Chapter One

Introduction to Investment

For most of your life, you will be earning and spending money. Rarely, though, will your current
money income exactly balance with your consumption desires. Sometimes, you may have more
money than you want to spend; at other times, you may want to purchase more than you can
afford. These imbalances will lead you either to borrow or to save to maximize the long-run
benefits from your income.

When current income exceeds current consumption desires, people tend to save the excess.
Others do any of several things with these savings. One possibility is to put the money under a
mattress or bury it in the backyard until some future time when consumption desires exceed
current income. However, when they retrieve their savings from the mattress or backyard, they
have the same amount they saved. Another possibility is that they can give up the immediate
possession of these savings for a future larger amount of money that will be available for future
consumption. This tradeoff of present consumption for a higher level of future consumption is
the reason for saving. What you do with the savings to make them increase over time is
investment.

Conversely, those who consume more than their current income (that is, borrowed) must be
willing to pay back in the future more than they borrowed. The rate of exchange between future
consumption (future dollars) and current consumption (current dollars) is the pure rate of
interest. Both people’s willingness to pay this difference for borrowed funds and their desire to
receive a surplus on their savings give rise to an interest rate referred to as the pure time value of
money.

1.1. What is Investment

Investment is the current commitment of dollars 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, and (3) the uncertainty of the future payments.

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

this definition includes all types of investments, including investments by corporations in plant

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and equipment and investments by individuals in stocks, bonds, commodities, or real estate. This
course emphasizes more on investments by individual investors. In all cases, the investor is
trading a known dollar amount today for some expected future stream of payments that will be
greater than the current outlay. Because investors have invested to earn a return from savings due
to their deferred consumption which is highly affected by the time, the expected rate of inflation,
and the uncertainty of the committed fund for future return.

Investment Decision Process

Investment management process is the process of managing money or funds. The investment
management process describes how an investor should go about making decisions. Investment
management process can be disclosed by five-step procedure, which includes following stages:

a. Setting of investment policy including the investor’s objective.

b. Analysis and evaluation of investment vehicles.
c. Formation of diversified investment portfolio.
d. Portfolio revision
e. Measurement and evaluation of portfolio performance.
a. Setting of Investment Policy (Goal)

It is the first and very important step in investment management process. Investment policy
includes setting of investment objectives. The investment policy should have the specific
objectives regarding the investment return requirement and risk tolerance of the investor. For
example, the investment policy may define that the target of the investment average return
should be 15 % and should avoid more than 10 % losses. Identifying investor’s tolerance for risk
is the most important objective, because it is obvious that every investor would like to earn the
highest return possible. But because there is a positive relationship between risk and return, it is
not appropriate for an investor to set his/ her investment objectives as just “to make a lot of
money”. Investment objectives should be stated in terms of both risk and return.
The investment policy should also state other important constrains which could influence the
investment management. Constrains can include any liquidity needs for the investor, projected
investment horizon, as well as other unique needs and preferences of investor. The investment
horizon is the period of time for investments. Projected time horizon may be short, long or even
indefinite.

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Setting of investment objectives for individual investors is based on the assessment of their
current and future financial objectives. The required rate of return for investment depends on
what sum today can be invested and how much investor needs to have at the end of the
investment horizon. Wishing to earn higher income on his/her investments investor must assess
the level of risk he/she should take and to decide if it is relevant for him or not. The investment
policy can include the tax status of the investor. This stage of investment management concludes
with the identification of the potential categories of financial assets for inclusion in the
investment portfolio. An identification of the potential categories is based on the investment
objectives, amount of investable funds, investment horizon and tax status of the investor.

b. Analysis and Evaluation of Investment Vehicles

When the investment policy is set up, investor’s objectives defined and the potential categories
of financial assets for inclusion in the investment portfolio identified, the available investment
types can be analyzed. This step involves examining several relevant types of investment
vehicles and the individual vehicles inside these groups. For example, if the common stock was
identified as investment vehicle relevant for investor, the analysis will be concentrated to the
common stock as an investment. The one purpose of such analysis and evaluation is to identify
those investment vehicles that currently appear to be mispriced. There are many different
approaches how to make such analysis. Most frequently two forms of analysis are used:
technical analysis and fundamental analysis.

Technical analysis involves the analysis of market prices in an attempt to predict future price
movements for the particular financial asset traded on the market. This analysis examines the
trends of historical prices and is based on the assumption that these trends or patterns repeat
themselves in the future.

Fundamental analysis in its simplest form is focused on the evaluation of intrinsic value of the
financial asset. This valuation is based on the assumption that intrinsic value is the present value
of future flows from particular investment. By comparison of the intrinsic value and market
value of the financial assets those which are underpriced or overpriced can be identified.

This step involves identifying those specific financial assets in which to invest and determining
the proportions of these financial assets in the investment portfolio.

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 c. Formation of Diversified Investment Portfolio:

Investment portfolio is the set of investment vehicles, formed by the investor seeking to realize
its’ defined investment objectives. In the stage of portfolio formation, the issues of selectivity,
timing and diversification need to be addressed by the investor. Selectivity refers to micro
forecasting and focuses on forecasting price movements of individual assets. Timing involves
macro forecasting of price movements of particular type of financial asset relative to fixed
income securities in general. Diversification involves forming the investor’s portfolio for
decreasing or limiting risk of investment.

The two techniques of diversification:

• Random diversification, when several available financial assets are put to the portfolio at
random.

