CHAPTER THREE

OVERVIEW OF INVESTMENT
 Chapter Outline
• Investment in general
• Investment Decision Process: Important Considerations
• Investment Alternatives: Money market, fixed income,
equity, and derivative
• Indirect investment through different types of investment
companies
• Return and risks from investment
• Asset Pricing Models Analysis
 Investment in General

• Investment according to Theoretical Economics

– Investment means the production of capital goods – goods
which are not consumed but instead used in future
production.
• Examples include building, a rail road, a factory
clearing land, putting oneself through college
• Investment according to Finance Term
– Investment means buying of Assets.
• For Examples: buying stocks and bonds, investing in real estate,
mortgages these investments may then provide a future
income and increase in value (i.e., investing in real estate).
 Cont...

• An investment is the current commitment of dollars

for a period of time in order to derive future payments
that will compensate the investor for
– the time the funds are committed,
– the expected rate of inflation, and
– the uncertainty of the future payments.
• Funds to be invested come from assets already owned,
borrowed money and savings.
• By foregoing consumption today and investing their
savings, investors expect to enhance their future
consumption possibilities by increasing their wealth.
Cont...

• Investors can be:

– Individual investors; who are investing on their own.
– Institutional investors - entities such as governments,
investment companies, commercial banks, insurance
companies, pension funds and other financial institutions.
• It is useful to make a distinction between real and
financial investments
• Real investments generally involve some kind of tangible
asset
• Financial investments involve contracts in paper or
electronic form such as stocks, bonds, etc
Cont...
 Investment Process: Important
Considerations
• is the process of managing
money or funds.
• describes how an investor
should go about making
decisions.
• There is of course no unique
“correct” investment
process. However, some
approaches are better than
others
• The investment process can
involve four stages
Stage I: Investment Policy
• Investment policy is the first stage of the investment
process.
• It determines the following aspects of the investor:
– Determination of Investable Wealth
– Determination of Portfolio Objectives
– Identification of Potential Investment Assets
– Consideration of Attributes of Investment Assets
– Allocation of Wealth to Asset Categories.
Stage II: Investment Analysis
• Investor analysis of the investment is made on the following
grounds:
– Equity Stock Analysis
– Screening of Industries
– Analysis of Industries
– Quantitative Analysis of Stocks
– Analysis of the Economy
– Debentures and Bond Analysis
– Analysis of Yield Structure
– Consideration of Debentures
– Quantitative Analysis of Debentures
– Other Asset Analysis
– Qualitative Analysis
– Quantitative Analysis
Stage IV: Valuation of Securities
• This stage involves:
– Valuation of Stocks
– Valuation of Debentures and Bonds
– Valuation of Other Assets
Stage IV: Valuation of Securities
• It involves:
– Determination of Diversification Level
– Consideration of Investment Timing
– Selection of Investment Assets
– Allocation of Investable Wealth to Investment Assets
– Evaluation of Portfolio for Feedback
 Investment Alternatives: Money market, fixed
income, equity and derivative
• Investment avenues are the outlets of funds.
• A bewildering range of investment alternatives are
available, they fall into two broad categories, viz,
financial assets and real assets.
• The main types of financial investment vehicles are:
– Short term investment vehicles; Money market
– Fixed-income securities;
– Common stock; equity
– Speculative investment vehicles; derivative
– Other investment tools.
I. Short term investment vehicles; Money market

• are all those which have a maturity of one year or

less.
• Short term investment vehicles often are defined as
money-market instruments,
– because they are traded in the money market which
presents the financial market for short term (up to
one year of maturity) marketable financial assets.
– The risk as well as the return on investments of short-
term investment vehicles usually is lower than other
types of investments.
– Short term, highly liquid, low risk
Major Components of the Money Market

 Treasury bills;
 Certificates of deposit;
 Commercial paper;
 Bankers’ acceptances;
 Eurodollars;
 Repurchase and Reverses agreements;
 Fed Funds.
Major Components of the Money Market

 Treasury bills:
 Maturities in weeks (4, 13, 26, 52)
 Tax-free
 Bid and asked price
 Bank discount method:

 Certificates of Deposit (CDs): Time deposit with a

bank
 Commercial Paper: Short-term (<270 days),
unsecured debt of a company
Major Components of the Money Market

