CHAPTER ONE

Introduction to investment
1. What is investment
An investment is the current commitment of dollars for a period 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.

What is investor?
An investor is an individual who commit money to investment products with the expectation
of financial return. Generally, the primary concern of an investor is to minimize risk while
maximizing return, as opposed to a speculator, who is willing to accept a higher level of risk
in the hopes of collecting higher-than-average profits.
An “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.
Thus, 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.

Why people or institutions invest?

At this point, we have answered the questions about why people invest and what they want
from their investments.
 It may invest the excess funds to earn a greater return—interest and dividends—
than it would get by just holding the funds in the bank.
 Companies purchase investments to generate earnings from investment income.
 Companies also invest for strategic reasons. A company can exercise some
influence over a customer or supplier by purchasing a significant, but not
controlling, interest in that company. Or, a company may purchase a non-
controlling interest in another company in a related industry in which it wishes to
establish a presence. A corporation may also choose to purchase a controlling
interest in another company.

1
 Take an illustration for the definition of investment:
For most of our life, we will be earning and spending money. Rarely, though, our current
money income will exactly balance with our consumption desires. Sometimes, we may have
more money than our want to spend; at other times, we may want to purchase more than we
can afford. These imbalances will lead us either to borrow or to save to maximize the long-run
benefits from your income.
When current income exceeds current consumption desires, we tend to save the excess. We
can do any of several things with these savings. One possibility is to put the money at home
until some future time when consumption desires exceed current income. When we retrieve
their savings from their place where we put, we have the same amount. Another possibility is
that we can give up the immediate possession of these savings for a future larger amount of
money that will be available for future consumption. This trade off present consumption for a
higher level of future consumption is the reason for saving. What we 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 exchange between future consumption (future dollars) and current consumption
(current dollars) 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).
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 when
inflation rates have varied from time to time. 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

2
 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.

2. Investment alternatives
There are many investment avenues or alternatives are available investors. They fall into
two broad categories, viz. financial assets and real assets. Financial assets are paper (or
electronic) claims on the issuer such as Bank or Government or a corporate body. Stocks,
bonds, mutual funds, and bank deposits are all examples of financial assets. Unlike land,
property, commodities, or other tangible physical assets, financial assets do not

necessarily have inherent physical worth or even a physical form. Real assets represent
tangible assets. In addition to the financial assets, investors are likely to be interested in
the following types of real estate.
Residential and Commercial property
Semi- urban land
Agriculture land (Farm house)

3. Investment Companies
The investment alternatives described so far are individual securities that can be acquired
from a government entity, a corporation, or another individual. However, rather than
directly buying an individual stock or bond issued by one of these sources, you may
choose to acquire these investments indirectly by buying shares in an investment
company, also called a mutual fund, that owns a portfolio of individual stocks, bonds, or a
combination of the two. Specifically, an investment company sells shares in itself and uses
the proceeds of this sale to acquire bonds, stocks, or other investment instruments. As a
result, an investor who acquires shares in an investment company is a partial owner of the
investment company’s portfolio of stocks or bonds.

3
 4. Security Markets
Securities market is a component of the wider financial market where securities can be bought
and sold between market participants. Security markets may be classified in to the following
based on different conditions.
 Based on Maturity as
Money vs. Capital markets
 Based on seasoning as
Primary vs. Secondary markets
 Based on the nature of claims as
Debt Vs equity market
 Base on physical place to the market as
Stock exchanges Vs. OTC

Money Vs Capital markets

Money markets are the markets for short-term, highly liquid debt securities like T-bills and
commercial papers.
Capital markets are the markets for intermediate or long-term debt and corporate stocks.
There is no hard and fast rule on this classification but generally “short term” generally means
less than one year, “intermediate term” means one to five years, and “long term” means more
than five years.

Primary Vs Secondary Market

Primary Market:
The primary market is where new issues of bonds, preferred stock, or common stock are sold by
government units, municipalities, or companies to acquire new capital. Market where new
securities are sold and funds would go directly to issuing unit.
It is also called New Issue Market (NIM) Trades on the primary market raise fresh capital for
firms.
In primary market there are usually four methods to issue the securities (especially bonds).
These are
1. Negotiation,
2. Private placement,
3. Public placement and
4. Competitive bid.

4
 1. Negotiated sale: It Involves the contractual arrangements between underwriters and issuers
wherein the underwriter helps the issuer prepare the bond issue and set the price and has the
exclusive right to sell the issue
2. Private placement: It involves the sale of securities by the issuer directly to an investor or a
small group of investors.
3. Public Placement: It involves the sale of securities by the issuer directly to an investing
public.
4. Competitive bid: It involves the sealed bids and securities are sold to the bidding syndicate
of underwriters that submits the bid with the lowest interest cost in accordance with the
conditions set forth by the issuer
Secondary markets
A market where securities are resold between investors is secondary market. The issuing unit
does not receive any funds in a secondary market transaction i.e. Secondary market do not serve
to raise additional capital for firms. The proceeds from a sale in the secondary market do not go
to the issuing unit (the government, municipality, or company) but, rather, to the current owner
of the security. The trading in the secondary market is between investors/security holders and
involvement of the initial issuer is limited except in some few occasions.

Debt Vs Equity market

Debt market: is a market where debt instruments are traded like commercial papers, commercial
notes, corporate bonds. Deb market can be either money market or capital market depending on
the maturity of the instrument being traded
Equity market: is a market where equity instrument like common stock and preferred stock are
traded. All equity market instruments are capital market instruments. There is no as such short
term equity instrument.

Spot Vs Futures markets

Spot markets: are markets in which assets are bought or sold for “on-the spot” delivery
(literally, within a few days). Futures markets: are markets in which participants agree today to
buy or sell an asset at some future date. This is a market for futures and options.

5
 Stock Exchanges Vs OTC (Over the counter)
Stock exchange: it has physical location for trading. It is an organized and regulated financial
market where securities are bought and sold at prices governed by the forces of demand and
supply. Although the exchanges typically consider similar factors when evaluating firms that
apply for listing, the level of requirement differs (the national exchanges have more stringent
requirements). Stock traded on exchange are listed stocks.
Over the counter (OTC) markets:- OTC is a security traded in some context other than on a
formal exchange. The phrase "over-the-counter" can be used to refer to stocks that trade via a
dealer network as opposed to on a centralized exchange. Over the counter communication are
electronic network of dealers all over the world. Over-the-counter (OTC) market, involves
trading in stocks not listed on an organized exchange. The OTC market is not a formal
organization with membership requirements or a specific list of stocks deemed eligible for
trading. In theory, any security can be traded on the OTC market as long as a registered dealer
is willing to make a market in the security (willing to buy and sell shares of the stock)