CHAPTER

ONE
Introduction to
investment
OBJECTIVE OF THE CHAPTER

At the end of this chapter the students is able to:

 Familiarized with Investment

 Describe investment alternatives

 Explain investment companies

 Describe security market

WHAT IS INVESTMENT
 Investment is defined as a sacrifice made now to obtain a
return later.
 It is current consumption that is sacrificed.

 It is current commitment of moneys 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.
WHAT IS INVESTOR?
 An investor may be an individual, a government, a
pension fund, or a corporation who commits 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.
WHY PEOPLE OR INSTITUTIONS
INVEST?
 To earn a greater return—interest and dividends—than it
would get by just holding the funds in the bank.
 To generate earnings from investment income.

 For strategic reasons.

 For risk diversification.

 Etc…..
 Investment alternatives
Generally there are 2 alternative investments those are
financial investment and real investment.
 Real Investments are concerned with tangible assets like
land or property.
 FI involve written or electronic contracts.

Basically, FI differs from real investment because;

 FAs are divisible, whereas most physical assets are not.

 FAs have more liquidity compared to real assets.

 The planned holding period of FAs can be much shorter than

the holding period of most physical assets. Holding period is
the time between signing a purchasing order for asset and
selling the asset.
 CONT’D
 The following are some of alternative instruments of investment
A. Bank savings: Savings accounts with major banks are one of
the most common and least risky ways to store your money for
the short term.  
B. Term deposits: Term deposits are sometimes called ‘fixed
interest’ investments.
C. Bond: is issued by a government, council, or company. You
lend them your money for a number of years, and they promise
to pay a certain interest rate – called a coupon. Bonds are also
sometimes called fixed interest investments.
D. Shares (Equity)

E. Property: Returns from investing in property come from rental

income and from any increase in the value of property over
time – called capital gain.
 Investment Companies
 The Investment Companies are the non-dipository
banking companies that are primarily engaged in the
business of buying and selling of securities.
 Simply, a company that pools the resources of investors to
reinvest it in the marketable securities ranging from shares
to debentures to money market instruments is called the
investment companies.
CONT’D
 We will distinguish investment companies by the types of investment
instruments they acquire.
 Money Market Funds: are investment companies that acquire high
quality, short-term investments such as T-bills, high grade commercial
paper and CDs.
 Bond Funds: are generally invest in various long-term government,
corporate, or municipal bonds.
 They differ by the type and quality of the bonds included in the portfolio as assessed
by various rating services.
 Specifically, the bond funds range from those that invest only in risk-free government
bonds and high-grade corporate bonds to those that concentrate in lower rated
corporate or municipal bonds, called high-yield bonds.
 Common Stock Funds: Numerous common stock funds invest to
achieve stated investment objectives, which can include aggressive
growth, income, precious metal investments and international stocks.
 Balanced Funds: Balanced funds invest in a combination of bonds
and stocks of various sorts depending on their stated objectives.
SECURITIES MARKET
 Securities market is a component of the wider 
financial market where securities can be bought and sold
between subjects of the economy, on the basis of
demand and supply.
 Financial Market refers to a marketplace, where creation
and trading of financial assets, such as shares,
debentures, bonds, derivatives, currencies, etc. take
place. It plays a crucial role in allocating limited
resources, in the country’s economy.
 It acts as an intermediary between the savers and
investors by mobilising funds between them.
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 CHAPTER TWO

RISK AND RETURN

 OBJECTIVE OF THE CHAPTER

At the end of the chapter the student be able to:

 Define risk and return

 Describe the concepts of return

 Differentiate Components of Return

 Describe the concepts of return

 Discuss with how to Measure Historical Risk and Return

 Discuss with how to Calculate Expected risk and Rates of

Return
 INTRODUCTION
 Itis obvious that people invest to earn a return due to
their deferred consumption.
 Investors want a rate of return that compensates them
for deferring current consumption, the expected rate
of inflation, and the uncertainty of the return.
 When we invest, we defer current consumption in
order to add to our wealth so that we can consume
more in the future.
 Therefore, when we talk about a return on an
investment, we are concerned with the change in
wealth resulting from this investment.
CONT’D

