CHAPTER 1: ORGANIZATION AND FUNCTIONS OF SECURITIES

1. Types of Investment Vehicles

Financial Assets Real Assets

Equipment and
Equity Contracts Real Estate Commodities
Lease

Pooled
Publicly Listed Private Forward Land Wheat and Grain
Investments

Common Shares Mutual Funds Futures Building Oil reserves

Preferred Shares Hedge Funds Insurance Energy minerals

Asset-Backed
Swap Gold and Silver
Securities

Derivatives

Options

Fixed-Income

Corporate Bonds

Treasury Bonds

Convertible Bonds

Junk Bonds

Currencies

Bank Reserves

Cryptocurrencies

Financial Assets include securities (stocks and bonds), derivative contracts, and currencies.
Real assets include real estate, equipment, commodities, and other physical assets.

Financial securities can be classified as debt or equity. Debt securities are promises to repay
borrowed funds. Equity Securities represent ownership positions.
Public (publicly traded) securities are traded on exchanges or through securities dealer and
are subject to regulatory oversight. Securities that are not traded in public markets are
referred to as private securities. Private securities are often illiquid and not subject to
regulation.

Derivative Contracts have values that depend on (are derived from) the values of other
assets. Financial derivative contracts are based on equities, equity indexes, debt, debt
indexes, or other financial contracts. Physical derivative contracts derive their values from
the values of physical assets such as gold, oil, and wheat.

Major types of Securities, Currencies, Contracts, Commodities, and Real Assets that trade
in Organized Markets

1. SECURITIES
Securities can be classified as fixed income or equity securities, and individual securities can
be combined in pooled investment vehicles. Corporations and governments are the most
common issuers of individual securities. The initial sale of a security is called an issue when
the security is sold to the public.

Fixed income Securities typically refer to debt securities that are promises to repay
borrowed money in the future. Short-term fixed income securities generally have a maturity
of less than one or two years; long-term maturities are longer than five to ten years, and
intermediate term maturities fall in the middle of the maturity range.

Although the terms are used loosely, bonds are generally long term, whereas notes, are
intermediate term. Commercial paper refers to short-term debt issued by firms.
Government issue bills and banks issue certificate of deposit. In repurchase agreements, the
borrower sells a high-quality asset and has both the right and obligation to repurchase it (at
a higher price) in the future. Repurchase agreements can be for terms as short as one day.

Convertible debt is debt that an investor can exchange for a specified number of equity
shares of the issuing firm.

Equity Securities represent ownership in a firm and include common stock, preferred stock,
and warrants.

Common Stock – is a residual claim on a firm’s assets. Common stock dividends are
paid only after interest is paid to debt holders and dividends are paid to preferred
stockholders. Furthermore, in the event of firm liquidation, debt holders and preferred
stockholders have priority over common stockholders and are usually paid in full before
common stockholders receive any payment.
 Preferred Stock – is an equity security with scheduled dividends that typically do not
change over the security’s life and must be paid before any dividends on common stock may
be paid.

Warrants – are similar to options in that they give the holder the right to buy a firm’s
equity shares (usually common stock) at a fixed exercise price prior to the warrant’s
expiration.

Pooled Investment Vehicles include mutual funds, depositories, and hedge funds. The term
refers to structures that combine the funds of many investors in a portfolio of investments.
The investor’s ownership interests are referred to as shares, units, depository receipts, or
limited partnership interests.

Mutual Funds – are pooled investment vehicles in which investors can purchase
shares either from the fund itself (open-end funds) or in the secondary market (closed-end
funds).

Exchange-traded funds (ETFs) and Exchange-traded Notes (ETNs) – trade like close-
end funds but have special provisions allowing conversion into individual portfolio
securities, or exchange of portfolio shares for ETF shares, that keep their market prices close
to the value of their proportional interest in the overall portfolio. These funds are
sometimes referred to as depositories, with their shares referred to as depository receipts.

Asset-backed securities – represent a claim to a portion of a pool of financial assets

such as mortgages, car loans, or credit card debt. The return from the assets is passed
through to investors, with different classes of claims (referred to as tranches) having
different level of risk.

Hedge Funds – are organized as limited partnerships, with the investors as the
limited partners and the fund manager as the general partner. Hedge funds utilize various
strategies and purchase is usually restricted to investors of substantial wealth and
investment knowledge. Hedge funds often use leverage. Hedge fund managers are
compensated based on the amount of assets under management as well as on their
investment results.

2. CURRENCIES
Currencies are issued by a government’s central bank. Some are referred to as reserve
currencies, which are those held by governments and central banks worldwide. These
include the dollar and euro and, secondarily, the British pound, Japanese yen, and Swiss
franc. In spot currency markets, currencies are traded for immediate delivery.

3. CONTRACTS
Contracts are agreements between two parties that require some action in the future, such
as exchanging an asset for cash. Financial contracts are often based on securities,
currencies, commodities, or security indices (portfolios). They include futures, forwards,
options, swaps, and insurance contracts.

