Elective 4: Chapter 1
Investment is the commitment of funds for a period of time
with the expectation of receiving more than the current outlay.
The returns could be in the form of annual income and/or
appreciation in price. Many readers would already have studied
investment analysis from the perspective of the firm. In this
chapter, we will examine financial decisions from the
perspective of persons investing in corporate securities and
other assets. These could be individuals, societies and trusts,
mutual funds etc.
Why Invest?
While the reasons for investing are unique to each
individual, common reasons could be to have money for
emergencies, to beat inflation, buy a car or house, pay for
education, indulge in travel and hobbies, to give to children or
charity and for retirement. It is important for each investor to
have a financial plan in order to achieve these goals.
Various types of assets are available for investment such as
land, buildings, fixed deposits, shares, bonds, gold etc. As
investors, we need to understand the implications of investing
in various assets, and the associated risks and returns. Most
investors hold a combination of assets, known as a portfolio.
Since, a portfolio may have different risk and return
characteristics as compared to the simple aggregation of its
component assets, we also need to analyze the risk/return
characteristics of portfolios and select portfolios suited to
individual risk and return preferences. As individual needs and
the risk and return of the portfolio change over time, the
selected portfolio needs to be reviewed periodically and
revised if necessary.
Types of Assets
Assets can be broadly classified into tangible assets,
financial assets, and intangible assets. Tangible assets consist of
real/physical assets such as buildings, land, precious metals,
commodities and luxury or collector's items. Financial
assets/paper assets represent a claim on physical assets or
future cash flows. They include savings deposits, fixed deposits,
cash back insurance policies, shares, bonds, and derivative
instruments. Intangible assets include patents, trademarks,
goodwill etc. Some assets such as collector's items may have
more sentimental value than financial value. In this chapter, we
will be concentrating on financial assets, although majority of
the concepts and techniques can also be applied to real assets.
Financial assets can be further divided into debt and
equity, based on the timing and nature of expected cash flows.
Debt is a fixed period loan, which comprises of periodic or
cumulative interest payments and return of the principal on
maturity. Equity, on the other hand, represents ownership of a
company, where returns are received in the form of dividends
and capital appreciation. Over the years, a variety of financial
instruments have evolved in response to the needs of
borrowers and investors.
Financial assets can be held in the form of personal
contracts or in the form of securities. In personal contracts, the
amount of money invested, rate of interest and period of
deposit etc. are based on mutually agreeable terms between
the borrower and the lender. For example, the bank announces
interest rates applicable for various periods and amounts
invested, while the investor decides the amount of money and
time period for his deposit. The principal is paid back on
maturity or on premature withdrawal with a penalty. Such
deposits normally cannot be sold or transferred to a third party.
Securities on the other hand, are issued in fixed denominations
and are fungible (each unit is indistinguishable from the other)
and tradable. Examples of securities include shares and bonds.
Tangible Assets
1. Real Estate: Can be viewed as an investment that provides
regular income in the form of rental and appreciation in
value.
2. Gold: Gold is a very liquid asset that has been traditionally
held by central banks all over the world. The disadvantage
of investment in gold is that it requires expenditure for safe
storage and its purity can only be guaranteed if purchased
and stored in the form of certified bars. Investors can
invest in gold exchange traded funds to overcome these
disadvantages.
Art: Appreciation is value depends on the painter and
future demand and supply for the paintings. The market is
unorganized and there is the problem of fakes, for which
proper documentation and authentication is necessary.
3. Financial Assets – Personal Contracts: Savings bank
accounts offer a safe deposit facility for cash and a nominal
interest rate, with facilities for instant withdrawal and
transfer. Fixed deposits in banks offer a higher rate of
interest. However, the funds are locked in for a fixed period
of time and there is a penalty for premature withdrawals.
There are also some flexible plans, which combine the
features of savings and fixed deposit accounts.
4. Tax Saving Instruments:
o Public provident fund: Contributions to the fund
qualify for deduction from income up to the
permissible limit and interest and withdrawals are tax
free. The disadvantage is the lock in period of 15 years,
with limits on loans and withdrawals before maturity.
o Pension plans: These are annuity schemes where
