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Investment Management
(BRM2102)
INTRODUCTION
Issues covered in the
Investment Analysis and Portfolio
Management Course
1.0 An overview of investment Management
1.1 Financial institutions and markets
• Introduction
• Financial institutions and their functions
• Types of Financial Institutions
• Banking and Non-Banking
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Course Objective
• How do we make the best or most informed investment decisions?

• How do we manage the portfolio of investments we have created?
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Overview of investment evaluation
Definition of terms
Investment
• According to Reilly and Brown (2000), investment is the current

commitment of funds 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.
• Investment is the commitment of funds to one or more assets that

will be held over some future time period (Jones, 1998).
• Investment is the study of the investment process.
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• Investment is concerned with the management of an investor’s
wealth, which is the sum of current income and the present value of
all future income. [This is why present value and compound interest
concepts have an important role in the investment process].
• The investor is trading a known pula amount today for some
expected future stream of payments that will be greater than the
current outlay.
• This answers the question: why do people invest and what do they
want from their investments?
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Investment Evaluation
• Investment evaluation is a crucial process that investors undertake to make informed decisions about
allocating their financial resources to various assets or projects. The goal is to assess the potential risks and
rewards associated with each investment opportunity. By carefully evaluating investments, investors can
optimize their portfolio and work towards achieving their financial objectives.
Key Concepts:
1. Risk and Return Trade-off: In finance, there is a fundamental relationship between risk and return.
Generally, investments with higher potential returns also carry higher levels of risk. Investors need to strike a
balance between seeking higher returns and managing risk to align with their risk tolerance and financial goals.
2. Diversification: Diversification is a strategy that involves spreading investments across different assets
or asset classes. By diversifying, investors aim to reduce the impact of individual asset performance on their
overall portfolio. This can help mitigate risk and create a more stable investment portfolio.
3. Investment Horizon: The investment horizon refers to the time period over which an investor plans to
hold an investment. Different investments may be suitable for short-term, medium-term, or long-term goals,
and the investment evaluation should align with the investment horizon.
Factors Influencing Investment Evaluation:
1. Financial Metrics: Investors analyze various financial metrics, such as earnings, revenue,
cash flow, and profitability, to evaluate the financial health and performance of a
company or investment opportunity.
2. Market Conditions: The overall market conditions, including economic trends, interest
rates, inflation, and geopolitical factors, can significantly impact investment decisions.
3. Industry Analysis: Understanding the dynamics and trends in a specific industry is crucial
for evaluating investments in companies within that sector.
4. Regulatory and Legal Considerations: Investors must consider the regulatory
environment and legal constraints when evaluating investments, especially in certain
industries or regions.
5. Competitive Landscape: Evaluating the competitive landscape helps investors assess the
potential growth and sustainability of a company or investment.

Methods of Investment Evaluation:
1. Fundamental Analysis: This approach involves analyzing a

company's financial statements, management team, industry position,
and competitive advantage to determine its intrinsic value.
2. Technical Analysis: Technical analysis involves studying past

market data, primarily price and volume, to forecast future price
movements and identify potential entry and exit points.
3. Valuation Models: Valuation models, such as discounted cash flow

(DCF), price-to-earnings (P/E) ratio, and price-to-book (P/B) ratio,
help investors assess the fair value of a company or asset.
Investment Decision-Making Process:
1. Setting Investment Objectives: Define specific investment objectives, such as
capital appreciation, income generation, or wealth preservation.
2. Risk Assessment: Evaluate the level of risk you are willing to accept and align it
with your investment goals.
3. Asset Allocation: Determine the allocation of funds among different asset classes
(stocks, bonds, real estate, etc.) to create a diversified portfolio.
4. Research and Analysis: Conduct thorough research and analysis of potential
investments using various methods and tools.
5. Implementation: Execute the investment strategy by purchasing selected assets
based on the evaluation.
6. Monitoring and Review: Regularly review the performance of investments and
make adjustments to the portfolio as needed.
•Investment evaluation is an ongoing process, and it requires continuous monitoring
and adaptation to changing market conditions and personal financial goals. Through a
systematic and well-informed approach, investors can make more rational decisions and
enhance their chances of achieving long-term success in their investment endeavors.
Introduction:
Definition of terms
Why do people invest?

• People invest to improve welfare (monetary wealth, both current
and future).
• They invest to earn a return from savings due to their deferred
consumption.
• They want a rate of return that compensates them for the time, the
expected rate of inflation, and the uncertainty of return.
• This return is the investor’s required rate of return. [The central
them is selection of investments that give investor their required
rate of return].
• Funds to be invested come from assets already owned, borrowed
money, and savings or forgone consumption.
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Difference between Investing and Saving
• Investing results in capital growth while saving is concerned about

capital preservation.
Introduction:
Definition of terms
Investment Analysis
• Investment analysis is the study of financial securities for the

purpose of successful investing, that is, how to trade and in what
assets as well as the calculation of risks and returns, and the
relationship between the two.
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Introduction:
Definition of terms
Real vs. Financial Investment
• Real investment is the purchase of physical capital such as land and

machinery to employ in the production process and earn increased
profit whereas financial investment is the purchase of “paper”
securities such as stocks and bonds.
• In this course, we are concerned about financial investment.
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Introduction:
Definition of terms
Real assets vs. financial assets
i. Real assets
• are those assets that directly contribute to the productive capacity of the economy such as
machines, land and buildings, and knowledge.
• They are physical and human assets.
ii. Financial assets
• contribute indirectly to the economy. They are the means by which individuals hold their
claims on real assets - claims to the income generated by real assets or on income from the
government.
• A financial asset is actually a legal contract representing the right to receive future benefits
under a stated set of conditions. These assets are created and destroyed in the course of
business whereas real assets are destroyed through wear and tear or nature related
accidents.
• Financial assets allow for the separation of ownership and management of firms and
facilitate the transfer of funds.
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Introduction:
Definition of terms
Types of investors:
• Individual investors are individuals who are investing on their own.

Sometimes individual investors are called retail investors.
• Institutional investors are entities such as investment companies,

commercial banks, insurance companies, pension funds, mutual
funds and other financial institution and are professional money
managers. They tend to have vast resources at their disposal.
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The Nature of Investment
• Every investor (individual or institutional) has certain specific objectives to

achieve through his long term/short term investment.
• Such objectives may be monetary/financial or personal in character.
• The objectives include:
 Safety and security of the funds invested (principal amount).
 Profitability (through interest, dividend and capital appreciation).
 Liquidity (convertibility into cash as and when required).
• These objectives are universal in character as every investor will like to

have a fair balance of these three financial objectives. An investor will not
like to take undue risk about his principal amount even when the interest
rate offered is extremely attractive. These objectives or factors are known
as investment attributes.
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• There are personal objectives which are given due consideration by

every investor while selecting suitable avenues for investment.
Personal objectives may be like
 Provision for old age and sickness.
 Provision for house construction.
 Provision for marriage and education of children.
 Provision for dependents including wife, parents or physically
handicapped member(s) of the family.
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• The investment avenue(s) selected should be suitable for achieving the objectives
(financial and personal) decided. The merits and demerits of various investment
avenues need to be considered in the context of such investment objectives.
• To enable the evaluation and reasonable comparison of various investment

avenues, the investor should study the following attributes:
 Rates of return
 Risk
 Marketability
 Taxes
 Convenience
 Safety
 Liquidity
 Duration
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Investment Environment
The investment environment has several elements:

• Financial markets: (money markets, capital markets, foreign
exchange markets, derivatives markets)
• Financial instruments or assets: (money market instruments:
treasury bills, certificates of deposits, etc; capital market
instruments: shares, bonds, exchange traded funds; foreign
exchange market: foreign currencies; derivative markets: forwards,
futures, options and swaps)
• Commodities markets: (minerals, metals and agricultural products)
• Real estate markets: (real estate investment trusts)
• Financial Institutions:
• Bank Financial Institutions: (commercial banks, investment banks,
savings banks, development banks, buildings societies, merchant
banks)
• Non-Bank Financial Institutions: (insurance and assurance

companies, management and fund firms, investment companies
with variable capital, asset management firms, microfinance
institutions)
• Deficit units: borrowers of loans or issuers or sellers of financial
instruments
• Surplus units: lenders or buyers of financial instruments
• Deficit and surplus units can either be individuals or corporates
(private sector and public sector businesses [local and central
government authorities])
• Deficit and surplus units can also be local residents and corporate or
foreign residents and corporates.
• Regulatory institutions and laws (Ministry of Finance and