• Objective diversification when financial assets are selected to the portfolio following
investment objectives and using appropriate techniques for analysis and evaluation of each
financial asset.

Investment management theory is focused on issues of objective portfolio diversification and

professional investors follow settled investment objectives then constructing and managing their
portfolios.

d. Portfolio Revision

This step of the investment management process concerns the periodic revision of the three
previous stages. This is necessary, because over time investor with long term investment horizon
may change his / her investment objectives and this, in turn means that currently held investor’s
portfolio may no longer be optimal and even contradict with the new settled investment
objectives. Investor should form the new portfolio by selling some assets in his portfolio and
buying the others that are not currently held. It could be the other reasons for revising a given
portfolio: over time the prices of the assets change, meaning that some assets that were attractive

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at one time may be no longer be so. Thus investor should sell one asset and buy the other more
attractive in this time according to his/her evaluation. The decisions to perform changes in
revising portfolio depend, upon other things, in the transaction costs incurred in making these
changes. For institutional investors portfolio revision is continuing and very important part of
their activity. But individual investor managing portfolio must perform portfolio revision
periodically as well. Periodic re-evaluation of the investment objectives and portfolios based on
them is necessary, because financial markets change, tax laws and security regulations change,
and other events alter stated investment goals.

e. Measurement and Evaluation of Portfolio Performance

This involves determining periodically how the portfolio performed, in terms of not only the
return earned, but also the risk of the portfolio. For evaluation of portfolio performance
appropriate measures of return and risk and benchmarks are needed. A benchmark is the
performance of predetermined set of assets, obtained for comparison purposes. The benchmark
may be a popular index of appropriate assets stock index, bond index. The benchmarks are
widely used by institutional investors evaluating the performance of their portfolios.

It is important to point out that investment management process is continuing process influenced
by changes in investment environment and changes in investor’s attitudes. Market globalization
offers investors new possibilities, but at the same time investment management become more
and more complicated with growing uncertainty.

1.2. Investment Alternatives

Investment activity includes buying and selling of the financial assets, physical assets and
marketable assets in primary and secondary markets. Investment activity involves the use of
funds or savings for further creation of assets or acquisition of existing assets, financial assets
and physical assets
Financial Assets are: Cash, Bank Deposits, Provident Fund, Pension Scheme, Post Office
Certificates and Deposits
Physical Assets are: House, Land, Building and Flats, Gold, Silver and other Metals, Consumer
Durables

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Investors, who invest directly in financial markets, either using a broker or by other means, have
a wide variety of assets from which to choose.
a. Nonmarketable Financial assets
A distinguishing characteristic of these assets is that they represent personal transactions between
the owner and the issuer. That is, you as the owner of a savings account at a bank must open the
account personally, and you must deal with the bank in maintaining the account or in closing it.
In contrast, marketable securities trade in impersonal markets- the buyer (seller) does not know
who the seller (buyer) is, and does not care. They are “safe” investments, occurring at typically
insured financial institutions or issued by the governments. At least some of these assets offer the
ultimate in liquidity, which can be defined as the ease with which an asset can be converted to
cash. An asset is liquid if it can be disposed of quickly, with, at most, small price changes,
assuming no new information in the marketplace. Thus, we know we can get all of our money
back from a savings account, or a money market deposit account, very quickly.
Savings accounts. Undoubtedly the best-known type of investment in the United States, savings
accounts are held at commercial banks or at “thrift” institutions such as savings and loan
associations and credit unions. Savings accounts in insured institutions (and your money should
not be in noninsured institution) offer a high degree of safety on both the principal and the return
on that principal. Liquidity is taken for granted and, together with the safety feature, probably
accounts substantially for the popularity of savings accounts. Historically, the rate of interest
paid on these accounts has been regulated by government agency.
Nonnegotiable certificates of deposit. Commercial banks and other institutions offer a variety
of savings certificates known as certificates of deposit (CDs). These certificates are available for
various maturities, with higher rates offered as maturity increases. Larger deposits may also
command higher rates, holding maturity constant. In effect, institutions are free to set their own
rates and terms on most CDs. Because of competition for funds, the terms on CDs have been
liberalized. Although some CD issuers have now reduced the stated penalties for early
withdrawal, and even waived them, penalties for early withdrawal of funds can be, and often are,
imposed. Government savings bonds. The nontraded debt of U.S. government, savings bonds,
is nonmarketable, nontransferable, and nonnegotiable, and cannot be used for collateral. They are
purchased from the treasury, most often through banks and saving institutions.

b. Money Market Securities

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Money market securities are short-term indebtedness. By “short term” we usually imply an
original maturity of one year or less. The most common money market securities are Treasury
bills, commercial paper, Eurodollars, repurchase agreements, negotiable certificates of deposit,
and bankers’ acceptances. Marketable: claims are negotiable or saleable in the marketplace. They
are Short-term, liquid, relatively low-risk debt instruments, issued by governments and private
firms.
i. Treasury Bills (T-bills)
Treasury bills (T-bills) are short-term securities issued by the governments; they have original
maturities of four weeks, three months, or six months. Unlike other money market securities, T-
bills carry no stated interest rate. Instead, they are sold on a discounted basis: Investors obtain a
return on their investment by buying these securities for less than their face value and then
receiving the face value at maturity. T-Bills are sold in denominations of $5,000, $25,000,
$100,000, and $1 million. T-bills accounted for about one-half of all outstanding money market
securities. Due to government backing, there is a very low risk of default, widely distributed and
actively traded – high liquidity. In subsequent chapters we will use government T-bill rates as a
measure of the “riskless rate” available to investors, commonly referred to as the risk-free rate.
ii. Commercial Paper
Commercial paper is a promissory note issued by a large, creditworthy corporation (including
finance companies). These securities have original maturities ranging from one day to 270 days
and usually trade in units of $100,000. Most commercial paper is backed by bank lines of credit,
which means that a bank is standing by ready to pay the obligation if the issuer is unable to.
Commercial paper may be either interest bearing or sold on a discounted basis.
iii. Certificates of deposit (CDs)