A forward contract is an agreement to buy or sell an asset in the future at a price specified
in the contract at its inception. An agreement to purchase 100 ounces of gold 90 days from
now for $1,000 per ounce is a forward contract. Forward contracts are not traded on
exchanges or in dealer markets.

Futures contracts are similar to forward contracts except that they are standardized as to
amount, asset characteristics, and delivery time and are traded on an exchange (in a
secondary market) so they are liquid investments.

In a swap contract, two parties make payments that are equivalent to one asset being
traded (swapped) for another. In a simple interest rate swap, floating interest payments are
exchanged for fixed-rate payments over multiple settlement dates. A currency swap
involves a loan in one currency for the loan of another currency for a period of time. An
equity swap involves the exchange of the return on an equity index or portfolio for the
interest payment on a debt instrument.

An option contract gives its owner the right to buy or sell an asset at a specific exercise price
at some point specified time in the future. A call option gives the option buyer the right (but
not the obligation) to buy an asset. A put option gives the option buyer the right (but not
the obligation) to sell an asset.

Sellers, or writers, of call (put) options receive a payment, referred to as the option
premium, when they sell the options but incur the obligation to sell (buy) the asset at the
specified price if the option owner chooses to exercise it.
Options on currencies, stocks, stock indices, futures, swaps, and precious metals are traded
on exchanges. Customized option contracts are also sold by dealers in the over-the-counter
market.

An insurance contract pays a cash amount if a future event occurs. They are used to hedge-
against unfavourable, unexpected events. Examples include life, liability, and automobile
insurance contracts. Insurance contracts can sometimes be traded to other parties and
often have tax-advantaged payouts.
Credit default swaps are form of insurance that makes a payment if an issuer defaults on its
bonds. They can be used by bond investors to hedge default risk. They can also be used by
parties that will experience losses if an issuer experiences financial distress and by others
who are speculating that the issuer will experience more or less financial trouble than is
currently expected.

4. COMMODITIES
Commodities trade in spot, forward, and futures markets. They include precious metals,
industrial metals, agricultural products, energy products, and credits for carbon reduction.

Futures and forwards allow both hedgers and speculators to participate in commodity
markets without having to deliver or store physical commodities.

Real Assets
Example of Real Assets are real estate, equipment, and machinery. Although they have been
traditionally held by firms for their us in production, real assets are increasingly held by
institutional investors both directly and indirectly.

Buying real assets directly often provides income, tax advantages, and diversification
benefits. However, they often entail substantial management costs. Furthermore, because
of their heterogeneity, they usually require the investor to do substantial due diligence
before investing. They are illiquid because their specialization may result in a limited pool of
investors for a particular real asset.

Rather than buying real assets directly, an investor may choose to buy them indirectly
through an investment such as a Real Estate Investment Trust (REIT) or master limited
partnership (MLP). The investor owns an interest in these vehicles, which hold the assets
directly. Indirect ownership interests are typically more liquid than ownership of the assets
themselves. Another indirect ownership method is to buy the stock of firms that have large
ownership of real assets.
FINANCIAL INTERMEDIARIES

Stock
Exchanges
Investment
Brokers
Banks

Alternative
Block
Trading
Brokers
System

Depository Financial Dealers

Institutions
Intermediaries

Arbitrageurs Securitizers

Insurance
Custodians
Companies
Clearing
House

Financial Intermediaries stand between buyers and sellers, facilitating the exchange of
assets, capital, and risk. Their services allow for greater efficiency and are vital to a well-
functioning economy. Financial intermediaries include brokers and exchanges, dealers,
securitizers, depository institutions, insurance companies, arbitrageurs, and clearinghouses.

Brokers help their clients buy and sell securities by finding counterparties to trades in a cost-
efficient manner. They may work for large brokerage firms, for banks, or at exchanges.

Block brokers help with the placement of large trades. Typically, large trades are difficult to
place without moving the market. For example, a large sell order might cause a security’s
price to decrease before the order can be fully executed. Block brokers help conceal their
client’s intentions so that the market does not move against them.

Investment Banks help corporations sell common stock, preferred stock, and debt securities
to investors. They also provide advice to firms, notable about mergers, acquisitions, and
raising capital.

Exchanges provide a venue where traders can meet. Exchanges sometimes act as brokers by
providing electronic order matching. Exchanges regulate their members and require firms
that list on the exchange to provide timely financial disclosures and to promote shareholder
democratization. Exchanges acquire their regulatory power through member agreement or
from their government.

Alternative Trading System (ATS), which serve the same trading function as exchanges but
have no regulatory function, are also known as electronic communication networks (ECNs)
or multilateral trading facilities (MTFs). ATS that do not reveal current client orders are
known as dark pools.

Dealers facilitate trading by buying for or selling from their own inventory. Dealers provide
liquidity in the market and profit primarily from the spread (difference) between the price at
which they will buy (bid price) and the price at which will sell (ask price) the security or
other asset.

Some dealers also act as brokers. Broker-dealers have an inherent conflict of interest. As
brokers, they should seek the best prices for their clients, but as dealers, their goal is to
profit through prices through spreads. As a result, traders typically place limits on how their
orders are filled when they transact with broker-dealers.

