CHAPTER I: INTRODUCTION TO INVESTMENT

Topics to be covered
1.1 Concept of Investment
1.2. Characteristics of Investment
1.2 Forms of investment
1.3 Financial markets overview
1.4 Types of securities
1.5 Major investors in securities
1.6. Investment and Speculation

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 1.1 Definition Of Investment

General Meaning of Investment

 Investment is defined as a sacrifice made now to
obtain a return later
–It is current consumption that is sacrificed
 Investment is a sacrifice of current money or other
resources in anticipation of a future benefits.
 Investment is the employment of funds on assets
with the aim of earning or capital appreciation.

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 General Meaning of Investment
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 Any investment involves a current commitment of

funds for some period of time in order to derive
future payments that will compensate for:
 the time the funds are committed- time value of money
 the expected rate of inflation (inflation premium)

 uncertainty of future flow of funds (risk premium)

 Investment is the commitment of money to purchase

financial instruments or other assets in order to gain
profitable returns in the form of interest, dividend, or
appreciation of the value of asset.

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 General Meaning of Investment
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 The term ‘investing” could be associated with the

different activities, but the common target in these
activities is to “employ” the money (funds) during the
time period seeking to enhance the investor’s wealth.
 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
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 General Meaning of Investment
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 Investment can be interpreted narrowly from

three perspective - from view point of:
 layman person/ and called general investment
 economist and economic investment
 financial profession and financial investment

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 General Meaning of Investment
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For consumer or any layman/ individual

 According to individual point of view,

 investment means some monetary commitment.

 A person's commitment to buy a flat or a house or car

for his personal use may be an investment from his point

of view.
 This cannot be considered as an actual investment as it

involves sacrifice but does not yield any financial return,

not for further production but for self use
 Include consumer spending and donation

 Example –spending on consumer goods or monitory gift

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 General Meaning of Investment Economic Meaning of Investment

For the economist

 investment is net addition to the economy’s capital stock
which consists of goods and services that are used in the
production of other goods and services.
 A net addition to the capital stock means an increase in the buildings,
equipments or inventories.
 These capital stocks are used to produce other goods and services and the
addition to capital stock is called Economic investment
 Capital goods
 Example -Formation of new and productive capital in the
form of:
 New construction
 Machinery and Factory
 Inventories
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• All these investments generate physical assets
 General Meaning of Investment Financial
Meaning of Investment
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 Generally, “investments” refers to commitment of fund on

financial assets and in particular to marketable securities.
 Financial assets are paper or claims on issuer, such as the
government or a company.
 Example -Purchasing of share, bond
 Future return in terms of:

 Interest rate

 Dividend

 Capital gain

 This course generally focus on financial investment made on

marketable securities.
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 1.2. Characteristics of Investment

 Returns
 Risk
 Safety
 Liquidity

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 The two key elements of any investment are TIME and

RISK.
 Present consumption is sacrificed to get a in the future.
 The sacrifice takes place NOW and is CERTAIN. The
return benefit is expected in the future and tends to be
UNCERTAIN.
 This attribute of investment indicates the risk factor.
 The risk is undertaken with a view to reap some return
from the investment.

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 Characteristics of Investment

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Return
 All investments are characterized by the
expectation of return which is the primary
motive
 Return
 Dividend

 Interest

 Capital appreciation

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 Characteristics of Investment

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Risk
 Risk is inherent in any investment.

 refers to the variability of its rate of return

 how much do individual outcomes deviate from expected
value?
 Risks may be related to:
 Loss of capital
 Delay in repayment of capital or return
 Non-payment of interest
 Variability in returns
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 Risk-Continues………..

