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Financial Investments
Introduction to Investments

Objectives
What is an investment?
What is the difference between real assets and
financial assets?
What are different types of financial assets?
What is a financial market and what is its role in
an economy?
What does typical investment process look like?

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Objectives
Are financial markets competitive?
Who are the main participants in financial
markets?
What are some of the questions that can be
studied in an investment course?
What are some of the considerations in investment
decisions?

Introduction to Investments
Investment

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Investment
Investing is the current commitment of money or
other resources with the expectation of reaping
future benefits.
For instance, an individual might purchase shares
of common stock with an anticipation that future
proceeds from the shares will justify both the time
that her money is tied up in the investment as well
as the risk of investment.

Investment
It is important to highlight that the value of
investment (and the income it generates) may fall
or rise and investor may get less than what she
invested.

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Investment
An important question to ask is: What motivates
a person or an organization to invest their
money in risky assets, rather than spending
their money immediately?

Investment
The most common answer is savings the desire
to pass money from the present into the future.

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Investment
People and organizations anticipate future cash
needs, and expect that their earnings in the future
will not meet those needs. Consequently, they
invest today to meet their future needs.
Investment, therefore, helps us achieve a tradeoff
between current consumption and future
consumption.

Investment
Another motivation is the desire to increase
wealth. Sometimes, the desire to become wealthy
can make us take big risks. For instance, many
investors buy a lottery ticket with a hope of
becoming very wealthy.

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Introduction to Investments
Real Assets and Financial Assets

Real Versus Financial Assets


Investors can invest their resources in real assets
as well as financial assets.

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Real Versus Financial Assets


Real Assets
Real assets are the assets used to produce goods
and services.
Land, buildings, equipment, and knowledge that
can be used to produce goods and services are
examples of real assets.

Real Versus Financial Assets


Financial Assets
Financial assets are claims on real assets or on
the income generated by them.
Most of these claims are marketable securities,
such as bonds and stocks, that are saleable in
various market places.

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Real Versus Financial Assets


Financial Assets
We can divide financial assets into two main
categories:
Direct Investments
Indirect Investments

Real Versus Financial Assets


Financial Assets
Direct investments are investments where
investors take direct ownership of the assets. In
these investments, the investors buy and sell
securities themselves, usually ,through brokerage
houses.
Indirect investments are investments where
investors have indirect ownership. In these
investments, the investors buy and sell the shares
of investment companies, such as mutual funds,
which hold portfolio of bonds and stocks.

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Real Versus Financial Assets


Financial Assets
If investors choose to buy financial assets, they
may purchase various securities (bonds and
stocks).
Money received by companies as a result of selling
various securities (bonds and stocks) to investors
is used to buy real assets (plant, equipment,
technology, or inventory).
Investors returns on their investment come from
the income produced by real assets.

Real Versus Financial Assets


Financial Assets
Some of the financial assets may be
non-marketable. Main characteristic of
non-marketable financial assets is that they cannot
be traded between investors. They may be
redeemable (a reverse transaction between the
borrower and the lender).
Some of the examples of non-marketable financial
assets are savings accounts and term deposits.

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Real Versus Financial Assets


Divergence
A saving account is a deposit account held at a
bank that provides principal and a modest interest
rate.
Savings account funds are considered as one of the
most liquid investments.

Real Versus Financial Assets


Divergence
A term deposit is a deposit held at a financial
institution for a fixed term. It, generally, matures
within a year.
When a term deposit is purchased, the lender (the
customer) understands that the money can only
be withdrawn after the term has ended or by
giving a pre-determined number of days notice.

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Real Versus Financial Assets


Example 1
Are the following assets real or financial?

Patents
Lease obligations
Customer goodwill
College education
$5 bill

Real Versus Financial Assets


Example 1
Lease obligations and $5 bill are financial assets,
while patents, customer goodwill, and college
education are real assets.

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Real Versus Financial Assets


Example 2
Suppose you discover a treasure chest of $10
billion in cash.
Is this a real or financial asset?
Is society any richer for the discovery?
Are you wealthier?

