Chapter 2Assets|Classestand Financial struments Chapter Investment En: ACT: Contents Meaning of Investment Types of Assets Real Assets and Financial Assets Financial Markets and the Economy The Investment Process ‘The Risk-Return Trade-off Efficient Market The Major Players in the Financial Markets Financial Intermediaries Role of Financial Intermediaries Ethical Issues in Investing Nepalese Investment Environment Securities Securities Markets Securities Markets Regulation Summary Review Questions Questions Case Analysis Money Market Treasury Bills Certificates of Deposit Commercial Paper Bankers’ Acceptances Eurodollars Yields on Money Market Instruments The Bond Market Treasury Notes and Bonds Inflation-Protected Treasury Bonds Federal Agency Bonds International Bonds Municipal Bonds Corporate Bonds * Mortgages and Mortgage-Backed Secu Equity Securities Common Stock Preferred Stock Depository Receipts Stock and Bond Market Indexes Stock Market Indicators ‘Nepal Stock Exchange Index Bond Market Indicators Derivative Markets 2 3 3 5 6 7 8 8 10 10 12 3 B 4 4 15 16 16 16 SSGERBVSSYLLBAISRBRRRBRARKROptions Futures Contracts Summary IMstrative Problems List of Formulae Review Questions Questions Problems, Case Analysis Concept of Securities Markets Types of Securities Markets Issue of Securities Privately Held Companies Publicly Traded Companies Shelf Registration Initial Public Offerings Trading of Securities Types of Markets ‘Types of Orders Trading Mechanisms The Rise of Electronic Trading Electronic Communication Networks (ECNs) New Trading Strategies Algorithmic Trading High-Frequency Trading Dark Pools Electronic Bond Trading Globalization of Stock Markets Growing Importance of International Stock Markets Trading Costs Explicit Costs Implicit Costs Types of Securities Transactions Long Purchase Short Selling Buying on Margin Margin Short Selling Nepal Stock Exchange Recent Reforms in NEPSE Functions of NEPSE Listing Policies of NEPSE Roles of Securities Board of Nepal Summary lustrative Problems stot Formulae Review Questions Questions Problems. Case Analysis SSIsISSslRvrzsy SSSVeeSRAESssSLSSReResegzagChapter4@ Mutual Runds'and Other Investment Companies Concept and Functions of Investment Companies 140 Types of Investment Companies ma ‘Unit Investment Trusts 142 Mutual Funds: Open-End Investment Company a2 (Closed-End Funds M6 Difference between Open-End Fund and Closed-End Fund “7 Other Types of Investment Companies M8 Exchange-Traded Funds 148 Real Estate Investment Trusts 9 Hedge Fund “9 ‘Commingled Funds 149 Selecting Mutual Funds 150 Mutual Funds in Nepal 14 Historical Development 154 Structure of Mutual Funds in Nepal 155 ‘Summary 156 Mustrative Problems, 157 Us of Formulae 165 Review Questions 165 Questions 166 Problems. 166 Case Analysis m Chapter S@Riskand Return Concept of Return 174 Components of Return 174 Measuring Investment Returns 176 Holding Period Return 1% Returns over Multiple Periods 179 Annualizing Rates of Return 184 Probability Distribution and Expected Return 185 Time Series of Retum ‘187 Inflation and Real Rates of Return 187 The Concept and Measurement of Risk 188 Measuring Risk of a Single Asset 189 ‘Summary 193 Mlustrative Problems 194 Uistof Formulae 210 Review Questions ant Questions 22 Problems. 213 218 Case AnalysisDynes ie LLL omc Luce Diversification and Portfolio Risk 220 ‘Asset Allocation with Portfolio of Two Risky Assets 22 Portfolio Return, 22 Portfolio Risk 224 Correlation and Covariance I ‘The Risk-Return Trade-off with Two Risky Assets ‘The Mean-Variance Criterion: Portfolio Efficient Set of Two Risky Assets 233 Portfolio of One Risky Asset and One Risk-Free Asset 236 ‘The Optimal Risky Portfolio with a Risk-Free Asset 240 ‘The Optimal Risky Portfolio with Two Risky Assets and a Risk-Free Asset 240 Determining of the Optimal Complete Portfolio 243 243 Efficient Diversification with Many Risky Assets The Efficient Frontier of the Portfolio of Many Risky Assets 244 Choosing the Optimal Risky Portfolio 245 ‘The Capital Asset Pricing Model eae Basic Assumptions cad ‘The Model ao Implications of CAPM Gad ‘The Security Market Line baad Calculation and Interpretation of Portfolio Beta 251 Summary = Ilustrative Problems bas List of Formulae 282 Review Questions 283 Questions 84 Problems 285 Case Analysis 293 hapter7mBond Prices and Yield: Bond Characteristics 296 Bond Pricing 299 ‘The Basic Bond Valuation Model 299 Bond Valuation with Semiannual Interest 302 Bond Pricing between Coupon Dates 302 Bond Pricing in Excel Discount Bond and Premium Bond a Required Return and Bond Values Interest Rate Risk oa Bond Prices over Time on Bond Yields ae Holding Period Return one Current Yield and Capital Gain Yield S Yield to Maturity oo Yield to Call (YTC) an oe rrr Reto : ~ 12,Illustrative Problems 315 List of Formulae at Review Questions ‘w2 Questions 32 Problems 333 Caso Analysis 37 ‘Common Stock Valuation by Comparables 340 Types of Common Stock 341 The Valuation Process 33 Stock Valuation Models 34 The Dividend Discounted Model uS Single Holding Period Valuation 345, Multiple Holding Period Valuation 346 Zero Growth Model 7 Constant or Normal Growth Model 347 Non-Constant Growth or Multi-stage Growth 348 Determining Expected Rate of Return 350 Stock Prices and Investment Opportunities 353 ‘The Price Earning Ratio 354 Other Comparative Valuation Ratios 355 Free Cash Flow Valuation Approaches 356 Preferred Stock 359 Preferred Stock Valuation 359 Summary ad Mlustrative Problems 361 List of Formulae 374 Reviow Questions 375 Questions 6 Problems 378 Case Analysis 382 Gee EOE LI LTA ‘The Domestic Macroeconomy 384 Demand and Supply Shocks 386 Government Policy 386 Business Cycles 389 Economic Indicators 392 Industry Analysis 304 Defining an Industry: A Key Issue in Industry Analysis 304 Sensitivity to Business Cycle 395 Sector Rotation 396 Industry Life Cycle 397 Industry Structure and Performance 398 Summary 400 Review Questions 401 8The Investment Environment XESS ruses {Upon completion of this chapter, students should be abe to: + Understand the meaning of investment. ‘Explain key features of diferent types of asso. * Discuss the role of financial market in an economy. ‘= Follow appropriate investment process. = Define concepts like risk-etum tradeot! and elicient market. * Identity major players in the financial markets, + Ethical issues. ‘+ _Nopalose investment environment ao oom Fundamental concepts are the key to understand in the realm of the investment for both students and investors. Conceptual aspects of investment, key features of different types of assets, role of financial market in an economy, investment process, concepts of risk- retum