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 The Risk of investment– depends on following factors—
a) Maturity period
 Longer maturity period higher risk- short and long term
financial securities
b) Creditworthiness of borrower-
 the more creditworthiness of borrowers – the lower risks are
lower (Govt securities)
Lower the creditworthiness of borrowers, the higher the risk

c) Ownership of securities-
 the risk varies with nature of investment.
 Investment in ownership securities like equity shares carry
higher risk compared to investment in debt instruments like
bond.
 Risk and return of an investment are related.
 the higher the risk, the higher Melaku
is theK.return
(MSC)
 Risk-Continues………..
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 Range is a simple measure of dispersion of the

range of values.
 Other measures used in finance are as follows.
Variance: this is the mean of the squares of deviations
of individual returns around their average value.
SD: the square root of variance
Beta: this reflect how volatile is the return from an
investment relative to market swings.
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 Characteristics of Investment

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 Safety
 Safety is another feature which an investor
desires for his investments
 Safety refers to the protection of investor’s
principal amount and expected rate of return
• Investment avenues should be under the legal and
regulatory framework.
• Approval of law itself adds flavour of safety.
• Every investor expects to get back his capital on maturity
without loss and without delay
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 Characteristics of Investment

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Liquidity:
 An investment which is easily saleable or marketable

 without loss of money and time

 With less transaction cost

is said to be possess liquidity.

Marketability– Easy and quick means of transferability of
an asset in to cash.
 If the asset is easily realizable, marketable then the liquidity is
higher.
 If there is time gap for realizing proceeds then it is less liquid.
 Investment is highly marketable or liquid,
 If it can be converted in to cash quickly ,

 the transaction cost is low

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 1.3. Investment Objectives
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 Primary Objectives
 Safety of principal
 Maximization of return and minimization

of risk
 Secondary Objectives

 Liquidity
 Hedge against inflation

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 1.4. Forms of Investment
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 Range of investments alternatives fall in to

two broad categories:
1. Financial assets
2. Real assets

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 Financial assets are paper (or electronic) claims on some issuer such as
the government or a corporate body.
 Ownership claims – A holder of stock (a shareholder) has a claim to a part of the corporation's
assets and earnings.
 Contractual claim to :
 Periodic interest payments-Investor receives interest Repayment of principal at due
date.
 A legal contract representing the right to receive future financial
benefits under a stated set of conditions"
 The piece of paper/certificate
 The important financial assets are equity shares, corporate bonds,
government securities, deposit with banks, mutual fund shares,
insurance policies, and derivative instruments.
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 Classification of securities-

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 it can be classified based on:

 Marketability
 Marketable and non marketable securities
 Duration
 Money and capital market securities
 Claim
 Debt and equity market securities

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 Marketable securities

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 Marketable securities is financial assets that are easily tradable

in secondary markets
 They Can be traded between or among investors after their
original issue in secondary markets and before they mature
or expire .
 Instrument listed on stock exchanges are Marketable
securities.
 Equity or debt instrument (share/stock, bond, note)
that are listed on an exchange and can be readily
bought or sold.
 Example : treasury bill, commercial paper, stock bond.
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 Non-marketable securities
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 Non marketable securities are not traded in

market such as bank drafts, saving deposit
 Cannot be traded between or among
investors
 Examples:
 Post office deposits
 Bank deposits-Savings deposit

 Employee Provident fund deposits-Pension

scheme
 Government Savings Bonds

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Based on maturity date, security can be categorized in to two

 Money Market Securities
 are short term debt securities with a maturity of one year or less.
 Contractual obligations to repay fixed amount of money at pre
determine date.
 Characteristics:

 Low expected return-return and maturity date

 Low level of risk
 Debt instrument only
 Issued by governments and business entity -financial institutions
and corporations
 Example : Certificate of deposit, Promissory note, Commercial Paper,
Treasury Bills
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Money market securities

1. Treasury Bills
 Short-term debt instruments Issued by federal government
to meet the short-term finance.
 T-bills are sold at a discount from face value.
 Attractive to investors
 Minimal default risk and so called risk free asset—backed

by Federal Government
 Excellent liquidity for investors

 Short-term maturity
 Very good secondary market
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2. Commercial Paper (CP)