Real Versus Financial Assets


Example 2
Cash is a financial asset because it is the liability of
the government.
No, the society is not richer. The cash does not
directly contribute to the productive capacity of
the economy.
Yes. Financial assets might contribute to the
wealth of the individuals or firms holding them.

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Introduction to Investments
Types of Financial Assets

Types of Financial Assets


There are three main types of financial assets:
Debt
Equity
Derivatives

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Types of Financial Assets


Debt
Debt securities promise either a fixed stream of
income or a stream of income that is determined
according to a specified formula.
For instance, a corporate bond would promise that
the bondholder receives a fixed amount of interest
each year.
Generally, the payments generated by debt
securities last for finite period of time.

Types of Financial Assets


Debt
Unless the borrower is bankrupt, debt securities
will always pay the promised payments. For this
reason, the investment performance of debt
securities is least closely tied to the financial
performance of issuer.

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Types of Financial Assets


Debt
Debt securities come in a variety of maturities and
payment provisions. Following are the major types
of debt securities:
Money Market Debt Securities
Capital Market Debt Securities

Types of Financial Assets


Debt
Money market debt securities refer to shortterm debt securities. They are highly marketable
and have very low risk.
Examples of money market securities are the
Treasury bills and certificates of deposit.

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Types of Financial Assets


Divergence
Treasury bill (T-bill) is used to provide shortterm liquidity for the government. T-bills are
backed by the government.

Types of Financial Assets


Divergence
Certificate of deposit (CD) is a special type of
deposit account with a bank that offers a higher
rate of interest than a regular savings account.

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Types of Financial Assets


Debt
Capital market debt securities include long-term
securities such as Treasury bonds, as well as
bonds issued by federal agencies, state and local
municipalities, and corporations.
These bonds range from very safe in terms of
default risk (for example, Treasury securities) to
relatively risky (for example, corporate bonds).

Types of Financial Assets


Divergence
Treasury bonds (T-bonds) are used to provide
long-term liquidity for the government. T-bonds
are backed by the government.

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Types of Financial Assets


Debt
Capital market debt securities are designed with
extremely diverse provisions regarding payments
provided to the investor and protection against the
bankruptcy of the issuer.

Types of Financial Assets


Equity
Equity securities represent ownership stake in the
corporation.
Equity holders are not promised any particular
payment. They may receive dividends, if the firm
decides to share its profits with equity investors
(shareholders).

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Types of Financial Assets


Equity
If the firm is successful, the value of equity will
increase and vice versa.
The performance of equity investments, therefore,
is tied directly to the success of firm and its real
assets. For this reason, equity investments tend to
be riskier than investments in debt securities.

Types of Financial Assets


Derivatives
Derivative securities provide payoffs that are
determined by the prices of other assets (such as,
bond or stocks).
For example, Call option an important derivative
security might turn out to be worthless if the
price of an underlying asset remains below a predetermined threshold value, but it can be very
valuable if the price of an underlying asset rises
above that level.

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Types of Financial Assets


Derivatives
Some of the examples of derivative securities are:
Option
Call Option
Put Option

Futures
Forward

Types of Financial Assets


Divergence
An option gives the holder the right, but not the
obligation, to buy or sell a given quantity of an
asset on (or perhaps before) a given date, at prices
agreed upon today.

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Types of Financial Assets


Derivative
Derivative securities are, generally, used for
hedging risk.

Introduction to Investments
Financial Market and its Role in an
Economy

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Financial Market and Economy


Financial market is a place where financial assets
are traded. It possesses all the characteristics of
real market. For example, just like a traditional
market, it has buyers, sellers, and intermediaries.

Financial Market and Economy


Financial markets provide plentiful of advantages
for the real economy. Some of these advantages are
as follows:

Provision of Information
Consumption Timing
Allocation of Risk
Separation of Ownership and Management

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Financial Market and Economy


Provision of Information
Financial markets play a central role in providing
information. The information reveals itself via
prices in financial markets.
Prices of securities depend on the future prospects
of firms. Firms that seems to have good prospects
for future profitability experience increase in
prices and vice versa. Prices, therefore, provide
information about firms.