Development Planning - central bank – Bank of Botswana; Non-Bank
Financial Institutions Regulatory Authority [NBFRA]; Botswana Stock
Exchange [BSE])
Financial Markets
An Overview of the Financial System
1. Function of Financial Markets and Financial Intermediaries
2. Structure of Financial Markets
• Debt and Equity Markets
• Primary and Secondary Markets
• Exchanges and Over-the-Counter Markets
• Money and Capital Markets
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3. Financial Instruments
• Money Market Instruments
• Capital Market Instruments
4. Role of Financial Intermediaries
• Transaction Costs and Economies of Scale
• Risk Sharing and Diversification
• Adverse Selection and Moral Hazard

5. Types of Financial Intermediaries
• Depository Institutions (Banks)
• Contractual Savings Institutions
• Investment Intermediaries
1. Function of Financial Markets and Financial Intermediaries
• Financial markets and financial intermediaries perform the function of
channeling funds from agents who have saved funds and want to lend
to agents who need funds and want to borrow.
2 Structure of Financial Markets
2.1 Debt and Equity Markets
• Debt instrument = a contractual agreement by the issuer of the
instrument (the borrower)to pay the holder of the instrument (the
lender) fixed dollar amounts (interest and

• principal payments) at regular intervals until a specified date
(maturity date) when a final payment is made.
Examples: Government and corporate bonds.
• Maturity = number of years or months until the expiration date.
• Short-term = maturity of less than one year.
• Long-term = maturity of more than ten years.
• Intermediate-term = maturity between one and ten years.

Equity = a contractual agreement representing claims to a share in the income and
assets of a business.
Example: Corporate stock.
• May pay regular dividends.
• Have no maturity date; hence are considered long-term securities.
Since equity holders own the firm, they are entitled to elect members of the firm’s
board of directors and vote on major issues concerning how the firm is managed.
A key feature distinguishing equity from debt is that the equity holders are the
residual claimants: the firm must make payments to its debt holders before making
payments to its equity holders.

Advantage to holders of debt instruments:
• Receive fixed payments, regardless of whether the borrower’s income and
assets become more or less valuable over time.
Disadvantage to holders of debt instruments:
• Do not benefit from an increase in the value of the borrower’s income or assets.
Advantage to holders of equities:
• Receive larger payments when the business becomes more profitable or the
value of its assets rises.
Disadvantage to holders of equities:
• Receive smaller payments when the business becomes less profitable or the
value of its assets falls.

2.2 Primary and Secondary Markets
• Primary market = market in which newly-issued securities are sold to initial buyers
by the corporation or government borrowing the funds.
• Example: Botswana Treasury issues a new Government bond, and sells it to Absa.
• Investment banks play an important role in many primary market transactions by

underwriting securities: they guarantee a price for a corporation’s securities and then
sell those securities to the public.
• Secondary market = market in which previously-issued securities are traded.
• Example: Absa sells the existing government bond to Imara Holding.
• Brokers and dealers play an important role in secondary markets:
• Brokers = facilitate secondary-market transactions by matching buyers with sellers.
• Dealers = facilitate secondary-market transactions by standing ready to buy and sell

securities.
Essential functions of secondary markets
• They allow the original buyers of securities to sell them before the
maturity date, if necessary. That is, they make the securities more
liquid.
• They allow participants in the primary markets to make judgements

about the value of newly-issued securities by looking at the prices of
similar, existing securities that are traded in the secondary markets
• Primary Markets:
1. Issuance of New Securities: The primary market is where new securities

are issued by corporations, governments, or other entities to raise capital
for various purposes. This is the initial offering of securities to the public.
2. Capital Formation: The primary market is crucial for capital formation as

it enables companies and governments to raise funds for business
expansion, research and development, infrastructure projects, and other
initiatives.
3. Investor Interaction: In the primary market, issuers directly interact with

investors by offering new securities at a specific price (initial offering
price) through methods like Initial Public Offerings (IPOs) or rights issues.
• Role of Intermediaries: Investment banks and underwriters often
play a significant role in the primary market by facilitating the
issuance process, determining the appropriate offering price, and
ensuring compliance with regulatory requirements.
• Ownership Transfer: Primary market transactions involve the transfer

of ownership from the issuer to the investors purchasing the newly
issued securities.
• Pricing: The price of securities in the primary market is determined

through negotiations between the issuer and the underwriters based
on market conditions and the perceived value of the securities.
• Secondary Markets:
1. Trading of Existing Securities: The secondary market is where previously

issued securities are traded among investors. It provides a platform for
buying and selling securities after the initial issuance in the primary
market.
2. Liquidity: The secondary market enhances the liquidity of securities by

allowing investors to buy or sell their holdings without requiring the
involvement of the original issuer. It provides a continuous marketplace for
trading.
3. Price Determination: Secondary markets play a key role in price discovery,

where the prices of securities are determined by the forces of supply and
demand among investors.
• Investor Interaction: Investors trade securities with each other in the
secondary market, and the issuer is typically not directly involved in
these transactions.
• Role of Intermediaries: Stock exchanges and brokerage firms
facilitate trading in the secondary market by providing platforms for
investors to execute transactions.
• Ownership Transfer: In the secondary market, ownership of
securities is transferred from one investor to another. The issuer is
not directly affected by these transactions.
• Pricing: Prices in the secondary market are determined by market
participants based on factors such as current market conditions,
investor sentiment, and fundamental company performance.
2.3 Exchanges and Over-the-Counter Markets
• Exchange = buyers and sellers meet in a central location.
• Example: New York Stock Exchange.
• Over-the-Counter (OTC) Market = dealers at different locations trade via

computer and
• telephone networks.
Examples: NASDAQ (National Association of Securities Dealers’ Automated

Quotation System); Government bond market.
2.4 Money and Capital Markets
• Money market = only short-term debt instruments are traded.
• Capital market = intermediate-term debt, long-term debt, and equities

traded.
3 Financial Instruments
3.1 Money Market Instruments
• The principal money market instruments are:
• Treasury Bills
• Negotiable Bank Certificates of Deposit
• Commercial Paper
• Banker’s Acceptances
• Repurchase Agreements
• Federal Funds
• Eurodollars
• All of these money market instruments are, by definition, short-term
debt instruments,
• with maturities less than one year
Treasury Bills:
• Issued by the US Government.
• Currently issued with maturities of 1, 3, and 6 months.
• Pay a fixedamountatmaturity.
• Make no regular interest payments, but sell at a discount.
• Example: A Treasury bill that pays off $1000 at maturity 6 months
from now sells
• for $950 today. The $50 difference between the purchase price and
the amount
• paid at maturity is the interest on the loan.
• Trade on a very active secondary market.
• Are the safest of all money market instruments, since it is very
unlikely that the US
• Government will go bankrupt
Negotiable Certificates of Deposit (CDs):
• Issued by banks.
• Make regular interest payments until maturity.
• At maturity, return the original purchase price.
• Large CDs, with value over $100,000, trade on a secondary market.
• “Negotiable” means that the CD trades on a secondary market.
Commercial Paper:
• Short-term debt issued by corporations..
• Make no interest payments, but sell at a discount.
• Trade on a secondary market.
Banker’s Acceptances:
• Bank draft (like a check) issued by a firm and payable at some future
date.
• Stamped “accepted” by the firm’s bank, which then guarantees that
it will be paid.
• Often arise in the process of international trade.
• Make no interest payments, but sell at a discount.
• Trade on a secondary market.
Repurchase Agreements:
• Very short-term loans, often overnight, with Treasury bills as
collateral, between a non-bank corporation as the lender and a bank
as the borrower.
• Non-bank corporation buys the Treasury bill from the bank.
• Simultaneously, the bank agrees to repurchase the Treasury bill later
at a slightly higher price.
• The difference between the original price and the repurchase price
is the interest.
Eurodollars:
• US dollar deposits at foreign banks.
3.2 Capital Market Instruments
• The principal capital market instruments are:
• Corporate Stocks
• Residential, Commercial, and Farm Mortgages
• Corporate Bonds
• Government Securities (Intermediate and Long-Term)
• State and Local Government (Municipal) Bonds
• Bank Commercial and Consumer Loans
• All of these capital market instruments are, by definition,
intermediate-term debt
• instruments, long-term debt instruments, or equities.
• Money Markets:
1.Short-Term Instruments: Money markets deal with short-term financial
instruments that have a maturity of one year or less. These instruments are
designed to facilitate the borrowing and lending of funds for short periods.
2.Liquidity Focus: The primary focus of money markets is on providing
liquidity and managing short-term cash needs. Participants in the money
market include institutions and individuals looking for safe and liquid
places to park their excess funds temporarily.
3.Examples: Money market instruments include Treasury bills, commercial
paper, certificates of deposit, repurchase agreements (repos), and short-
term government bonds.
4.Risk Profile: Money market instruments are generally considered to have
lower risk compared to longer-term investments. They are often backed
by government or high-quality corporate issuers.
5.Investment Horizon: Investors in money market instruments typically
have a short investment horizon and are interested in preserving capital
while earning a modest return.
• Capital Markets:
1. Long-Term Instruments: Capital markets deal with long-term financial
instruments that have maturities beyond one year. These markets are
focused on raising capital for businesses and governments for
investment in long-term projects.
2. Capital Formation: The primary function of capital markets is to
facilitate the issuance and trading of long-term securities, allowing
companies to raise funds for expansion, acquisitions, research, and
development.
3. Examples: Capital market instruments include stocks (equity), bonds
(debt securities with maturities over one year), preferred stock, and
other equity-linked instruments.
4. Risk Profile: Capital market instruments can vary widely in terms of risk.
Stocks are considered riskier due to their exposure to market
fluctuations, while bonds can range from very safe government bonds
to riskier corporate bonds.
5. Investment Horizon: Investors in capital market instruments typically
have a longer investment horizon, seeking returns over several years or
more. They are often willing to take on more risk in exchange for
potential higher returns.
4 Role of Financial Intermediaries
4.1 Transaction Costs and Economies of Scale
• Transaction costs = the time and money spent in carrying out