Certificates of deposit (CDs) are written promises by a bank to pay a depositor. Nowadays they
have original maturities from six months to three years. Negotiable certificates of deposit are
CDs issued by large commercial banks that can be bought and sold among investors. Negotiable
CDs typically have original maturities between one month and one year and are sold in
denominations of $100,000 or more. Negotiable certificates of deposit are sold to investors at
their face value and carry a fixed interest rate. On the maturity date, the investor is repaid the
amount borrowed, plus interest.
iv. Eurodollars

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Eurodollar certificates of deposit are CDs issued by foreign branches of U.S. banks, and
Yankee certificates of deposit are CDs issued by foreign banks located in the United States.
Both Eurodollar CDs and Yankee CDs are denominated in U.S. dollars. In other words, interest
payments and the repayment of principal are both in U.S. dollars. Maturities are mostly short-
term, often less than six months.
v. Repurchase Agreements (RPs)

Repurchase Agreements (RPs) are agreements between a borrower and lender (typically
institutions) to sell and repurchase money market securities. Borrower initiates an RP by
contracting to sell securities to a lender and agreeing to repurchase these securities at a pre-
specified (higher) price on a stated future date. Maturity is generally very short, from 3 to 14
days, and sometimes overnight. Minimum denomination is typically $100,000.
vi. Bankers Acceptances (BAs)

Bankers’ acceptances are short-term loans, usually to importers and exporters, made by banks
to finance specific transactions. An acceptance is created when a draft (a promise to pay) is
written by a bank’s customer and the bank “accepts” it, promising to pay. The bank’s acceptance
of the draft is a promise to pay the face amount of the draft to whomever presents it for payment.
The bank’s customer then uses the draft to finance a transaction, giving this draft to her supplier
in exchange for goods. Since acceptances arise from specific transactions, they are available in a
wide variety of principal amounts. Typically, bankers’ acceptances have maturities range from
30 to 180 days, with 90 days being the most common and issued in minimum denominations of
$100,000. Bankers’ acceptances are sold at a discount from their face value, and the face value is
paid at maturity. Since acceptances are backed by both the issuing bank and the purchaser of
goods, the likelihood of default is very small.
Money market securities are backed solely by the issuer’s ability to pay. With money market
securities, there is no collateral; that is, no item of value (such as real estate) is designated by the
issuer to ensure repayment. The investor relies primarily on the reputation and repayment history
of the issuer in expecting that he or she will be repaid.
c. Fixed-Income Securities
Capital markets encompass fixed –income and equity securities with maturities greater than one
year. Risk is generally much higher than in the money market because of the time to maturity
and the very nature of the securities sold in the capital markets. Marketability is poorer in some

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cases. The capital market includes both debt and equity securities, with equity securities having
no maturity date.
Fixed-income investments have a contractually mandated payment schedule. A security such as
a bond that pays a specified cash flow over a specific period. Marketable debt with maturity
greater than one year. Riskier than money market securities. They have a specified payment
schedule. Their investment contracts promise specific payments at predetermined times, although
the legal force behind the promise varies and this affects their risks and required returns. At one
extreme, if the issuing firm does not make its payment at the appointed time, creditors can
declare the issuing firm bankrupt.
In other cases, (for example, income bonds), the issuing firm must make payments only if it
earns profits. In yet other instances (for example, preferred stock), the issuing firm does not have
to make payments unless its board of directors votes to do so.
Investors who acquire fixed-income securities (except preferred stock) are really lenders to the
issuers. Specifically, you lend some amount of money, the principal, to the borrower. In return,
the borrower promises to make periodic interest payments and to pay back the principal at the
maturity of the loan.

Fixed-income security includes:

Treasury Bonds: Debt obligations of the federal government that make semiannual coupon
payments and are issued at or near par value.

Corporate Bonds: Long-term debt issued by private corporations typically paying semiannual
coupons and returning the face value of the bond at maturity.

Asset-Backed Securities Debt securities whose interest and principal payments are provided by
the cash flows coming from a discrete pool of assets (Asset securitization).

Eurobond: it is a bond denominated in a currency other than that of the country in which it is
issued.

d. Equity Securities

Equity Instruments, which differ from fixed-income securities because their returns are not
contractual. As a result, you can receive returns that are much better or much worse than what

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you would receive on a bond. We begin with common stock, the most popular equity instrument
and probably the most popular investment instrument.

i. Common stock

Common stock represents the ownership interest of corporations, or the equity of the
stockholders, and we can use the term equity securities interchangeably. If a firm’s shares are
held by only a few individuals, the firm is said to be “closely held.” Most companies choose to
“go public”; that is, they sell common stock to the general public. This action is taken primarily
to enable the company to raise additional capital more easily. Owners of the common stock of a
firm share in the company’s successes and problems. Notably, the firm’s preferred stockholders
and common stock owners receive what is left, which is usually little or nothing. Investing in
common stock entails all the advantages and disadvantages of ownership and is a relatively risky
investment compared with fixed-income securities.

ii. Preferred stock

An equity security, preferred stock is known as a hybrid security because it resembles both
equity and fixed-income instruments. As an equity security, preferred stock has an infinite life
and pays dividends. Preferred stock resembles fixed-income securities in that the dividend is
fixed in amount and known in advance, providing a stream of income very similar to that of a
bond. The difference is that the stream continues forever, unless the issue is called or otherwise
retired (most preferred is callable). The price fluctuations in preferred often exceed those in
bonds.

