Business Finance

CHAPTER 6
Introduction to
Investments
Types of Investments and
the Related Risks
 Learning Objective
• To identify the features of basic investment
instruments particularly their risk and return
characteristics
Describing the Basic Types of Investments
and Identifying the Related Risks
We describe the basic types of investments
and identify the related risks by asking
THESE QUESTIONS.

1. Is the return provided by the investment fixed or

variable?
2. Who is the issuer of the investment?
3. Can the investment be liquidated immediately at a
known price?
4. How long is the term to maturity of the investment?
 Type of Investment: Deposit
The major DEPOSIT INSTRUMENTS include…

• Time Deposit
• Checking Account • Savings Account
Account
 It usually requires a  It allows the depositor  It provides a low fixed
minimum amount of to issue checks from rate of return but
deposit with a fixed his/her account to pay provides the
term to maturity, for various expenditures convenience of
meaning the depositor instead of delivering
cannot withdraw from
availability by allowing
bills or coins as the depositor to easily
his/her account before payment.
the fixed maturity date. deposit and withdraw
 Checks issued are from the account at
 This type of account
subject to a clearing any banking day.
provides a higher fixed
float (usually 3 days)
rate of return compared to
when deposited by the
a savings account or a
checking account. payee.
 Type of Investment: Deposit

What is the RISK involved in this type of

investment?

Although banks are monitored by the Bangko Sentral ng

Pilipinas (BSP), there is the possibility that these financial
institutions may face the risk of bankruptcy. If this scenario
arises, the bank would not be able to pay for all their deposit
liabilities.
While bank deposits are insured with the Philippine
Deposit Insurance Corporation (PDIC), the insured amount
is only up to ₱500,000 per depositor for every bank.
 Type of Investment: Deposit

What can you do to MINIMIZE the RISK

involved in this type of investment?

Depositors need to determine the bank’s overall financial

position and performance before transacting with them.
A comprehensive rating system, commonly known
through its acronym CAMELS, was developed in
assessing the overall condition of the bank.
CAMELS stands for: Capital adequacy, Asset
quality, Management indicators, Earnings quality,
Liquidity, and Sensitivity to risk factors.
Type of Investment: Deposit
Here are the Top 10 banks in the Philippines
as of June 30, 2015.
 Self-Test Questions
1. Do deposits provide a fixed or variable rate of
return?
2. How do you differentiate a savings account from a
checking account and a time deposit account?
3. What is the CAMELS rating?
 Exercise 1
Visit the branches of the 10 largest banks listed on the earlier
slide or search their websites. Ask or locate the interest rates for
their various deposit accounts [savings, checking, time deposit
(different tenors)]. Compare the rates of return they provide.

Exercise 2
Visit the branches of the 10 largest banks listed on the earlier
slide or search their websites. Ask for the latest CAMELS rating
provided by the BSP. Rank the 10 largest banks based on their
CAMELS rating from highest to lowest.
 Type of Investment:
Government Securities
The National Government through the Bureau of
Treasury issues DEBT SECURITIES known as…

• Treasury Bills (T-bills) • Treasury Notes (T-notes) and

 They have maturities of one year
or less.
 There are three major types of
Treasury bills—91-day, 182-day,
and 364-day T-bills.
 They are considered discount
securities because they are issued at
a discount relative to their face value.
 Investors earn from the difference
between the face value and the
discounted price they paid for upon
purchase of the instrument.
Treasury Bonds (T-bonds)
 T-notes and bonds have maturities
longer than one year which could be
from two to 25 years.
 T-notes and bonds pay coupon
interest at regular intervals. Fixed
rate T-notes, for example, pay
coupon interest every semi-annual
period. Retail T-bonds denominate
every ₱5,000 pay coupon interest
quarterly.
 The principal is repaid upon maturity of
the instrument.
 Type of Investment:
Government Securities
What is the RISK involved in this type of
investment?

 From the point of view of a local investor, government

securities, particularly treasury securities, are credit risk-
free.
We expect the National Government to back up its
direct, unconditional, and general obligation to the
holders of these instruments. The government can
simply print local currency to pay off these
instruments.
 Type of Investment:
Government Securities
What is the RISK involved in this type of
investment?