trade-off and efficient market, major players in the financial markets, investment environment in Nepalese context and cthical values are the essentials to know for students and investors. So, this chapter focuses on these conceptual aspects of investment and deals with Nepalese investment environment and significance of ethical investing. as 0m2 INVESTMENT ANALYSIS Meaning of Investment INVESTUENTS ‘Conminent eat resoues int xeon of doting roar resources htewwe. SAVING Brees ofncore oer expendi. ‘SPECULATION Aron ‘in atviy nan expectalon ot dtl gai in a very short etd of wih excessive fk, GAMBLING ‘oar to salah personal saree sah per Think of some activities such as buying stocks of Nepal oe Ltd., bonds issueg + by the Government of Nepal or Kumari Bank Ltd., or a piece of land in your town, These activities are the examples of investment and have some common, characteristics. The common characteristics of these activities are: you spend money to get the assels now, you do so in an expectation of return in the future, and you bear risk when you buy these asses. Based on the common characteristics of investments, we may define investment as commitment of funds to one or more assets in the expectation of generating more funds in the future. In other words, it is the sacrifice of certain present value for (possibly uncertain) future value. In all the above examples ~ buying stocks, bonds, a piece of land, we pay now in an expectation of return in the future and bear risk, We invest to grow our wealth. It happens when our investment brings positive return. Return is the reward for investing. It may come in the form of current income or in the form of increased value of the asset or capital gain. The interest we receive in fixed deposit in a bank account and the dividend we receive on Our investment in stocks are examples of current income. The appreciation in the value of security from the time it is purchased and to the time it is sold is capital gain. 1s saving an investment? Saving, which is excess of income over expenditure, if kept under the pillow is not an investment. But if the sa me saving is deposited in a bank saving account, itis an investment because it earns interest (return) and Possesses some amount of risk, Some writers investment. To them saving refers to tisk. Itis also useful to comp: differentiate saving from 'ured saving bank account which has no are investment with speculation, Speculation bears all characteristics of investment, that way some consider it a engages in an activity in an expectation of windfall gain in a very short period of time and takes excessive tisk, it is known as Speculation. In speculation you Conjecture about a subject without firm evidenc: in stocks, property, For example, your investment or other ventures with too little information and too short time to analyze and make @ sound investme Speculation. Then, is gambling an example of sp. {0 satisfy your personal desire. It mimics to spec chance for money. In many Countries, gambling is declared illegal and it is not investment, nt decisions are examples of eculation? Gambling is a game ulation because it is a game ofTHE INVESTMENT ENVIRONMENT Types of Assets Real Assets and Financial Assets Assets are classified as real assets and financial assets based on their nature. REALASSETS Real assets are mostly tangible and they possess productive capacity. They ar¢ ‘Asses usodiopoaee gee seq to produce goods and services. The examples of real assets are property, asovess. plant and equipment, human capital, etc. Financial assets represent claims on FNANGLASSETS income and other assets and define the allocation of income or wealth. The ‘esas eprsonirg carson ‘ , See eeaescs cxamples of financial assets are shares of stocks, bonds, Treasury securities, ete. Financial assets have the following characteristics. Financial assets do not have physical character: Financial assets do not exist physically. They represent the ownership right through a piece of paper known as certificate of ownership. For example, if you deposit money in a fixed deposit account of a bank, you receive a certificate of deposit. If you purchase shares issued by a company you receive a certificate of shares from the company. Similarly, if you buy Iife insurance policy from an insurance company, the ue a policy certificate to you. In all these cases your insurance company will i ownership right is stated in a piece of paper and financial assets do not have any physical character. Financial assets are more liquid: Generally, financial assets are considered more liquid than physical assets. It means they can be easily converted into cash. Real assets generally do not pose this character. They may take relatively longer time to sell and convert into cash. In other words, it takes longer time to sell land than to sell shares of stock. The reason is that the markets for financial assets (the capital market and money market) are well developed than the markets for real assets. Financial assets do not have own productive capacity: Financial assets do not have their own productive capacity. They generate income from the investment in real assets. For example, if you purchase shares issued by a company, the investment in shares do not generate income directly. The funds you invested in shares are used by the company to buy real assets such as land, building, machinery, inventory etc. which generate income. “inancial assets are easily moveable with ir Financial assets have easy mobility: case, They can be easily carried from one place to another place because th existence is simply represented. by certificate of ownership. Further, the ownership also can be easily transferred simply by selling the certificate of ownership. Financial assets for one party is financial liability for the other: The creation of financial instrument (shares, bonus, certificate of deposit, etc) requires two parties. One party issues/sclls it and another party buys. For example, you can buy share only when a company issues it. You can buy certificate of deposit only when a bank issues it. The shares and the certificates of deposit are assets for4 INVESTMENT ANALYSIS resent liabilities for the issuing company and the banj Sia, 7 eat purchase life insurance policy, it represents an _ iG you bal liability for the insurance company. Thus, financial instruments are assets fo, one party and financial liability for another party. In this book we study about investing in financial assets, therefore, our focus will be on financial assets. Financial assets, also known as securities are classified into three types - debt, equily and derivatives. Debt Securities iti i