financial transactions.
• Financial intermediaries help reduce transaction costs by taking

advantage of economies of scale.
• Example: a bank can use the same loan contract again and again,
thereby reducing the costs of making each individual loan.
4.2 Risk Sharing and Diversification
• Risk = uncertainty about the returns investors will receive on any

particular asset.
• By purchasing a large number of different assets issued by a wide range

of borrowers, financial intermediaries use diversification to help with
risk sharing.
• Example: by lending to a large number of different businesses, a bank

might see a few of its loans go bad; but most of the loans will be repaid,
making the overall return less risky.
• Here, again, the bank is taking advantage of economies of scale, since it

would be difficult for a smaller investor to make a large number of
loans.
4.3 Adverse Selection and Moral Hazard
• Financial intermediaries also use their expertise to screen out bad credit risks and
monitor borrowers.
• They thereby help solve two problems related to imperfect information in financial
markets.
• Adverse Selection = refers to the problem that arises before a loan is made because
borrowers who are bad credit risks tend to be those who most actively seek out loans.
• Financial intermediaries can help solve this problem by gathering information about
potential borrowers and screening out bad credit risks.
• Moral Hazard = refers to the problem that arises after a loan is made because
borrowers may use their funds irresponsibly.
• Financial intermediaries can help solve this problem by monitoring borrowers’

activities.
5 Types of Financial Intermediaries
5.1 Depository Institutions (Banks):
• Commercial Banks
• Savings and Loan Associations
• Mutual Savings Banks
• Credit Unions
5.2 Contractual Savings Institutions
• Life Insurance Companies
• Fire and Casualty Insurance Companies
• Pension Funds
5.3 Investment Intermediaries
• Finance Companies
• Mutual Funds
• Money Market Mutual Funds
1.2 Investment management fundamentals
• Investment management involves making informed decisions to allocate funds among

various investment opportunities in order to achieve specific financial goals. Here are some
fundamental concepts in investment management:
• Diversification: Diversification is the practice of spreading investments across different

securities and sectors to reduce risk. It helps mitigate the impact of poor performance in
one investment on the overall portfolio.
• Investment Strategies: Investment managers employ various strategies, such as value

investing, growth investing, and passive indexing, to select and manage investments in line
with the investor's objectives.
• Risk Management: Effective risk management involves identifying, assessing, and mitigating
potential risks that could impact investment performance. Techniques include
diversification, hedging, and managing exposure to market volatility.
• Investment Vehicles: Investment managers choose from a range of investment vehicles,

including stocks, bonds, mutual funds, exchange-traded funds (ETFs), real estate, and
alternative investments, to achieve diversification and target specific objectives.
• Market Analysis: Investment managers conduct thorough market analysis to identify trends,
opportunities, and potential risks in different asset classes. Fundamental analysis (evaluating
financial health) and technical analysis (studying price patterns) are common approaches.
• Performance Measurement: Investment managers track and evaluate the performance of
investments against benchmarks. Performance measurement helps assess whether
investment decisions are meeting their intended goals.
• Risk and Return Trade-Off: One of the core principles in investment management is the
relationship between risk and return. Generally, higher returns are expected from
investments with higher levels of risk. Investment managers aim to balance risk and return
based on an investor's risk tolerance and financial objectives.
• Asset Allocation: Asset allocation involves deciding how to distribute investments across
different asset classes, such as stocks, bonds, real estate, and cash. The allocation should
reflect the investor's goals, time horizon, and risk tolerance.

• measurement helps assess whether investment decisions are meeting their intended goals.
• Rebalancing: Over time, the initial asset allocation of a portfolio can shift due to market
movements. Investment managers periodically rebalance portfolios to bring them back in line
with the target allocation.
• Tax Efficiency: Investment managers consider tax implications when making investment
decisions. Tax-efficient strategies aim to minimize taxes on investment gains and income.
• Investor Suitability: Investment managers take into account the unique financial circumstances,
goals, risk tolerance, and time horizon of each investor to create customized investment plans.
• Regulatory Compliance: Investment managers must adhere to regulations and legal
requirements governing financial markets. Compliance ensures ethical and legal behavior in
managing investments.
• Continuous Monitoring: Effective investment management involves ongoing monitoring of
portfolio performance and adjusting strategies as needed to adapt to changing market conditions
or the investor's changing circumstances

Chapter one: Investment
Overview Continued
• The Learners should be able to:
d. Explain the asset classes
i. Real assets.
ii. Financial assets.
e. Explain the fundamental principles of return:
iii. Time value of money.
iv. Risk versus return ( the required rate of return).
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v. Diversification.
f. Described the major steps in the construction of an investment
process.
What is an Investment:
 Is the current commitment of money or other resources in the
expectation of reaping future benefits. (Zvi Bodie et al, essentials
of investment)
 Is the current commitment of money for a period of time in
order to derive future payments that will compensate the
investor for:
i. The time the funds are committed.
ii. The expected rate of inflation , and
iii. The uncertainty of the future payments.
( Reilly& Brown, Investment Analysis)
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Class activity one
1. Why do people investment?
2. What do they want from their investment?
 Answers
1. They investment to earn a return from savings due to their
deferred consumption.
2. They want a rate of return that compensates them for the
time, the expected rate of inflation, and the uncertainty of
the return.
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Investment background
wealth, investment, speculation and
gambling
i.WEALTH
 may be created by putting assets to their most productive use in
order to earn a return that will exceed the opportunity cost of
making the investment. The opportunity cost is the best return that
could be earned on an alternative investment.
 the return should compensate the investor for the time during which
the funds are committed, the expected rate of inflation, and the
uncertainty of the future financial benefits expected from the
investment( this is also referred to as the “required rate of return” of
the investor.
 The goal of the investment management is to find investments that

satisfy the investor’s required rate of return.
 Wealth may be measured in various ways:
i. It may be measured by determining the present value of an
income stream
ii. Or the present value of an amount available for spending or
consumption.
iii. It may also be measured in terms of net worth ( the difference
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between assets and liabilities of an individual/firm)
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 The most important decision in creating wealth is to decide upon