Preferred stockholders are paid after the bondholders but before the common stockholders in
terms of priority of payment of income and in case the corporation is liquidated. However,
preferred stock dividends are not legally binding but must be voted on each period by a
corporation’s board of directors. If the issuer fails to pay the dividend in any year, the unpaid
dividend(s) will have to be paid in the future before common stock dividends can be paid if the
issue is cumulative. If noncumulative, dividends in arrears do not have to be paid.

e. Derivative Securities

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It is probably impossible to define universally. In general, the value of such an asset derives from
the value of some other asset or the relationship between several other assets. Future and options
contracts are the most familiar derivative assets.

i. Options

In the securities markets, an option is the right to buy or sell stock at a specified price within a
specified time period. The value of an option is derived from (that is, depends on) the underlying
security for which the option is a right to buy or sell. Hence, options are often referred to as
derivative securities. Options are created not by corporations but by investors seeking to trade in
claims on a particular common stock. A call (put) option gives the buyer the right but not the
obligation to purchase (sell) a fixed quantity of shares at a specified price (called the exercise
price) within a specified time.

ii. Futures and Forwards

A futures contract is a formal agreement between a buyer or seller and a commodity exchange.
In the case of a purchase contract, the buyer agrees to accept a specific commodity that meets a
specified quality in a specified month. In the case of a sale, the seller agrees to deliver the
specified commodity during the designated month. It is an agreement that provides for the future
exchange of a particular asset between a buyer and seller. This agreement provides for the future
exchange of a particular asset at a specified delivery date (usually within nine months) in
exchange for a specified payment at the time of delivery. Although the full payment is not made
until the delivery date, a good-faith deposit, the margin, is made to protect the seller. This is
typically about 10 percent of the value of the contract.

If the investor expected the price of a commodity to rise, he or she could buy a futures contract
on one of the commodity exchanges for later sale. If the investor expected the price to fall, he or
she could sell a futures contract on an exchange with the expectation of buying similar contracts
later when the price had declined to cover the sale.

A forward contract, just like a futures contract, is an agreement for the future delivery of the
underlying at a specified price at the end of a designated period of time. A forward contract
differs in that it is usually non-standardized (that is, the terms of each contract are negotiated

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individually between buyer and seller), there is no clearinghouse, and secondary markets are
often nonexistent or extremely thin. Forward contract is an agreement between two
counterparties that requires the exchange of a commodity or security at a fixed time in the future
at a predetermined price.

Futures markets formalize and standardize forward contracting. Buyers and sellers do not have to
rely on a chance matching of their interests; they can trade in a centralized futures market. The
futures exchange also standardizes the types of contracts that may be traded: It establishes
contract size, the acceptable grade of commodity, contract delivery dates, and so forth. While
standardization eliminates much of the flexibility available in informal forward contracting, it
has the offsetting advantage of liquidity because many traders will concentrate on the same small
set of contracts. Futures contracts also differ from forward contracts in that they call for a daily
settling up of any gains or losses on the contract. In contrast, in the case of forward contracts, no
money changes hands until the delivery date.

1.3. Investment Companies

What is an investment company? An investment company is a financial service organization that

sells shares in itself to the public and uses the funds to invest in a portfolio of securities such as
money market instruments or stocks and bonds. By pooling the funds of thousands of investors, a
widely diversified portfolio of financial assets can be purchased and the investment company can
offer its owners (shareholders) a variety of services.

 Types of Investment Companies

All investment companies begin by selling shares in themselves to the public. Most investment
companies are managed companies, offering professional management of the portfolio as one of
the benefits. One less well-known type of Investment Company is unmanaged. We begin here
with the unmanaged type and then discuss the two types of managed investment companies.
After we consider each of the three, we focus on mutual funds, the most popular type of
Investment Company for the individual investor.

i. Unit Investment Trusts

Unit investment trusts are pools of money invested in a portfolio that is fixed for the life of the
fund. To form a unit investment trust, a sponsor, typically a brokerage firm, buys a portfolio of

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securities which are deposited into a trust. It then sells to the public shares, or “units,” in the
trust, called redeemable trust certificates. All income and payments of principal from the
portfolio are paid out by the fund’s trustees (a bank or trust company) to the shareholders.
An alternative form of Investment Company that deviates from the normal managed type is the
unit investment trust, which typically is an unmanaged, fixed-income security portfolio put
together by a sponsor and handled by an independent trustee. Redeemable trust certificates
representing claims against the assets of the trust are sold to investors at net asset value plus a
small commission. All interest (or dividends) and principal repayments are distributed to the
holders of the certificates. Most unit investment trusts hold tax-exempt securities. The assets are
almost kept unchanged and the trust ceases to exist when the bonds mature, although it is
possible to redeem units of the trust.
In general, unit investment trusts are passive investments. They are designed to be bought and
held, with capital preservation as a major objective. They enable investors to gain diversification,
provide professional management that takes care of all the details, permit the purpose of
securities by the trust at a cheaper price than if purchased individually, and ensure minimum
operating costs. If conditions change, however, investors lose the ability to make rapid,
inexpensive, or costless changes in their positions.
ii. Close-end Investment companies
One of the two types of managed investment companies, the closed-end investment company,
usually sells no additional shares of its stock after the initial public offering.