eturn over a period of time to the investors; vesrsecuaies Debt securities promise fixed retui P ‘Assestaiponseime — therefore, they are also known as fixed-income securities. Debt securities are tomees 9" further divided into money market and capital market fixed-income securities, Money market securities are of short-term nature, hence mature within one SEUTES' "year, Treasury bills, certificates of deposits, banker's acceptance, commercial maueynociea "Paper, etc. are examples of money market debt securities. Capital market debt nee Securities have maturity longer than one year. Bonds issued by the governments Securing “STE and corporations are example of capital market debt securities. Debt securitice Unplomabenieana @fC useful for investors who are willing to accept fixed return for low risk. We ‘monuustyowreeeyes. discuss in detail about different types of debt securities in Chapter 7. Equity Securities Equity securities represent ownership interest in a corporation - the investor EQUTY secuRmes ° ee Seats Fates becomes the owner of the corporation and possesses the residual right on asset omesspineesing and income but does not have the experain. ight to claim on dividend. Being the the investor is not promised with fixed return; but has the right on all income that remains after paying to debt holders. ‘The return to the shareholders is tied to the success of the corporation, Sharcholders get higher retum on the belter performance of the corporation. But, they get no return in case the corporation incurs loss. Thus, equity securities are riskier than the fixed income securities to the investors. We discuss about equity securities in detail in Chapter 8, shareholder, Derivative Securities Denvarvesecurmes Derivative securities are those securities ‘Secures whose vae ~~ -«Other assets (known as underlying, assets), By investing in the derivative Srakomaseiah securities, the investor has right to buy or sell an underlying asset on which the asset, ° derivative is written, Options, warrants and futures are the examples of derivative securities. Call option gives You right to buy stocks at predetermined Price and put option gives you right to sell stocks at predetermined price. Futures are contracts between two parties that obligate to: (i) the seller of the contract to deliver an asset, and (i) the buyer of the contract to take the delivery of an asset at some specific date, at a Price agreed on the date of the contract. The derivative market is yet to develop in Nepal. Only commodity derivatives are traded in a few exchanges but the market for call and put options do not exist in Nepal. whose value depends on the value ofTHE INVESTMENT ENVIRONMENT echaptert 5 Derivative securities posses high risk because they have uncertain returns oF unstable market value, but they have high expected value as well. These securities are primarily used to hedge the risk. Therefore, they have become integral part of the investment environment. Financial Markets and the Economy Financial assets and financial markets play important rol Financial markets offer a platform where the prices of financial asscts are set. The price of a sccurity conveys important information to the investors of the security as well as to the economy. The markets also offer an opportunity to shift our consumption - save now and consume in the future or borrow and consume now and earn and pay in the future, Financial markets also offer us an opportunity to choose securities to match our risk appetite. We discuss in detail in an economy. the role of financial assets and financial markets below. ‘inancial_markets offer a The informational role of financial markets: platform for setting the prices of securities which are valuable information to the investing community as well as to the economy. For example, the price of a share of Nabil Bank is set at Rs 3,000 per share and that of Kumari Bank is set at Rs 600 per share in the financial markets. For the investors, the prices of securities speak a lot about the performance of the respective companies. ‘Anybody can generalize based on the price, which is the consensus opinion of the market participants that the bank with high-priced stock is doing better than the other. To the economy, the pricing mechanism helps to allocate resources to the most efficient units of the economy. Consumption timing: Consumption timing means shifting consumption from ther period as per our will. Financial assets and financial markets help us to do so, Assume that you are just employed at a monthly income of Rs 30,000 and wish to ride a bike costing Rs 300,000. You will have to wait many months until you save Rs 300,000 to consume bike-riding, However, because of the financial markets with its constituents, e. g. banks and finance companies, you can borrow now and ride the bike against your future income. Alternatively, you may wish to save from your current income to retirement age by storing your wealth in financial assets. Both are possible because of the one period to an financial markets. ‘Allocation of risk: We find different types of financial instrument markets, They have been developed in response to diverse class of investors with respect to their risk preference. An investor with low risk preference may choose bond of a corporation, while the other risk-tolerant investors may choose common stock of the same corporation; the third more conservative may choose government debt security. Thus, the financial markets offer alternatives to allocate one’s risk as per investor's preference for risk. ement: In a small firm, the owner often firm. The management of such firm ts in the Separation of ownership and managi involves in the management of the6 INVESTMENT ANALYSIS tomatically changes once the ownership of the firm changes. But there is ng such change where there is separation of ownership and management Mey, Bank Ltd has approximately 150 thousand shareholders. They a foe et in t of the Bank, Therefore, they elect involved in the day-to-day management Board of Directors which in turn appoints a team of management to run the Bank. The existing sharcholders may exit and new shareholders may join the bank by trading shares at any time in the stock market. But such changes in shareholders do not impact the management and provides stability in the management. ‘The financial markets facilitate the change in the ownership without disturbing the management. The Investment Process SECURITY ANALYSIS, ‘The process of doting secures those ar worth buyig. Investment process involves the steps an investor follows to take decisions on the selection of securities, allocation of funds among securities