may perform valuation of securities
looking for the higher price and the lower cost of capital; but the investors’ side they

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may be using valuation for searching attractive securities with the lower price and the
higher possible required rate of return on their investments.

TYPES OF INVESTORS
Investors can be categorized in to two as:
 Individual investors; and
 Institutional investors.
Individual investors are individuals who are investing by their own. Sometimes individual
investors are called retail investors.
Institutional investors are entities such as investment companies, commercial banks,
insurance companies, pension funds and other financial institutions. In recent years the
process of institutionalization of investors can be observed. As the main reasons for this
can be mentioned the fact that institutional investors can achieve economies of scale
One of the important preconditions for successful investing for both individual and
institutional investors is the favorable investment environment. The basic principles of
investment management are applicable for both individual and institutional investors.

1.2 FINANCIAL INVESTMENT ALTERNATIVES

These investment alternatives are commonly classified as follows:
 Short term securities
 Long term securities, and
 Derivatives

1. SHORT-TERM SECURITIES
These are all those which have a maturity of one year or less. Short term investment
alternatives 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 alternatives usually is lower than for other types of investments.
The main short term investment alternatives 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 been 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

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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. Bills are thus regarded as high liquid assets.
Commercial paper is a name for short-term unsecured promissory notes issued by
corporation. Commercial paper 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.
Commercial paper 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. Commercial paper 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; hence their market is not liquid.
Bankers’ acceptances are the alternatives created to facilitate commercial trade
transactions. These alternatives are called bankers’ acceptances because a bank accepts the
responsibility to repay a loan to the holder of the vehicle in case the debtor fails to perform.
Bankers’ 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.

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2. LONG TERM SECURITIES
Long term securities can be categorized in to two main categories as follows :
 Fixed income securities, and
 Common stock

Fixed-Income Securities
These are securities which have fixed return up to some redemption date or indefinitely.
The fixed amounts may be stated in monetary terms or indexed to some measure of the
price level. Securities categorized under this category are:
 Long-term debt securities
 Preferred stocks.
Long-term debt securities
Such securities can be described as long-term debt instruments representing the issuer’s
contractual obligation. Long term securities’ maturity is longer than 1 year. The buyer
(investor) of these securities is lending money to the issuer, who undertakes 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 stock is 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 differences between preferred stock and bonds are:
 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.

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  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.
Because of having the features attributed for both equity and debt- securities preferred
stock is known as hybrid security.

The Common Stock

It is the other type of investment alternatives. 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 than 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.

3. DERIVATIVE
Derivative is a security whose price is dependent upon or derived from one or more
underlying assets. A derivative is basically a financial instrument whose value is derived
from the value of an underlying security. The derivative itself is merely a contract between
two or more parties. Its value is determined by fluctuations in the value of underlying asset.
The most common underlying assets include stocks, commodities, currencies, interest rates
and others. Derivatives are generally used as instrument to hedge risk from fluctuations of
the value of underlying asset. Derivatives may include:
 Options- A privilege sold by one party to another offering the holder the right, but
not the obligation, to buy (call) or sell (put) a security at the strike price at a certain
time. A call option gives the holder the right to buy. A put option gives the holder
the right to sell.
 Future contracts- A financial contract that obligates the buyer to purchase (or in
the case of a seller, to sell and deliver) the assets underlying the contract at a certain
future date. Since they trade within secondary markets, the contracts are
standardized.
 Forward contracts- A cash market transaction where the delivery of the asset
underlying the contract is deferred until a future date. Contracts are not
standardized, as they are an agreement between two parties.
Forward contracts are agreements negotiated directly between two parties in the
OTC (i.e., Non-exchange-traded) markets. A typical participant in a forward contract
is a commercial or investment bank that, serving the role of the market maker, is

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 contacted directly by the customer (although customers can form an agreement
directly with one another). Forward contracts are individually designed agreements
and can be tailored to the specific needs of the ultimate end user.
 Swaps- The exchange of one security, currency or interest rate for another.

1.3 DIRECT VERSUS INDIRECT INVESTING

Investors can use direct or indirect type of investing. Direct investing is realized using
financial markets and indirect investing involves financial intermediaries. The primary
difference between these two types of investing is, in the case of direct investing, investors
buy and sell financial assets and manage individual investment portfolio by themselves.
Consequently, when investing directly through financial markets; investors take all the risk
and their successful investing depends on:
 Their understanding of financial markets
 Its fluctuations and
 Their abilities to analyze and to evaluate the investments and to manage their
investment portfolio.
Contrary, using indirect type of investing, investors are buying or selling financial
instruments through financial intermediaries (financial institutions) which invest large
pools of funds in the financial markets and hold portfolios. Indirect investing makes
investors free from making decisions about their portfolio. As shareholders with the
ownership interest in the portfolios managed by financial institutions (investment
companies, pension funds, insurance companies, commercial banks) the investors are
entitled to their share of dividends, interest and capital gains generated and pay their share
of the institution’s expenses and portfolio management fee. The risk for investor using
indirect investing is related more with the credibility of chosen institution and the
professionalism of portfolio managers. In general, indirect investing is more related with
the financial institutions which are primarily in the business of investing in and managing a
portfolio of securities (various types of investment funds or investment companies, private
pension funds). By pooling the funds of thousands of investors, those companies can offer
them a variety of services, in addition to diversification, including professional
management of their financial assets and liquidity. Investors can “employ” their funds by
performing direct transactions, by passing both financial institutions and financial markets
(for example, direct lending). But such transactions are very risky, if a large amount of
money is transferred only to one’s hands following the well-known American proverb
“don't put all your eggs in one basket” is better in investment. That turns to the necessity to
diversify your investments. All types of investing discussed above and their relationship
with the alternatives of financing are presented in Table below

