Investment

Investment is an activity that is engaged in by people who have

savings, that is investments are made from savings. Other word People
invest their savings.
An investment is the current commitment of money for a period of time
in order to derive future payments that will compensate the investor for

(1) the time the funds are committed,

(2) the expected rate of inflation during this time period, and
(3) the uncertainty of the future payments.

The “investor” can be an individual, a government, a pension fund, or a

corporation.
• In the financial sense Investment is the commitment of a persons
funds to derive future income in the form of interest, dividend,
premiums, pensions benefits or appreciation in the value of their
capital.

Purchasing shares, debentures, saving certificate, insurance policy etc.

are the investment in financial sense which generate financial assets .
• In the economic sense Investment means the net additions to the
economy’s capital stock which consists of goods and services that
are used in the production of other goods and services.
New construction, Plant and machinery , Inventories etc. are
investment which generate physical assets.

.
• According to Donald E. Fischer & Ronald J.
Jordan “Investment may be defined as a commitment
of funds made in the expectation of some positive rate
of return”

• V. K. Bhalla “Investment is the sacrifice of certain

present value for the uncertain future reward”

• Bodie, Alex Kane & Alan J Marcus “ An investment is

the current commitment of money or other resources in
the expectation of repaying future benefits”
 Characteristics of investment
The common characteristics of Investment are :
• Return: Investments are made with the primary objectives of deriving a return.
Different types of investments promises different rate of return which depends
upon the nature of the investment, the maturity period and a host of other
factors.
• Risk: Risk is inherent in any investment. The risk may relate to loss of capital,
delay in repayment of capital, non-payment of interest, or variability of return.
The risk of investment depends upon the following factors:
1. The longer the maturity period, the larger is the risk.
2. The lower the credit worthiness of the borrower, the
higher is the risk.
3. The risk varies with the nature of investment.
Risk and return of an investment have a positive correlation which means higher is
the risk lead higher profit.
• Safety: The safety of an investment implies the certainty of
return of capital without loss of money or time.
• Liquidity: An investment which is easily saleable or
marketable without loss of money and without loss of time is
said to posses liquidity.
 Objectives of investment
Investors invest money to earn a return from savings due to their
deferred consumption. They want a rate of return that
compensates them for the time period of the investment, the
expected rate of inflation, and the uncertainty of the future cash
flows. The main objectives are as follows:
1. Maximization of return
2. Minimization of Risk.
3. Hedge against inflation
 Risk
• In the ordinary sense, the risk is the outcome of an
action taken or not taken, in a particular situation which
may result in loss or gain. It is termed as a chance or
loss or exposure to danger, arising out of internal or
external factors, that can be minimized through
preventive measures.

• In the financial glossary, the meaning of risk is not

much different. It implies the uncertainty regarding the
expected returns on the investments made i.e. the
probability of actual returns may not be equal to the
expected returns. Such a risk may include the probability
of losing the part or whole investment.
 Risk
Risk implies future uncertainty about deviation from expected
earnings or expected outcome. Risk measures the uncertainty that
an investor is willing to take to realize a gain from an investment.
Block and Hirt “ Risk may be defined in terms of the variability
of possible outcomes from a given investment.”
L. J. Gitman “ Risk is the financial loss or more formally , the
variability of returns associated with a given assets”
Risk Vs Uncertainty
In short, risk describes a situation, in which there is a chance of loss or
danger. Conversely, uncertainty refers to a condition where you are
not sure about the future outcomes.
Basis for
Risk Uncertainty
Comparison
Uncertainty implies a
The probability of winning or
situation where the
Meaning losing something worthy is
future events are not
known as risk.
known.
Ascertainment It can be measured It cannot be measured.
Chances of outcomes are The outcome is
Outcome
known. unknown.
Control Controllable Uncontrollable
Minimization Yes No
Probabilities Assigned Not assigned
 Elements of Risk
The two major components of risk systematic risk and
unsystematic risk, which when combined results in total risk.
The systematic risk is a result of external and uncontrollable
variables, which are not industry or security specific and affects
the entire market leading to the fluctuation in prices of all the
securities.
On the other hand, unsystematic risk refers to the risk which
emerges out of controlled and known variables, that are
industry or security specific.