and timing of ions. Generally, it involves five steps which are described a first step, an individual must decide why s/he is investing, Stating the objective like “earning return as high as possible” cannot be the objective of investment. Such objective is vague - how high is high return? Again high return is attached to high risk. Are you ready to accept high risk for high return? Therefore, investment objective must be set in light of the tisk and return preference of the investor. Different investors have different objective for investing, It could be saving for old age, financing children’s education or financing a holiday trip. These different objectives lead to the selection of different types of securities and different holding periods. For example, if the objective is to save for retirement, the investor will have to choose long-term securities with growth opportunities like common stocks. But if the objective is to save for travel trip in Dasain vacation, the investor will have to invest in short-term money market securities that can be sold easly. tnvesting for children’s education may suggest investing in both bond and stocks. This step guides to fix which broad class of securities - Stocks, bonds, money market securities, etc. will be appropriate for the investors, Perform security analysis: It involves examining individual securities for investment. The purpose of t his step is to identify securities that are worth buying. Once an investor decides to invest in one broad type of security, say for example the stock, s/he will have to select Particular stock(s) out of hundreds of stocks available in the market, Security analysis helps to do so. There are mainly two methods of security analysis - technical analysis and fundamental analysis. 'n lechuical analysis, we examine the prices of securities to detect trend or pattern of price movement : and use i to predict the future price. We believe that the past trend will continue. Accordingly, ifthe price of the se it leads us to believe that the value of Therefore, we buy the stock, ‘curity has increasing trend, the security is expected to increase In fundamental analysis, we examine the 82/3PORTFOLIO ifvesenontin re han one socal THE INVESTMENT ENVIRONMENT chapter! = 7 fundamentals (e.g, cash flows, liming and growth rate of cash flows, required rate of return, ete) of the security and use them to predict the fair (intrinsic) value of the security. If market price is lower than intrinsic value we believe that the market price will increase to intrinsic value, therefore that security is worth buying. Construct portfolio: Portfolio refers to investment in more than one security. And portfolio construction refers to choosing specific securities to include in the portfolio and determining the proportion of investible funds among, chosen securities. This step is important because the portfolio reduces risk in investment. Portfolio revision: Portfolio constructed once does not work forever. Over time, the investor's preferences, market conditions and securities’ performance may change. Accordingly, the portfolio needs to be revised to reflect these changes. In this process, the existing securitics may need {o be replaced with the new ones. This is done by following the three steps described above. Evaluate the performance of the portfolio: The final step in the investment n of the performance of the portfolio. It involves and process is the evalu: determining periodically how the portfolio performed in terms of ris return. It should be noted that the portfolio revision and performance evaluation are in cycle rather than stepwise order - we evaluate performance of the portfolio, revise them, again evaluate and revise. _ The Risk-Return Trade-off RISK-RETURN TRADEOFF ‘The wlalorship betwoon isk and lu, in wich investrert wih more sk shoud provide higher res, andvicovesa Imagine there are two stocks: Stock A and Stock B with equal risk, but Stock B offers higher relurn than the Stock A does. Which stock would you buy? Naturally, you (in fact, every rational investor) would prefer Stock B. If everybody demands for Stock B, is price will rise in the market causing the return to fall. The price will rise until the returns from equal risk stocks are equal. Similarly, if there are equal return unequal risk securities (Stock A and Stock B offer same return but Stock A is riskier), the price of high risk stock will decline until the relurn from unequal risk securities are also brought tothe same restors attempt to minimize risk for a given level of return or to maximize return for a given level of risk. ‘This relationship between risk and return is called the risk-return tradeoff. In other words, the risk-eturn trade-off is the relationship between risk and return, in which investment with more risk should provide higher returns, and vice versa. The financial markets play key role in adjusting prices of securities and establish a relationship between risk ovel. In general, inv and return.B __INVESTMENT ANALYSIS Efficient Market ifficient market is a market condition in which security price reflects 4, E uraer ea Fee ESTERa™ possible information quickly and accurately. It means all available information wepUemananeuen, affecting security prices are processed quickly and efficiently such that the Sawoeae, security price is fair. Therefore, there would be neither overpriced no, underpriced securities in the market. This happens in the market because many knowledgeable and competitive investors actively analyze and trade securities thereby eliminating profit opportunities. The implication of the efficient market is that investors should choose passive investment strategy instead of active strategy. Passive investment strategy suggests for holding diversified portfolio without spending resources for security analysis. Active investment strategy involves security analysis and attempts to search for mispriced securities. It also looks for correct timing for buying and selling securities. Why do investors still pursue active investment strategy if there are no profit opportunities? The answer is - market is not perfectly efficient leaving scope for creative and insightful investors. The Major Players in the Financial Markets FINANCIAL INTERMEDIARIES instutons hatissuetror ‘on sccuiis lo ase funds to purchase the sccuos of ‘ther compares. There are three major players in the financial markets - households, firms and the government. Households are net savers hence they supply funds to firms and the government by buying securities and earn income on their funds. Firms are net borrowers. They raise fund by issuing securities and invest in productive