contributions qualify for deduction in the years when
payments are made but the interest and principal are
taxable at the time of withdrawal (pension payments).
o Insurance: Some life insurance plans build in an
investment component, which offer periodic and/ or
terminal cash benefits. The returns can be compared
with other investments if the payment for pure
insurance is deducted from the annual premium
before calculating returns.
5. Financial Assets – Securities:
o Debt Securities: Bonds and debentures are debt
securities like loans that offer a predetermined rate of
interest for a fixed period. Central government bonds
will usually offer the lowest interest among all debt
securities as they are risk-free and need to
 compensate the lender only for the time and the There could be fluctuation in expected returns in the form of
inflation. delayed or rescheduled payments or not-payments. The
estimation of risk and return is, therefore, a very important part
State government bonds and municipal bonds would of investments analysis. Realized return can also be higher than
incorporate some premium for risk and offer slightly expected return if there are unexpected favorable events that
higher interest rate. Although the probability of result in increased annual payments such as dividends or prices
default in any government backed bonds is very low, of assets owned.
there is lower liquidity in these bonds. Corporate
There are various theories and models that attempt to
bonds should normally offer higher returns than all the
explain the complex dynamics of risk and return. The Efficient
other bonds to compensate for the risk associated
Market Hypothesis (EMH) basically asserts that it is not possible
with the issuer of the bond. The interest will be based
to consistently outperform the market by using historical
upon the credit rating of the issue, the lower the rating
prices, fundamental analysis or even insider information. The
the higher the risk premium. In the corporate bonds,
Capital Asset Pricing Model (CAPM) and the competing
the public sector bonds are perceived to be safer than
Arbitrage Pricing Theory (APT) describe how assets should be
private sector bonds because of the implicit backing of
priced relative to risk. We study these theories and their
the government.
implications and see whether they are applicable in the Indian
context. The prices of certain assets such as stocks,
Equity shares represent partial ownership in a
commodities and precious metals fluctuate every day. The
company. Returns are earned in the form of dividends
same asset would give higher profit if purchases could be timed
and appreciation in the value of shares. The equity
to buy when prices are low and sell when prices are high.
holders have a residual claim on the earnings and
Technical analysis claims that a study of past prices and
assets of the company; interest and preference
volumes can help forecast future price movements. Though this
dividend are paid before equity dividends and in case
is contradictory to the efficient market hypothesis, these
the company is liquidated, all other claimants are paid
techniques have become very popular and are reported in
first. Because of this, the returns on equity are
leading economic dailies and finance sites.
normally higher than interest on corporate bonds and
preference shares. Preference shares combine some
of the features of debt and equity. They normally have
no maturity date, and represent ownership in the
company like equity shares, but do not have voting
rights. They have a fixed dividend payable every year
just like interest payments on debt. Normally, dividend
is cumulative, i.e., gets added to the amount payable
in subsequent periods if not paid when due. The
shareholders get voting rights if dividend is not paid
consecutively for three years. Redeemable preference
shares are more like debt as the principal amount is
repaid at the end of a fixed period.

Derivatives are financial instruments that derive their

value from underlying assets. The underlying asset can
be real assets, financial assets, stock market indices,
exchange rates etc. Derivatives include futures,
options, warrants, convertible bonds, mortgage
derivatives and securitized assets.

Return and Risk

Investors sacrifice current consumption in order to be able

to consume more in the future. The required rate of return
therefore depends on the time for which funds are locked up,
the expected rate of inflation during that period and risk
involved. The real risk-free rate of return can be considered as
the compensation for time. Since inflation erodes the future
purchasing power of money, the return has to be higher to
account for expected inflation. Investors are also concerned
with the safety of their returns, so more risky investments have
to offer higher returns to attract investors.

The expected return on any asset depends on the initial

outlay and timing of expected cash flows. For debt, the
calculation is relatively simple as cash flows are known and
fixed in advance. For equity, we need to project future expected
cash flows i.e., expected dividends and projected stock price.
For both debt and equity, there is a risk that expected return.