• Total Risk= Systematic Risk+ Unsystematic Risk

• Systematic Risk: Interest Risk, Inflation Risk, Market Risk, etc.
• Unsystematic Risk: Business Risk and Financial Risk
 systematic risk
Systematic risk is the variation in the returns on securities, arising due to
macroeconomic factors of business such as social, political or economic
factors. Such fluctuations are related to the changes in the return of the
entire market. Systematic risk is caused by the changes in government
policy, the act of nature such as natural disaster, changes in the nation’s
economy, international economic components, etc. It is divided into
three categories, that are explained as under:
• Interest risk: Risk caused by the fluctuation in the rate or interest
from time to time and affects interest-bearing securities like bonds
and debentures.
• Inflation risk: Alternatively known as purchasing power risk as it
adversely affects the purchasing power of an individual. Such risk
arises due to a rise in the cost of production, the rise in wages, etc.
• Market risk: The risk influences the prices of a share, i.e. the prices
will rise or fall consistently over a period along with other shares of
the market.
 Unsystematic risk
The risk arising due to the fluctuations in returns of a company’s security
due to the micro-economic factors, i.e. factors existing in the
organization, is known as unsystematic risk. The factors that cause such
risk relates to a particular security of a company or industry so
influences a particular organization only. The risk can be avoided by the
organization if necessary actions are taken in this regard. It has been
divided into two category business risk and financial risk, explained as
under:
• Business risk: Risk inherent to the securities, is the company may or
may not perform well. The risk when a company performs below
average is known as a business risk. There are some factors that
cause business risks like changes in government policies, the rise in
competition, change in consumer taste and preferences, development
of substitute products, technological changes, etc.
• Financial risk: Alternatively known as leveraged risk. When there is
a change in the capital structure of the company, it amounts to a
financial risk. The debt – equity ratio is the expression of such risk.
Basis for
Systematic Risk Unsystematic Risk
Comparison

Unsystematic risk refers to

Systematic risk refers to the hazard
the risk associated with a
Meaning which is associated with the market
particular security,
or market segment as a whole.
company or industry.

Nature Uncontrollable Controllable

Factors External factors Internal factors

Large number of securities in the

Affects Only particular company.
market.

Interest risk, market risk and Business risk and financial

Types
purchasing power risk. risk

Protection Asset allocation Portfolio diversification

 Risk- Return Relationship
The entire scenario of security analysis is built on two concepts of
security: return and risk. The risk and return constitute the framework for
taking investment decision. Return from equity comprises dividend and
capital appreciation.
To earn return on investment, that is, to earn dividend and to get capital
appreciation, investment has to be made for some period which in turn
implies passage of time. Dealing with the return to be achieved requires
estimate of the return on investment over the time period.
Risk denotes deviation of actual return from the estimated return. This
deviation of actual return from expected return may be on either side
-both above and below the expected return.
 Measurement of Return and Risk
•The  risk of an investment cannot be measured without
reference to return. The return depends on the cash
inflows to be received from the investment. Measurement
indicate
• The expected return from investment.
• The risk of the investment.
Return R-1
Or
R
Where
D= Divined,
P1= End of stock Price,
Po= Initial Stock Price
 Problem 1
•Suppose
  a investor interested to purchase a share which is
sold at TK 120 that the company will pay a dividend of TK.
5 in the next. Moreover he expects to sell the share at TK.
175 after one year. Calculate Expected return from this
investment.

Forecasted Dividend + Forecasted end of the period stock price

R= -1
Initial Investment

Alternatively R= +
R= (5+175)/120-1=0.50 =50%
 Problem 2
•Shayla
  purchased 100 shares of common stock for Tk.
4000 plus Tk. 100 commission in a single year. She sold
the stock for Tk. 4500 less a Tk. 100 commission. During
the year, she received Tk. 250 in dividends. What was the
rate return?
R= +
R= +
=+
= 550/4100
=0.1341
=13.41%
 Weighted Expected Return
The expected return of he investment is the probability weighted
average of all the possible returns.
Where returns are denoted by X and the related probabilities are
P(Xi) and the expected return represented as X

X   ∞
¿ ∑ 𝑋𝑖𝑃 (𝑋𝑖 )
𝑛=1
 Risk Measurement (Page60)
•The  expected returns are insufficient for decision making.
The risk aspect should also be considered. The most
popular measure of risk is the variance or standard
deviation of the probability distribution of possible
returns.
 Possible Deviation
Probability Deviation Product
return Xip(Xi) Squared
p(Xi) (Xi-X) (Xi-X)2p(Xi)
(Xi) (Xi-X)2

30 0.10 3.00 -18 324 32.4

40 0.30 12.00 -8 64 19.2
50 0.40 20.00 2 4 1.6
60 0.10 6.00 12 144 14.4
70 0.10 7.00 22 484 48.4
    48.00    116
 Problem 3
An investor has analyzed a share for a one year
holding period. The share is currently selling for
Tk. 43 but pays no dividends and there is a fifty-
fifty chance that the share will sell for either Tk.
55 or Tk. 60 by the year end. What is the
expected return and risk if 250 shares are
acquired with 80% borrowed funds? Assuming
the cost of borrowed funds to be 12 % ignoring
commission and taxes. ex4
 Measurement of systematic Risk
The systematic risk of a security is measured by a statistical
measure called Beta. For calculating Beta , requirements are
 The historical data of returns of the individual security.
 Return of the representative stock market index.

Two statistical methods may be used for the calculation of Beta

which are
• The correlation method .
• The regression method.
 The Correlation Method
•  

βi
• Where =Correlation coefficient between the returns of
stock i and the returns of the market index.
• = Standard deviation of returns of stock i,
• = Standard deviation of returns of the market index.
• = Variance of the market returns
 The Regression Method
•  

Y
Where
• Y=Dependent variables
X= Independent variables
a and are constant
ά=