Financial Market and Economy


Provision of Information
Firms that experience surge in stock prices find it
easy to raise capital by issuing new shares or
borrowing funds.
It is because increase in prices indicate to
prospective investors that the firm has bright
future prospects.

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Financial Market and Economy


Provision of Information

Financial Market and Economy


Provision of Information
Previous slide illustrates that, as Googles stock
price surpassed $400 a share in 2005, it was able
to expand and initiate many new business
prospects.

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Financial Market and Economy


Provision of Information
However, if a companys prospects seem poor,
stock prices will drop, and company will find it
hard to attract capital.

Financial Market and Economy


Consumption Timing

Financial markets help us shift purchasing


power from high-earnings periods to lowearnings periods of life.
This is accomplished by investing our wealth in
financial assets during high-earnings periods.
In low-earnings periods, we can sell these
assets to get funds for our consumption needs.
By so doing, we can shift our consumption
over the course of our lifetime.

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Financial Market and Economy


Allocation of Risk
Financial markets and the financial instruments
traded in these markets allow investors with the
greatest taste for risk to bear that risk.
Less risk-tolerant individuals can, to a greater
extent, stay on the sidelines.

Financial Market and Economy


Allocation of Risk
For example, if GM raises the funds by selling both
stocks and bonds to the public, the more
optimistic or risk-tolerant investors can buy
shares of stock in GM, while the more conservative
ones can buy GM bonds.

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Financial Market and Economy


Allocation of Risk
Because bonds promise to provide a fixed
payment, the stockholders bear most of the risk
but reap potentially higher rewards.
Thus, financial markets allow the risk that is
inherent to all investments to be borne by the
investors most willing to bear that risk.

Financial Market and Economy


Allocation of Risk
Depending on the tolerance towards risk, investors
can achieve any risk-return spectrum, such as the
one shown below.
Stocks
E(R)

Bonds

Risk-free Asset
Risk

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Financial Market and Economy


Allocation of Risk
Investors who are more tolerant towards risk may
invest in stocks (higher risk) with the expectations
of higher return.
Investors that are less tolerant towards risk may
choose to invest in bonds or risk-free assets (low
risk).

Financial Market and Economy


Separation of Ownership and Management
The complexity and size of modern corporations
have increased many folds. For example, GE listed
total assets of worth $660 billion in 2006.
Single owners cannot finance such huge
corporations. It, therefore, requires pooling of
capital from many investor. GE had about 650000
stockholders in 2006.

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Financial Market and Economy


Separation of Ownership and Management
Such a large group of individuals cannot actively
participate in the day-to-day management of the
firm. As a result, they elect a board of directors
which hires and supervises the management of the
firm.
This structure means that the owners and the
managers of firm are different entities. This gives
the firm a stability that the owner-managed firm
cannot achieve.

Financial Market and Economy


Separation of Ownership and Management
This stability can be observed by the fact that if
some stockholders decide that they no longer wish
to hold shares in the firm, they can sell their
shares to other investors, with no impact on the
management of firm.
Thus, financial assets and the ability to buy and
sell those assets in the financial markets allow for
easy separation of ownership and management.

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Introduction to Investments
Investment Process

Investment Process
The Process
The process governing investment consists of the
following elements:
Asset Allocation: It involves allocation of an
investment across broad asset classes.
Security Selection: It is the choice of specific securities
within each asset classes.

Investors use asset allocation and security


selection to construct their portfolios. An
investors portfolio is simply the collection of his
investment assets.

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Investment Process
The Process
Once the portfolio is established, it is updated or
rebalanced by doing the following:
Selling existing securities and using the proceeds to buy
new securities.
By investing additional funds to increase the overall size
of the portfolio.
By selling securities to decrease the size of the portfolio.