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Companies can obtain necessary funds directly from the general public (those who have
excess money to invest) by the use of the financial market, issuing and selling their
securities. Alternatively, they can obtain funds indirectly from the general public by using
financial intermediaries. And the intermediaries acquire funds by allowing the general
public to maintain such investments as savings accounts, certificates of deposit accounts
and other similar alternatives.

1.4 RETURNS AND RISKS FROM INVESTMENT

RETURN
An investment is the current commitment of using money for a period of time in order to
derive future payments that will compensate the investor for:
 The time the funds are committed
 The expected rate of inflation, and
 The uncertainty of the future payments.
When we invest, we defer current consumption in order to add to our wealth so that we
can consume more in the future. The tradeoff of present consumption for a higher level of
future consumption is the reason for saving. What you do with the savings to make them
increase over time is investment. Those who give up immediate possession of savings (that
is, defer consumption) expect to receive in the future a greater amount than they gave up.
Conversely, those who consume more than their current income (that is, borrow) must be
willing to pay back in the future more than they borrowed.
The rate of change between future consumption (future value of money) and current
consumption(current amount of money) is the pure rate of interest. Both people’s
willingness to pay this difference for borrowed funds and their desire to receive a surplus
on their savings give rise to an interest rate referred to as the pure time value of money.
This interest rate is established in the capital market by a comparison of the supply of
excess income available (savings) to be invested and the demand for excess consumption
(borrowing) at a given time. If you can exchange $100 of certain income today for $104 of
certain income one year from today, then the pure rate of exchange on a risk-free
investment (that is, the time value of money) is said to be 4 percent (104/100 – 1).

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The investor who gives up $100 today expects to consume $104 of goods and services in
the future. This assumes that the general price level in the economy stays the same. This
price stability has rarely been the case during the past several decades. If investors expect a
change in prices, they will require a higher rate of return to compensate for it. For example,
if an investor expects a rise in prices (that is, he or she expects inflation) at the rate of 2
percent during the period of investment, he or she will increase the required interest rate
by 2 percent. In our example, the investor would require $106 in the future to defer the
$100 of consumption during an inflationary period (a 6 percent nominal, risk-free interest
rate will be required instead of 4 percent).

Further, if the future payment from the investment is not certain, the investor will demand
an interest rate that exceeds the pure time value of money plus the inflation rate. The
uncertainty of the payments from an investment is the investment risk. The additional
return added to the nominal, risk-free interest rate is called a risk premium. In our
previous example, the investor would require more than $106 one year from today to
compensate for the uncertainty. As an example, if the required amount were $110, $4, or 4
percent, would be considered a risk premium.

Holding period return

The period during which an investor owns an investment is called investment holding
period, and the return for that period is known as the holding period return (HPR). The
holding period return is the ratio of ending value of investment to the beginning value of
investment.
Example 1,
If you commit $200 to an investment at the beginning of the year and you get back $220 at
the end of the year, what is your return for the period? The HPR can be calculated as
follows:

This value will always be

zero or greater; that is, it can
never be a negative value. A value greater than 1.0 reflects an increase in your wealth,
which means that you received a positive rate of return during the period. A value less than
1.0 means that you suffered a decline in wealth; which indicates that you had a negative
return during the period. An HPR of zero indicates that you lost all your money. Although
HPR helps us express the change in value of an investment, investors generally evaluate
returns in percentage terms on an annual basis. This conversion to annual percentage
rates makes it easier to directly compare alternative investments that have markedly
different characteristics.

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The first step for converting an HPR to an annual percentage rate is deriving a percentage
return during the holding period, referred to as the holding period yield (HPY). The HPY
is equal to the HPR minus 1; mathematically it can be expressed as follows:

To measure the annual

performance of an investment, we have to derive an annual
Annual HPYHPY. Annual
= Annual HPRHPY
– 1. can be
computed by subtracting one from annual HPR.
Therefore Annual HPR must be computed first by using the following formula.

Here:
n = number of years in which the investment is held.
Example 2.
Consider an investment that costs $250 and is worth $350 after being held for two years
and compute the annual holding period yield.

