Unit 1

Investment- Investment is the employment of funds with the

aim of getting return on it. In general terms, investment means
the use of money in the hope of making more money.
Portfolio- “Portfolio means combined holding of many kinds of
financial securities i.e. shares, debentures, government bonds,
units and other financial assets.”
Portfolio Management- Portfolio management includes
portfolio planning, selection and construction, review and
evaluation of securities.
1. RISK AND RETURN
Risk- Risk is the possibility of loss or injury; risk is the possibility
of not getting the expected return. The difference between
expected return and actual return is called the risk in
investment.
Return- A return, also known as a financial return, is the money
made or lost on an investment over some period of time.
Return, is the amount of money you receive from an
investment.
Types of Risks
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.
Types of Systematic risk
1. Interest rate risk: Interest rate risk is the variation in the
rates of return caused by the fluctuations in the market interest
rate. Most commonly the interest rate risk affects the debt
securities like bond, debentures.
2. Market risk: Market risk is variability of return caused by the
alternating forces of bull and bear market. This is a type of
systematic risk that cause market price of shares move up and
down consistently for some period of time.
3. Purchasing power risk: it refers to the variation in investor
return caused by inflation.
4. Exchange Rate Risk: This risk arises from the uncertainty in
the changes in the value of the currencies. So, it affects only the
companies doing foreign exchange transactions, like export and
import companies.
5. Political Risk: Such type of risk occurs primarily due to
political instability in a country or a region. For instance, if a
country is at war, then the companies operating there would be
considered risky.

Unsystematic risk: In case of unsystematic risk the factors are

specific, unique and related to the particular industry or
company.
Types of unsystematic risk
1. Business risk: Every company operates within a particular
operating environment, operating environment comprises both
internal environment within the firm and external environment
outside the firm. Business risk is the risk caused by operating
conditions faced by a company and is the variability in
operating income caused by the operating conditions of the
company.
2. Financial risk: It refers to the variability of the income to the
equity capital due to the debt capital. Financial risk in a
company is associated with the capital structure of the
company.
Risk and Return Tradeoff
The risk-return tradeoff states that the potential return rises
with an increase in risk. Using this principle, individuals
associate low levels of uncertainty with low potential returns,
and high levels of uncertainty or risk with high potential
returns. According to the risk-return tradeoff, invested money
can render higher profits only if the investor will accept a
higher possibility of losses.
The appropriate risk-return tradeoff depends on a variety of
factors including an investor’s risk tolerance, the investor’s
years to retirement and the potential to replace lost funds.
Time also plays an essential role in determining a portfolio with
the appropriate levels of risk and reward.
Investors use the risk-return tradeoff as one of the essential
components of each investment decision, as well as to assess
their portfolios as a whole.

3. Application of Standard Deviation

Standard deviation is a statistical tool in finance that, when
applied to the annual rate of return of an investment, sheds
light on that investment's historical volatility.
The greater the standard deviation of securities, the greater the
variance between each price and the mean, which shows a
larger price range. For example, a volatile stock has a high
standard deviation, while the deviation of a stable blue-chip
stock is usually rather low.
Formula for Standard deviation
Standard deviation is an especially useful tool in investing and
trading strategies as it helps measure market and security
volatility—and predict performance trends.
For example, an index fund is likely to have a low standard
deviation versus its benchmark index, as the fund's goal is to
replicate the index.
On the other hand, one can expect aggressive growth funds to
have a high standard deviation from relative stock indices, as
their portfolio managers make aggressive bets to generate
higher-than-average returns.

Coefficient of variation
The coefficient of variation (CV) is a statistical measure of the
dispersion of data points in a data series around the mean. The
coefficient of variation represents the ratio of the standard
deviation to the mean, and it is a useful statistic for comparing
the degree of variation from one data series to another, even if
the means are drastically different from one another.
In finance, the coefficient of variation allows investors to
determine how much volatility, or risk, is assumed in
comparison to the amount of return expected from
investments.
The lower the ratio of the standard deviation to mean return,
the better risk-return trade-off.
Coefficient of Variation= Standard Deviation/Mean
5. Beta and Alpha
Beta- Beta is a measure of a stock's volatility in relation to the
overall market. By definition, the market, such as the S&P 500
Index, has a beta of 1.0, and individual stocks are ranked
according to how much they deviate from the market.
A stock that moves more than the market over time has a beta
above 1.0. If a stock moves less than the market, the stock's
beta is less than 1.0. High-beta stocks are supposed to be riskier
but provide higher return potential; low-beta stocks pose less
risk but also lower returns.
Alpha- Alpha is a measure of the active return on an
investment, the performance of that investment compared
with a suitable market index. An alpha of 1% means the
investment's return on investment over a selected period of
time was 1% better than the market during that same period; a
negative alpha means the investment underperformed the
market.
6. Present value of bond
Bond- A bond is a debt instrument that provides a steady
income stream to the investor in the form of coupon payments.
At the maturity date, the full face value of the bond is repaid to
the bondholder.
Bond valuation is a technique for determining the theoretical
fair value of a particular bond. Bond valuation includes
calculating the present value of a bond's future interest
payments, also known as its cash flow, and the bond's value
upon maturity, also known as its face value or par value.
Because a bond's par value and interest payments are fixed, an
investor uses bond valuation to determine what rate of return
is required for a bond investment to be worthwhile.

