Chapter One

Introduction to Investment
1.1 What is investment
 Investment is defined as the current commitment of resources funds in the expectation
of harvesting some positive rate of return in the future. Expectation of return is an
essential element of investment. Since the return is expected to be realized in the
future, there is a possibility that the return actually realized is lower than the return
expected to be realized. This possibility of variation in the actual return is known as
investment risk. Thus, every investment involves return and risk.
 It is a sacrifice made now to obtain a return in the future.
 It is current consumption that is sacrificed
1.2 Elements (Characteristics) of Investment
The following are the typical (basic) elements (Characteristics) or features of an investment:
Return: All Investments are characterized by the expectation of a return. In fact, investments
are made with the primary objective of deriving a return. The return may be received in the
form of yield (interest or dividend) or capital appreciation (which is the difference between
the sales price and the purchase price).
Risk: Risk is inherent in any investment. This risk may relate to loss of capital, delay in
repayment of capital, non-payment of interest, or variability of return. Literally, while
investments in government securities and bank deposits are risk free, other investment
vehicles are more risky.
Anyhow, the risk of an investment depends on:
 The maturity period; the longer the maturity period, the larger is the risk
 The credit worthiness of the borrower; the lower the credit worthiness of the borrower,
the larger is the risk.
 The nature of investment; investment in equity securities like equity shares carry
higher risk compared to in debt instruments like bonds or debentures.
Safety: The safety of investment implies the certainty of return, without any loss of money or
time. Safety is another common feature which an investor desires for his investment. Every
investor expects to get back his capital on maturity without loss and without delay.
Liquidity: An investment which is easily marketable without loss of value and time is said to
liquid.
Note: Generally, an investor favors liquidity for his investments, safety of his funds, a good
return with a minimum risk or minimization of risk with maximization of return.

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 1.3 Objectives of Investment
The objective of the investor is to minimize the risk involved in investment and to maximize
the return from investment.
Kept cash on hand is not an investment. Because, they do not earn anything and loses its
value to the extent of rise in prices. Thus, rise in prices or inflation erodes the value of money.
Savings are invested to provide a hedge or protection against inflation. Thus, the objectives of
investment can be stated as:
 Maximization of return
 Minimization of risk
 Hedge against inflation
Investors, in general, desire to earn as large returns as possible with the minimum of risk.
Risk here may be understood as the probability that actual returns realized from investment
may be different from the expected return.
Investors in the financial market have different attitudes towards risk and varying levels of
risk bearing capacity. Some investors are risk averse, while some may have an affinity to risk.
The risk bearing capacity of an investor, on the other hand, is a function of his income. A
person with higher income is assumed to have a higher risk bearing capacity.
What is investors?
An investor is an individuals or institutions 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. An “investor” can be an individual or an institution.
Why people invest?
At this point, we have answered the questions about why people invest and what they want
from their investments.
 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 the return.

1.4 Investment alternatives

There are many kinds of investments, each with its own level of risk and return. The more
money you can make from an investment, the higher the risk that you might not get all your
money back. Though there are a range of investment alternatives, they can be classified into
two broad categories:

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 1) Financial Investments (Financial Assets) Financial assets are pieces of paper (or
electronic) evidencing claim on some issuer. The most important financial assets are
equity shares, corporate bonds, government securities, deposit with banks and like

2) Real Investments (Real Assets) Real assets are represented by tangible assets like
residential house, commercial property, agricultural farm, precious stones and like

 Investment in financial asset differ from investment in physical asset in those

different aspects
Divisibility; Financial assets are divisible, whereas most physical assets are not.
 An asset is divisible if investor can buy or sell small portion of it.
 In case of financial assets it means, that investor, for example, can buy or sell a small
fraction of the whole company as investment object buying or selling a number of
common stocks.
Marketability (or Liquidity); is a characteristic of financial assets that is not shared by
physical assets, which usually have low liquidity.
 Liquidity reflects the feasibility of converting of the asset into cash quickly and
without affecting its price significantly.
 Most of financial assets are easy to buy or to sell in the financial markets.
The planned holding period; of financial assets can be much shorter than the holding period
of most physical assets.
 The holding period for investments is defined as the time between signing a
purchasing order for asset and selling the asset.
 Investors acquiring physical asset usually plan to hold it for a long period,
 But investing in financial assets, such as securities, even for some months or a
year can be reasonable.
 Holding period for investing in financial assets vary in very wide interval and
depends on the investor’s goals and investment strategy.
Information about financial assets; is often more abundant and less costly to obtain, than
information about physical assets.
 Information availability shows the real possibility of the investors to receive the
necessary information which could influence their investment decisions and
investment results.
 So it’s good to have a mix of different kinds of investments to spread your risk
and get the results you want. 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.  