asset allocation.
 Asset allocation – is the process of deciding how to distribute an
investor’s wealth among different countries and asset classes for the
investment purposes.
 Asset classes – comprises securities that have similar characteristics,
attributes and risk/return relationships.
 Asset allocation decision is a component of the portfolio
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management process and is the key factor in successful investment
and the creation of wealth.
ii. SPECULATION
1. involves the commitment of money in the
hope of making an extraordinary profit
based on presumptions about risks and
possible return associated with a particular
transaction. ( Johan Marx, investment management)
2. It is the assumption of considerable investment risk to obtain
commensurate gain.
 Considerable risk means the risk is sufficient to affect the
decision.
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 Commensurate gain means a positive risk premium, that is an
expected profit greater than the risk –free alternative
iii. Gambling
 involves betting on an uncertain outcome and taking a risk for the sake of
the enjoyment of risk itself and accepting any return (even a low return or a
loss)
Class activity 2
 What then is the difference between Speculation and Gambling?
 From the definitions, the central difference is the lack of commensurate
gain.
 Economically speaking, a gamble is the assumption of risk for no purpose
but enjoyment of the risk itself, whereas speculation is undertaken in spite
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of the risk involved because one perceives an adequate risk premium to
compensate risk-averse investors for the risks they bear.
The required rate of return
• Is the minimum return an investor should accept from an investment

to compensate him/her for deferring consumption.
RRR should compensate investors for:
i. The time value of money during the period of the investment.
ii. The expected rate of inflation during the period.
iii. The risk involved.
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• The time value of money refers to the real risk-free rate of return
(RRFR), which is the price charged for the exchange between current
goods (consumption) and future goods (consumption).
• A risk free rate investment is one which provides the investor with
certainty regarding the amount and timing of the expected returns
eg treasury bills.
• To determine the required return, the investor has to determine the
nominal risk-free rate of return and add risk premium to compensate
for the risks associated with the investment.
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Real and nominal rates of return
• The rate of inflation influences a country’s nominal rates of interest.

Inflation causes a decrease in the purchasing power of a monetary
unit.
• Another factor that influence the nominal risk-free rate (NRFR) is the
conditions in the capital market.
• To determine the required rate of return:
• The investor has to determine the nominal risk free rate of return
and then add risk premium to compensate for the risk associated
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with the investment.
• Where: RRFR = real rate of return (in decimal form)

• EI = expected inflation (in decimal form)
• Rearranging the equation above enables one to calculate the RRFR
on an investment as follows:
Example:
• Assume the RRFR is 3% and the expected rate rate of inflation is 5%.
calculate:
i. NRFR
ii. RRFR
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• Solution:
i.
ii.
ACTIVITY:
Given that the real risk-free rate of return is 3% and the expected rate
of inflation is 4.5%. Calculate the nominal risk-free rate of return.
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Fundamental principles of investment
 Time value of Money

It refers to the phenomenon that an amount of money can increase in
value because of interest earned from an investment over time. To be
looked at in detail in chapter 5 of the module
 Risk versus Return

Risk is the uncertainty about future outcome or the probability of an
adverse outcome.
S Nyoni
Risk can be divided into non financial and financial
Non financial/pure risk is an exposure to uncertainty that has a non-
monetary outcome or implication.
• Non-financial risk is usually associated with pure danger or hazard.
People face this type of risk on a daily basis.
• Examples include smoking (health risk) and speeding (safety risk).
• What distinguishes these risks from financial risk is that there can be
no financial benefit from an increased exposure to this risk category.
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• Return refers to the sum of cash dividends, interest and any capital
appreciation or loss resulting from an investment.
• Historically, returns may be measured by means of the holding
period return (HPR) and the holding period yield (HPY).
• The HPR is one of the measures of the change in wealth resulting
from an investment.
• The risk and return principle is that ‘the greater the risk, the higher
the investor’s required rate of return’
S Nyoni
• The beginning value of an investment is P1400. After 8 years the
ending value is P1 900. Calculate the holding period yield (HPY) of
the investment.
• A value greater than one indicates an increase in wealth or a positive

rate of return. Vice versa.
S Nyoni
• To express the rate of return in percentage terms on annual basis,
one can convert HPR to the HPY.
 An annual HPY may be found by:
Where
Example:
Assume an investment cost R1 000 and is worth R1 450 after three
years. The HPR is 1.45, calculated as follows:
S Nyoni
Activity:
• Given that the beginning value of an investment in the Satrix 40
share is R500. after 3 years the ending value is R760.
• Calculate the annual holding period yield (HPY).
S Nyoni
 Measures of risk
Risk of a single asset may be measured by means of the standard
deviation and the coefficient of variation (CV). In order to calculate
these measures of risk one has to calculate the expected rate of return
first .
 Expected return
The expected return is calculated by multiplying the probabilities of
S Nyoni
occurrence by their associated outcome, so that:
 Expected return is given by
Where:
– the probability of the state occurring
– the outcome associated with the the state
– the number of possible states
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 Standard deviation
One measure of risk or variability is the standard deviation
 The standard deviation is a measure of total risk.
 It measures how tightly the probability distribution is centred around
the expected value.
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 Coefficient of variation (CV)
 It’s a measure of relative dispersion that is useful in comparing
the risk of assets with differing expected returns. When expected
returns differ, the standard deviation should be standardised and
the risk per unit of return calculated.
 The higher the coefficient of variation (CV) , the greater the risk.
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 Class activity 3
 Evaluate the riskiness of the following two investments by calculating
the following for each of the alternatives
a) The expected return and comment on your findings
b) Standard deviation
c) Coefficient of variation (CV)
Investment A Probability Associated return
Muchingami L
Boom 0.3 25%
Normal 0.4 20%
Recession 0.3 10%
Investment B Probability Associated return

Boom 0.3 16%
Normal 0.4 12%
Recession 0.3 8%
Muchingami L
• Calculate the coefficient of variation (CV) of Green Ltd given the
following information:
Possible Probability (%) Return (%)

Outcomes
Pessimistic 20 5
Muchingami L
Most likely 30 8
Optimistic 50 10
Diversification
It refers to a method of reducing the unsystematic risk of a portfolio

by investing in various asset classes.
Benefits of diversification
 Risk is reduced
Muchingami L
 The risk adjusted return of the portfolio is improved
Diversifying into more securities continues to reduce exposure to

firm’s specific factors, hence the more securities in a portfolio they’re
the lesser the risk.
International diversification
Achieved by investing in foreign bonds and or shares, by investing
in units (mutual funds) that invest internationally or by investing in
depository receipts.
Depository receipts are local traded securities that represent a
claim to foreign shares.
Constraints and costs of international diversification
 unfamiliarity with foreign markets
Regulations
S Nyoni
Market efficiency
Risk perception
Taxes
Management fees
Major categories of asset
i. Real assets
i. Real assets - are assets used to produce goods and
services e.g land, buildings, equipment and knowledge
 Real assets generally involve some kind of tangible asset.
 They may also be commodities such as gold, platinum and
diamonds as well as manufacturing equipment. Art and
collectible items such as coins and stamps are also examples of
real assets.
 Characteristics of a real asset
S Nyoni
1. It does not have the same liquidity as a financial asset.
2. Information on its value is not always readily available.
 Financial assets represent legal claims to some future benefit and
are also called financial instruments or securities.
 Examples include fixed income securities (such as bonds,
debentures and preference shares) and equity instruments (such as
ordinary shares)
S Nyoni
Investment management process
Establishing investment
objectives and constraints
Establishing
investment policy
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Selecting a portfolio
strategy
Selecting assets
Measuring and
evaluating
performance
1.Establishing investment objectives and constraints
The investment objectives depend on the investor
If the investor is an individual, the investment decision is strongly
influenced by the phase of his life cycle.
If the investor is a financial institution, like an insurance company,
it must invest in such a way as to be able to meet its obligations in
terms of the policies sold, as well as earn a return for the company
which sold the policies.
A pension fund must, similarly, invest with the objective of
meeting its pension obligations towards its beneficiaries.
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2.Establishing an investment policy statement (IPS)
An IPS is a written statement which guides and controls
investment decision making because it represents the long term
objectives of the investor, with due cognisance of the objectives
and constraints of the investor.
The process of generating an IPS is the same for both individuals
and institutional clients but time horizons and unique
circumstances play a more prominent role in the case of
individuals’ IPSs
S Nyoni
3.Selecting a portfolio
An investor may pursue either an active or a passive portfolio
strategy
An active portfolio strategy uses information and forecasting
techniques to seek a better performance than would be expected
from a well diversified portfolio of securities.
A passive portfolio strategy involves minimal expectational input
and relies instead on diversified to match the performance of
some market index, for the JSE all shares index (ALSI).
S Nyoni
4. Selecting the assets
This involves the construction of an efficient portfolio.
An efficient portfolio is one that provides the greatest return for a
given level risk.
The assets may be selected based on fundamental and technical
analysis.
5. Measuring and evaluating performance

