L1: INVESTMENT

SETTING
Objectives: 1
• What is an investment?

• Types of Investments (Traditional vs Alternative)

• Historical versus Future Return and Risk Measurement

• Arithmetic Mean versus Geometric Mean

M.Mukwena
WHY DO INDIVIDUALS
INVEST ?

There are 2 choices with

your earnings:
Save & tradeoff present
consumption for a larger
future consumption
Riskier option of investments
M.Mukwena 2
DEFINING AN INVESTMENT

Current commitment of money for a

period of time in order to derive future
payments that will compensate for:

the time the funds are committed

the expected rate of inflation
uncertainty of future flow of funds.

These three make up required rate of return

M.Mukwena 3
INVESTMENT CHOICES:
BONDS
Issued by:
 Corporate
 Municipal Council (finance infrastructural
projects)
 Government (Treasury bonds)
 Depending on maturity:

 Bills matures in less than 1 year

 Notes mature in 1 - 10 years
 Bonds mature in over 10 years
 Mortgage-backed bonds:
 Prime
 Subprime
M.Mukwena 4
INVESTMENT CHOICES

EQUITY:
• Fixed income obligations that trade in secondary market

• Prior to 1990s reform financial market was strictly

regulated. The liberalisation that followed opened up the
local market
• Enactment of Securities Act saw establishment of LuSE in
1994 now has 30 listed companies
• BaDex established in 2011 for bond and derivatives
exchange
M.Mukwena 5
INVESTMENT CHOICES:
ALTERNATIVE INVESTMENTS
An alternative investment is any
investment that doesn’t fall in the
realm “traditional” securities such
as stocks, bonds or mutual funds
These investments are worth
consideration if you want to
diversify your portfolio and
achieve higher returns
M.Mukwena 6
WHAT ARE THE OBJECTIVES OF ALTERNATIVE IN
VESTMENTS?

Increased
Diversification
Lower Correlations
Lower Portfolio
Volatility
Portfolio Performance
M.Mukwena 7
WHAT ARE THE RISKS OF
ALTERNATIVE IN VESTMENTS?
Lack of Regulation
Lack of Transparency
Inappropriate Use of
Leverage
Fraud
Manager Selection Risk

M.Mukwena 8
TRADITIONAL VS
ALTERNATIVE
Traditional Alternative
Performance dependent Performance dependent
primarily on market returns primarily on advisor skill

Historically high correlation with Historically low to moderate

market indices correlation with market indices

Typically offers daily liquidity Typically have reduced liquidity

ranging from monthly to 12+
year lock-ups

Fixed management fee on Generally higher fees which

assets may include performance fees
under management

M.Mukwena 9
TYPES OF ALTERNATIVE
INVESTMENT
Crypto-Currencies
 Digital or virtual currency created as a peer-to-peer
payment system. Code was created in 2009 by
developer Satoshi Nakamoto.
 Bitcoins are created as a reward for payment
processing work in which users who offer their
computing power. Called mining, individuals
engage in this activity in exchange for transaction
fees and newly minted bitcoins.
 Besides mining, bitcoins can be obtained in
exchange for other currencies, products, and
services. Users can buy, send, and receive bitcoins
electronically for a nominal fee using wallet
software on a personal computer, mobile device, 10
M.Mukwena

or a web application.
TYPES OF ALTERNATIVE
INVESTMENT
Crowdfunding
 funding through a large pool of backers—the "crowd"—usually
online through a web platform.
 4 types
 Donation-based in which the backers essentially donate
money to support a cause.
 Reward-based in which the backer receives a reward with a
clear monetary value in exchange of the pledge. The reward
is often a product or a pre-series item that the backer
helped producing by pledging money.
 Credit-based in which the backer lends the money and
receives an interest rate in exchange.
 Equity-based in which the backer receives shares of a
company in exchange of the money pledged. In this case the
money is pledged in the form of risk capital.
M.Mukwena 11
TYPES OF ALTERNATIVE INVESTMENT

Business Development Companies (BDCs)

 Regulated, closed-end investment firms that make
loans to, and/or invest in small, developing, or
financially troubled companies. They’ve stepped
into a role than commercial banks vacated during
the financial crisis, lending to companies that may
not otherwise get financing.
 BDCs are very similar to venture capital funds, but
can be sold to retail investors. Many BDCs are set
up much like closed-end investment funds and are
actually public companies that are listed on the
NYSE, AMEX and Nasdaq.

M.Mukwena 12
TYPES OF ALTERNATIVE
INVESTMENT
Regulation A+
 A new exemption from the registration
requirements of the Securities Act of 1933
that would permit nonpublic companies to
conduct securities offerings of up to $50
million in any rolling 12-month period.
 Passed as part of the JOBS Act and is
designed to provide greater access to small
businesses by creating a bridge from private
placements to public offerings.