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Note that we made some implicit assumptions when converting the HPY to an annual basis.
This annualized holding period yield computation assumes a constant annual yield for each
year. In the two-year investment, we assumed an 18.32 percent rate of return each year,
compounded. In the partial year HPR that was annualized, we assumed that the return is
compounded for the whole year. That is, we assumed that the rate of return earned during
the first part of the year is likewise earned on the value at the end of the first six months.
The 12 percent rate of return for the initial six months compounds to 25.44 percent for the
full year. Because of the uncertainty of being able to earn the same return in the future six
months, institutions will typically not compound partial year results. Remember one final
point: The ending value of the investment can be the result of a positive or negative change
in price for the investment alone (for example, a stock going from $20 a share to $22 a
share), income from the investment alone, or a combination of price change and income.
Ending value includes the value of everything related to the investment (income and capital
gain).

RISK
Risk is the uncertainty that an investment will earn its expected rate of return. In the
examples in the prior section, we examined realized historical rates of return. In contrast,
an investor who is evaluating a future investment alternative expects or anticipates a
certain rate of return. The investor might say that he or she expects the investment will
provide a rate of return of 10 percent, but this is actually the investor’s most likely
estimate, also referred to as a point estimate.
Pressed further, the investor would probably acknowledge the uncertainty of this point
estimate return and admit the possibility that, under certain conditions, the annual rate of
return on this investment might go as low as –10 percent or as high as 25 percent. The
point is, the specification of a larger range of possible returns from an investment reflects
the investor’s uncertainty regarding what the actual return will be. Therefore, a larger
range of expected returns makes the investment riskier.

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An investor determines how certain the expected rate of return on an investment is by
analyzing estimates of expected returns. To do this, the investor assigns probability values
to all possible returns. These probability values range from zero, which means no chance of
the return, to one, which indicates complete certainty that the investment will provide the
specified rate of return. These probabilities are typically subjective estimates based on the
historical performance of the investment or similar investments modified by the investor’s
expectations for the future. The expected return from an investment is mathematically
defined as:

Let us

begin our analysis of the effect of risk with an example of perfect certainty wherein the
investor is absolutely certain of a return of 5 percent. Perfect certainty allows only one
possible return, and the probability of receiving that return is 1.0. Few investments provide
certain returns. In the case of perfect certainty, there is only one value for Pi Ri: in this case
risk is zero.

In an alternative scenario, suppose an investor

believed an investment could provide several different rates of return depending on
different possible economic conditions. As an example, in a strong economic environment
with high corporate profits and little or no inflation, the investor might expect the rate of
return on common stocks during the next year to reach as high as 20 percent. In contrast, if
there is an economic decline with a higher-than-average rate of inflation, the investor
might expect the rate of return on common stocks during the next year to be –20 percent.
Finally, with no major change in the economic environment, the rate of return during the
next year would probably approach the long-run average of 10 percent.
The investor might estimate probabilities for each of these economic scenarios based on
past experience and the current outlook as follows:

The computation of the expected rate of return [E(Ri)] is as follows:

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A third example is an investment with 10 possible outcomes ranging from –40 percent to
50 percent with the same probability for each rate of return. In this case, there are
numerous outcomes from a wide range of possibilities. The expected rate of return [E(Ri)]
for this investment would be:

The expected rate of return for this investment is the same as the certain return discussed
in the first example; but, in this case, the investor is highly uncertain about the actual rate
of return. This would be considered a risky investment because of that uncertainty. We
would anticipate that an investor faced with the choice between this risky investment and
the certain (risk-free) case would select the certain alternative. This expectation is based
on the belief that most investors are risk averse, which means that if everything else is the
same, they will select the investment that offers greater certainty.
Measuring the Risk of Expected Rates of Return
Statistical measures allow you to compare the return and risk measures for alternative
investments directly. Two possible measures of risk (uncertainty) have received support in
theoretical work on portfolio theory: the variance and the standard deviation of the
estimated distribution of expected returns. Variance and standard deviation measure the
dispersion of possible rates of return around the expected rate of return

Variance: The larger the variance for an expected rates of return, the greater the
dispersion of expected returns and the greater the uncertainty, or risk, of the investment.
The variance for the perfect-certainty example would be:

Standard Deviation
The standard
deviation is the square root of the variance

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Consider the second example and compute the variance and standard deviation.
Q2 = ∑ P1[R1- E(R)]2 +P2[R2- E(R)]2 + P3 [R3- E(R)]2
= 0.15[0.2- 0.07]2 + 0.15 [-0.2- 0.07]2 + 0.7 [0.1- 0.07]2
= 0.15*0.0169 +0.15*0.0729+ 0.7*0.0009
= 0.002535+0.010935+0.00063
The standard deviation would be:
= 0.0141

Therefore, when describing this

example, you would contend that you expect a return of 7 percent, but the standard
deviation of your expectations is 11.87 percent. It indicates that the actual return will be
deviated11.87 percent above or below the expected return. It will decrease to -4.87% or
increase to 18.87%.

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