This involves measuring the portfolio performance and comparing
it to an appropriate bench mark.
S Nyoni
• Activity
• Given the following information:
Possible
outcomes
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• The beginning value of an investment is P1 600. After 8 years the
ending value is P2 200. Calculate the holding period yield (HPY) of
the investment.
S Nyoni
Chapter three
ORGANISATION AND
FUNCTIONING OF SECURITIES
MARKETS
Organisation and functioning of securities
market
Organisation and functioning of securities market
Overview
• The student should be able to:
I. Understand organisations
II. The functioning of securities markets
III. The characteristics of well functioning securities markets
IV. The role of financial markets as primary and secondary
markets
V. Securities markets in Botswana
VI. Market indices
VII. Changes in global securities market
Organisation and functioning of securities market
Introduction
 A market is simply the means by which the buyers and

sellers are put in contact with one another for the
purpose of trading goods and/or services.
 A market does not have to be a physical place, as long

as the buyers and sellers can communicate with one
another.
 A market does not necessarily own the goods or

services involved.
 For a good market, ownership is not involved, the

important criterion is the smooth, cheap transfer of
goods and services.
 In most financial markets, those who establish and administer the
market do not own the assets but simply provide a physical
location or an electronic system that allows potential buyers and
sellers to interact.
 Advances in communication and computer technologies increase

the possibility of trading from remote areas without buyer and
seller meeting physical.
Characteristics of well functioning securities markets
i. Availability of information
ii. Liquidity and price continuity
iii. Low transaction costs
iv. External efficiency
Organisation and functioning of
securities market
i. Availability of information
• In order to determine an appropriate price, participants must

be able to timeously and accurately determine the volume
and prices of past transactions and all current bids and offers.
• Well functioning markets offer timely and accurate

information on the prices, volume and prevailing bid and ask
price
ii. Liquidity and price continuity
• Liquidity here refers to assets which can be bought and sold

quickly at a price close to the prices of previous transactions.
• Price continuity means prices do not change much from one

transaction to the next unless substantial new information
becomes available.
securities market
iii. Transaction costs
• In a well functioning market, transactions can be concluded at

low costs, including the cost of reaching the market, the
actual brokerage cost and the cost of transferring the asset.
iv. External efficiency
In a well functioning market, prices rapidly adjust to new information,

hence a well functioning market must be informational efficient.
The prevailing prices are regarded as fair because they reflect all the
available information about the assets and hence the expected returns
implicit in the current price of each security will reflect its risk.
Continued…
Liquidity
Transaction price
costs continuity
External Characteristics of
efficiency well functioning
markets
r
tte
Le f
o in t
po
Ap ent
m
Availability of
information
securities market
 Financial markets serve as both primary and secondary markets:
i. Primary markets – sells newly issued securities of
companies (‘new issues’) and is also involved in initial
public offerings (IPOs).
• An example of a new issue would be if Mascom ltd decided to
issue 1 million additional ordinary shares at 30 thebe each.
• An IPO involves the sale of ordinary shares of a company to the
public for the first time.
securities market
ii. Secondary markets
• a market serves as a secondary market once the shares

are traded among investors.
• Secondary markets support the primary market by

giving investors liquidity, price continuity and depth.
• Secondary markets also support primary markets by

providing information about current prices and yields.
 Over and above the primary and secondary markets

there are also third and fourth markets, which include
over the counter markets (OTC)
market
iii. Third Market
• OTC trading of shares listed on an exchange
• Mostly well known stocks e.g BWNAF
• Competes with trades on exchange
• May be open when exchange is closed or trading

suspended
iv. Fourth Market
• Direct trading of securities between two parties with no

broker intermediary
• Usually both parties are institutions
• Can save transaction costs
• No data are available

securities market
Market structures refer to the way in which a market is
organised and the role members of the exchange play in
completing transactions.
What are the exchange requirements on the BSE?

Major Types of transactions
i. Market orders
ii. Limit orders
iii. Short sales
iv. Special orders and
v. Margin transactions
i. Market orders
• Are orders to buy or sell securities at the best prevailing price.
• Investors often indicate “sell at best” or

“buy at best” for these transactions.
• Market orders provide liquidity to
investors who are willing to accept the
prevailing market price.
securities market
ii. Limit orders
• Order that specifies the buy or sell price
• Time specifications for order may vary:

Instantaneous - “fill or kill”, part of a day, a full day,
several days, a week, a month, or good until
canceled (GTC)
iii. Short sales
• Involve the sale of shares the investor does not own with the
intention of buying them back at a lower price at a later date.
• Sell overpriced stock that you don’t own and purchase it back
later (at a lower price).
• Borrow the stock from another investor (through your broker).
• The investor who lends the shares receives the proceeds as

collateral and can invest this in short-term, risk-free securities.
• A short sale can usually only be made on the uptick trade- in

other words at a price higher than the last trade price.
market
iv. Special Orders
A. Stop loss
 Conditional order to sell stock if its price falls below a
stipulated level. As the name suggests, the order lets the
stock be sold to stop further losses from accumulating.
 Does not guarantee price you will get upon sale. Market
disruptions can cancel such orders
B. Stop buy order
 Specify that the stock should be bought when its price
rises above a limit. Investor who sold short may want to
limit loss if stock increases in price

Pre-contingent orders
CONDITION
Price below the limit Price above the limit
ACTION
Buy Limit-Buy Stop-Buy

Order Order
Sell Stop-loss Limit-Sell

Order Order
Activity
What type of trading order might you give your broker in each of the following
circumstances?
a) You want to buy shares of Choppies to diversify your portfolio. You believe the
share price is approximately at the “fair” value, and you want the trade done
quickly and cheaply.
b) you want to buy shares of Sefalana, but believe that the current stock price is too
high given the firm’s prospects. If the shares could be obtained at a price 5%
lower than the current value, you would like to purchase shares for your portfolio.
c) You plan to purchase a condominium sometime in the next month or so and will
sell your shares of Choppies to provide the funds for your down payment. While
you believe that the Choppies share price is going to rise over the next few weeks,
if you are wrong and the share price drops suddenly, you will not be able to afford
the purchase. Therefore, you want to hold on to the shares for as long as possible,
but still protect yourself against the risk of a big loss.
market
v. Margin Transactions
 On any type order, instead of paying 100% cash, borrow a portion
of the transaction, using the stock as collateral.
 Buying on margin means the investor pays for the shares with some
cash and borrows the rest from the broker while making the shares
available as collateral.
 Interest rate on margin credit may be below prime rate
 Regulations limit proportion borrowed
 Margin requirements (proportion of cash payment) are from 50%
up.
 Changes in price affect investor’s equity

• When purchasing securities, investors have easy access to a source of
debt financing called broker’s call loans.
• The act of taking advantage of broker’s call loans is called buying on

margin.
• Purchasing stocks on margin means the investor borrow part of the

purchase price of the stock from a broker.
• The margin in the account is the portion of the purchase price

contributed by the investor, the remainder is borrowed from the
broker.
• The broker in turn borrow money from banks at the call money rate
to finance these purchases; they then charge their clients that rate,
plus a service charge for the loan.
• All securities purchased on margin must be maintained with the

brokerage firm in street name, for the securities are collateral for the
loan.
Margin
• The percentage margin is defined as the ratio of the net worth, or

the equity value of the account to the market value of the securities.
Illustration.
Suppose an investor initially pays P6 000 toward the purchase of P10
000 worth of stock (100 shares at P100 per share), borrowing the
remaining P4 000 from a broker. The initial balance sheet looks like
this:
Assets Liabilities and Owners’ Equity
Value of stock P 10 000 Loan from broker P 4 000
Equity P 6 000
P 10 000 P 10 000
• The initial percentage margin is:
If the price declines to P70 per share, the
account balance becomes:
Assets Liabilities and Owners’ Equity
Value of stock P7 000 Loan from broker P4 000
Equity P3 000
P7000 P7 000
• The percentage margin is now:
Maintenance Margin
maintenance margin is the required amount of securities an investor must

hold in his account if he purchases shares on margin
Suppose the maintenance margin is 30%. How far could the stock price fall
before the investor would get a margin call?
- Let be the price of stock.
- The value of the investors’ 100 shares is then
- Equity in the account is .
- The percentage margin is