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  When you deposit money in an account you are lending it to the bank, which pays
you some interest in return.
 The interest you can earn is relatively low, so savings accounts are not the best
option if you are looking for long-term growth.
b. Term deposits
 Like savings accounts, term deposits also pay interest.
 The difference is that you agree to lend your money to the bank for a fixed period
of time such as 6 or 12 months in return for a higher rate of interest.
 Term deposits are sometimes called ‘fixed interest’ investments.
c. Bonds
 A 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.
 The level of risk involved when investing in bonds depends on the issuer.
 Unlike term deposits, you can sell your bonds early. However the price you will
get can go up and down. Bonds are also sometimes called fixed interest
investments.
d. Shares (Equity)
 When you buy a share, you are buying a small part of a company.
 If that company makes money, you may be paid a share of the profit, called a
dividend. 
 Share prices are generally expected to go up over time and give you a ‘capital
gain’ on your money when you sell.
 However, prices can fall in value as well. 
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.
 Some people view their own home as an investment because it may grow in value. It
doesn’t have the income that letting property to other individuals or businesses brings.

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 1.5 Financial Markets
A financial market is a market where financial asset are traded.
Role of Financial Markets
Financial markets are important in a financial system because they provide different economic
functions. Financial markets provide the following three additional functions beyond that of
financial assets themselves.
1. The price discovery process
First, the interactions of buyers and sellers in a financial market determine the price of the
traded asset. Or, equivalently, they determine the required return on a financial asset. This is
called the price discovery process.
2. Liquidity Function
Financial markets provide a mechanism for an investor to sell a financial asset when
circumstances either force or motivate him / her to sell. Because of this feature, it is said that a
financial market offers liquidity.
In the absence of financial markets, the owner would be forced to hold a debt instrument.
3. Reducing the cost of transacting
 The two costs associated with transacting are search costs and information costs.
 Search costs represent explicit costs, such as the money spent to advertise one’s intention to
sell or purchase a financial asset, and
 Implicit costs, such as the value of time spent in locating counterparty.
The presence of some form of organized financial market reduces search costs.
Classification of financial Markets
There are many ways to classify financial markets. The following are some of the ways to
classify financial markets:
1. Based on nature of financial claim
Financial markets are classified as: Debt market vs. Equity market
Debt market; Debt market is a market for debt securities (including both short term and long-term
debts). Security holders, here, have priority in liquidation of claims than equity holder.
Equity Market; Equity market is a market for residual claim securities, namely common stock and
preferred stock. Equity holders are paid after debt holders are paid first.

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2. Based on maturity of financial claim
Financial markets are classified as: Money market vs. capital market
Money market; the money market is designed for the making of short-term loans. It is the
institution through which individuals and institutions with temporary surpluses of funds meet
borrowers who have temporary funds shortages.
Capital market; In contrast, the capital market is designed to finance long term investments by
businesses, governments, and households.
3. By seasoning of financial claim
Financial markets are classified as: the primary market and secondary market
The primary market; is where new issues of bonds, preferred stock, or common stock are
sold for the first time to acquire new capital.
 Market where new securities are sold and funds would go directly to issuing unit.
 It is also called New Issue Market (NIM)
 Trades on the primary market raise fresh capital for firms.
Secondary market; a market where securities are resold between investors.
 The issuing unit does not receive any funds in a secondary market transaction i.e.
 Secondary market do not serve to raise additional capital for firms.
 The proceeds from a sale in the secondary market do not go to the issuing unit but, rather, to
the current owner of the security.
4. By immediate delivery or future delivery
Financial markets could be: spot market vs. future market
Spot market; A spot market is one where securities are traded for immediate delivery
(usually within one or two business days).
If you pick up the telephone and instruct your broker to purchase ABC Corporation’s shares at
today’s going price, this is a spot market transaction. You expect to acquire ownership of
ABC shares within a matter of minutes or hours
Future market; (also called derivative market) are markets in which participants agree today to
buy or sell an asset at some future date.
For example, you may call your broker and ask to purchase a contract from another investor calling
for delivery to you of Br, 1 Million in ABC bonds six months from today.
5. Base on physical place to the market as
Financial markets are classified as Stock exchanges Vs. OTC market
Stock exchanges; is physical location for trading.

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  It is an organized and regulated financial market where securities are bought and sold
at prices governed by the forces of demand and supply.
 Although the exchanges typically consider similar factors when evaluating firms
that apply for listing, the level of requirement differs (the national exchanges
have more stringent requirements).
 Stock traded on exchange are listed stocks
Over the counter (OTC) markets; OTC is a security traded in some context other than on a
formal exchange. The phrase "over-the-counter" can be used to refer to stocks that trade via
a dealer network as opposed to on a centralized exchange.
 The OTC market is not a formal organization with membership requirements or a
specific list of stocks deemed eligible for trading.
 Over-the-counter (OTC) market, involves trading in stocks not listed on an organized
exchange.
1.6 Investment Companies
An investment company sells shares in itself and uses the proceeds of this sale to acquire
bonds, stocks, or other investment instruments. As a result, an investor who acquires
shares in an investment company is a partial owner of the investment company’s portfolio
of stocks or bonds.
We will distinguish investment companies by the types of investment instruments they
acquire.
a. Money Market Funds: Money market funds are investment companies that
acquire high quality, short-term investments (referred to as money market
instruments), such as T-bills, high grade commercial paper (public short-term
loans) from various corporations.
b. Bond Funds: Bond funds 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.
c. Common Stock Funds: Numerous common stock funds invest to achieve stated
investment objectives, which can include aggressive growth, income.
d. Balanced Funds: Balanced funds invest in a combination of bonds and stocks of
various sorts depending on their stated objectives.

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