Securitizers pool large amount of securities or other assets then sell interests in the pool to
the investors. The returns form the pool, net of securitizer’s fees, are passed through to the
investors. By securitizing assets, the securitizers creates a diversified pool of assets with
more predictable cash flows than the individual assets in the pool. This creates liquidity in
the assets because the ownership interests are more easily valued and traded. There are
also economies of scale in management costs of large pools of assets and potential benefits
from the manager’s selection of assets.

Assets that are often mortgages, car loans, credit and receivables, bank loans, and
equipment leases. The primary benefit of securitization is to decrease the funding costs for
the assets in the pool. A firm may set up a special purpose vehicle (SPV) or special purpose
entity (SPE) to buy firm assets, which removes them from the firm’s balance sheet and may
increase their value by removing the risk that financial trouble at the firm will give other
investors a claim to the assets’ cash flows.

The cash flows from securitized assets can be segregated by risk. The different risk
categories are called tranches. The senior tranches provide the most certain cash flows,
while the junior tranches have greater risk.

Depository Institutions
Examples of depository institutions include banks, credit unions, and savings and loans. They
pay interest on customer deposits and provide transaction services such as checking
accounts. These financial intermediaries then make loans with the funds, which offer
diversification benefits. The intermediaries have expertise in evaluating credit quality and
managing the risk of a portfolio of loans of various types.

Other intermediaries, such as payday lenders and factoring companies, lend money to firms
and individuals on the basis of their wages, accounts receivable, and other future cash
flows. These intermediaries often finance the loans by issuing commercial paper of other
debt securities.
Securities brokers provide loans to investors who purchase securities on margin. When this
margin lending is to hedge funds and other institutions, the brokers are referred to as prime
brokers.

The equity owners (stockholders) of banks, brokers, and other intermediaries absorb any
loan losses before depositories and other lenders. The more equity capital an intermediary
has, the less risk for depositors. Poorly capitalized intermediaries (those with less equity)
have less incentive to reduce the risk of their loan portfolios because they have less capital
at risk.

Insurance Companies are intermediaries, in that they collect insurance premiums in return
for providing risk reduction to the insured. The insurance firm can do this efficiently because
it provides protection to a diversified pool of policyholders, whose risks of loss are typically
uncorrelated. This provides more predictable losses and cash flows compared to a single
insurance contract, in the same way that a bank’s diversified portfolio of loans diversifies
the risk of loan defaults.

Insurance firms also provide a benefit to investors by managing the risks inherent in
insurance; moral hazard, adverse selection, and fraud. Moral hazard occurs because the
insured may take more risks once he is protected against losses. Adverse selection occurs
when those most likely to experience losses are the predominant buyers of insurance. In
fraud, the insured purposely causes damage or claims fictitious losses so he can collect on
his insurance policy.

Arbitrageurs
In its pure (riskless) form, arbitrage refers to buying an asset in one market and reselling it
in another at a higher price. By doing so, arbitrageurs act as intermediaries, providing
liquidity to participants in the market where the asset is purchased and transferring the
asset to the market where it is sold.

In markets with good information, pure arbitrage is rare because traders will favor the
markets with the best prices. More commonly, arbitrageurs try to exploit pricing differences
for similar instruments. For example, a dealer who sells a call option will often also buy the
stock because the call and stock price are highly correlated. Likewise, arbitrageurs will
attempt to exploit discrepancies in the pricing of the call and stock. Many (risk) arbitrageurs
use complex models for valuation of related securities and for risk control. Creating similar
positions using different assets is referred to as replication. This is also a form of
intermediation because similar risks are traded in different forms and in different markets.

Clearing houses act as intermediaries between buyers and sellers in financial markets and
provide:
 Escrow services (transferring cash and assets to the respective parties).
 Guarantees of contract completion.
 Assurance that margin traders have adequate capital.
  Limits on the aggregate net order quantity (buy orders minus sell orders) of
members.

Through these activities, clearinghouses limit counterparty risk, the risk that the other party
to a transaction will not fulfil its obligation. In some markets, the clearinghouse ensures only
the trades of its member brokers and dealers, who, in turn, ensure the trades of their retail
customers.

Custodians also improve market integrity by holding client securities and preventing their
loss due to fraud or other events that affect the broker or investment manager.

2. Types of Financial Markets

Financial
Market

Foreign Government
Alternative Derivatives
Capital Market Money Market Exchange Securities
Market Market
Market Market

Primary and Treasury

Certificate of Money Bills/Notes
Secondary Hedge Funds Options Market
Deposit Changers
Market (Short-Term)

Equity/Shares Commercial Commodities Treasury Bonds Forward and

Bond Market Foreign Banks
Market Papers Market (Long-Term) Futures Market

Repurchase Equipment and Importers and

Agreements Lease Exporters

In economics, a financial market is a mechanism that allows people to buy and sell (trade)
financial securities (such as stocks and bonds), commodities (such as precious metals or
agricultural goods), and other fungible items of value at low transaction costs and at prices
that reflect the efficient-market hypothesis. Financial markets can be domestic or they can
be international.