• The price at which the percentage margin equals the maintenance
margin of 30% is found by solving the equation:
If the price of the stock were to fall below P57.14 per share, the
investor would get a margin call.
Activity
• Suppose the maintenance margin is 40%, how far can the stock price
fall before the investor gets a margin call?
Why do investors buy securities on margin?
• They do so when they wish to invest an amount greater than their

own money allows. Thus, they can achieve greater upside potential,
but they also expose themselves to greater downside risk.
• Let’s suppose an investor is bullish on Sefalana stock, which is
currently selling for P100 per share. An investor with P10 000 to
invest expects Sefalana to go up in price by 30% during the next year.
Ignoring any dividends, the expected rate of return would be 30% if
the investor invested P10 00 to buy 100 shares.
• But now assume the investor borrows another P10 000 from the
broker and invests it in Sefalana, too.
• The total investment would be P20 000 (for 200 shares). Assuming
an interest rate on the margin loan of 9% per year, what will the
investor’s rate of return be now (again ignoring dividends) if Sefalana
stock goes up 30% by year’s end?
Solution
• The 200 shares will worth P26 000. Paying off P10 900 of principal
and interest on the margin loan leaves P15 100.
• The rate of return in this case will be :
The investor has parlayed a 30% rise in the stock’s price into a 51%
rate of return on the P10 000 investment.
Downside risk
• Suppose that, instead of going up by 30%, the price of Sefelana stock

goes down by 30% to P70 per share.
• In that case, the 200 shares will be worth P14 000, and the investor
is left wit P3 100 after paying off the P10 900 of principal and
interest on loan. The result is a disastrous return of
Summary
Change in stock price End-of-year Value of Repayment of Principal Investor’s Rate of
shares and Interest Return
30% increase P26 000 P10 900 51%
No change P20 000 P10 900 -9
30% decrease P14 000 P10 900 -69
Assuming the investor buys P20 000 worth of stock, borrowing P10 000 of he purchase price at an
interest rate of 9% per year.
Activity
• Suppose that in the same margin example, the investor borrows only P5
000 at the same interest rate of 9% per year.
Required:
a) What will be the rate of return be if the price of Sefalana
i. goes up by 30%?
ii. Goes down by 30%?
iii. Remains unchanged?

market
 Market indices
A market indices are a convenient way of providing

investors with an indication of the movement of the
aggregate market.
Many indices are cited by news or financial services

firms and are used as benchmarks, to measure the
performance of portfolios such as mutual funds.
Alternatively, an index may also be considered as an

instrument (after all it can be traded) which derives its
value from other instruments or indices.
Uses of market indices
I. As benchmarks to evaluate the performance of professional

portfolio managers. A superior portfolio manager should be
able to outperform an individual investor and the market.
II. To create and monitor the index fund. The objective of an index
fund is to track the performance of the specific index over time
and at least achieve similar rates of return.
iii. To measure market rates of return in economic
studies.
iv. To predict market movements. Technical analysis believe

past price changes can be used to predict future movements.
v. As a proxy for the market portfolio of risky assets when

calculating the systematic risk of an asset.
Factors need to be considered when constructing indices
i. The size, breath and source of the sample. The sample should
be representative of the population.
ii. The weight given to each constituent of the sample. The
weighting scheme may be a price-weighted series or a value-
weighted series or equally weighted series.
iii. The calculation procedure, whether it is an arithmetic average
or geometric average of the constituents, or an index that
reflects all changes reported in terms of the basic index.

6
• The index may be weighted to reflect the market

capitalization of its components, or may be a simple
index which merely represents the net change in the
prices of the underlying instruments.
• Most publicly quoted stock market indices are

weighted.
securities market
Market indices are useful in understanding the level of
prices and the trend of price movements of the market.
A market index is created by selecting a group of

securities that are capable of representing the whole
market or a specified sector or segment of the market.
The change in the prices of this basket of securities is
measured with reference to a base period.
There is usually a provision for giving proper weights

to different securities on the basis of their importance
in the economy.
A market index acts as the indicator of the

performance of the economy or a sector of the
economy.
Background of BSE
• In Botswana, the BSE initially operated under interim regulations

1989-1995, which were applied with assistance from the ZSE in
Zimbabwe, until it gained a legal status in November 1995.
CHAPTER 4
DEVELOPMENTS IN INVESTMENT THEORY
• Investment theory attempts to explain the way in which investors
specify and measure risk and return in the valuation process.
• Because investors are rational, as risk increases so will their required

rate of return.
• Investors are faced by systematic and unsystematic risk. They deal

with risk by constructing portfolios which are diversified (invested in
various asset classes).
Efficient Market Theory
An Efficient Market:
• Is a market in which the prices of securities adjust rapidly to the

arrival of new information.
• This implies that the current prices of securities reflect all the
information about a security.
Assumptions of the efficient market
i. It requires large number of independent, competing, profit-
maximising participants who analyse and value securities.
ii. New information regarding securities comes to the market in a
random fashion. The timing of the announcements is
independent.
iii. The competing investors attempt to adjust security prices
rapidly to reflect the effect of the new information. It is also
assumed that the adjustment is unbiased.

Forms of the Efficient Market Hypothesis
i. The weak form
• Assumes that current security prices fully reflect all security market
information. Security market information includes security prices,
trading volume and rates of return.

ii. The semi-strong form
• Assumes that the security prices adjust rapidly to all public
information. The semi-strong form encompasses the weak form
because all the market information is considered to be public.
• Public information is regarded as market information plus
information such as economic and political news, as well as news, as
well as news about companies such as mergers and acquisitions,
earnings and divided announcements.

iii. The strong form
• Assumes that security prices fully reflect all information, from both
public and private sources.
• The strong form extends the assumption of efficient markets to

assume perfect markets. A perfect market exist if all information
were cost free and available to everyone at the same time.
GRAPH
Implications of the efficient market theory
i. Implication for fundamental analysts
• Fundamental analysts believe security values depend on underlying
economic factors such as gross national product (GNP), inflation and
interest rates.
The implication of the EMH for fundamental analysis is that above-
average rates of return can only be achieved if one has access to
reports of superior analysts and if one is able to invest (buy before the
rest of the market realises there is a discrepancy between market
value and intrinsic value) superior market timing.

ii. Implication for technical analysts
• Technical analysts use graphs and charts to identify buying and
selling signals from market information.
• They believe individual investors do not analyse information and act
immediately, rather, investment professionals disseminate
information to aggressive investors and the information gradually
reaches the rest of the market.

• They also contend that security prices move in persisting trends.
• The EMH states that security prices fully reflect all relevant
information and adjust rapidly.
• The implication for EMH for technical analysts is that the use of
historical trading information only should not enable the investor to
generate abnormal returns, particularly if risk and transaction costs
are taken into consideration.

iii. Implications for portfolio managers
• Portfolio managers can either manage portfolios actively or passively

(buy-and-hold).
• Normally the passive strategy is pursued if the portfolio manager

does not have superior analysis, nor the time and ability to do asset
allocation in order to be a superior investor.
• In that event the portfolio manager would have to:

Establish risk preferences and construct a portfolio that matches the
acceptable risk level.
Completely diversify so that the portfolio performance moves in line

with the market.
Minimise transaction costs by minimising taxes, reducing trading

turnover and investing in liquid securities (to avoid losses due to
illiquid securities).
• One of the implications of the EMH for portfolio management, given
the above-mentioned considerations, is that the equity portfolio
manager without superior analysis, time and ability to do asset
allocation, should set up an index fund (also called a market fund).
• An index fund is a portfolio designed to duplicate the composition
and performance of a selected market index series, such as the All
Share Index (ALSI), the Financial Index (FINI), the Gold Index (GLDI)
or Industrial Index (INDI) of the JSE