 Bankers’ Acceptances: An order to a bank by a

customer to pay x money on a future date (think of
a postdated check)
 Eurodollars: dollar-denominated time deposits in
banks outside the U.S. (not just Europe)
 Repos and Reverses: Short-term loan backed by
government securities (and more).
 Fed Funds: Very short-term loans between banks.
Paid often on cash collateral
Major Components of the Money Market

 Bankers’ Acceptances: An order to a bank by a

customer to pay x money on a future date (think of
a postdated check)
 Eurodollars: dollar-denominated time deposits in
banks outside the U.S. (not just Europe)
 Repos and Reverses: Short-term loan backed by
government securities (and more).
 Fed Funds: Very short-term loans between banks.
Paid often on cash collateral
II. Fixed-income securities
 return is fixed, up to some redemption date or indefinitely.
 The fixed amounts may be stated in money terms or indexed to
some measure of the price level.
 This type of financial investments is presented by two different
groups of securities:
 Long-term debt securities
 Preferred stocks.
 Long-term debt securities can be described as long-term debt
instruments representing the issuer’s contractual obligation.
 have maturity longer than 1 year.
 The buyer (investor) of these securities is lending money to the
issuer, who undertake obligation periodically to pay
interest on this loan and repay the principal at a stated
maturity date.
II. Fixed-income securities
 are traded in the capital markets.
 From the investor’s point of view these securities
can be treated as a “safe” asset.
 But in reality the safety of investment in fixed –
income securities is strongly related with the default
risk of an issuer.
 The major representatives of long-term debt securities
are
 bonds, but today there are a big variety of different kinds of
bonds,
 which differ not only by the different issuers
(governments, municipals, companies, agencies, etc.), but by
different schemes of interest payments
Cont...

 Bond Market
 T-Notes (<10y) and T-Bonds (10-30y)
 Inflation-Protected T-Bonds (“TIPS”)
 Federal Agency Debt (“agencies”)
 International Bonds or Eurobonds
 Municipal Bonds (“munis”)
 Corporate Bonds (“corporates”)
 Mortgages and Mortgage-Backed Securities (“RMBS” vs.
“CMBS”)
Cont...

 Preferred stocks are equity security, which has

infinitive life and pay dividends.
 Fixed dividends (discretionary)
 Cumulative, priority over common
 Non-tax deductible for issuer
 But preferred stock is attributed to the type of
fixed-income securities, because the dividend for
preferred stock is fixed in amount and known in
advance.
 Though, this security provides for the investor the
flow of income very similar to that of the bond.
III. Equity or common stock

 Ownership interest on the issuer.

 Holders of common stock are entitled
 to attend and vote at a general meeting of
shareholders,
 to receive declared dividends and
 to receive their share of the residual assets, if any,
if the corporation is bankrupt.
IV. Derivatives/Speculative investment vehicles

 A derivative is a security that derives its value from the values

of another asset.
 with a high risk and high investment return.
 Using these investment vehicles speculators try to buy
low and to sell high, their primary concern is with
anticipating and profiting from the expected market
fluctuations.
 Speculative investment vehicles could be presented by these
different vehicles:
 Options;
 Futures;
 Commodities, traded on the exchange (coffee, grain metals,
other commodities);
 V. Other investment tools:

 Various types of investment funds; receive money from investors

with the common objective of pooling the funds and then
investing them in securities according to a stated set of
investment objectives. Two types of funds:
 open-end funds (mutual funds) ,
 closed-end funds (trusts).
 Investment life insurance;
 Pension funds;
 Hedge funds. A hedge fund is an aggressively managed portfolio
which takes positions on both safe and speculative opportunities.
 Hedge funds are unregulated private investment partnerships,
 limited to institutions and high-net-worth individuals, which seek to
exploit various market opportunities and thereby to earn larger
returns than are ordinarily available.
 Indirect Investment through different Types of
Investment Companies
 Investors can use direct or indirect type of investing.
 Direct investing is realized using financial markets
and
 indirect investing involves financial intermediaries.
 The primary difference between these two types of
investing is that applying direct investing
investors
 buy and sell financial assets and manage individual
investment portfolio themselves.
Cont...

 Consequently, investing directly through financial

markets investors take all the risk and
 their successful investing depends on
 their understanding of financial markets, its
fluctuations and
 on their abilities to analyze and to evaluate the
investments and to manage their investment portfolio.
Cont...
 Indirect type of investing
 Indirect investing can be undertaken by purchasing the shares of
an investment company.
 An investment company sells shares in itself to raise funds to
purchase a portfolio of securities.
 Indirect investing relieves investors from making decisions
about their portfolio.
 As shareholders with the ownership interest in the portfolios
managed by financial institutions (investment companies,
pension funds, insurance companies, commercial banks)
 the investors are entitled to their share of dividends,
interest and capital gains generated and
 pay their share of the institution’s expenses and portfolio
management fee.
Cont...