In finance, financial markets facilitate:

 The raising of capital (in the capital markets)
 The transfer of risk (in the derivatives markets)
 International trade (in the currency markets)
And are used to match those who want capital to those who have it.

Markets for immediate delivery are referred to as spot markets. Contracts for the future
delivery of physical and financial assets include forward, futures, and options. Options
provide the buyer the right, but not the obligation, to purchase (or sell) assets over some
period or at some future date at predetermined prices.

The primary market is the market for newly issued securities. Subsequent sales of the
securities are said to occur in the secondary market.

Money markets refer to markets for debt securities with maturities of one year or less.
Capital markets refer to markets for longer-term debt securities and equity securities that
have no specific maturity date.

Traditional investment markets refer to those for debt and equity. Alternative markets
refer to those for hedge funds, commodities, real estate, collectibles, gemstones, leases,
and equipment. Alternative assets are often more difficult to value, illiquid, require investor
due diligence, and therefore often sell at a discount.

HOW SECONDARY MARKETS SUPPORT PRIMARY MARKETS

Primary Capital Markets refer to the sale of newly issued securities. New equity issues
involve either:
 New shares issued by firms whose shares are already trading in the marketplace.
These issues are called seasoned offerings or secondary issues.
 First time issues by firms whose shares are not currently publicly traded. These are
called initial public offerings (IPOs).

Secondary Financial Markets are where securities trade after their initial issuance. Placing a
buy order on the London Stock Exchange is an order in the secondary market and will result
in purchase of existing shares from their current owner.

PRIMARY MARKET: PUBLIC OFFERINGS

Corporate stock or bond issues are almost always sold with the assistance of an investment
banking firm. The invest bank funds investors who agree to buy part of the issue. These are
not actual orders but are referred to as indications of interest. When the number of shares
covered by indications of interest are greater (less) than the number of shares to be offered,
the offering price may be adjusted upward (downward). This process of gathering
indications of interest is referred to as book building. In London, the book builder is referred
to as the book runner. In Europe, an accelerated book build occurs when securities must be
issued quickly. To build a book, the investment bank disseminates information about the
firm’s financials and prospects. The issuer must also make disclosures including how the
funds will be used.

The most common way an investment bank assists with a security issuance is through an
underwriting offering. Here, the investment bank agrees to purchase the entire issue at a
price that is negotiated between the issuer and bank. If the issue is undersubscribed, the
investment bank must buy the unsold portion. In the case of an IPO, the investment bank
also agrees to make a market in the stock for a period after the issuance to provide price
support for the issue.

An investment bank can also agree to distribute shares of an IPO on a best efforts basis,
rather than agreeing to purchase the whole issue. If the issue is undersubscribed, the bank
is not obligated to buy the unsold portion.

Note that investment banks have a conflict of interest in an underwritten offer. As the
issuer’s agents, they should set the price high to raise the most funds for the issuer. But as
underwriters, they would prefer that the price be set low enough that the whole issue sells.
This also allows them to allocate portions of an undervalued IPO to their clients. This results
in IPOs typically being underpriced. Issuers also could have an interest in under pricing the
IPO because of negative publicity when an undersubscribed IPO initially trades at a price
below the IPO price investor pay. An IPO that is oversubscribed and has the expectation of
trading significantly above its IPO price is referred to as a hot issue.

PRIMARY MARKET: PRIVATE PLACEMENTS AND OTHER TRANSACTIONS

In private placement, securities are sold directly to qualified investors, typically with the
assistance of an investment bank. Qualified investors are those substantial wealth and
investment knowledge. Private placements do not require the issuer to disclose as much
information as they must when securities are being sold to the public. The issuance costs
are less with a private placement and the offer price is also lower because the securities
cannot be resold in public markets, making them less valuable than shares registered for
public trading.

In a shelf registration, a firm makes its public disclosures as in regular offering but then
issues the registered securities over time when it needs capital and when the markets are
favorable.

A dividend reinvestment plan (DRP or DRIP) allows existing shareholders to use their
dividends to buy new shares from the firm at a slight discount.

In a rights offering, existing shareholders are given the right to buy new shares at a discount
to the current market price. Shareholders tend to dislike rights offering because their
ownership is diluted unless they exercise their rights and buy the additional shares.
However, rights can be traded separately from the shares themselves in some
circumstances.

In addition to firms issuing securities, government issue short-term and long-term debt
either by auction or through investment banks.

IMPORTANCE OF SECONDARY MARKET

Secondary markets are important because they provide liquidity and price/value
information. Liquid markets are those in which a security can be sold quickly without
incurring a discount from the current price. The better the secondary market, the easier it is
to for firms to raise external capital in the primary market, which results in a lower cost of
capital for firms with share that have adequate liquidity.

3. Definition of Investments
Investment is putting money into something with the expectation of profit. The word
originates in the Latin "vestis", meaning garment, and refers to the act of putting things
(money or other claims to resources) into others' pockets.