Therefore, their capitalizations are fixed unless a new public offering is made. The shares of a
closed-end fund trade in the secondary markets (e.g., on the exchanges) exactly like any other
stock. To buy and sell, investors use their brokers, paying (receiving) the current price at which
the shares are selling plus (less) brokerage commissions. Because shares of closed-end funds
trade on stock exchanges, their prices are determined by the forces of supply and demand.
Interestingly, however, the market price is seldom equal to the actual per-share value of the
closed-end shares.
iii. Open-ended Investment Companies (Mutual Funds)
Open-ended investment companies, the most familiar type of managed company, are popularly
referred to as mutual funds and continue to sell shares to investors after the initial sale of shares
that starts the fund. The capitalization of an open-ended investment company is continually

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changing- that is, it is open-ended- as new investors buy additional shares and some existing
shareholders cash in by selling their shares back to the company. Mutual funds typically are
purchased either: (1) directly, from a fund company, using mail, telephone, or at office locations;
(2) indirectly, from a sales agent, including securities firms, banks, life insurance companies, and
financial planners.
Mutual funds may be affiliated with an “underwriter,” which usually has an exclusive right to
distribute shares to investors. Most underwriters distribute shares through broker/dealer firms.
Mutual funds are corporations typically formed by an investment advisory firm that selects the
board of trustees (directors) for the company. The trustees, in turn, hire a separate management
company, normally the investment advisory firm, to manage the fund. The management
company is contracted by the investment company to perform necessary research and to manage
the portfolio, as well as to handle the administrative chores, for which it receives a fee.
A mutual fund holds a portfolio of securities, usually in line with a stated policy and objective.
Mutual funds exist which hold only a small set of securities (e.g., short-term tax-free securities or
stocks in a particular industry or sector), or broad classes of securities (such as stocks from major
stock exchanges around the world, or a broad representation of any country’s stocks and bonds).
Mutual funds may offer the investor special services such as check-writing privileges or the
ability to switch between mutual funds (types of investments) in the same family of funds at no
costs. Although most offer liquidity, diversification, and professional management, they do not
offer these qualities without a cost. Investors pay a pro rata share of the expenses and
management fees charged by the mutual fund company.
1.4. Security Markets
A financial market, like any market, is just a way of bringing buyers and sellers together. In
financial markets, it is debt and equity securities that are bought and sold. The principal
distinction between primary markets, where new securities are sold, and secondary markets,
where outstanding securities are bought and sold. Each of these markets is further divided based
on the economic unit that issued the security.
i. Primary Markets
In primary market, the issuers of the securities receive cash from the buyers who, in turn,
receive financial claims on the issuing organization.
 Issue facilitated by investment dealers

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 • Specialists in advice, design, and sales
• Intermediaries between issuer and investor
There are two types of primary market issues of common stock. Initial public offerings and
seasoned. Initial public offerings (IPOs) are stocks issued by a formerly privately owned
company that is going public, that is, selling stock to the public for the first time. Seasoned new
issues are offered by companies that already have floated equity.
In the case of bonds, we also distinguish between two types of primary market issues, a public
offering and a private placement. The former refers to an issue of bonds sold to the general
investing public that can then be traded on the secondary market. The latter refers to an issue that
usually is sold to one or a few institutional investors and is generally held to maturity. New
securities may be traded repeatedly in the secondary market, but the original issuers will be
unaffected.
Pricing of IPOs is a complex and important decision. Firms do not want to set their price too low
since a higher price means that fewer shares have to be issued to raise the same amount of
capital.

ii. Secondary Markets

Markets where investors trade previously issued securities. Exist for the trading of common
stocks, preferred stocks, warrants, bonds, put and call options. It is mostly performed through
Auction and over counter trade markets. Once securities are issued to the public, investors may
trade them among themselves. Purchase and sale of already-issued securities occur in the
secondary markets, which include (1) national and local securities exchanges, (2) the over-the-
counter market, and (3) direct trading between two parties. For instance, there are several stock
exchanges in the United States. Two of these, the New York Stock Exchange (NYSE, or the Big
Board) and the American Stock Exchange (Amex), are national in scope and are located in New
York City. The others, such as the Boston or Pacific stock exchanges, are to a considerable
extent regional exchange, which tend to list firms located in a particular geographic area. London
Stock Exchange, Nairobi stock exchange (in Kenya), Mumbai stock exchange (in India), Tokyo
stock exchange are also some of other country secondary market for different securities
particularly on stock. There also are several exchanges for the trading of options and futures
contracts. Participants of secondary markets are; dealers, underwriters.

