Lecture 1

Understanding Investment
Investment decision process
 Some Definitions
Investment: An investment is the current
commitment of money or other resources in
the expectation of reaping future benefits
(Kane, Bodie and Marcus 2005)
 Definitions
Generally, investments refers to financial assets
and in particular to marketable securities
Financial assets are paper or electronic claims on
some issuer, such as the government or a
company
Marketable securities financial assets that are
easily and cheaply tradable in organized markets
Real assets are tangible assets such as gold, silver,
diamonds, real estate,
 Why to invest?
Investment increases future consumption
possibilities

By foregoing consumption today and investing the

savings, investors expect to increase their future
consumption possibilities by increasing their
wealth
 If we do not invest, then?
If we do not invest, we cant earn anything on
cash
Second, the purchasing power of cash
diminishes in inflation

This means that if savers do not invest their

savings, they will not only lose possible return
on their savings, but will also lose value of
their money due to inflation
 But investment has problems
Investment has the following three problems:
A. Sacrifice
While investing, investor delay their current
consumption (delaying consumption is kind of
sacrifice)
B. Inflation - Investment loses value in periods of
inflation
C. Risk - giving your money to someone else
involves risk
 Compensation to investors
Due to the three problems, investors will not
invest until they are compensated for these
problems

Required rate of return = compensation for

(sacrifice , inflation, risk)
RRR= opportunity cost + risk premium
 Understanding the investment
decision process
The basis of all investment decisions is to earn
return and assume risk
By investing, investors expect to earn a return
(expected return)
 Expected return and risk
Realized returns(actual return) might be more or
less than the expected return
The chance that the actual return on an
investment will be different from the expected
return is called risk
This way t-bills has no risk as the expected return
and actual return are the same
But actual returns on common stock have greater
chances of deviating from expected return and
hence have high risk
The expected risk-return trade-off
The expected risk-return trade-off
The expected risk-return is depicted in the graph
The line from RFR shows risk-return
combinations
It shows that at zero level of risk, investor can
earn risk free rate (RFR) which is equal to the rate
on t-bills
To earn a little higher return than the risk free rate,
investors can invest in corporate bonds, but the
investors will have to take some risk as well
 Ex-ante and ex-post risk-return
To earn even higher return than on corporate
bonds, investor can invest in common stocks,
but the risk is also high
The risk return trade-off depicted in the graph
in ex-ante i.e. before the fact or before the
investment is made
Ex post (after fact or actual) trade-off may be
positive, flat or even negative
 Steps in the decision process
Traditionally, the investment decision process
has been structured using two-steps:
Security analysis
Portfolio management
 Security Analysis
Security analysis: this is the first part of
investment decision process
It involves the analysis and valuation of
individual securities
To analyze securities, it is important to
understand the characteristics of the various
securities and the factors that affect them
Then valuation model is applied to find out
their value or price
 Security Analysis
Value of a security is a function of estimated
future earnings from the security and the risk
attached
For securities valuation, investors must deal
with economy, industry or the individual
company
Both the expected return and risk must be
estimated keeping in view the economic,
market or company related factors
 Portfolio Management
The second major component of the decision
processes is portfolio management
After securities have been analyzed and
valued, portfolio of selected securities is made
Once a portfolio is made, it is managed with
the passage of time
For management, there can be two
approaches
 Portfolio Management
Approaches to portfolio management:
A. Passive investment strategy
B. Active investment strategy
In Passive Strategy, investors make few changes in
the portfolio so that transactions costs, time and
search costs are minimum
In Active Strategy, investors believe that they can
earn better returns by actively making changes in
the portfolio
 Lecture 2

Investment Alternatives
 Organizing Financial Assets
It is necessary for all investors to understand
the basic nature of different investment
alternatives
Investors can invest directly in financial assets
i.e. they themselves buy and sell securities
(Direct investing)
Investors can buy and sell the shares of
investment companies which in turn hold
securities (Indirect investing)
 Direct investing
Non-Marketable Financial assets
Saving deposits
Certificate of deposit
Money market deposits accounts
US saving bonds
Money Market securities
T-bills
Negotiable certificates of deposits
Commercial papers
Repurchase agreements
Bankers acceptance
 Direct investing
Capital market securities
A. Fixed income securities
Treasury or government bonds
Corporate bonds
B. Equity securities
Preferred stock
Common stocks
Derivative Securitas
Options
Futures
 Indirect Investing
Investment companies
Unit trusts
Open end mutual fund
Close end mutual fund
 Money Market Securities
Money market securities include short-term,
highly liquid, relatively low risk debt
instruments
This market is dominated by financial
institutions like banks
Maturity of money market securities range
from one day to one year
Investor may directly or indirectly invest in
these instruments
 Types of Money marekt securites
Treasury bills
This is a short term money market security
sold at discount by government and redeemed
at face value
Return or yeild on t-bills is calculated as
follows:

( Face.value Pur. Pr ice) 365

Yield X
Pur . price Maturiy in Days
 Commercial Papers
Same as t-bills, the only difference is that it is
issued by a firm
Negotiable certificates of deposits
Investors deposits money in a banks in return
they get a deposits certificates that can be
negotiated
Upon maturity, principal plus interest is paid
to the depositor
 Repurchase agreements
Short-term sales of government securities with an
agreement to repurchase the securities at a higher price
Bankers acceptance
It is an order to a bank by a customer to pay a sum of
money at a future date
Once the bank accepts it, it is the bankers responsibility to
pay to the holder
It can be traded in the secondary market
It allows traders to substitute the banks credit standing for
their own
Used in foreign trade
 Eurodollars
Dollar denominated deposits at foreign bank
Pakistani example can be MCB rupee
dominated deposits in UAE
 Capital market securities
Capital market encompasses fixed-income and
equity securities with maturities greater than
one year
Risk is much higher than the money market
securities
Marketability is poorer in some cases
It includes both debt and equity securities
 Debt (Fixed income securities)
Bonds
It is a long term debt instrument
It is a fixed income security because interest
rate is fixed at the time of issue
Buyer can sell the bond before maturity, the
priced received will depend on the level of
interest rates at that time
 Characteristics of bond
Par value or face value of most bonds is $1000
Typical bonds have a maturity time
Most bonds are coupon bonds, where coupon
refers to the periodic interest that the issuer
pays to the holder of the bond
Interest on bonds is typically paid semi-
annually