The term "investment" is used differently in economics and in finance. Economists refer to a
real investment (such as a machine or a house), while financial economists refer to a
financial asset, such as money that is put into a bank or the market, which may then be used
to buy a real asset.

Financial Meaning of Investments

Financial investment involves of funds in various assets, such as stock, Bond, Real
Estate, Mortgages etc.

 Investment is the employment of funds with the aim of achieving additional income
or growth in value.

 It involves the commitment of resources which have been saved or put away from
current consumption in the hope some benefits will accrue in future. Investment
involves long term commitment of funds and waiting for a reward in the future.

 From the point of view people who invest their finds, they are the supplier of Capital
and in their view, investment is a commitment of a person s funds to derive future
income in the form of interest, dividend, rent, premiums, pension benefits or the
appreciation of the value of their principle capital.

 To the financial investor it is not important whether money is invested for a

productive use or for the purchase of secondhand instruments such as existing
shares and stocks listed on the stock exchange.
  Most investments are considered to be transfers of financial assets from one person
to another.

Economic meaning of Investment

 Economic investment means the net additions to the capital stock of the society
which consists of goods and services that are used in the production of other goods
and services. Addition to the capital stock means an increase in building, plants,
equipment and inventories over the amount of goods and services that existed.

 The financial and economic meanings are related to each other because investment
is a part of the savings of individuals which flow into the capital market either
directly or through institutions, divided in new and secondhand capital financing.
Investors as suppliers and investors as users of long-term funds find a meeting place
in the market.

Basic Investment Objectives

Security

Liquidity

Yield

1. Security
Central to any investment objective, we have to basically ensure the safety of the
principal. One can afford to lose the returns at any given point of time but s/he can ill afford
to lose the very principal itself. By identifying the importance of security, we will be able to
identify and select the instrument that meets this criterion. For example, when compared
with corporate bonds, we can vouch safe the safety of return of investment in treasury
bonds as we have more faith in governments than in corporations.
Hence, treasury bonds are highly secured instruments. The safest investments are
usually found in the money market and include such securities as Treasury bills (T-bills),
certificates of deposit (CD), commercial paper or bankers' acceptance slips; or in the fixed
income (bond) market in the form of municipal and other government bonds, and in
corporate bonds.

2. Liquidity
Because we may have to convert our investment back to cash or funds to meet our
unexpected demands and needs, our investment should be highly liquid. They should have
been cashable at short notice, without loss and without any difficulty. If they cannot come
to our rescue, we may have to borrow or raise funds externally at high cost and at
unfavorable terms and conditions. Such liquidity can be possible only in the case of
investment, which has always-ready market and willing buyers and sellers. Such instruments
of investment are called highly liquid investment.

3. Yield
Yield is best described as the net return out of any investment. Hence given the level or
kind of security and liquidity of the investment, the appropriate yield should encourage the
investor to go for the investment. If the yield is low compared to the expectation of the
investor, s/he may prefer to avoid such investment and keep the funds in the bank account
or in worst case, in cash form in lockers. Hence yield is the attraction for any investment and
normally deciding the right yield is the key to any investment.

Secondary Investment Objectives

 Tax Minimization
An investor may pursue certain investments in order to adopt tax minimization as part of his
or her investment strategy. A highly-paid executive, for example, may want to seek
investments with favorable tax treatment in order to lessen his or her overall income tax
burden. Making contributions to tax-sheltered retirement plan, can be an effective tax
minimization strategy.

 Marketability / Liquidity
Many of the investments we have discussed are reasonably illiquid, which means they
cannot be immediately sold and easily converted into cash. Achieving a degree of liquidity,
however, requires the sacrifice of a certain level of income or potential for capital gains.

Common stock is often considered the most liquid of investments, since it can usually be
sold within a day or two of the decision to sell. Bonds can also be fairly marketable, but
some bonds are highly illiquid, or non-tradable, possessing a fixed term. Similarly, money
market instruments may only be redeemable at the precise date at which the fixed term
ends. If an investor seeks liquidity, money market assets and non-tradable bonds aren't
likely to be held in his or her portfolio.

Characteristics of Investments

 Risk
Risk refers to the loss of principal amount of an investment. It is one of the major
characteristics of an investment. The risk depends on the following factors:
 When investment maturity period is longer; investor will take larger risks.
 Government or Semi-Government bodies issue securities, which have lesser risks.
 In the case of the debt instrument or fixed deposit, the risk of above investment is
less due to their secured and fixed interest payable. For instance, debentures. In the
case of ownership instrument like equity or preference shares, the risk is more due
to their unsecured nature and variability of their return and ownership character.
  The risk of degree of variability of returns is more in the case of ownership capital as
compared to debt capital.
 The tax provisions would influence the return of risk.

Marketability

Tax Benefits Return

Stability of
Safety
Income

Investment
Liquidity Concealability

Capital
Risk
Growth
Purchasing
Power
Stability

 Return
Return refers to expected rate of return from an investment. Return is an important
characteristic of investment. Return is the major factor which influences the pattern of
investment that is made by the investor. Investor always prefers high rate of return for his
investment.