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 Why Secondary Markets Are Important
Because the secondary market involves the trading of securities initially sold in the primary
market, it provides liquidity to the individuals who acquired these securities. After acquiring
securities in the primary market, investors want the ability to sell them again to acquire other
securities, buy a house, or go on a vacation. The primary market benefits greatly from the
liquidity provided by the secondary market because investors would hesitate to acquire securities
in the primary market if they thought they could not subsequently sell them in the secondary
market. That is, without an active secondary market, potential issuers of stocks or bonds in the
primary market would have to provide a much higher rate of return to compensate investors for
the substantial liquidity risk.
Secondary markets are also important to those selling seasoned securities because the prevailing
market price of the securities is determined by transactions in the secondary market. New issues
of outstanding stocks or bonds to be sold in the primary market are based on prices and yields in
the secondary market. Even forthcoming IPOs are priced based on the prices and values of
comparable stocks or bonds in the public secondary market.
iii. Third Market
This market refers to trading of exchange-listed securities on the over-the-counter market. In the
past, members of an exchange were required to execute all their trades of exchange listed
securities on the exchange and to charge commissions according to a fixed schedule. This
procedure was disadvantageous to large traders when it prevented them from realizing
economies of scale on large trades. Because of this restriction, brokerage firms that were not
members of the NYSE and so not bound by its rules, established trading in the OTC market of
large NYSE-listed stocks. These trades could be accomplished at lower commissions than would
have been charged on the NYSE, and the third market grew dramatically until 1972, when the
NYSE allowed negotiated commissions on orders exceeding $300,000.

In general, an OTC market for trading in securities listed on organized exchanges and it is used
in the US for extremely large transactions to avoid minimum exchange-regulated commission
fees.

iv. Fourth Market

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The fourth market refers to direct trading between investors in exchange-listed securities without
the benefit of a broker. The direct trading among investors that characterizes the fourth market
has exploded in recent years due to the advent of electronic communication networks, or ECNs.
ECNs are an alternative to either formal stock exchange like the NYSE or dealer markets like
NASDAQ for trading securities. These ECNs allow members to post buy or sell orders and to
have those orders matched up or “crossed” with orders of other traders in the system. Both sides
of the trade benefit because direct crossing eliminates the bid-ask spread that otherwise would be
incurred. Early versions of ECNs were available exclusively to large institutional traders.

Chapter Two
Risk and Return

This chapter describes how to measure the expected or historical rate of return on an investment
and also how to quantify the uncertainty of expected returns. You need to understand these
techniques for measuring the rate of return and the uncertainty of these returns to evaluate the
suitability of a particular investment.
2.1.Return

All investments are characterized by the expectation of a return. In fact, investments are made
with the primary objective of deriving return. The expectation of a return may be from income
(yield) as well as through capital appreciation. Capital appreciation is the difference between the
sale price and the purchase price. The expectation of return from an investment depends upon the
nature of investment, maturity period, and market demand and so on.

In finance, rate of return is also known as return on investment (ROI), rate of profit or also called
as return. Rate of Return is the ratio of money gained or lost generated on an investment relative
to the amount of money invested, whether realized or unrealized. The amount of money gained
or lost may be referred to as interest, gain/loss, or net income/net loss.

17
 As we have seen, whether investors are willing to make an investment, and the price they are
willing to pay, depends on the return they expect. A return, the benefit an investor receives from
an investment, can be in the form of:

 a change the in the value of the asset-it’s appreciation or depreciation,

 a cash flow from the investment, such as a dividend or an interest payment, or
 both a cash flow and a change in value.
2.2.Risk

Whenever you make a financing or investment decision, there is some uncertainty about the
outcome. Uncertainty means not knowing exactly what will happen in the future. There is
uncertainty in most everything we do as financial managers, because no one knows precisely
what changes will occur in such things as tax laws, consumer demand, the economy, or interest
rates. Though the terms “risk” and “uncertainty” are often used to mean the same thing, there is a
distinction between them. Uncertainty is not knowing what’s going to happen. Risk is how we
characterize how much uncertainty exists: The greater the uncertainty, the greater the risk. Risk
is the degree of uncertainty.

Risk (or uncertainty) refers to the variability of expected returns associated with a given
investment. Risk, along with the concept of return, is a key consideration in investment and
financial decisions. Probabilities are used to evaluate the risk involved in a security. The
probability of an event taking place is defined as the chance that the event will occur. It may be
thought of as the percentage chance of a given outcome.

• Controllable Risks (Unsystematic Risks)

Represents the portion of a security’s risk that can be controlled through diversification.

i. Operating risk: The risk of loss resulting from inadequate or failed internal processes, people
and systems

ii. Liquidity risk: This is the risk of not being able to sell an investment immediately with a
reasonable price.

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iii. Credit Risk is the risk that a borrower will not repay a loan according to the terms of the loan,
either defaulting entirely or making late payments of interest or principal

• Uncontrollable Risks (Systematic Risks)

i. Market risk is the risk that a stock’s price will change due to changes in the stock market
atmosphere as a whole since prices of all stocks are correlated to some degree with broad
swings in the stock market.

ii. Interest rate risk is the risk resulting from fluctuations in the value of an asset as interest rates
change. For example, if interest rates rise (fall), bond prices fall (rise).

iii. Inflation risk: This is the uncertainty over future rates of inflation. If the return from an
investment is barely keeping up with the rate of inflation, an investor’s purchasing power
will be eroded as time goes on. In other words, the investor will receive a lesser amount of
purchasing power than what was originally invested because the cost of buying everything
has gone up. Inflation risk is also known as purchasing power risk.

iv. Country risk, also called political risk, is the uncertainty of returns caused by the possibility
of a major change in the political or economic environment of a country. The United States is
acknowledged to have the smallest country risk in the world because its political and
economic systems are the most stable.

v. Exchange rate risk is the uncertainty of returns to an investor who acquires securities
denominated in a currency different from his or her own. The likelihood of incurring this risk
is becoming greater as investors buy and sells assets around the world, as opposed to only
assets within their own countries.

vi. Political risk: This is caused by changes in the political environment that affect an
investment’s market value. Political risk can be classified as either domestic or foreign
political risk. An example of domestic political risk is a change in the tax laws, and an
example of foreign political risk is a change in a foreign government’s policy regarding
capital outflow.