assets. The income from these assets is distributed to suppliers of funds (shareholders and lenders). The government can be the borrower or the lender. When there is budget deficit (tax revenue falling short of expenditures) it borrows. When there is budget surplus, it lends (or retires debt). Nepal Government has always been the net borrower till date. Between the ultimate borrowers (e.g. firms) and the ultimate lenders (eg. households) lie other important players in the financial markets. They are: + Financial intermediaries . Investment bankers + Venture capital and private equity partners Financial intermediaries: In the foregoing paragraph we grouped thrce major players in an economy (households, business, and government) into two groups ~ Ret savers and net borrowers. How do funds move from net savers (surplus units) to net borrowers (deficit units)? There are two processes ~ direct financing and indirect financing. In direct financing the surplus unit supplios funds directly to the deficit units by buying the securities issued by the deficit units. Direct financing takes place when an investor (surplus unit) buys stocks or bonds issued by a corporation in the primary market. Direct financing, though very useful, has serious limitations. For example, the surplus unit's saving, mayINVESTMENT ‘COMPANIES ‘Tre companies Pa pou wa ‘manage ro mency ol many inestos. INVESTMENT BANKERS, VENTURE CAPITAL Fonts setup as ied panerstip ond startup comparies. PRIVATE EQUITY Thearvesineatinnow staups and deve fis by weal investors olimited parr fs. THE INVESTMENT ENVIRONMENT echaptert = 9 be too small to buy securities, or the security's maturity period does not match to that of the issuer, or the surplus unit is unable to analyze the risk and return involved in the security. Fi with these limitations of direct financing. Financial intermediaries issue their own sccurities suitable to the savers and collect funds in their own account. ‘Then, they lend it by buying the securities of the deficit units and bear the risk. ‘Thus, financial intermediaries come in between ultimate savers and ultimate borrowers and facilitate the fund transfer process. Banks, finance companies, insurance companies, investment companies and pension funds are examples of financial intermediaries. When intermediaries are involved, there is indirect financing - the fund of the saving unit goes to the deficit unit via financial intermediaries. For example, investment companies pool and manage the money of many investors. They run mutual funds primarily for small investors and also design portfolios for large investors. They offer professional management service and enjoy economics of scale in operation. In Nepal, however, their role, though growing, is still insignificant. Investment bankers: Investment bankers act as an intermediary between issuers and the ultimate purchasers of securities. They underwrite and manage the issue of securities as well. They also advise the issuing companics on the types of securities to be issued, price to be charged, issue timing, etc. At this point, the readers should not be confused and take investment bankers as example of financial intermediary. It is because, investment bankers do not issue their own securities and create liability in their own account which financial intermediaries do. Investment bankers merely help in fund transfer process being in between issuers of the securities and investors. In Nepal, the same company functions as investment banker as well as investment company making their distinction difficult. For example, Nabil Capital Ltd or Siddhartha Capital Ltd function as issue manager as investment bankers and run mutual funds as investment companies. Venture capital and private equity: Venture capital funds are usually set up as limited partnership to fund startup companies. A management company starts with its own money and raises additional capital from a few partners such as pension funds, insurance companies, wealthy individuals (known as angel investors), etc. The fund is then invested in new and small firms which are unable to raise funds directly from the markets. The equity investment in these ew and small firms is known as venture capital. The venture capitalists normally sit in the board of the startup firm, assist the management and oversce the investment. Afler some period of time, the fund is liquidated and proceeds distributed to the investors. Unlike venture capitalists who focus on invest in who focus on firms in distress, They invest in mance and sell in profit. Thus, the investment k exchanges by private equity. are startups, there are other investors distress firms, improve their perfor in new startups and distress firms which do not trade in stoc wealthy investors or limited partnership firms is known as Venture capital and private equity firms are yet to develop in Nepal.10 INVESTMENT ANALYSIS Financial Intermediaries nancial intermediaries obtain the funds from surplus u | NANCIL HTERVEDARES innsprs alcoho ds am pls by isi tartans apart Renekes tomate, pata. DIRECT INVESTHENT invesimen rade act ec ts, INDIRECT INVESTMENT Investment rade trough th laa intemedaes, ts by issuin financial claims against themselves to market participants. For example, No ‘nvestment Bank Lid. obtained Rs 300 million by issuing seven-year bonds at 1p Percent interest in July 201, This isthe claim issued by Nepal Investment Ban, Ld, against itself. This isthe first function of financial intermediaries. Busines, sector is always in need of funds. So, Nepal Investment Bank lent Rs 300 million ‘o different business firms. So, obtaining the funds from surplus units ang mobilize the funds to deficit units of the economy are the prime roles of financial intermediaries. Thus, first financial intermediaries generate the liabilities while obtaining the funds from surplus units and create the assets while mobilizing the funds to the deficit units of economy. Here, investment of Nepal Investment Bank Lid. in business loans is the direct investment and investment of surplus units is the indirect investment. It is noteworthy here that the claims against the financial intermediaries are indirect investment. For example, individual investors purchased the bonds issued by Nepal Investment Bank Ld. So, individuals have claims against this bank. So, the investment of individual on bonds is indirect investment but investment of this bank in business loan is direct investment for the bank. In short, investment made through the financial intermediaries is indirect investment and investment made by surplus unit directly to deficit unit or investment made by financial intermediaries