 Safety
Safety refers to the protection of investor principal amount and expected rate of return.
Safety is also one of the essential and crucial elements of investment. Investor prefers his
capital’s safety. Capital is the certainty of return without loss of money or it will take time to
retain it. If investor prefers less-risky securities, he chooses Government bonds. In cases,
where investor prefers high rate of returns, investor will choose private securities, whose
safety is low.

 Liquidity
Liquidity refers to investments ready to be converted into cash. In other words, it is
available immediately in the cash form. Liquidity means that investment is easily realizable,
saleable or marketable. When the liquidity is high, then the return may be low. For example,
UTI units. An investor generally prefers liquidity for his investments and safety of funds
through a minimum-risk and maximum-return investment.

 Marketability
Marketability refers to buying and selling of securities in market. Marketability means
transferability or salability of an asset. Securities listed in a stock market are more easily
marketable than which are not listed. Public Limited Companies’ shares are more easily
transferable than those of private limited companies.

 Concealability
Concealability is another essential characteristic of the investment. Concealability means
investment to be safe from social disorders, government confiscations or unacceptable
levels of taxation. Property must be concealable and should leave no record of income
received from its use or sale. Gold and precious stones have long been esteemed for these
purposes, because they combine high-value with small bulk and are readily transferable.

 Capital growth
Capital growth refers to appreciation of investment. Capital growth has today become an
important character of investment. Capital appreciation, also known as capital growth,
refers to the increase in the value of an investment over time. It tells you how much profit
you would pay taxes on, if you sold the investment that day. Investors and their advisers are
constantly seeking ‘growth stock’ in the right industry; bought at the right time.

 Purchasing power stability

It refers to the buying capacity of investment in market. Purchasing power stability has
become one of the import traits of investment. Investment always involves the commitment
of current funds with the objective of receiving greater amounts of future funds.

 Stability of income
It refers to constant return from an investment. Another major characteristic feature of the
investment is the stability of income. Stability of income must look for different paths just as
the security of the principal. Every investor must always consider stability of monetary
income and stability of the purchasing power of income.

 Tax benefits

Tax benefit is the last characteristic feature of the investment. Planning an investment
programme without considering the tax burden may be costly to the investor.

There are actually two problems:

 One concerned with the amount of income paid by the investment
 Another is the burden of income tax upon that income.

Types of Investors

Conservative investors often invest in cash. This means that they put their money in interest
bearing savings accounts, money market accounts, mutual funds, US Treasury bills, and
Certificates of Deposit. These are very safe investments that grow over a long period of
time. These are also low risk investments.
Moderate investors often invest in cash and bonds, and may dabble in the stock market.
Moderate investing may be low or moderate risks. Moderate investors often also invest in
real estate, providing that it is low risk real estate.

Aggressive investors commonly do most of their investing in the stock market, which is
higher risk. They also tend to invest in business ventures as well as higher risk real estate.
For instance, if an aggressive investor puts his or her money into an older apartment
building, then invests more money renovating the property, they are running a risk. They
expect to be able to rent the apartments out for more money than the apartments are
currently worth or to sell the entire property for a profit on their initial investments. In some
cases, this works out just fine, and in other cases, it doesn't. It's a risk.

Investment Risk and Return Characteristics

Time frame of Investments

Types of Risks

Systematic Unsystematic
Risk Risk

RISK
Systematic risk
The systematic risk is caused by factors external to the particular company and
uncontrollable by the company. The systematic risk affects the market as a whole.

Unsystematic risk
In case of unsystematic risk, the factors are specific, unique and related to the particular
industry or company.

Sources of Risk

1. Personal Risks
This is a category of risk which deals with the personal level of investing. The investor is
likely to have more control over this type of risk compared to others.

a. Timing risk is the risk of buying the right security at the wrong time. It also refers to
selling the right security at the wrong time. For example, there is the chance that a
few days after you sell a stock it will go up several dollars in value. There is no
surefire way to time the market.
 b. Tenure risk is the risk of losing money while holding onto a security. During the
period of holding, markets may go down, inflation may worsen, or a company may
go bankrupt. There is always the possibility of loss on the company-wide level, too.

2. Company Risks
There are two common risks on the company-wide level.

a. Financial risk is the danger that a corporation will not be able to repay its debts. This
has a great effect on its bonds, which finance the company's assets. The more assets
financed by debts (i.e., bonds and money market instruments), the greater the risk.
Studying financial risk involves looking at a company's management, its leadership
style, and its credit history.

b. Management risk is the risk that a company's management may run the company so
poorly that it is unable to grow in value or pay dividends to its shareholders. This
greatly affects the value of its stock and the attractiveness of all the securities it
issues to investors.