2.3. Measures of Return and Risk

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Returns on the investments can be seen in two ways. These are: Ex-post returns and ex-ante
returns.

 Ex Post Returns: Return calculations done ‘after-the-fact,’ in order to analyze what rate of
return was earned. Ex-post return is based on historical data.
 Ex Ante Returns: Return calculations may be done ‘before-the-fact,’ in which case;
assumptions must be made about the future. Ex-ante returns forecasted returns for the future.

The selection process among alternative investment assets requires that you estimate and
evaluate the expected risk-return trade-offs for the alternative investments available. Therefore,
you must understand how to measure the rate of return and the risk involved in an investment
accurately. To meet this need, in this section we examine ways to quantify return and risk. The
presentation will consider how to measure both historical and expected rates of return and risk.

We consider historical measures of return and risk because these historical results are often used
by investors when attempting to estimate the expected rates of return and risk for an asset class.
The first measure is the historical rate of return on an individual investment over the time period
the investment is held (that is, its holding period). Next, we consider how to measure the average
historical rate of return for an individual investment over a number of time periods.

Given the measures of historical rates of return, we will present the traditional measures of risk
for a historical time series of returns (that is, the variance and standard deviation). Following the
presentation of measures of historical rates of return and risk, we turn to estimating the expected
rate of return for an investment. Obviously, such an estimate contains a great deal of uncertainty,
and we present measures of this uncertainty or risk.

2.3.1. Measures of Historical Rates of Return (Ex Post Returns)

With most investments, an individual or business spends money today with the expectation of
earning even more money in the future. The concept of return provides investors with a
convenient way to express the financial performance of an investment. To illustrate, suppose you
buy 10 shares of a stock for $1,000. The stock pays no dividends, but at the end of 1 year you
sell the stock for $1,100. What is the return on your $1,000 investment? One way to express an
investment’s return is in dollar terms:

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Dollar return = Amount to be Received−Amount invested = 1,100-$1,000= $100

If at the end of the year you sell the stock for only $900, your dollar return will be -$100.
Although expressing returns in dollars is easy, two problems arise:(a) to make a meaningful
judgment about the return, you need to know the scale (size) of the investment; a $100 return on
a $100 investment is a great return (assuming the investment is held for 1 year), but a $100
return on a $10,000 investment would be a poor return. (b) You also need to know the timing of
the return; a $100 return on a $100 investment is a great return if it occurs after 1 year, but the
same dollar return after 20 years is not very good. The solution to these scale and timing
problems is to express investment results as rates of return, or percentage returns. For example,
the rate of return on the 1-year stock investment, when $1,100 is received after 1 year, is 10%:

= =0.10=10%

The rate of return calculation “standardizes” the dollar returns by considering the annual return
per unit of investment. Although this example has only one out flow and one inflow, the
annualized rate of return can easily be calculated in situations where multiple cash flows occur
over time by using time value of money concepts. Generally historical return can be calculated
using the following formula.

( )

When we invest, we defer current consumption in order to add to our wealth so that we can
consume more in the future. Therefore, when we talk about a return on an investment, we are
concerned with the change in wealth resulting from this investment. This change in wealth can
be either due to cash inflows, such as interest or dividends, or caused by a change in the price of
the asset (positive or negative). If you commit $200 to an investment at the beginning of the year
and you get back $220 at the end of the year, what is your return for the period? The period
during which you own an investment is called its holding period, and the return for that period is
the holding period return (HPR)

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Example: To illustrate, suppose you buy 10 shares of a stock for $1,000. The stock pays no
dividends, but at the end of 1 year you sell the stock for $1,100. What is the return on your
$1,000 investment?

Holding period Return (HPR) = = =1.10

Holding period yield (HPY)= HPR-1 =1.10-1=0.1= 10%

To derive an annual HPY, you compute an annual HPR and subtract 1. Annual HPR is found by:
/n
Annual HPR = PR , where n = number of years the investment is held

Consider an investment that cost $250 and is worth $350 after being held for two years:

Holding period Return (HPR)= → =1.4

Annual HPR= . =1.1832 → Annual HPY=1.1832-1= 0.1832 =18.32%

 Computing Mean Historical Returns

Now that we have calculated the HPY for a single investment for a single year, we want to
consider mean rates of return for a single investment and for a portfolio of investments. Over a
number of years, a single investment will likely give high rates of return during some years and
low rates of return, or possibly negative rates of return, during others.

Given a set of annual rates of return (HPYs) for an individual investment, arithmetic mean return
measures of return performance. To find the arithmetic mean (AM), the sum (∑) of annual PYs
is divided by the number of years (n) as follows:

AM =∑ PY/n, where: ∑ PY = the sum of annual holding period yields

To illustrate these alternatives, consider an investment with the following data:

Year Beginning Value Ending Value HPR HPY

1 100 115 1.15 0.15

2 115 138 1.20 0.20

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 3 138 110.4 0.80 -0.20

AM = [(0.15) + (0.20) + (–0.20)]/3 = 0.15/3 = 0.05 = 5%

2.3.2. Risk Measures for Historical Returns

To measure the risk for a series of historical rates of returns, we use the same measures as for
expected returns (variance and standard deviation) except that we consider the historical holding
period yields (HPYs) as follows:

=∑ ( ( )) , where = the variance of the series

• = the holding period yield during period i

• E(HPY) = the expected value of the holding period yield that is equal to the arithmetic
mean of the series

• n = the number of observations

Assume that you are given the following information on annual rates of return (HPY) for
common stocks listed on the New York Stock Exchange (NYSE): In this case, we are not
examining expected rates of return but actual returns.