7. Bond Yield
Meaning- A bond's yield is the return to an investor from the
bond's coupon (interest) payments. Low-yield bonds may be
better for investors who want a virtually risk-free asset. High-
yield bonds may instead be better-suited for investors who are
willing to accept a degree of risk in return for a higher return.
Yield to Maturity- Yield to maturity (YTM) is the total return
anticipated on a bond if the bond is held until it matures. Yield
to maturity is considered a long-term bond yield. Yield to
maturity (YTM) is the total rate of return that will have been
earned by a bond when it makes all interest payments and
repays the original principal.
Yield to Call- Yield to call (YTC) refers to the return a
bondholder receives if the bond is held until the call date,
which occurs sometime before it reaches maturity. A callable
bond (also called redeemable bond) is a type of bond that
allows the issuer of the bond to retain the privilege of
redeeming the bond at some point before the bond reaches its
date of maturity.
Yield to Put- The annual yield on a bond, assuming the security
will be put (sold back to the issuer) on the first permissible date
after purchase. A putable bond is a type of bond that provides
the holder of a bond (investor) the right, but not the obligation,
to force the issuer to redeem the bond before its maturity date.

8. Risks
Price Risk- Price risk is the risk that the value of a security or
investment will decrease. Factors that affect price risk include
earnings volatility, poor business management, and price
changes. Diversification is the most common and effective tool
to mitigate price risk. Financial tools, such as options and short
selling, can also be used to hedge price risk.
Default risk- Default risk is the probability that a borrower fails
to make full and timely payments of principal and interest,
according to the terms of the debt security involved.
9. Yield Curve
Yield curve is a curve that shows the interest rate associated
with different contract lengths for a particular debt instrument
(e.g., a treasury bill). It summarizes the relationship between
the term (time to maturity) of the debt and the interest rate
(yield) associated with that term.

A yield curve is typically upward sloping; as the time to maturity

increases, so does the associated interest rate. The reason for
that is that debt issued for a longer term generally carries
greater risk because of the greater likelihood of inflation or
default in the long run. Therefore, investors usually require a
higher rate of return for longer-term debt.
An inverted yield curve, which slopes downward, occurs when
long-term interest rates fall below short-term interest rates. In
that unusual situation, long-term investors are willing to settle
for lower yields, possibly because they believe the economic
outlook is bleak (as in the case of an imminent recession).

Theories Regarding yield curve

1. Expectation theory- Expectation theory says the long-term
yield of a financial instrument is the average of the short-term
yields that are expected to occur over the life of the
instrument. Thus:
• An upward yield curve means investors expect short-term
yields to rise in the future
• A downward yield curve means investors expect short-term
yields to decline in the future
The yield curve, therefore, changes as investors’ expectations
about future short-term yields change. This explains why yields
with different maturities tend to move together.
2. Market segmentation theory- Market segmentation theory
says that yields for different terms are based on supply and
demand. In short, some investors have a preference for
financial instruments with a certain maturity, and these
preferences determine yields. The downside of market
segmentation theory is that it fails to explain why yields with
different maturities tend to move together.
3. Liquidity premium theory- Liquidity premium theory is a
combination of expectations theory and market segmentation
theory. According to this theory, the long-term yield is the
average of short-term yields throughout the life of the bond
plus a liquidity premium that represents the supply and
demand for bonds at that term.
11. Duration and modified Duration
Duration- Duration is a measure of the sensitivity of the price of
a bond to a change in interest rates. It is a tool used in the
assessment of the price volatility of a fixed-income security.
Modified Duration- The modified duration of a bond helps
investors understand how much a bond's price will rise or fall if
the YTM rises or falls by 1%. This is an important number if an
investor is worried that interest rates will be changing in the
short term.

12. Immunization of bond portfolio

Bond immunization is an investment strategy used to minimize
the interest rate risk of bond investments by adjusting the
portfolio duration to match the investor's investment time
horizon. It does this by locking in a fixed rate of return during
the amount of time an investor plans to keep the investment
without cashing it in.
Normally, interest rates affect bond prices inversely. When
interest rates go up, bond prices go down. But when a bond
portfolio is immunized, the investor receives a specific rate of
return over a given time period regardless of what happens to
interest rates during that time. In other words, the bond is
"immune" to fluctuating interest rates.