to deficit Units is direct investment. Take the example of investment made by investment companies. As we know that investment companies pool up the funds of market participants and use those funds to buy a portfolio of securities such as stocks, bonds, debentures. Investors who provide the funds to the investment banks quity claims against the concerned investment cor issued by the investment company. Here, acquired by investment company is the direct against the company is the indirect investment. and receive mpany. And equity claims are the portfolio of financial assets investment and the equity claims Financial intermediaries desirable into the assets which transformation process of one one of the these economic functions: (1) 2) reducing risk via diversifi Play a basic role in transforming. the assels less are more widely preferable by the public. The financial asset to another assets involve at least Providing the maturity intermediation, () reducing the costs of contracting and iding a payment mechanism, We discuss n. ication, information processing, and (4) provi all these function in the ensuing sectio Maturity intermediation: M, units may not. match the mat example, a business firm 1 aturily period for the funds demanded by deficit ‘arity period of funds supplied by surplus units, For eds Rs 3 million loans for 3 years. In the absence ofMATURITY INTERMEDIATION ‘Tho ntomodaton fr alin bo may prod lira asses and sbi. DIVERSIFICATION ‘process ovansiom more ky ase nt ess ky asso by vsti in mary mor financial asst. THE INVESTMENT ENVIRONMENT «chapters 11 financial intermediaries, this firm has to seck for the investors who want to invest their money for three years. Investors may be interested to invest for less than 3 years or more than 3 years. This firm may be in difficult to find out the investors who want to invest their funds exactly for 3 years, But a commercial bank can solve the problem of this firm very easily in comfortable manner by issuing claims against it and granting the loans for the firm for 3 years. Bank may issue the claims with different maturity period. ‘This type of role of financial intermediaries is known as maturity intermediation. Maturity intermediation is the intermediation for matching the maturity of period of financial assets and liabilities. Thus, financial intermediaries play roles in providing the loans for desired period of deficit units and investing the funds as per the desired investment horizon, ‘These are two implications of maturity intermediation for financial markets. First, maturity intermediation provides investors more choices concerning, their investments and borrowers have more choices for the maturity of their debt obligation. Second, investors want higher interest rate for longer period investment than for short-term investment. This is because of the commitment of their funds for longer period. But financial institutions can provide borrowers the longer term loans at lower cost than individual investors. Financial institutions can raise the funds from successive deposits until the maturity of the long term loan. So, the second implication of maturity intermediation is the likely reduction in the costs of longer term borrowing. Reducing risk via diversification: Diversification is a process to transform more risky assets into less risky asset by investing in many more financial assets. Individual investors have a small amount of funds for investment. They cannot invest their in many securities and diversify the risk in investment. So, it is almost impossible for small investor to diversify and reduce the risk. But, for financial institutions, itis easy to reduce risk via diversification. Take an example of investors who invest their money in the stock of investment companies. An investment company invests the funds received in the stock from large number of individual investors in the securities of a large number of companies. Thus, they reduce the risk via diversification, Individual investors with small amount of saving can achieve the same by investing in investment this is the second basic function of intermediaries. For individual intial large amount of funds for investment is possible to vidual companies. So, investors with substai reduce the tisk via diversification. But this is not cost effective for indi investors as for financial institutions. Cost of contracting and information processing: Investor needs the skill o evaluate an investment. It takes more time to develop the required skill Developing the skill required for evaluation Of an investment has high opportunity costs. And after acquiring the skill for evaluation, investors have to apply to evaluate the specific financial assets that are candidates for purchase or subsequent sales, Investors who want to lend the money need to draw up the Joan contract, They have to hire lawyer to write the loan contract.12 INVESTMENT ANALYSIS: - i issuers and financial, assets boy, Investors need information about the ues a an Ob There is high indi i s. We call all th i ment decision for individual investors. all these rs costs. We have to pay fee for lawyer for writing the loan, agreement and making the contract with the borrowers in the case of loan. In addition to the cost for lawyer, investors have to incur the costs for enforcing the terms of the contract. All these costs are called contracting costs. Financial intermediaries have professional staff to evaluate the target financial securities and evaluate the financial condition of borrowers. They have the professional staff to obtain and process the information on specific securities and loan applicants. They process information at large scale and gain the benefits of economies of scale. In the case of loan agreement, financial intermediaries have their own legal department and set format for loan contract. And investment Professional monitor the terms of the loan agreement. So, they can gain the benefits of the economies of scale and professional staff and reduce the contracting costs. Thus, intermediaries have a key role in reducing the information processing and contracting costs. Providing payment mechanism: Payment mechanism is the method of making PAYwenTuecHansn Payments. We always do not make payment in cash. In developed financial ‘Tremethodotmating system, Payments in cash are not often made. We make payments using checks, fomeineahacrernny. credit cards, debit cards and electronic transfer of funds. These methods of Payments are cheap and safe. Financial intermediaries provide the mechanism for these methods of payment. In an under developed financial markets, these modern methods of payment such as debit