 From the point of view of an international investor,

investing in the government securities of particular
countries involves the risk of default.
They rely on the credit ratings assessed by
international credit rating agencies such as
Moody’s Investors Services, Standard and Poor’s
(S&P), and Fitch Ratings. These agencies
generally classify countries and individual issues
as either investment-grade or speculative.
Investors would require a higher required rate of
return for them to invest in speculative securities.
 Type of Investment:
Government Securities
There are other government securities
issued by government agencies aside
from the Bureau of Treasury such as
bonds issued by local government units
(LGUs). The primary difference is that
these bonds are not backed
unconditionally and are not direct and
general obligations of the National
Government. Because of this difference, a
higher rate of return is required compared
to Treasury securities.
 Self-Test Questions
1. How do you differentiate a Treasury bill from a
Treasury bond?
2. Why are Treasury securities considered credit risk-
free instruments?
3. How are government securities quoted in the
market?
 Exercise 3
Research on the credit ratings classification used by Moody’s
Investors Services, Standard and Poor’s (S&P), and Fitch
Ratings. What credit ratings are considered investment grade
and which ones are speculative? What is the current credit rating
of the Philippines as assessed by these three agencies? Are our
credit ratings considered investment grade or speculative?

Exercise 4
Go to the PDEx website and determine the latest market yield of
the on-the-run 91-day, 182-day, and 364-day T-bills.
 Type of Investment:
Corporate Debt Securities
Corporations issue DEBT INSTRUMENTS
in the form of…

• Commercial papers

• Corporate bonds
 Type of Investment:
Corporate Debt Securities

• Commercial papers

These are short-term instruments issued by

corporation for their immediate needs.
 Type of Investment:
Corporate Debt Securities
• Corporate bonds
 These are long-term debt instruments issued by corporations.
 Most of them provide fixed coupon payments although there
are already variable-rate corporate securities. Fixed rate bonds
pay coupon payments at regular intervals, usually semi-
annually.
 They are characterized by its maturity, par value, and coupon
rate.
 They may be classified as short-term (1 to 5 years),
intermediate (5 to 12 years), and long-term (more than 12
years).
 Bonds with longer maturities require a higher rate of return.
The par value is the amount of principal expected to be repaid
upon maturity.
 Type of Investment:
Corporate Debt Securities
• Corporate bonds
 Bond prices are also stated relative to its par value
 Annual coupon payments are determined by multiplying the
annual coupon rate as a percentage of par value regardless of
the interval. A final tax of 20% is also levied on coupon interest
of corporate bonds.
 Corporate bonds are also traded like government
securities using the PDEx platform.
 Type of Investment:
Corporate Debt Securities
What is the RISK involved in this type of
investment?

The risk in this type of investment lies with the issuers. In

government, we assume that the government is credit risk-
free. The same cannot be said with these corporations.

Because of the assumed higher risk of default, a

higher rate of return is also required compared to
government securities.
 Self-Test Questions
1. What are the basic features of a corporate bond?
2. How are Treasury securities different from corporate
bonds?
 Exercise 5
Research on the credit rating classification used by Philratings
and CRISP. Identify the latest bond issuances during the past
year. Which companies issued corporate bonds during this
period? What were their credit ratings? What are the market
yields of these corporate bonds? Choose one of the newly
issued bonds and describe its basic features (maturity, par value,
and coupon rate).
 Type of Investment:
Equity Securities

EQUITY SECURITIES are classified under

two MAIN CATEGORIES. These are…

• Common stocks

• Preferred stocks
 Type of Investment:
Equity Securities
Let us summarize the FEATURES of COMMON
STOCKS investment by answering our guide
questions earlier in the lesson.

1. Is the return provided by the investment fixed or variable?

Investors earn from an equity investment through dividends and
capital gains. Dividends issued by corporations may vary from year
to year since the earnings of the company also fluctuate from period
to period. Companies are not required to declare annual dividends.
Since owners of common shares only have a residual interest in the
earnings of the business, dividends are only declared if there are
enough available funds after the payment of commitments to
creditors. Thus, equity investors are exposed to greater variability of
returns. Being exposed to greater variability also means that if the
fixed obligations have been settled, then the excess earnings would
all go to the common stockholder.
 Type of Investment:
Equity Securities
Let us summarize the FEATURES of COMMON
STOCKS investment by answering our guide
questions earlier in the lesson.

2. Who is the issuer of the investment?

Only corporations issue common shares. The credit standing of

these corporations influences the protection of capital of their
shareholders. If corporations default on their debt obligations, more
so that they cannot provide sufficient returns or even repay the
capital of shareholders since creditors have seniority over claims to
the assets of the corporation.
 Type of Investment:
Equity Securities
Let us summarize the FEATURES of COMMON
STOCKS investment by answering our guide
questions earlier in the lesson.