Investment Process
Investment Philosophies
Generally, there are two philosophies that govern
the portfolio construction:
Top-Down Portfolio
Bottom-Up Portfolio

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Investment Process
Investment Philosophies: Top-Down Process
Top-down portfolio construction starts with
asset allocation. For example, an individual who
currently holds all of his money in a bank account
would first decide what proportion of the overall
portfolio ought to be moved into stocks, bonds,
and so on. In this way, the broad features of the
portfolio are established.

Investment Process
Investment Philosophies: Top-Down Process
After this, a top-down investor turns to the
decision of the particular securities to be held in
each asset class. This process involves significant
effort in security analysis.

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Investment Process
Investment Philosophies: Bottom-Up Process
In bottom-up process, the portfolio is
constructed from the securities that seem
attractively priced without as much concern for
the resultant asset allocation.

Investment Process
Investment Philosophies: Bottom-Up Process
Such a technique can result in unintended bets on
one or another sector of the economy. For
example, it might turn out that the portfolio ends
up with a very heavy representation of firms in
one industry, from one part of the country, or with
exposure to one source of uncertainty.

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Investment Process
Investment Philosophies: Bottom-Up Process
An important feature of bottom-up strategy is that
it focuses on the assets that seem to offer the most
attractive investment opportunities.

Introduction to Investments
Financial Markets and
Competitiveness

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Competitiveness and Markets


Thousands of financial analysts and investors
constantly search for information in financial
markets.
This competition for information means that we
should not expect to find any securities that are
extremely underpriced or overpriced.

Competitiveness and Markets


Example 1
What will happen if you identify severely
underpriced security? What will be the impact of
your actions on prices of mispriced security?

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Competitiveness and Markets


Example 1

Competitiveness and Markets


Minimal mispricing of securities make financial
markets highly competitive.

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Competitiveness and Markets


There are several implications of price
competitiveness on the working of financial
markets. Most important of them are:
Risk-return tradeoff
Efficient markets

Competitiveness and Markets


Risk-Return Tradeoff
Investors invest for anticipated future returns, but
those returns can be rarely predicted precisely.
Actual or realized return will almost always
deviate from the expected return anticipated at the
start of investment period.

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Competitiveness and Markets


Risk-Return Tradeoff
The divergence between actual return and
expected return is due to risk embedded in
investment.

Competitiveness and Markets


Risk-Return Tradeoff
Financial markets ensure that, in equilibrium,
return of an investment is a function of risk
associated with investment.
It is not possible for investors to consistently earn
return that does not correspond to risk associated
with investment. Competition for information
ensure that it is impossible for investors to return
that does not correspond with the risk of
investment.

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Competitiveness and Markets


Risk-Return Tradeoff
If investors are able to obtain higher returns
without experiencing associated risk, there will be
a rush to buy the high-return assets. It will result
in driving up the prices of high-return assets.

Competitiveness and Markets


Risk-Return Tradeoff
Individuals considering investing in the asset at
the now-higher price will find the investment less
attractive.
The price will keep on going up till investors get a
fair return relative to the assets risk, but no
more.

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Competitiveness and Markets


Risk-Return Tradeoff
Similarly, if returns were independent of risk,
there would also be a rush to sell high-risk assets.
Their prices would fall (and their expected future
rates of return rise) until they eventually were
attractive enough to be included again in investor
portfolios.

Competitiveness and Markets


Risk-Return Tradeoff
Therefore, we conclude that there should be a
risk-return tradeoff in financial markets, with
higher-risk assets priced to offer higher expected
returns than lower-risk assets.

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Competitiveness and Markets


Efficient Markets
Another implication of competitiveness
proposition is that we should rarely expect to find
bargains in security markets.
Therefore, prices will, generally, be fairly priced.
Fair price means that, at any given point in time,
prices will reflect all available information. In
other words, markets are efficient.

Competitiveness and Markets


Efficient Markets
Proponents of efficient markets believe that, as
new information about a security becomes
available, the price of the security should quickly
adjust to reflect the market consensus estimate of
the value of the security. Therefore, there would be
neither underpriced nor overpriced securities.

