Investment Decision and Portfolio

Management (ACF 722)

Chapter 1 – Investment: Introduction

and over views

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 Investment
defined
• Investment is defined as a sacrifice made now to
obtain a return later.
 It is current consumption that is sacrificed.
 It involves the commitment of cash today for the chance
of more cash at some future date.
 current commitment of money for a period of time in
order to derive future payments that will compensate
the investor for:
• the time the funds are committed (Pure time value of money
or rate of interest).
• The expected rate of inflation, and
• the uncertainty of the future payments.

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 Investment …..
• The difference between investing and gambling?
Investing: The chances are in your favor.
• There is a favorable risk-return tradeoff.
• It is part of a long-term plan
• You have done your homework
• It involves the creation of wealth
Gambling: The chances are in another’s favor.
• There is no favorable risk-return tradeoff.
• There is no long-term plan
• There is no homework, only chance
• It is a zero-sum game—no wealth is created

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What do Investors Want?

¨ Investors seek current or future income or sometimes

both.
¨ Future income might be used for personal consumption at a
later date or for future generations.
¨ Aggressiveness of investor depends on risk preferences.
¨ Generally, the reasons for investments are:
 To accomplish our personal and family goals
 To have resources for retirement, education, etc.
 To grow our financial assets to serve and bless our families and
others.

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 Forms of Investment
• Two forms of investment can be defined: real and financial

– Real investment is the purchase of land, machinery, etc

– Financial investment is the purchase of a "paper" contract

• Real investments and financial investments are linked

– The share issue of a firm finances the purchase of asset

– Commitment to a mortgage finances the purchase of

property

• Financial investment can provide finance for real investment

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 Financial
• There areInvestment
numerous components to financial
investment
• Markets: where assets are bought and sold, and the
forms of trade
• Securities: the kinds of securities available, their returns
and risks
• Investment process: the decision about which securities,
and how much of each
• Financial theory: the factors that determine the
rewards from investment (and the risks) 6
 Markets
• A market is any organized system for connecting buyers
and
sellers
• There are many security markets
• Markets may have a physical location
– The New York Stock Exchange

• Or exist only as computer networks

– Nasdaq

• Markets vary in the securities that are traded and in

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Characteristics of Markets
• There are a number of ways to classify markets

Primary/Secondary
– Primary markets are security markets where new issues
of securities are traded.
– A secondary market is a market where securities are
resold.

• Most activity on stock exchanges is in the

secondary market.
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 Characteristics of
• TradesMarkets
on the primary market raise capital for firms
• Trades on the secondary market do not raise
additional capital for firms
• The secondary market is still important
– It gives liquidity to primary issues. New securities would
have a lower value if they could not be subsequently
traded
– It signifies value. Trading in assets reveals information
and provides a valuation of the assets. This helps to
guide investment decisions 9
 Characteristics of Markets
• Markets can also be characterized by the lifespan of the
assets
traded

Money/Capital
– Money market: for assets with a life of less than 1 year

– Capital market: for assets with a life greater than 1 year

• Some assets, such as most bonds, have a fixed lifespan

• Common stock have an indefinite lifespan

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 Brokers
• A broker is a representative appointed by an individual
investor
• Brokers have two conflicting roles

– An advisor: a broker can offer investment advice and

information
– A sales person: brokers are rewarded through
commission and have an incentive to encourage trade
• A full service broker is a brokerage house that can offer a
full range of services including investment advice and
portfolio management 10 1
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Brokers...Con’d
• A discount broker offers a restricted range
of services at a lower price
 To complete a trade additional brokers
are needed
• A floor broker is located on the floor of the
exchange and does the actual buying and
selling

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 Securities

• The standard definition of a security is:

"A legal contract representing the right to

receive
future benefits under a stated set of conditions"
• The piece of paper defining the property
rights held by the owner is the security

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 Securities…Cont’d
• Money market securities

– Short-term debt instruments sold by governments,

financial institutions and corporations
– They have maturities of one year or less

• 1. Treasury Bills

– Treasury Bills are the least risky and the

most marketable of all money markets
instruments
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 Securities…Cont’d
• T -bills
– An active secondary market with very low transaction
costs for trading it.
– T-bills are sold at a discount from face value and pay
no explicit interest payments.
• T-bills are considered to have no risk of default, have
very short-term maturities, and have a known return.
• T-bills are the closest approximations that exist to a risk-
free investment.

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 Securities…Cont’d
• Capital market securities
– Instruments having maturities greater than one year
and those having no designated maturity at all.

• 1. Fixed income securities

– Fixed income securities have a specified payment
schedule
– Bonds promise to pay specific amounts at specific times

– Failure to meet any specific payment puts the bond

into default with all remaining payments.

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 Securities…Cont’d
– Fixed income securities differ from each other
in promised return for several reasons
• The maturity of the bonds
• The creditworthiness of the issuer
• The taxable status of the bond

– Income (interest in this case) and capital gains

are
taxed differently in many countries
– Bonds are designed to exploit these differences 17
Securities…Cont’d
1. Treasury notes and bonds
– The government issues fixed income securities over a
broad range of maturity spectrum
– Both notes and bonds usually pay interest twice a year and
repay principal on the maturity date
2. Corporate bonds
– These promise to pay interest at periodic intervals and
to return principal at a fixed date
– These bonds are issued by business entities and thus have
a risk of default

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Securities…Cont’d

2. Common stock (shares, equity)

– Common stock represents an ownership claim on the
earnings and assets of a corporation
– After holders of debt claims are paid, the management of
the company can either pay out the remaining earnings to
stockholdings in the form of dividends or reinvest part or all
of the earnings
– The holder of a common stock has limited liability