Investment Theory
• The development of investment theory was accelerated once a

concept known as the risk-free asset was introduced by researchers
such as Sharpe (1964), Lintner (1965) and Mossin (1966).
• A risk-free asset is an asset with zero (0) variance, which has zero
correlation with all other risky assets, and which produces a risk-free
rate of return (Rf)
• This implies a standard deviation () of zero for the risk-free asset,
because its expected return will equal its actual return.
• On the other hand, a risky asset is characterised by uncertain future

returns which can be measured by the variance () or standard
deviation () of expected returns.
Risk and return: The security market line (SML)
• SML reflects the best combinations of risk and return available on

alternative investments.
• A portfolio consisting of risk-free assets and combinations of

alternative risky assets can be constructed.
• The standard deviation of such a portfolio is the linear proportion of

the standard deviation of the risky asset portfolio.
GRAPH
• On a graph such a combination creates a straight line between the
assets, because both the expected return and the standard deviation
of return are linear combinations.
GRAPH
• Individual investors will choose investments based on their risk
preferences as demonstrated by risk indifference curves, which are
illustrated below:
• With high risk aversion, the investor would be prepared to accept a
relatively low rate of return and an optimal investment, as indicated
by point A, while with low risk aversion the investor may be prepared
to accept a higher return for additional risk and an optimal
investment, as indicated by point B
• NB: the steeper the indifference curves the higher an investor’s risk
aversion.
Three changes that may occur with
respect to SML
i. Movement along the SML

ii. Changes in the slope of SML
iii. A parallel shift in the SML
i. Movement along the SML
• Would be due to a change in the perceived risk of an invest. The
consequence is that an investment is now required to generate a
higher return if it is to remain an attractive investment alternative.
The SML remains unchanged.
ii. Changes in the slope of the SML
• Would be caused by a change in the return required per unit of risk.
• This change occurs because the market risk premium is nor constant
over time. If the market risk premium changes, this will affect the
required return for every risky asset even if there is no change in
each asset’s risk profile.
iii. A parallel shift
• Would occur if there was a change in the nominal risk-free rate.
• This shift would affect the return required on all assets.
Graphical Illustrations
Systematic Versus Unsystematic risk
i. Systematic (undiversifiable) risk
• Is that element of risk in a security that cannot be diversified away.
The risk is caused by factors that influence the entire market.
• Examples include changes in interest rates between currencies
ii. Unsystematic (diversifiable) risk
• Is the risk in a security that can be diversified away. This can also be
called firm specific risk.
• Investors needs around 12 diverse securities in a portfolio to
eliminate most of the unsystematic risk.
Markowitz Efficient Frontier
• Represents that set of portfolios (of risky investments) that has the
maximum return for every given level of risk, or the minimum risk for
every level of return.
• Individual securities are unlikely to be on the efficient frontier due to
the benefits of diversification.
• Consequently the efficient frontier is a curve (not a straight line)
which will not touch the .
• Markowitz regards portfolio risk as the square root of the weighted
average of the individual variances plus the weighted covariance
between pairs of individual assets, which translates into the
following equation for the measurement of portfolio risk ().
• For two asset portfolio the Markowitz portfolio risk equation
simplifies to:
GRAPH
ASSET PRICING THEORIES AND
MODELS
I. Capital Asset Pricing Model

II. Arbitrage Pricing Theory
NB: in both cases it should be remembered that investors are risk
averse, and that for any increase in risk they require an increase in
their required rate of return.
i. Capital Asset Pricing Model (CAPM)
• Indicates the return an investor should require from a risky asset

assuming that he is exposed only to the asset’s systematic risk as
measured by .
• The rationale is that for any level of risk, the SML indicates the return
that could be earned by using the market portfolio and the risk-free
asset.
• This provides a benchmark return against which one can assess any
investment.
Assumptions of capital market theory.
i. Investors are risk averse and rational. Each investor wants to

invest somewhere on the efficient frontier in line with his
required risk and return.
ii. Investor can borrow or lend any amount at the risk-free rate ().
iii. Investors have homogeneous expectations: that is, they estimate
identical probability distributions for future rates of return.
iv. Investors have the same one-period time horizon, which could be a
month, six months or a year.
v. There are no taxes or transaction costs involved in buying or selling
assets.
vi. There is no inflation, or any change in interest or inflation rates is
fully anticipated.
vii. Capital markets are properly priced in line with their risk levels.
Calculation and interpretation of beta()
• The CAPM equation is:
where:
= required return
= the risk-free rate of return
= beta
= return on the market portfolio
) = market risk premium
• The beta of an individual security my be found by means of the
following:
Graphs for beta
• The beta of a portfolio (is the weighted average of the individual
betas. The weights should reflect the proportion of the portfolio’s
value represented by each asset.
where:
= beta of the portfolio
= weight (proportion) of portfolio
= beta of asset
Example
A portfolio consists of the following assets with associated betas:
Calculate the beta of the porfolio.

Security Beta Value
X 0.9 P1 000 000
Y 1.2 P2 000 000
Z 0.7 P2 000 000

Solution:
Capital Market Line
• The SML has made no made no provision for lending and borrowing.
• If an investor is able to borrow at the risk-free rate, then the risk and
return will increase in a linear fashion along the original line ()
• This extension dominates all assets or portfolios below the line on
the original efficient frontier.
• The newly created efficient frontier is a straight line from the risk-
free rate () tangent to point , and is called a capital market line
(CML).
• This implies that all portfolios on the CML are perfectly positively
correlated.
• Because Portfolio lies at the point of tangency, it has the highest
portfolio possibility line, and every investor would want to invest in
portfolio and borrow or lend to be somewhere on the CML.
• This portfolio must include all risky assets (Is called the market
portfolio).
Capital market line
• The investor could invest part of his portfolio in the risk-free asset
and the rest in the risky portfolio , or he could borrow at the risk free
rate and invest the borrowed sum in the risky asset portfolio.
• For an investor to be on the CML efficient frontier, he initially decides
to invest in the market portfolio ().
• Subsequently, based on his risk preferences, he will make a separate
financing decision to either borrow or lend to attain his preferred
point on the CML (The separation theorem by Tobin, 1958).
Difference between the CML and SML
Under the CML, risk is measured by means of variance.

While, in the case of the SML, risk is measured by means of beta.
Using CAPM to assess an asset
• An investment in an asset can be assessed by means of CAPM to

determine whether an asset is over or undervalued.
• The estimated rate of return that the investor anticipates, assuming
the assets are so priced that their estimated rates of return are
consistent with their levels of systematic risk.
• Any security with an estimated rate of return that plots above the
SML is considered to be undervalued (and vice versa)
• In a highly efficient market, all assets should plot on the SML, but in a
less efficient market assets may at times be mispriced due to
investors perhaps being unaware of all the relevant information.
Example:
The estimated return on the market is 15% and the risk-free rate is 8%.
Assume FNB’s beta is 1.25 and the estimated rate of return is 17%.
Required:
Using the CAPM, determine whether the shares are over or
undervalued.
Solution:
• This indicates that the FNB share is undervalued by percent points
(17%-16.75%).
Plot of estimated returns on SML
• Asset A is plotted on the SML to illustrate an asset which is properly
valued (priced), while asset B is overvalued (overpriced) and plotted
below (asset C undervalued).
Arbitrage Pricing Theory (Ross 1976)
• Is an alternative theory to the CAPM.

Assumption of APT
i. Capital markets are always perfectly competitive.
ii. Investors always prefer more wealth to less wealth with
certainty.
iii. The stochastic process generating asset returns can be
represented as a factor model.
APT Model
• The factor model can be represented as:
where:
= expected return on an asset with zero systematic risk.
=risk premium related to each common factor.
= price relationship between the risk premium and asset .
• The common factors may include macroeconomic factors, such as
growth in GNP, interest rate changes, inflation and changes in
exchange rates.
• The is a measure of the responsiveness of asset to common factors .
Example
An analyst has used a multiple regression model to determine the

relationship between the Absa share price (the dependent variable)
and a set of independent variables, namely growth in GNP, interest
rates, and the exchange rate between the US dollar and South African
rand (ZAR). The analyst uses an expected return on an asset with zero
systematic risk of 12% and the following model to determine the
required rate of return,
)
• If the increase in the GNP is expected to be , the prime interest rate
is expected to increase by , and the rand is expected to strengthen
against the dollar by , then the required rate of return on Absa may
be calculated as follows:
)
If the estimated return on Absa is 15%, then the share is regarded as
undervalued based on the APT model.
If the estimated return is 10%, then the Absa share is regarded as
overvalued.
A comparison of CAPM and APT
CAPM APT
Only considers one factor influencing an asset’s Considers many factors that may influence an
return, namely the beta () asset’s return.
Assumes that unique risk can be diversified away Assumes that unique risk is diversified away in a
in a large portfolio. large portfolio.
Theories of term structure of interest rates
• What is the Term Structure of Interest Rate?
• The term structure of interest rate can be defined as the graphical