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Competitiveness and Markets


Efficient Markets
If the efficient market hypothesis were taken to
the extreme, there would be no point in active
security analysis.

Introduction to Investments
Main Participants of Financial
Markets

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Financial Market Participants


There are four main participants in financial
markets.

Firms
Households
Governments
Intermediaries

Financial Market Participants


Firms
Firms are net borrowers. They raise capital now to
pay for investments in plant and equipment.
The income generated by those real assets
provides the returns to investors who purchase
the securities issued by firms.

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Financial Market Participants


Households
Households are net savers. They purchase the
securities issued by firms that need to raise funds.

Financial Market Participants


Governments
Governments can be borrowers or lenders,
depending on the relationship between tax
revenue and government expenditures.
They are also responsible for regulating the
market.

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Financial Market Participants


Intermediaries
Financial intermediaries bring lenders and
borrowers together. These financial intermediaries
include banks, investment companies, insurance
companies, and credit unions.
Financial intermediaries issue their own securities
to raise funds to purchase the securities of other
corporations.

Financial Market Participants


Intermediaries
For example, a bank raises funds by borrowing
(taking deposits) and lending that money to other
borrowers. The spread between the interest rates
paid to depositors and the rates charged to
borrowers is the source of the banks profit.
In this way, lenders and borrowers do not need to
contact each other directly. Instead, each goes to
the bank, which acts as an intermediary between
the two.

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Financial Market Participants


Intermediaries
Similarly, corporations do not directly market their
securities to the public. Instead, they hire agents,
called investment bankers, to represent them to
the investing public.

Introduction to Investments
Some Introductory Questions

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Some Introductory Questions


The objective of this course is to help us
understand some of the following questions.
Answers to these questions will help us make
better and well-informed investment decisions.

Some Introductory Questions


Question 1
In one of the years, the Asia Pacific Fund gained
109%. Should foreign investors be participating in
emerging stock markets? If so, how? Should most
investors invest some part of their funds in
international assets?

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Some Introductory Questions


Question 2
In less than two years, from its peak in March
2000, the S&P500 Index lost about 50% of its
value, while the Nasdaq Stock Market Index lost
75% of its value. In less than two years, investors
lost $5 trillion in stocks. With volatility like this,
should most investors avoid stocks?

Some Introductory Questions


Question 3
In early 1990s, 75% of all company employees
with retirement plans had none of their funds
invested in stocks, although over the years stocks
have significantly outperformed the alternative
assets. Was this a smart move?

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Some Introductory Questions


Question 4
For a recent ten year period, only a quarter of
professionally managed stock portfolios were able
to outperform the overall stock market. Why?

Some Introductory Questions


Question 5
How can futures/options contracts, with
reputation of being extremely risky, be used to
reduce investors risk?

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Some Introductory Questions


Question 6
What is the historic average annual return on
common stocks? What can an investor reasonably
expect to earn from stocks in the future?

Introduction to Investments
Important Considerations in
Investment Decisions

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Important Considerations
Unknowns
You have to understand that being wrong is a part
of the process (Peter Bernstein Prominent
Investment Expert).

Important Considerations
Unknowns
All investors must realize that there is uncertainty
present in investment process. Investors buy
various financial assets, expecting to earn various
returns over some future holding period. These
returns may never be realized.

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Important Considerations
Unknowns
The best an investor can do is to make the most
informed risk and return estimates and act on
them with the condition that he will be prepared
for new circumstances.
Regardless of how careful and informed investors
are, the future is uncertain, and mistakes will be
made.

Important Considerations
Unknowns
Although future is uncertain, but it is still
manageable. Thorough understanding of basic
principles of investing will allow investors to cope
with this uncertainty.

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Important Considerations
Global Investment Arena
Samsung Electronics from South Korea was the
Worlds most profitable firm in 2004. It suggests
that investors must think globally while investing.
However, surprisingly investors do not pay enough
attention to global investments. Investors tend to
have local bias (home bias) in their investments.
Increased profitability of global firms highlight the
importance of foreign investment.