Year Annual Rate of Return

2003 0.07
2004 0.11
2005 -0.04
2006 0.12
2007 -0.06
Therefore, we assume equal probabilities, and the expected value (in this case the mean value, R)
of the series is the sum of the individual observations in the series divided by the number of
observations, or 0.04 (0.20/5). The variances and standard deviations are:

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 =∑ ( ( )) √∑ ( ( ))

The variances and standard deviations are:

Year ̅ ( ̅)

2003 0.07 0.03 0.0009

2004 0.11 0.07 0.0049

2005 -0.04 -0.08 0.0064

2006 0.12 0.08 0.0064

2007 -0.06 -0.10 0.0110

=0.00572,

√ =0.0756

A measure of relative dispersion is the coefficient of variation, which is defined as:

A larger value indicates greater dispersion relative to the arithmetic mean of the series. For the

previous example, the CV would be: =1.89

2.3.3. Calculating Expected Rates of Return (Ex-Ante Return)

Risk is the uncertainty that an investment will earn its expected rate of return. In the examples in
the prior section, we examined realized historical rates of return. In contrast, an investor who is
evaluating a future investment alternative expects or anticipates a certain rate of return. The
specification of a larger range of possible returns from an investment reflects the investor’s
uncertainty regarding what the actual return will be. Therefore, a larger range of expected returns
makes the investment riskier.

An investor determines how certain the expected rate of return on an investment is by analyzing
estimates of expected returns. To do this, the investor assigns probability values to all possible
returns. These probability values range from zero, which means no chance of the return, to one,
which indicates complete certainty that the investment will provide the specified rate of return.
These probabilities are typically subjective estimates based on the historical performance of the

24
investment or similar investments modified by the investor’s expectations for the future. As an
example, an investor may know that about 30 percent of the time the rate of return on this
particular investment was 10 percent. Using this information along with future expectations
regarding the economy, one can derive an estimate of what might happen in the future. The
expected return from an investment is defined as:

• ∑

̅ =∑ , ̅ =Expected Return, = Probability, = return at each state of nature

2.3.4. Measuring the Risk of Expected Rates of Return

We have shown that we can calculate the expected rate of return and evaluate the uncertainty, or
risk, of an investment by identifying the range of possible returns from that investment and
assigning each possible return a weight based on the probability that it will occur. Two possible
measures of risk (uncertainty) have received support in theoretical work on portfolio theory: the
variance and the standard deviation of the estimated distribution of expected returns.

( )=∑ ( ) ( )

=( ̅)

√∑ ( ) ( ) , √∑ ( ̅)

Example: Consider the possible rates of return that you might earn next year on a $ 50,000
investments in stock A or on a $50,000 investment in stock B, depending up on the states of the
economy: recession, normal, and prosperity.

State of Economy Return of Stock A Return of Stock B Probability

Recession -5% 10% 0.2

Normal 20% 15% 0.6

Prosperity 40% 20% 0.2

Calculate:

25
 i. The expected return of stock A and B

ii. The standard deviation of stock A and B

iii. The coefficient of variation of stock A and B

iv. Which one is riskier?

Answer

 Then the expected rate of return for stock A is computed as follows:

̅ =∑ = (-5%)(0.2) + (20%)(0.6) + (40%)(0.2) = 19%

 Stock B’s expected rate of return is:

̅ =∑ = (10%) (0.2) + (15%) (0.6) + 20%(0.2) = 15%

 Measuring Risk: The Standard Deviation

The standard deviation ( ), which is a measure of dispersion of the probability distribution, is

commonly used to measure risk. The smaller the standard deviation, the tighter the probability
distribution and, thus, the lower the risk of the investment.

Mathematically √∑ ( ̅)

Compute the standard deviation for each stock and set up the tables as follows for stock A:

̅ ( ̅) ( ̅)
-5% 0.2 -1% -24 576 115.2
20% 0.6 12% 1 1 0.6
40% 0.2 8% 21 441 88.2

√ = 14.28%

For Stock B

26
 ̅ ( ̅) ( ̅)
10% 0.2 2% -5 25 5

15% 0.6 4% 0 0 0

20% 0.2 9% 5 25 5

√ = 3.16%

Stock A is riskier; it is likely to either fall far below its expected rate of return or far exceed the
expected return. With such a small , there is only a small probability that stock B's return will
be far less or greater than expected; hence, stock B is not very riskier.

Measure of Relative Risk Coefficient of Variation

One must be careful when using the standard deviation to compare risk since it is only an
absolute measure of dispersion (risk) and does not consider the dispersion of outcomes in
relationship to an expected value (return). Therefore, when comparing securities that have
different expected returns, use the coefficient of variation. The coefficient of variation is
computed simply by dividing the standard deviation for a security by expected value: ̅ . The

higher the coefficient, the riskier the security.

Stock A Stock B
̅ 19% 15%

14.28% 3.16%

0.75% 0.21%
̅

Although stock A is expected to produce a considerably higher return than stock B, stock A is
overall riskier than stock B, based on the computed coefficient variation.

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