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 Securities…Cont’d
3. Derivative instruments

– Derivative instruments are securities whose value

derives from the value of an underlying security or
basket of securities
– The instruments are also known as contingent claims,
since their values are contingent on the performance
of underlying assets
– The most common contingent claims are options and
futures
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 Securities…Cont’d
1. An option on a security gives the holder the right to
either buy (a call option) or sell (a put option) a
particular asset at a future date or during a particular
period of time for a specified price

2. A future is the obligation to buy or sell a particular

security or bundle of securities at a particular time for
a stated price

– A future is simply a delayed purchase or sale of a

security 21
 Securities…Cont’d
3. A forward contract is a private agreement between two
parties giving the buyer an obligation to purchase an
asset (and the seller an obligation to sell an asset) at a
set price at a future point in time.

4. A swap is a derivative in which two counterparties

exchange cash flows of one party's financial
instrument for those of the other party's financial
instrument. The benefits in question depend on the
type of financial instruments involved.
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 Securities…Cont’d
5. The corporation can issue contingent claims.
– Corporate-issued contingent claims include rights and
warrants, which allow the holder to purchase common
stocks from the corporation at a set price for a
particular period of time
– Warrants can b e traded just like stocks

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 Securities…Cont’d
5. Indirect investing
– The purchase of a shares of an investment
portfolio
• mutual fund

• Unit trusts

• Investment trusts

• Hedge funds

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 Securities…Cont’d
• Mutual funds are a type of investment that take money

from many investors and uses it to make investments on

financial markets based on a stated investment

objective.

– Each shareholder in the mutual fund participates

proportionally (based upon the number of

shares owned) in the gain or loss of the fund.

– They are open ended, well diversified, 25

 Securities…Cont’d
• A unit trust is a form of collective investment constituted under a trust

deed. It pools investors money into a single fund, which is managed by a

fund . It is unincorporated mutual fund structure that allows funds to hold

assets and provide profits that go straight to individual unit.

• Unit trusts are also referred to as open-ended funds, because they will

always accept more cash from investors.

– They just become bigger to accommodate the demand.

– If there are more sellers than buyers, the fund will become smaller.
– They are open ended, invests on smaller diversified portfolio

of securities , with passive strategy and defined life funds

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 Securities…Cont’d

• Investment trusts are form of collective investment found

mostly in Uk. They are known as closed- ended funds, as
they tend to raise a set amount of cash, then invest it.

– They do not create new shares

whenever someone wants to buy them.
– They are listed on stock market

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 Securities…Cont’d
• Hedge fund is investment fund that pooled capitals from
accredited individuals and institutional investors and invest in
variety of Assets.
• It is investment pools that are relatively unconstrained
in what they do; relatively unregulated; charge very
high fees.
• The primary aims of most hedge funds is to reduce
volatility and risk, while attempting to preserve
capital, and deliver positive returns under all market 28
 Key Participants in Investment
• Process
Government
– Federal, state and local

– Typically net demanders of funds

• Business

– Investments in production of goods and services

– Typically net demanders of funds but can also be

suppliers

• Individuals

– Some need for loans (house, auto)

– Typically net suppliers of funds

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 Types of
• Investors
Individual Investors
– Invest for personal financial goals (retirement,
house)

• Institutional Investors
– Paid to manage other people’s money
– Typically manage large amounts of money
– Include: banks, life insurance companies, mutual
funds and pension funds
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 Institutional investors
• Life Insurance Companies

• Insure against death

• Receive funds in the form of premiums

• Use of funds is based on mortality statistics—

predict
when funds will be needed
• Invest in long-term securities—high yield

– Long-term corporate bonds

– Long-term commercial mortgages

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 Institutional investors
• Pension and Retirement Funds

• Concerned with long run investment

• Receive funds from working individuals building

“nest- egg”
• Accurate prediction of future use of funds

• Invest mainly in long-term corporate bonds and

high- grade stock

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 Institutional
investors
• Money Market Mutual Funds

• Individuals purchase shares in the fund

• Fund invests in highly liquid short-term

money
market instruments
– large-size negotiable CD’s

– Treasury bills

– high-grade commercial paper

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 Institutional
•
investors
Property and Casualty Insurance Companies
• Insure homeowners and businesses against losses

• Receive premiums

• Need to be fairly liquid due to uncertainty of claims

• Purchase a variety of securities

– high-grade stocks and bonds

– short-term money market instruments for

liquidity
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 The Investment
35

Process
The
Client
Utility Risk Investment Tax Tax Code
Function Tolerance/ Horizon Status
s Aversion

The Portfolio Manager’s

Job
Asset Views on Risk and
Views Asset Allocation Bonds
Stocks Real - inflation Return
on - rates -Measuring risk
Classes:
Countries: Domestic Assets
Non-Domestic
markets - growth -Effects of
diversificatio
n
Valuatio
based on
n Security Selection Privat Market
- Cash flows - Which stocks? Which bonds? Which real Informatio
e Efficiency
- Comparables assets? n - Can you
- beat the
Technicals market?

Tradin Execution
g Tradin Trading Systems
- How often do you trade? g
Costs - How does
- How large are your trades? Speed
- Com trading affect
- Do you use derivatives to manage or enhance
missi prices?
risk?
ons
- Bid
Ask
Sprea Performance Risk
dMarket Evaluation Models
1. How much risk did the portfolio manager take? Stock
- Price
Timin 2. What return did the portfolio manager make? Selectio - The CAPM
Impac
g 3. Did the portfolio manager underperform or n - The APM
t outperform? 3
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End

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