card, credit card and electronic transfer are hardly used. Even checks are not easily accepted for payments in the markels where payment mechanism is not well developed. We can take the example of our market. In ‘most of the shops and shopping point, we cannot use the credit cards, debit cards and other electronic funds transfer methods. But financial intermedi iaries should have the key role in introduc cing the innovative mechanism of payment, Ethical Issues in InvestingETHICAL INVESTMENT Thetoganon of personal — ‘vas, soil consi ‘and econo actors ie Investment isin THE INVESTMENT ENVIRONMENT chapters 13 Ethical investment or socially responsible investment is broadly defined as “the integration of personal values, social considerations and economic factors into the investment decision. Financial return remains an important outcome but itis not the sole criterion driving investments; ethical concerns are also included” (Michelson, G., et al). It is said “There is nothing wrong with making money but it’s how you make the money that counts” (Murray, 1). ‘There are two major ways of establishing whether an investment is ethical. The first is to apply a negative screen (a “never if* case) whereby certain businesses are avoided, because they are injurious to human health, For example, investing in firms producing or dealing with alcohol, tobacco and gambling are avoided. The second way is to apply a positive screen (an “only if" case) to those firms that remain possible investment targets; in particular, those identified as engaging in socially responsible practices are scen as more attractive investment options. What should we do to restrain from unethical practices and promote ethical behavior in investing? We may suggest a long list of prescriptions such as appropriate legal and institutions sct ups, enforcement of the rule of law and adherence to the principles of good governance, etc, All these are useful, but ‘most importantly our firm commitment on our ethical values - uprightness and compassion is the fundamental. Once these values guide our investment decisions we may restrain from unethical practices and promote ethical ones. Nepalese Investment Environment Securities SECURITIES Francia assos hal represent aims on he Jncamo and asses ol an nty. Investment environment refers to the surroundings in which investment decisions are made. Then what constitutes the investment environment? A broad framework useful for understanding investment environment consists of securities, securities markets and securities regulations, They are described below. Securities are financial assets that represent claims on the income and assets of an entity. Nepal has brief history of securities. The history of securities markets began with the floatation of shares of Biratnagar Jute Mills and Nepal Bank in 1937. Government bonds were issued for the first time in 1964. There are limited types of securities available in Nepal. Common stock is the most popular one. Government bonds have been issued in sizable amount but their trading is low. Only a few preferred stocks and corporate bonds are in the market; and municipal securities are yet to come. Mutual funds units are becoming popular in recent times. Treasury bill is the only security available for investment among, the short-term securities. ‘Thus the investment environment, in terms of sccurities, is characterized by limited types of securities and the investors will have to make a choice out of them.14 INVESTMENT ANALYSIS Securities Markets ‘SECURITIES MARKETS Matos a dal win vadng ‘ol socutites or ancl sss, Securities markets refer to the markets that deal with trading, of securities g financial assets. Though the first issue of securities was made in 1937, the ofc forum for securities trading started with the establishment of Securities Marketing Center (later changed to Securities Exchange Center) only in 197 ‘The establishment of Nepal Stock Exchange in 1993 replaced this Center. Nepal Stock Exchange which started trading in 1994, now in 2016, provides trading platform for the securities of 241 listed companies. It stared with open-out-cry system of trading and itis yet to be fully automated. The trading follows ord driven system and is facilitated by 50 brokers. Unlike in many exchanges in the world, fee for trading is still in fixed percentage basis and it may take as high as Uhre days to clear the transaction. The size of the market in terms of number of traders and volume of trading is still small as compared to that of the developed markets, but it is growing gradually. The trading is dominated by common stocks. The trade of other securities (preferred stocks, government bonds, corporate bonds, and mutual fund units) is very thin, Mostly individual investors trade in securities; the participation of institutional investors is rare, Foreign investors (except the institutional investors) are not allowed to trade in securities in this exchange. Information dissemination is weak and tampered. Most investors rely on technical analysis and very few investors analyze fundamentals of the company or the economy for investing, ‘The dealer market is limited to government securities only. The over-the-counter (OTC) market is run by Nepal Stock Exchange, but it is still in infantile stage ‘The establishment of Securities Central Depository Service Company (CDS and Clearing Company) and Credit Rating Agency (ICRA Nepal) has contributed in the smooth trading of sccurities in Nepal. The investors will have to take investment decisions given this backdrop of securities markets related investment environment. Securities Markets Regulation In a process of developing securities markets, the then Nepal Government established Securities Exchange Centre in 1976 followed by enactment of Nepal Securities Act in 1984. ‘The Act also had a provision of establishing a security market regulator ~ Nepal Securities Board. Thus, the three essential components of ‘securities markets - the market platform—Nepal Stock Exchange, the regulation— the Securities Act, and the regulator - Nepal Securities Board, are all in place. The Securities Act, 1984 was replaced by Securities Act, 2007. A number of other regulations like Securities Board Regulation, 2007; Securitis Businessperson Regulation, 2007; Securities Registration and Issues Regulation, 2008; Mutual Fund Regulation, 2010; Securities’ Central Depositary Services Regulation, 2010; Credit Rating Regulation, 2011; and many byelaws, guidelines and circulars have been put in place. The establishment of Nepal Securities Board and various regulations have definitely put the market in order. Hiowevet there are complains