Important Considerations
Global Investment Arena
Furthermore, investors should also be aware that
foreign investors can significantly effect local stock
markets. Clark and Berko (1997) document
positive relationship between foreign equity
purchases in Mexico and stock market returns.

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Important Considerations
Importance of Internet
Internet has changed the investment environment
in a way that it has the ability to provide huge
amount of information instantaneously. Investors
can gain real time quotes throughout the day and
can track their portfolios.
Internet has also allowed investors to trade
instantly using their online brokerage accounts.

Important Considerations
Institutional Investors
Institutional investors are the most sophisticated
investors. They have highly skillful and have
greater resources. Therefore, they can identify
profitable investment opportunities within the
stock markets.
NOTE: Institutional investors consist of banks, pension
funds, mutual funds, and insurance companies.

Individual investors, therefore, can obtain valuable


information from the trade of institutional
investors.

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Introduction to Investments
Problems

Problem 1
Question
A risk averse investor will not assume risk. Do
you agree or disagree with this statement.

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Problem 1
Answer
Disagree.
Risk-averse investors will assume risk if they
expect to be adequately compensated for it.
NOTE: Risk aversion means that you dislike risk it
does not mean that you will not take risk.

Problem 2
Question
Define risk. How many specific types of risks can
you think of?

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Problem 2
Answer
Risk is defined as the chance that the actual return
on an investment will differ from its expected
return. Some important risks are:

Default Risk
Liquidity Risk
Political Risk
Interest Rate Risk
Market Risk

Problem 3
Question
Are all rational investors risk averse?

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Problem 3
Answer
All rational investors are risk averse because it is
not rational when investing to assume risk unless
one expects to be compensated for doing so.

Problem 4
Question
Do all investors have the same degree of risk
aversion?

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Problem 4
Answer
All investors do not have the same degree of risk
aversion. They are risk averse to varying degrees,
requiring different risk premiums in order to
invest.

Introduction to Investments
Practice Questions

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Practice Questions
Question 1
You see an advertisement for a book that claims to
show how you can make $1 million with no risk
and with no money down. Will you buy the book?

Practice Questions
Question 2
ADA Corporation is a start-up computer software
development firm. It currently owns computer
equipment worth $30000 and has cash on hand of
$20000 contributed by ADA Corporations owners.
For each of the following transactions, identify the
real and/or financial assets that trade hands.

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Practice Questions
Question 2
ADA Corporation takes out a bank loan. It receives
$50000 in cash and signs a note promising to pay
back the loan over three years.
ADA Corporation uses the cash from the bank plus
$20000 of its own funds to finance the
development of new financial planning software.

Practice Questions
Question 2
ADA Corporation sells the software product to
Microsoft, which will market it to the public under
the Microsoft name. ADA Corporation accepts
payment in the form of 1500 shares of Microsoft
stock.

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Practice Questions
Question 3
Although we stated that real assets comprise the
true productive capacity of an economy, it is hard
to conceive of a modern economy without welldeveloped financial markets and security types.
How would the productive capacity of any
economy be affected if there were no markets in
which one could trade financial assets?

Practice Questions
Question 4
Historically, the average rate of return on
investments in large stocks has outpaced that on
investments in government securities. Why, then,
does anyone invest in government securities?

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Practice Questions
Question 5
What are some advantages and disadvantages of
top-down versus bottom-up investing styles?

Introduction to Investments
References

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References
Bodie, Z., Kane, A., and Marcus, A.J., (2013).
Chapter 1 (Sections 1.1, 1.2, 1.3, 1.4, 1.5, 1.6):
Essentials of Investments. 9th Edition, McGrawHill/Irwin.

References
Clark, J. and Berko, E., (1997). Foreign Investment
Fluctuations and Emerging Market Stock Returns:
The Case of Mexico. Staff Report No. 24, Federal
Reserve Bank of New York.

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