M.Mukwena 13
GIVEN THE CHOICE BETWEEN 2
INVESTMENTS WHICH ONE WOULD
YOU PICK?
Investment A Investment B
Yr1 Yr2 Yr3 Yr1 Yr2

K150 K250 K250 K350

M.Mukwena 14
HPR & HPY

Holding Period Return:

 

HPR =

Holding Period Yield:

HPY = HPR -1

M.Mukwena 15
MEASURES OF
HISTORICAL RATES OF
RETURN
Investment cost K250 and is worth
 

K350 after 2 years holding period.

HPR= = 1.40 Note this is for 2
years
Annual HPR= = 1.1832
Annual HPY = Annual HPR-1=
1.1832-1=0.1832

M.Mukwena 16
EXPECTED RETURN AND
VARIANCE
 
Expected Standard
Return Deviation
N (years, Σ
months or
days)
Probabilities ΣPR
Probabilities ΣPR

M.Mukwena 17
MEASURING PAST RISK

K100 K105 K117.6 K104.664

Step 1: Find HPR for each year

Step 2: Find past return
Step 3: Find risk

M.Mukwena 18
MEASURES OF FUTURE
RETURN

 (Probability of Return)  (Possible Return)

i 1

=0.2(5) +0.6(15) +0.2(25)

M.Mukwena 19
MEASURING FUTURE
RISK
 

=0.2 +0.6+0.2
=20+0+20
=40 = variance
Standard deviation = 6.3246

M.Mukwena 20
AM VS GM
Arithmetic Mean:

AM   HPY/ n
where :

 HPY  the sum of annual

holding period yields

M.Mukwena 21
AM VS GM
Geometric Mean:

GM   HPR  1
n 1

  the product of
annual HPR

M.Mukwena 22
AM VS GM
 

AM= =0.05

GM= -1= 0.03353

M.Mukwena 23
EXPECTED RETURN AND
VARIANCE
 
Expected Standard
Return Deviation
N (years, Σ
months or
days)
Probabilities ΣPR
Probabilities ΣPR

M.Mukwena 24
COEFFICIENT OF VARIATION

Measure of relative variability

that indicates risk per unit of
return
i

CV E(R)

M.Mukwena 25
COEFFICIENT OF VARIATION

Investment Investment
A B
Expected 7% 12%
Return
Standard 5% 7%
Deviation

M.Mukwena 26
COEFFICIENT OF VARIATION
Investment A Investment B
Expected Return 7% 12%
Standard 5% 7%
Deviation

Coefficient of 5/7 = 0.714 7/12 = 0.583

Variation

B has less risk per

unit and is
therefore better
investment

M.Mukwena 27
END OF TOPIC QUESTIONS
A stock costing K100 pays K5 dividend with every
possible outcome. The possible outcomes that the
stock might sell for at year-end and the probability of
each are:
A. What is the expected return on the stock?
B. What is the standard deviation of the expected
return?
Year End Price (K) Probability
90 0.1
95 0.2
100 0.4
110 0.2
115 0.1
M.Mukwena 28
   End-of-Year Price (K) Annual Total
Year Dividends (K) Return (%)

END OF TOPIC QS 2000

2001
2002
K65.00
K72.00
K67.00
K1.20
K1.50
K1.50
—
13.07%
–4.86%
2003 K70.00 K1.60 6.87%
2004 K72.50 K1.60 5.86%

A. Calculate the arithmetic mean return over 2000 to 2004.

B. Calculate the geometric mean return over 2000 to 2004.

C. What is the dividend yield earned by an investor who purchases

the stock at the end of 2000 and holds it till the end of 2001?

D. Using you answer in part A, calculate the standard deviation of

over the holding period 2000 to 2004.

E. Calculate the coefficient of variation and interpret your results.

M.Mukwena 29
PAST PAPER QUESTIONS
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M.Mukwena
 MID DEC 2015: MCQ (1, 2, 3, 4, 5, 6, 7)
 MID DEC 2016: MCQ (1)
 MID DEC 2017 :MCQ (10), SECTION B
(4)
 MID DEC 2018: Q3A
 MID DEC 2019: MCQ (1, 2, 7, 8),
SECTION B(Q2C, Q3C)
 MID JUNE 2014: MCQ (4)
 MID JUNE 2015: MCQ (1,2, 16, 18)
 MID JUNE 2016: Q3A&B
 MID JUNE 2017: MCQ (4), SECTION B
(Q1)
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