Timing Risks Financial Risks

Tenure Risks Management Risks

Personal Company
Risks Risks

National and
Market Risks International
Market Risks Risks Economic Risks
Liquidity Risks
Interest Rate Risks Industry Risks
Inflation Rate Risks Tax Risks
Exchange Rate Risks Political Risks
Reinvestment Risks
3. Market Risks Fluctuation in the market as a whole may be caused by the following risks:

a. Market risk is the chance that the entire market will decline, thus affecting the prices
and values of securities. Market risk, in turn, is influenced by outside factors such as
embargoes and interest rate changes.

b. Liquidity risk is the risk that an investment, when converted to cash, will experience
loss in its value. When you want to sell the stock you are currently holding, there is
nobody there to buy your stock, meaning that there is no volume in that stock.

c. Interest rate risk is the risk that interest rates will rise, resulting in a current
investment's loss of value. A bondholder, for example, may hold a bond earning 6%
interest and then see rates on that type of bond climb to 7%.

d. Inflation risk is the danger that the dollars one invests will buy less in the future
because prices of consumer goods rise. When the rate of inflation rises, investments
have less purchasing power. This is especially true with investments that earn fixed
rates of return. As long as they are held at constant rates, they are threatened by
inflation. Inflation risk is tied to interest rate risk, because interest rates often rise to
compensate for inflation. Return of investment (ROI) is less than the market inflation
rate. e.g. Return of investment (ROI) : 5%; Market Inflation rate (IR) : 8.5%

e. Exchange rate risk is the chance that a nation's currency will lose value when
exchanged for foreign currencies.

f. Reinvestment risk is the danger that reinvested money will fetch returns lower than
those earned before reinvestment. Individuals with dividend-reinvestment plans are
a group subject to this risk. Bondholders are another.

4. National and International Risks

National and world events can profoundly affect investment markets.

a. Economic risk is the danger that the economy as a whole will perform poorly. When
the whole economy experiences a downturn, it affects stock prices, the job market,
and the prices of consumer products.

b. Industry risk is the chance that a specific industry will perform poorly. When
problems plague one industry, they affect the individual businesses involved as well
as the securities issued by those businesses. They may also cross over into other
industries. For example, after a national downturn in auto sales, the steel industry
may suffer financially.

c. Tax risk is the danger that rising taxes will make investing less attractive. In general,
nations with relatively low tax rates, such as the United States, are popular places for
entrepreneurial activities. Businesses that are taxed heavily have less money
available for research, expansion, and even dividend payments. Taxes are also levied
 on capital gains, dividends and interest. Investors continually seek investments that
provide the greatest net after-tax returns.

d. Political risk is the danger that government legislation will have an adverse effect on
investment. This can be in the form of high taxes, prohibitive licensing, or the
appointment of individuals whose policies interfere with investment growth. Political
risks include wars, changes in government leadership, and politically motivated
embargoes.

4. Need and Importance of Investing

 Longer life expectancy

Investment decisions have become more significant as most people retire between the ages
of 56 to 65. Investment decisions have to be planned to make wise saving decisions. Saving
on their own does not increase wealth; the saving must be invested in such a way that the
principal and income will be adequate for a greater number of retirement years. Longer life
expectancy is one reason for effective savings and further investment activities that help the
investment decisions.

 Increasing rates of taxation

When tax rate is increased, it will focus on generating savings by the tax payer. When the
tax payer invests their income in provident fund, pension fund, Unit Trust Funds, Life
Insurance, Unit Linked Insurance Plan, National Saving Certificates, Development Bonds,
Post Office Cumulative Deposit Schemes, etc., it affects their taxable income.

 Interest rates
Interest rate is one of the most important aspects of a sound investment plan. The interest
rate differs from one investment to another. There may be changes between degree of risk
and safe investments. They may also differ due to different benefit schemes offered by the
institutions. A high rate of interest may not be the only factor favoring the outlet for
investment. Stability of interest is an important aspect of receiving a high rate of interest.

 Inflation
Inflation has become a continuous problem. It affects in terms of rising prices. Several
problems are associated and coupled with falling standards of living. Therefore, investor’s
careful scrutiny of the inflation will make further investment process delayed. Investor
ensures to check the safety of the principal amount and security of the investment. Both are
crucial from the point of view of the interest gained from the investments.

 Income
Income is another important element of the investment. When government provides jobs to
the unemployed persons in the country, the ultimate result is ensuring income than saving
the extra income. More incomes and more avenues of investment have led to the ability
and willingness of working people to save and invest their funds.

 Investment channels
The growth and development of the country leading to greater economic prosperity has led
to the introduction of a vast area of investment outlets. Investment channels mean an
investor is willing to invest in several instruments like corporate stock, provident fund, and
life insurance, fixed deposits in the corporate sector and unit trust schemes.

Why is Investing important?

Written by: Jay Mehta as published on on www.quora.com

There are only two ways to make money in our modern world: by working, for yourself or
someone else, and/or by having your assets work for you. If you keep your life savings in
your back pocket or under a mattress, instead of investing, the money doesn't work for you
and you'll never have more than what you save or receive through inheritance. Conversely,
investors generate money by earning interest on what they set aside or by buying assets
that increase in value.

Some of the richest people say that you need your money to work for you even when you
sleep. Only then you can be wealthy.