 The risk for investor using indirect investing is

related more with the credibility of chosen
institution and the professionalism of portfolio
managers.
 In general, indirect investing is more related
 with the financial institutions which are primarily in the
business of investing in and managing a portfolio of
securities (various types of investment funds or
investment companies, private pension funds).
 Risk and Return
 Trade- off exists between expected return and risk
 Return:
 Investors wish to earn a return on their money.
 The measure of reward that is used in investment
analysis.
 Income received on an investment plus any change in
market price, usually expressed as a percent of the
beginning market price of the investment.
 The increase in value over a given time period (called
the holding period) as a proportion of the initial value
 Risk and Return
 Rates of Return: Single Period

 Example:
Ending Price = 24
Beginning Price = 20
Dividend = 1
HPR = ( 24 - 20 + 1 )/ ( 20) = 25%
 Risk and Return
 Measuring Investment Returns: Multiple Periods
 May need to measure how a fund performed over a
preceding five-year period
 Return measurement is more ambiguous in this case

Bodie, Kane & Marcus (2003, p.133)

 Risk and Return
Arithmetic
ra = (r1 + r2 + r3 + ... rn) / n
ra = (.10 + .25 - .20 + .25) / 4
= .10 or 10%
Geometric
rg = {[(1+r1) x (1+r2) x .... x (1+rn)]} 1/n - 1
rg = {[(1.1) x (1.25) x (.8) x (1.25)]} 1/4 - 1
= (1.5150) 1/4 -1 = .0829 = 8.29%
 Risk and Return
Dollar Weighted Average

Internal Rate of Return (IRR) - the discount rate

that results in present value of the future cash flows
being equal to the investment amount
 Considers changes in investment
 Initial Investment is an outflow
 Ending value is considered as an inflow
 Additional investment is a negative flow
 Reduced investment is a positive flow
 Risk and Return
Dollar Weighted Average

Net CFs 1 2 3 4
$ (mil) - 0.1 -0 .5 0.8 1.0
 Quoting Conventions

APR = annual percentage rate

(periods in year) X (rate for period)
EAR = effective annual rate
( 1+ rate for period)Periods per yr - 1
Example: monthly return of 1%
APR = 1% X 12 = 12%
EAR = (1.01)12 - 1 = 12.68%
 Risk and Return
RISK AND RISK PREMIUMS
 Risk is explained theoretically as the fluctuation in returns
from a security.
 Risk is defined as the uncertainty about the actual return
that will earn on an investment.
 A security that yields consistent returns over a period of
time is termed as “risk-less security” or “risk-free security”.
 The standard measure of risk used in investment analysis is
the variance of return
 An investor cannot foresee the future definitely; hence, risk
will always exist for an investor.
 Investment risk can be an extraordinary stress for many
investors.
 Risk and Return
 An asset with a return that never changes has no risk.
 For this asset the variance of return is 0.
 Any asset with a return that does vary will have a variance
of return that is positive.
 The more risk is the return on an asset the larger is the
variance of return.
 When constructing a portfolio it is not just the risk on
individual assets that matters but also the way in which this
risk combines across assets to determine the portfolio
variance.
 Risk and Return
 The measure of the way returns are related across assets is
called the covariance of return. The covariance will be
seen to be central to understanding portfolio construction
 The covariance indicates the tendency of the returns on two
assets to move in the same direction (either up or down) or
in opposite directions.
 Cont’d
• Covariance can be used to maximize diversification
in a portfolio of assets. By adding assets with a
negative covariance to a portfolio, the overall risk is
reduced. This risk drops off, quickly at first, but
more slowly as additional assets are added. Formula
for population covariance:
 Portfolio Return and Risk
 By investing in many different stocks to form a portfolio,
we can lower the risk without lowering the expected return.
 A portfolio is a bundle or a combination of individual
assets or securities.
 The effect of lowering risk via appropriate portfolio
formulation is called diversification.
 By learning how to compute the expected return and risk on
a portfolio, we illustrate the effect of diversification
 Portfolio Return