 Is short-term debt instrument, unsecured

promissory notes, issued by well-known and
financially strong companies .
 Short-term corporate debt - most CP has mature of 30 days
or less.
 Used only by well-known and creditworthy firms
 Unsecured-backed by creditworthiness of borrowers
 CP defaults are rare
 Do not have interest rate but sold on discount basis
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 3.Negotiable Certificates of Deposit
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 large denomination fixed deposits of

commercial banks and can be sold in
secondary markets.
 A deposit that earns a fixed interest rate for a
specified length of time.
 has a fixed interest rate-But sold at discount in
secondary market.
 Freely transferable by endorsement and
delivery
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 Money market securities
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Promissory note
 Written promise by borrower to
repay specific some of money to
lender or bearer
 Example – three month after date,
I promise to pay ABC or bearer the
sum of birr 200 for value received
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 2. Capital Market Securities

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 long-term securities with maturity greater than one year and those
having no maturity date at all
 Type- long term debt and equity securities
1. long-term debt securities
 Contractual claim to receive Periodic interest payments and
repayment of principal at due date
 Fixed maturity date
 Example-Corporate bond, government security and mortgage
2. Equity securities
 Represent ownership interest or claims
 Do not have maturity date
 Types-Common and preferred stock
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 Capital market securities

Treasury notes and bonds
Municipal Bonds- issued by state/ local governments.
Corporate bonds-issued by corporate
Stock (Common and Preferred stock)
Mortgage

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1. Treasury notes and bonds

 Treasury note is medium term debt security
issued by federal government with maturity
ranging from 1 and 10 years.
 Treasury bond is long-term debt securities

issued by governments to raise funds

2. Municipal bonds
 are long-term debt security issued by state/ local
governments.
 The interest paid by these bonds are exempt

from federal income taxes.

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4. Corporate bonds
 long-term debt securities issued by corporations
 Corporations issue bonds that typically have

original maturities of 5 to 30 years, and

occasionally as long as 100 years (Coca-Cola).
 thus have a risk of default

4. Mortgages
 They are loans to households or firms to purchase

housing and land, where the building or land itself

serves as collateral for the loans
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5. Stock
 It is an equity security which represents ownership interest in
the issuing firm.
 No maturity date—need market to sell
 Types:
 Common Stock
 Preferred stock
 Convertible stock
 Like bonds, existing stock may be exchanged through
secondary markets.
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Real assets are represented by tangible assets like

residential house, commercial property,
agricultural farm, gold, precious stones, and art
objects.
As the economy advances, the relative importance of
financial assets tends to increase. Of course, by
and large the two forms of investments are
complementary and not competitive.

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 1.5. Investment & Speculation

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 Investment and speculation are closely related.

 Both involve security trade-buying and selling of

financial assets-shares & bond with expectation of

return.
 However, investment can be distinguished from

speculation by
 Risk bearing capacity,
 Return expectations, and
 Duration of trade
 Investment decision
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Risk
 High return is associated with higher risk
Investor : commits his funds in low risk investment
 Speculator: commits his funds to higher risk investment
to achieve high returns.
Capital Gain
 Investor expects regular income in the form of dividend or

interest in addition to capital gain

 whereas Speculator looks for Capital appreciation.

 Speculation associated with buying at lower price and

selling at higher price with the hope of making large
capital gains.
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Time period
 Investment is long-term in nature
 Speculator is interested in short term trade gain

through buying and selling of instruments

Investment decision
 Investment is generally made based on
fundamental analysis
 whereas Speculation is done based on
hearsay(unfounded information) and rumors etc
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 Investors vs speculator
Basis INVESTMENT SPECULATION
Objective Specific goal/objectives Objectives, only to gain
37 high return
Priority An investors is interested in A speculators is interested
safety of his investment in appreciation of capital
and earning profits quickly

Level of Risk Low or moderate risk High risk

Length of Comparatively Long term For Short time only
commitment
Base for Investment decisions are Speculator relies more on
decision based on fundamental factors hear saying or rumors
Source of Earning of enterprise Change in market price
income (dividend and interest) beside
capital gain
Stability of Very stable Uncertain
income
Psychological Causation and conservative Daring and careless
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attitude
 1.6. Types of Investors

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•Individual Investors
–Invest for personal financial goals (retirement,
house)
•Institutional Investors
–Paid to manage other people’s money
–Typically manage large amounts of money
–Include: banks, life insurance companies, mutual
funds and pension funds

Melaku K. (MSC)