It doesn't matter how you do it. Whether you invest in stocks, bonds, mutual funds, options,
futures, precious metals, real estate, a small business or a combination of assets, the
objective is the same: to make investments that generate additional cash. As the old
expression goes, "Money isn't everything but happiness alone can't keep out the rain." So,
whether your goal is to send your kids to college or to retire on a yacht in the
Mediterranean, investing is essential in getting where you want to go in life.

 Investing your money can allow you to grow it. Most investment vehicles, such
as stocks, certificates of deposit, or bonds, offer returns on your money over the
long term. This return allows your money to build, creating wealth over time.
 As you are working, you should be saving money for retirement. Put your retirement
savings into a portfolio of investments, such as stocks, bonds, mutual funds, real estate,
 businesses, or precious metals. Then, at retirement age, you can live off funds earned
from these investments.
 Some investment vehicles, like employer-sponsored 401(k)s, allow you to invest your
pre-tax dollars. This option allows you to save more money than if you could only invest
your post-tax dollars.
 Investing is an important part of business creation and expansion. Many investors
like to support entrepreneurs and contribute to the creation of new jobs and new
products. They enjoy the process of creating and establishing new businesses and
building them into successful entities that can provide them with a strong return on
their investment.
 Many investors like investing in people, whether they are business owners, artists, or
manufacturers. These investors feel good helping others achieve their goals.

5. Saving Versus Investing

Saving Vs. Investing Money: Finding the Right Balance between Saving and Investing
Written by: Joshua Kennon as published on www.thebalance.com
March 27, 2020

Many new investors don't understand that saving money and investing money are entirely
different things. They have different purposes and play different roles in your financial
strategy and your balance sheet. Making sure you are clear on this fundamental concept
before you begin your journey to building wealth and finding financial independence is vital
because it can save you from a lot of heartache and stress. You can still lose everything
despite having a wonderful portfolios because you don't appreciate the role of cash in your
portfolio. Cash deserves respect. The goal of cash is not always to generate a return for you.

What is the Definition of Saving Money?

Saving money is the process of putting cold, hard cash aside and parking it in extremely safe,
and liquid (meaning they can be sold or accessed in a very short amount of time, at most a
few days) securities or accounts. This can include checking accounts and savings accounts
secured by the FDIC. This can include United States Treasury bills. This can include money
market accounts (but not always money market funds as you need to look at the holdings
and structure closely).

Above all, cash reserves must be there when you reach for them; available to grab, take
hold of, and deploy immediately with a minimal delay no matter what is happening around
you. Many famous wealthy investors actually advocate keeping a lot of cash hidden on hand
somewhere that only you know about even if it involves a major loss.

What Is the Definition of Investing Money?

Investing money is the process of using your money, or capital, to buy an asset that you
think has a good probability of generating a safe and acceptable rate of return over time,
making you wealthier even if it means suffering volatility, perhaps even for years. True
investments are backed by some sort of margin of safety, often in the form of assets or
owner earnings. As you know, the best investments tend to be so-called productive assets
such as stocks, bonds, and real estate.

How Much Should I Save vs. Invest?

Saving money should almost always come before investing money. Think of it as the
foundation upon which your financial house is built. The reason is simple. Unless you inherit
a large amount of wealth, it is your savings that will provide you with the capital to feed
your investments. If times get tough and you require cash, you'll likely be selling out your
investments at the worst possible time. That is not a recipe for getting rich.
There are two primary types of savings programs you should include in your life. They are:

 As a general rule, your savings should be sufficient to cover all of your personal
expenses, including your mortgage, loan payments, insurance costs, utility bills, food,
and clothing expenses for at least three to six months. 3 That way, if you lose your
job, you’ll be able to have sufficient time to adjust your life without the extreme
pressure that comes from living paycheck to paycheck.
 Any specific purpose in your life that will require a large amount of cash in five years
or less should be savings-driven, not investment-driven. The stock market in the
short-run can be extremely volatile, losing more than 50% of its value in a single
year.

Only after that these things are in place, and you have health insurance, should you begin
investing. The only possible exception is putting money into a 401(k) plan at work if your
company matches your contributions. That’s because not only will you get a substantial tax
break for putting money into your retirement account, but the matching funds basically
represent free cash that is being handed to you on a silver tray and there are material
bankruptcy protections in place for assets held within such an account should you be wiped
out entirely.
Review Questions
1. What is the role that the Capital Market play in an economy?
2. What could be the investor’s mood during a Pandemic or a Recession and its effect in the
Capital Market?
3. How does the government contribute to the health of the Capital Market?
4. Is investing prescribed during a recession? Why or why not?
5. Why are Filipinos intimidated with the idea of Investing? How can a future Financial
Management graduate like you change this cultural mindset?
6. Huge corporations in the Philippines function because of the Capital Markets. Do you think
that capitalism has brought more advantage or disadvantage to this country? Explain your
answer with actual examples.
7. How is risk associated with the reward characteristics of investments?
8. They say that investing combats inflation risk? Why is that so?
9. What type of investor would you classify yourself? Explain in detail based on your
characteristics and spending behavior.
10. Investments have hedging characteristics, which means, “to secure.” How does Financial
Contracts hedge individual and institutional investors from risks?