 The return of a portfolio is equal to the weighted average

of the returns of individual assets (or securities) in the
portfolio with weights being equal to the proportion of
investment value in each asset.
Expected return on a portfolio
=weight of security x*expected return on security x+ weight
of security y*Expected return on security y
 Example: portfolio return
Consider the portfolio of three stocks described below.
Stock Holding Initial Price Final Price
A 100 2 3
B 200 3 2
C 150 1 2

The return on the portfolio is r =(100 × 3 + 200 × 2 + 150 × 2)

− (100 × 2 + 200 × 3 + 150 × 1)/100 × 2 + 200 × 3 + 150 × 1=
0.052 (5.2%).
Example on portfolio proportion

Consider the portfolio in Example above. The initial

value of the portfolio is 950 and the proportional
holdings are XA =200/950 , XB =600/950 , XC
=150/ 950
The returns on the stocks are : rA =(3 − 2)/2=1/2 , rB
=
(2 − 3)/3= −1/3 , rC =(2 − 1)/1= 1
The return on the portfolio is therefore: r =200/950
×1/2 +600/950 ×−1/3+150/950 × (1) = 0.052(5.2%).
 Example on covariance
The table provides the returns on three assets over a
three-year period. calculate covariance and variance?
Asset Year 1 Year 2 Year 3
A 10 12 11
B 10 14 12
C 12 6 9
 Cont.
The mean returns are rA = 11, rB = 12, rC = 9.
The covariance between A and B is
σAB =1/3[[10 − 11] [10 − 12] + [12 − 11] [14 − 12] + [11 − 11]
[12 − 12]] = 1.333,
while the covariance between A and C is
σAC =1/3[[10 − 11] [12 − 9] + [12 − 11] [6 − 9] + [11 − 11] [9
− 9]] = −2, and that between B and C
σBC =1/3[[10 − 12] [12 − 9] + [14 − 12] [6 − 9] + [12 − 12] [9
− 9]] = −4.
 Correlation Coefficient
 It is a standardized statistical measure of the linear
relationship between two variables.
 While covariance can show the direction between two assets, it
cannot be used to calculate the strength of the relationship
between the prices. Determining the correlation coefficient
between the assets is a better way to measure the strength of the
relationship.
 Correlation coefficient=covariance / standard deviation
 Its range is from -1.0 (perfect negative correlation), through
0 (no correlation), to +1.0 (perfect positive correlation).
 Portfolio Risk: Two-Asset Case
 The portfolio variance or standard deviation depends on the
co-movement of returns on two assets. Covariance of
returns on two assets measures their co-movement.
 The formula for calculating covariance of returns of the two
securities X and Y is as follows:
Covariance XY = Standard deviation X * Standard
deviation Y * Correlation XY
 The variance of two-security portfolio is given by the
following equation:
 Example

A portfolio is composed of 12 of asset A and 12 of asset B.

Asset A has a variance of 25 and asset B a variance of 16. The
covariance between the returns on the two assets is 10. The
correlation coefficient is
ρAB =10/ 5 × 4= 0.5, and the variance of return on the
portfolio is
σ2P =(1/2)2*25 +(1/2)2*16 + 2(1/2)*(1/2)0.5 × 5 × 4 = 20.25.
 Risk classification
Total Risk = Systematic Risk + Unsystematic Risk

 Systematic Risk is the variability of return on stocks

or portfolios associated with changes in return on the
market as a whole.
 Unsystematic Risk is the variability of return on stocks
or portfolios not explained by general market
movements. It is avoidable through diversification.
 Systematic sources of risk (such as inflation, war,
interest rates) are common to most investments
resulting in a perfect positive correlation and no
diversification benefit.
 Cont.
Systematic risk can not be eliminated through diversification, as a
result, no matter how many assets we put into a portfolio, the
systematic risk doesn’t go away. Thus, for obvious reasons, the terms
systematic risk and non-diversifiable risk are used interchangeably.
Systematic risk is measured by beta coefficient, which estimates the
extent to which a particular investment’s returns vary with the returns
on the market portfolio or it is the amount of systematic risk present in
a particular risky asset relative to that in an average risky asset.

 The beta of a portfolio measures the systematic risk of the portfolio

and is calculated by taking a simple weighted average of the betas for
the individual investments contained in the portfolio
 Cont.
 The unsystematic risk is the element of risk that does not contribute
to the risk of the market. This component is diversified away when the
investment is combined with other investments. For example: Product
recall, labor strike, change of management.
Unsystematic risk is essentially eliminated by diversification, so a
portfolio with many assets has almost no unsystematic risk.
The terms diversifiable risk and unsystematic risk are often used
interchangeably.