3. Can the investment be liquidated immediately at a known

price?

If the equity investment represents ownership in a listed company,

then the instrument is considered liquid since the stock exchange
would facilitate the availability of known bid and ask prices for the
shares and access to a wide base of buyers and sellers as well.
Investors would only need to look for a stock broker in order for the
individual to purchase and sell shares in the stock market.
 Type of Investment:
Equity Securities
Let us summarize the FEATURES of COMMON
STOCKS investment by answering our guide
questions earlier in the lesson.

4. How long is the term to maturity of the investment?

Common shares do not have a term to maturity. The shareholder

may hold the stock indefinitely.
 Type of Investment:
Equity Securities
What is the RISK involved in investing in
COMMON STOCKS?

The risk lies in the variability of the returns with a maximum

loss equal to the initial investment of the stockholder. Equity
investments have higher required rates of return compared
to fixed income instruments because of this variability.
 Type of Investment:
Equity Securities
What are the FEATURES of
PREFERRED STOCKS?

Preferred stocks differ from common shares in terms of:

PREFERENCE AS TO SENIORITY OVER CLAIMS
DIVIDENDS TO ASSETS
Corporations are not required to In case of liquidation, preferred
pay dividends annually to shareholders also have
preferred stockholders but when preference over claims to the
they do, they declare dividends; assets relative to common
preferred shareholders are paid shareholders but not over
first before common shareholders. creditors.

THE ABSENCE OF VOTING Preferred shareholders also do not have

RIGHTS voting rights in stockholders’ meetings.
 Self-Test Questions
1. What makes the returns from common stocks
variable?
2. How are common stocks different from preferred
stocks?
 Exercise 6
Select five stocks included in the PSEi. Compute their annual
holding period returns based on their prices a year ago and
today and the dividends issued during this period. How do these
returns compare with the market yields of the corporate bonds
you selected in Exercise 5 and the market yields of the T-bills in
Exercise 4?
 Type of Investment:
Pooled Funds
What are the COMMON TYPES
of POOLED FUNDS?

An individual may invest in the shares of mutual funds, units

in the Unit Investment Trust Funds (UITFs) offered by
banks, or in Exchange Traded Funds (ETFs) traded in the
stock exchange.
 Type of Investment:
Pooled Funds
What are the ADVANTAGES in
investing in POOLED FUNDS?

• Most pooled funds only require a small amount of

investment relative to the capital required if the individual
would create his/her own portfolio.
• Investing in pooled funds avoids the transaction costs
incurred in buying individual securities, as well as the
required time spent if one was to manage his/her own
portfolio.
• Investment professionals with the appropriate knowledge
and skill manage these pooled funds.
 Type of Investment:
Pooled Funds
When are GAINS EARNED and LOSSES
INCURRED in POOLED FUNDS?

 The initial price and the returns derived from mutual

funds and UITFs are based on the movement of the net
asset value (NAV) per share or per unit. Gains are
earned when the NAV per share or per unit increases
from the price a share or a unit was bought. Losses are
incurred when the NAV per share or per unit decreases.

 Investments in ETFs earn gains and incur losses similar to

how listed equity investment works.
 Type of Investment:
Pooled Funds
What is one of the biggest
DISADVANTAGES in investing
in POOLED FUNDS?

Numerous fees and charges are levied against the

investor for the management service rendered.
 Self-Test Question
What are the different types of pooled funds?
 Exercise 7
Select one of each of the following pooled funds from those
currently available for investments:
1. Money market funds
2. Bond funds
3. Balanced funds
4. Equity funds
Compare and contrast the pooled funds you have selected
in terms of fees, fund objectives, portfolio composition, and
annual holding period returns.
 Type of Investment:
Alternative Investments
What are COMMON
ALTERNATIVE INVESTMENTS?

Common alternative investments are in the form of tangible

assets such as real estate, antiques, art works, horses, etc.

RISK?
Higher risk premium is associated with these
investments since the future cash flows associated with
owning these assets are unclear and the absence of a
ready market increases their liquidity risk.
 Self-Test Question
Why are alternative investments considered very risky
assets?
 Exercise 8
Select a piece of artwork (painting, sculpture, etc.) created
by a National Artist. Approach three art dealers and ask for
a price quotation for this work of art. Did they provide the
same quotations?