 This change in wealth can be either due to cash inflows, such as

interest or dividends, or caused by a change in the price of the
asset (Capital appreciation).
 The rate of return expected by investor’s is called required rate of
return.
Investors have different motives for investing—
1. Regular income—dividend/interest
2. Capital gains or capital appreciation

3. Hedge against inflation i.e. Positive real returns

4. Safety of funds– regular returns and refund on maturity

5. Liquidity and maturity

The first three motives refer to the returns while the last
two are related to risks..
COMPONENTS OF RETURNS
 Returns depend on risks and naturally investors want more
returns and lower risks.
Return is measured by taking the income plus the price change.
The term yield is also used in respect of fixed income
securities.
 The return is to be calculated on the purchase price. The
expected return may differ from realized returns and this
variation is a risk factor.
 Many investments have two components of their measurable
return:
 Capital gain or loss;
 Some form of income (dividend or
interest income)
 THE CONCEPT OF RISK
 Risk refers to the possibility that the actual outcome of an
investment will differ from its expected outcome.
 Risk can also be defined as the variability of possible
outcomes from that which was expected.
 Generally, investments considered to carry higher levels of
risk are those that have the potential to deliver you higher
investment returns, such as growth assets.
 investments with the potential to deliver you lower
investment returns, such as defensive assets, generally
carry lower risk levels.
 Risk can come from a range of sources depending on the
type of investments you hold.
 Measuring Historical Risk and Return
 Return is income received on an investment plus any
change in market price, usually expressed as a percent of
the beginning market price of the investment.
 The rate of return is the percentage increase in returns
associated with the holding period:
 The period during which you own an investment is called
its holding period, and the return for that period is the
holding period return (HPR).
 Such type of rate of return is called holding period
return, because its calculation is independent of the
passages of the time.
 Investor can‘t compare the alternative investments using
holding period returns, if their holding periods
(investment periods) are different.
 CONT’D
 HPR=Ending
CONT’DValue of Investment / Beginning Value of
Investment.
 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.
 The first step in converting an HPR to an annual percentage rate
is to derive a percentage return, referred to as the holding
period yield (HPY). The HPY is equal to the HPR minus 1.
 Alternatively it can be calculated as follows (see next slide)
CONT’D
end of period wealth (V1) -- beginning of period wealth (v0)
Return 
beginning of period wealth (V0)

V1  V0
r 
V0

V1  V0
Or as a percentage r ( )  100
V0
 CONT’D
Example 1
An initial investment of Br.10,000 is made.
One year later, the value of the investment has
risen to Br. 12,500. Holding period return and
holding period yield on the investment is
HPR =ending value/beginning value
=12500/10000=1.25
HPY = HPR-1=1.25-1=0.25

or 12500  10000
r 100  25%
10000
 MEAN HISTORICAL RETURNS

 Over a number of years, a single investment will

likely give high rates of return during some years and
low rates of return, or possibly negative rates of
return, during others.
 In this case it would be important to consider mean
rates of return for a single investment and for a
portfolio of investments.
 Given a set of annual rates of return (HPYs) for an
individual investment, there are two summary
measures of return performance. The first is the
arithmetic mean return; the second is the geometric
mean return
CONT’D
 Arithmetic mean (AM), the sum (Σ) of annual HPYs is
divided by the number of years (n) as follows:
AM = ΣHPY/n
 An alternative computation, the geometric mean (GM), is
the nth root of the product of the HPYs for n years minus
one
GM  1  r1 1  r2 ...1  rn   1
1/ n