 An investment ’ s systematic risk is far more important than its

unsystematic risk.
 Security Market Line
It is a positively sloped straight line displaying
the relationship between expected return and
beta.

Rm
Rf
 Risk Premium
Risk premium is the difference between the return
on a risky investment and that on a risk-free
investment or it is the difference between the
expected return on a risky investment and the
certain return on a risk free investment.
 Capital Asset
Pricing Model (CAPM)

CAPM is a model that describes the relationship between

risk and expected (required) return; in this model, a
security’s expected (required) return is the risk-free rate
plus a premium based on the systematic risk of the security
or it is the equation of the SML showing the relationship
between expected return and beta
The key insight of CAPM is that investors will require a
higher rate of return on investments with higher betas. The
relation is given by the following linear equation:
Rj = Rf + bj(RM - Rf)
 Cont’d

Where,
Rj is the required rate of return for stock j,
Rf is the risk-free rate of return,
bj is the beta of stock j (measures
systematic risk of stock j),
RM is the expected return for the market
portfolio.
 Determination of the Required Rate of
Return

• ABC company is attempting to

determine the rate of return required
by their stock investors. ABC is using
a 6% Rf and a long-term market
expected rate of return of 10%. A
stock analyst following the firm has
calculated that the firm beta is 1.2.
What is the required rate of return on
the stock of ABC company?
 ABC Required Rate of Return

R = Rf + bj(RM - Rf)
R = 6% + 1.2(10% - 6%)
R = 10.8%
The required rate of return exceeds the
market rate of return as ABC’s beta exceeds
the market beta (1.0).
 Beta estimation
Direct Method—The ratio of covariance between
market return and the security’s return to the market
return variance:
 Example

Returns on NYSE index and ABC limited

Year Market return (rm) ABC (rj)

1 18.6% 23.46

2 -16.50 -36.13

3 63.83 52.64

4 -20.65 -7.29

5 -17.87 -12.95
 Cont.
Year rm rj (rm - ̄rm) (rj- ̄rj) (rm- ̄rm)2
(1) (2) (3) (4) 3*4

1 18.6% 23.46 13.11 19.51 255.91 171.98

2 -16.50 -36.13 -21.98 -40.08 880.83 483.08

3 63.83 52.64 58.35 48.69 2841.35 3404.85

4 -20.65 -7.29 -26.13 -11.24 293.64 682.96

5 -17.87 -12.95 -23.35 -16.90 394.57 545.35

̄rm=5.48 ̄rj=3.98 =4666.30 =5288.23

Cov m,j=4666.30/5=933.26
σ2m=5288.23/5=1057.65
βj=Cov m,j/σ2m=933.26/1057.65=0.88
 Portfolio Beta
In general, if we had a large number of assets in a portfolio, we
would multiply each asset’s beta by its portfolio weight and then
add the results to get the portfolio’s beta.
Suppose we had the following investments:
Example:
Security Amount Invested Expected Return Beta
Stock A $1,000 0 8% 0 .80
Stock B $ 2,000 12% 0.95
Stock C $ 3,000 15% 1.10
Stock D $ 4,000 18% 1.40
 Cont.
What is the expected return on this portfolio? What is the
beta of this portfolio? Does this portfolio have more or less
systematic risk than an average asset?
To answer, we first have to calculate the portfolio weights.
Notice that the total amount invested is $10,000. Of this,
$1,000/10,000 = 10% is invested in Stock A. Similarly, 20
percent is invested in Stock B, 30 percent is invested in
Stock C, and 40 percent is invested in Stock D. The
expected return, E(RP), is thus:
 Cont.
E(RP ) =.10 * E(RA) + .20 * E(RB ) + .30 *E(RC ) + .40 * E(RD)
E(RP ) =.10 * 8% +.20 * 12% + .30 *15% +.40 *18%= 14.9%
Similarly, the portfolio beta, βP, is:
βP = .10 * βA + .20 * βB + .30 *βC + .40 * βD
= .10 *.80 + .20 *.95 + .30 * 1.10 +.40 * 1.40
= 1.16
This portfolio thus has an expected return of 14.9 percent and a
beta of 1.16. Because the beta is larger than 1, this portfolio has
greater systematic risk than an average asset.
End of chapter three