representation that depicts the relationship between interest rates
(or yields on a bond) and a range of different maturities.
• The graph itself is called a “yield curve.” The term structure of

interest rates plays an important part in any economy by predicting
the future trajectory of rates and facilitating quick comparison of
yields based on time.
• The yield curve helps traders understand the bond market well. For
example, when the interest rates are studied against their tenor, it
helps investors and analysts assess the market concerning how much
investors would earn from their investments in short-term and long-
term bonds.
Types of Yield Curve
• Whether it is a treasury or bond yield curve, plotting the interest rate

value and the maturity term on the graph brings investors to multiple
forms of yield curves, exhibiting different shapes. These include:
Normal curve
Inverted curve
Humped curve
Flat curve
1. Normal Curve
• A normal yield curve shows an increase in the yields with maturity.
Such curves indicate a healthy economy and an actively functioning
market. This helps investors understand that if they preserve the
investment for longer-term, they are likely to reap more profits with
time.
2. Inverted Curve
• This curve is formed with slopes moving down to the right instead of
going up, indicating a recession or unstable market conditions. The
inverted graph is derived when the rates for short-term investments
are more than those for long-term securities. As a result, when
analysts and investors derive an inverted yield curve, they know it’s
an indication of a bearish market.
3. Humped Curve
• When the medium-term investment is likely to yield more than

expected from both short-term and long-term securities, a humped
curve emerges. Such curves are rare but indicate a slow and inactive
economy.
4. Flat Curve
• A flat curve appears when the securities with short-term, medium-

term, and long-term securities are likely to yield the same returns. It
indicates an uncertain economic condition.
• Formula
• When plotting the figures on the graph to prepare a yield curve chart, the
following formula serves useful:
• Formula
• Example
• Let us try and create a treasury yield curve. The X-axis begins with the
interest rates or yields (%) for bills of shorter-term maturity and moves above
with the securities with maturity terms ranging from a couple of days to one
year, two years, and so on to the right. First, however, the maturity period is
plotted on the Y-axis.
• Yield (%) Maturity Term (months)

0.2 1
0.5 5
1.5 15
2 25
2.5 30
Solution:
Therefore, it signifies an optimistic market, i.e.,
better returns for investors who have invested in
long-term
The theories of interest rates
• 1. Liquidity Premium Hypothesis
• 2. Market Segmentation Hypothesis
• 3. Unbiased Expectations Theory— (Irving Fisher and Fredrick Lutz).
• Interest: Theory # 1. Liquidity Premium Hypothesis:
• Investors are risk averse and would prefer liquidity and consequently short-term
investments. The longer they prefer liquidity the preference would be for short-term
investments. The longer the maturity of the security, the greater will be the risk or the
fluctuation in value of Principal to the investor.
• For a long-term, therefore, a risk or liquidity premium must be offered to induce investors
to purchase long-term securities. This premium is above the average of the current short
rate and expected future short rates. Therefore, the interest rates would be higher for a
longer period of time and the yield curve would be upward sloping.
• Whilst lenders would prefer to lend money for a short period of time, borrowers would like
to obtain funds for longer periods of time. The fact that in the real world yield curves have
been upward sloping lends credence to the liquidity premium theory (Post-World War II
period).
• Once liquidity premium exists, it is clear that expected future short rates would have to be
less than the current short rate by an amount greater than the liquidity:
• (i) An increase in risk aversion will make the yield curve steeper by increasing the required
premium on long-term securities,
• (ii) Higher return or changes in supply of securities will cause term structure rates to be
altered.
• f supply of short-term decreases, an increasing number of people will enter the long-term
bonds market. The yield curve should then become steeper as a result of the postulated
change in supply.
• Questions not explained in liquidity premium hypothesis.
• Why are short-term rates sometimes higher than long-term rates?
• It does not explain the fact that market may not be dominated by holders of liquidity
preference and short-term investments create problems in re-investments.
2. Market Segmentation Hypothesis
Market segmentation hypothesis is also called “preferred habitat hypothesis”. It
suggests that the term structure depends on the supply demand conditions.
Some investors will prefer to invest in short-term securities and will move out to
longer-term securities if higher yield is promised to them. Others will only move to
short-term investments to avoid cost of interest, life insurance and Unit Trusts will
prefer longer-term investments.
Because they are risk averse and would like to avoid costs of reinvestment.
Commercial banks prefer short-term investments. Obviously, relative supplies help
to determine the short and long-term structure as they are not perfect substitutes
for each other. Clearly if there is a change in supply, some investors will be induced
to invest in a available securities.
The determination of the term structure is viewed as the outcome of the supply
and demand in the two segmented markets of demand and supply, the markets
for shorts and markets for longs. The relative demand for “longs” and “shorts” are
determined by the relative flows of funds through intermediaries which invest only
in long-term compared with the flows of funds into those which invest only in
short-terms.
• The existence of a lump in the yield curve can be explained by the
segmentation hypothesis. If institutions have rigid maturity
preference, it is quite possible that a large excess of an intermediate
maturity security will cause a lump in the curve. Transaction costs are
more during short-term than long-term cyclical change.
3. Unbiased Expectations Theory— (Irving Fisher and Fredrick Lutz):
• The expectation of the future course of interest rates is the sole
determinant. When the yield curve is upward sloping, it implies that
market participants expect interest rates to rise in the future
downward slope implies the expectation of interest rates to fall in
future. Horizontal line suggests that interest rates are not expected
to change.
INSTUTIONAL INVESTORS
• Institutional investors are large entities such as pension funds, hedge

funds, and insurance companies that hire finance and investment
professionals to manage large sums of money on behalf of their
clients or members.

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Investment Management

1.0 An overview of investment Management

1.1 Financial institutions and markets

• Financial institutions and their functions

• Types of Financial Institutions

• Banking and Non-Banking

• How do we make the best or most informed investment decisions?

• According to Reilly and Brown (2000), investment is the current

 the time the funds are committed,

 the expected rate of inflation and

 the uncertainty of the future payments.

• Investment is the commitment of funds to one or more assets that

• Investment is the study of the investment process.

company or investment opportunity.

for evaluating investments in companies within that sector.

4. Regulatory and Legal Considerations: Investors must consider the regulatory

environment and legal constraints when evaluating investments, especially in certain

potential growth and sustainability of a company or investment.

1. Fundamental Analysis: This approach involves analyzing a

2. Technical Analysis: Technical analysis involves studying past

3. Valuation Models: Valuation models, such as discounted cash flow

Why do people invest?

• Investing results in capital growth while saving is concerned about

• Investment analysis is the study of financial securities for the

Real vs. Financial Investment

• Real investment is the purchase of physical capital such as land and

• In this course, we are concerned about financial investment.

Real assets vs. financial assets

• They are physical and human assets.

ii. Financial assets

• Individual investors are individuals who are investing on their own.

• Institutional investors are entities such as investment companies,

• Every investor (individual or institutional) has certain specific objectives to

• Such objectives may be monetary/financial or personal in character.

• The objectives include:

 Safety and security of the funds invested (principal amount).

 Profitability (through interest, dividend and capital appreciation).

 Liquidity (convertibility into cash as and when required).

• These objectives are universal in character as every investor will like to

• There are personal objectives which are given due consideration by

 Provision for old age and sickness.

 Provision for house construction.

 Provision for marriage and education of children.

 Provision for dependents including wife, parents or physically

handicapped member(s) of the family.

• To enable the evaluation and reasonable comparison of various investment

The investment environment has several elements:

• Non-Bank Financial Institutions: (insurance and assurance

• Regulatory institutions and laws (Ministry of Finance and

An Overview of the Financial System

1. Function of Financial Markets and Financial Intermediaries

2. Structure of Financial Markets

• Debt and Equity Markets

• Primary and Secondary Markets

• Exchanges and Over-the-Counter Markets

• Money and Capital Markets

• Money Market Instruments

• Capital Market Instruments

4. Role of Financial Intermediaries

• Transaction Costs and Economies of Scale

• Risk Sharing and Diversification

• Adverse Selection and Moral Hazard