GM  n 1  r1 1  r2 ...1  rn   1
 CONT’D

Year Beg. value End value HPR HPY

1 100 115 1.15 0.15
2 115 138 1.20 0.20
3 138 110.4 0.80 -0.20

AM = [(0.15) + (0.20) + (–0.20)]

3
= 0.15/3
= 0.05 = 5%
Under geometric mean
GM  n 1  r1 1  r2 ...1  rn   1
Gm  3 (1.15)(1.20)( 0.80)  1
GM  3
1.104  1.03353  1
GM  0.03353  3.353%
RISK MEASURES FOR HISTORICAL
RETURNS
 To measure the risk for a series of historical rates of
returns, we use the same measures as for expected returns
(variance and standard deviation) except that we consider
the historical holding period yields (HPYs).
 The most common risk measure is standard deviation.
Standard deviation is an absolute form of risk measure; it
is not measured in relation to other assets or market
returns.
 Standard deviation measures the spread of returns around
the average return.
 But the variance measures the differences between the
annual returns of the stock: the higher the variance, the
more volatile the stock.
CONT’D
 The variance of the data is the average squared distance
between the mean and each data value.

 The standard deviation is the square root of the variance.

Therefore standard deviation is=

0.00919832
= 0.0959
9.59%
End of the lesson
Thank you!!!
 MEASURING EXPECTED RATE OF RETURN
 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.
 CONT’D
 The expected return from an investment is defined as:
n
Expected Return =  ( probabitity of return) x ( possible return)
i 1
E ( Ri )  ( P1 )( R1 )  ( P2 )( R2 )  ( P3 )( R3 )  ...  ( Pn )( Rn )
n
E ( Ri )   ( Pi )( Ri )
i 1

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.
 In the case of perfect certainty, there is only one value for

E(Ri) = PiRi
E(Ri) = (1.0)(0.05) = 0.05 = 5%
 CONT’D
 Example: The investor might estimate probabilities for each
of these economic scenarios based on past experience and
the current outlook as follows:
Economic condition Probability Rate of return
Strong economy, 0.15 0.20
Weak economy, 0.15 -0.20
No major change in economy 0.70 0.10

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

follows:
E(Ri) = [(0.15)(0.20)] + [(0.15)(–0.20)] + [(0.70)(0.10)]

= 0.07= 7%
 MEASURING THE RISK OF EXPECTED RATES OF RETURN
 the total risk of investments can be measured with such common
absolute measures used in statistics as variance and standard
deviation and covariance. Therefore risk of expected rate of
return is as follow:

2
n  possible   Expected 
  probability  x 
2
Variance ( )   
i 1  return   Re turn 
n
Variance ( 2 )   
 ( Pi ) Ri  E ( Ri )
2
i 1

n
S tan dard deviation ( )   ( Pi )Ri  E ( Ri )2
i 1
 Example the variance for the perfect-certainty:
n
Variance ( 2 )   ( Pi ) Ri  E ( Ri )2
i 1
 2  1.0(0.5  0.5) 2
 1.0(0.0)  0
CONT’D
Example: calculate variance and standard deviation of the
following investment
Economic condition Probability Rate of return
Strong economy, 0.15 0.20
Weak economy, 0.15 -0.20
No major change in economy 0.70 0.10
 A RELATIVE MEASURE OF RISK
 In some cases, an unadjusted variance or standard deviation
can be misleading.
 If conditions for two or more investment alternatives are
not similar—that is, if there are major differences in the
expected rates of return—it is necessary to use a measure of
relative variability to indicate risk per unit of expected
return.
 A widely used relative measure of risk is the coefficient of
variation (CV), calculated as follows:
S tan dard Deviation of Re turns
coefficient of var iation CV  
Expected Rate of Re turn

 i
E ( R)
 CONT’D

As an illustration, consider the following two investments:

Investment A Investment B
Expected Return 0.07 0.12
Standard Deviation 0.05 0.07

 Compare alternative investments by using coefficient of

variation (CV)
End of chapter two
Thanks!!!!