on the effective implementation ofthe legal provisions an! Supervision by the regulator. There are cases of trading on insider’s information and violation of investor's riohteTHE INVESTMENT ENVIRONMENT chapters 15 @ Summary TTT » _ Investment is commitment of funds to one or more assets in thé ic i n 1¢ expectation of generating more funds in the future, We invest to grow our wealth, It happens when our investment brings positive return. «Return is the reward for investing, It may com ‘ the form of current income or in the form of increased value of the asset or capital gain, ‘+ Real assets are mostly tangible and they possess i ity. T productive capacity, They are used to produce goods and services. The examples of eal assets are property, plant and equipment, human capital, et. . Financial assets represent claims ‘on income and other assets and define the allocation of income or Nees The cxamples of financial assels are shares of stocks, bonds, Treasury securities, etc, + Derivative securities are those securities whose value depends on the value of underlying ase. ‘+ Financial assets and financial markets serve by providing information, assist in consumption timing, allocate risk, and assist in separation of ownership and management. ‘+ The:investment process involves two steps ~ assets allocation and security selection. + The financial markets play key role in adjusting prices of securities and establish a relationship between risk and return. + Efficient market is a market condition in which security price reflects all possible information quickly and accurately. It means all available information affecting security prices are processed quickly and efficiently such that the security price is fair. © There are three major players in the financial markets - houscholds, firms and the government. Households are net savers hence they supply funds to firms and the government by buying their securities and earn income on their funds. Firms are net borrowers. They raise fund by issuing securities and invest in productive asscls. © Between the ultimate borrowers (e.g. firms) and the ultimate lenders (e.g. houscholds) lie other important players in the economy such as financial intermediaries, investment companies, investment bankers, venture capital and private equity. * Ethics refer to moral principles that control or influence a person's behavior. + Ethical investment or socially responsible investment is broadly defined as the integration of personal values, social considerations and economic factors into the investment decision. ynment refers to the surroundings in which investment decisions are made. A broad , Securities markets © Investment em framework useful for understanding investment environment can be: securit and securities regulations. «The history of securities markets in Nepal began with the floatation of shares of Biratnagar Jute Mills and Nepal Bank in 1937. Government bonds were issued for the first time in 1964. There are limited types of securities available in Nepal. Common stock is the most popular one. Only a few preferred slocks and corporate bonds are in the market; and municipal securities are yet to come. Mutual funds units are becoming popular in recent times. Treasury bill is the only security available for investment among the short-term securities. +The official forum for securities trading started with the establishment of Securities Marketing Center only in 1976. The establishment of Nepal Stock Exchange in 1998 replaced this Center. Nepal Stock Exchange which started trading in 1994, now in 2016, provides trading platform for the securities of 241 listed companies. + The dealer market is limited to government securities only. The over-the-counter (OTC) market is run by Nepal Stock Exchange, but itis still in infantile stage. «Nepalese securities markets are regulated by Nepal Securities Act 2007. A number of other regulations like Securities Board Regulation, 2007; Securities Businessperson Regulation, 2007; Securities Registration and Issues Regulation, 2008; Mutual Fund Regulation, 2010; Securities’ Cental Depositary Services Regulation, 2010; Credit Rating Regulation, 2011; and many byelaws, guidelines and circulars have been put in place.‘16 INVESTMENT ANALYSIS i Review Questions jowl rrue” or “False” answers with reason, Indicate whether the following statements are “True” or “False”. Support your son id services. 1. Financial assets are tangible properties and they are used to produce goods and servic 2 Speculation and gambling are also a form of investing, A3, Debt securities are useful to investors with low risk appetite. . Aa Dative securities are those securities whose value depends on the value of underlying assets, “5. _ Risk-returm tradeoff is the relationship between risk and return, ; & Iman efficent market, all available information is processed quickly, therefore, there is better chang, of eaming high profit. 7, Biratnagar Jute Mills issued shares for the first time in Nepal in 1964. - 8. Nepal Stock Exchange started trading of securities since 1976, : 9. Securities Registration and Issues Regulation is the primary legislation to regulate securities marke in Nepal. A 10. Nepal Securities Board is the apex body to regulate securities markets in Nepal. HB Questions 1. - Whatiis investment? Is saving an investment? 2 Define financial assets and how they can be classified? 5: What role do financial markets play in an economy? Discuss. 4. Describe investment process with suitable examples. 5. What do you mean by efficient markets? What kind of investment strategy is suitable when the marketis efficient? Why? 6 Identify the major players in the financial markets and briefly describe their functions. 7 There is nothing wrong with making money but i's how you make the money that counts", ‘Comment on the statement, 8. Describe the investment environment in Nepal. 9. How are Nepalese securities markets regulated? @ Case Analysis Mr. Ram Sharma and Mrs. Sita Sh ma, @ married couple, both have been engaged in a privae . They have two children - a son anda their own retirement life, financial markets. However, they are not sure that which investment funding needs, Suppose, Sharma are seekin, 1 ynent Purpose and need. Therefore, you are required to cen 1 2) 1G Your advise with regard to thei : sel them in the following matter. What spteps in investment process do you suggest to Mr. and Mrs. Sharma? What do you recommend about the investment objecti Should pursue? ‘estment objective that Mr. and Mrs. Sharma s! 3. What kind of investment alternative . | eotu and Mrs. Sharma? Give reason, Y°S 2” Be sitabe fo sats the investment objective of +e