Investment and Risk

CHAPTER ONE

INVESTMENT AND RISK

1.1 Meaning of 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 and equipment and investments by individuals in stocks, bonds, commodities, or real estate. 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.

At this point, we have answered the questions about why people invest and what they want from their investments. They invest to earn a return from savings due to their deferred consumption.

They want a rate of return that compensates them for the time, the expected rate of inflation, and the uncertainty of the return. Investing may be very conservative as well as aggressively speculative. Whatever be the perspective, investment is important to improve future welfare. Funds to be invested may come from assets already owned, borrowed   money, savings or foregone consumptions.

By forgoing consumption today and investing the savings, investors expect to enhance their future consumption possibilities by increasing their wealth. Investment can be made to intangible assets like marketable securities or to real assets like gold, real estate etc.  More generally it refers to investment in financial assets. Investments Refers to the study of the investment process, generally in financial assets like marketable securities to maximize investor’s wealth, which is the sum of investor’s current income and present value of future income. It has two primary functions: analysis and management.

 

Investment environment

Investment environment can be defined as the existing investment vehicles in the market available for investor and the places for transactions with these investment vehicles.

 

1.2 Investment vehicles

Investment in financial assets differs from investment in physical assets in those important aspects:

• Financial assets are divisible, whereas most physical assets are not. An asset is divisible if investor can buy or sell small portion of it. In case of financial assets it means, that investor, for example, can buy or sell a small fraction of the whole company as investment object buying or selling a number of common stocks.

• Marketability (or Liquidity) is a characteristic of financial assets that is not shared by physical assets, which usually have low liquidity. Marketability (or liquidity) reflects the feasibility of converting of the asset into cash quickly and without affecting its price significantly. Most of financial assets are easy to buy or to sell in the financial markets.

The main types of financial investment vehicles are:

• Short term investment vehicles;
• Fixed-income securities;
• Common stock;
• Speculative investment vehicles;
• Other investment tools.

 

Short - term investment vehicles are all those which have a maturity of one year or less. Short term investment vehicles often are defined as money-market instruments, because they are traded in the money market which presents the financial market for short term (up to one year of maturity) marketable financial assets. The risk as well as the return on investments of short-term investment vehicles usually is lower than for other types of investments. The main short term investment vehicles are:

• Certificates of deposit;
• Treasury bills;
• Commercial paper;
• Bankers’ acceptances;
• Repurchase agreements.

 

Certificate of deposit is debt instrument issued by bank that indicates a specified sum of money has been deposited at the issuing depository institution. Certificate of deposit bears a maturity date and specified interest rate and can be issued in any denomination. Most certificates of deposit cannot be traded and they incur penalties for early withdrawal. For large money-market investors financial institutions allow their large-denomination certificates of deposits to be traded as negotiable certificates of deposits.

 

Treasury bills (also called T-bills) are securities representing financial obligations of the government. Treasury bills have maturities of less than one year. They have the unique feature of being issued at a discount from their nominal value and the difference between nominal value and discount price is the only sum which is paid at the maturity for these short term securities because the interest is not paid in cash, only accrued. The other important feature of T-bills is that they are treated as risk-free securities ignoring inflation and default of a government, which was rare in developed countries, the T-bill will pay the fixed stated yield with certainty. But, of course, the yield on T-bills changes over time influenced by changes in overall macroeconomic situation. T-bills are issued on an auction basis. The issuer accepts competitive bids and allocates bills to those offering the highest prices. Noncompetitive bid is an offer to purchase the bills at a price that equals the average of the competitive bids. Bills can be traded before the maturity, while their market price is subject to change with changes in the rate of interest. But because of the early maturity dates of T-bills large interest changes are needed to move T-bills prices very far. Bills are thus regarded as high liquid assets.

 

Commercial paper is a name for short-term unsecured promissory notes issued by corporation. Commercial paper is a means of short-term borrowing by large corporations. Large, well-established corporations have found that borrowing directly from investors through commercial paper is cheaper than relying solely on bank loans. Commercial paper is issued either directly from the firm to the investor or through an intermediary. Commercial paper, like T-bills is issued at a discount. The most common maturity range of commercial paper is 30 to 60 days or less. Commercial paper is riskier than T-bills, because there is a larger risk that a corporation will default. Also, commercial paper is not easily bought and sold after it is issued, because the issues are relatively small compared with T-bills and hence their market is not liquid.

 

Bankers acceptances are the vehicles created to facilitate commercial trade transactions. These vehicles are called bankers acceptances because a bank accepts the responsibility to repay a loan to the holder of the vehicle in case the debtor fails to perform. Banker’s acceptances are short-term fixed-income securities that are created by non-financial firm whose payment is guaranteed by a bank. This short-term loan contract typically has a higher interest rate than similar short –term securities to compensate for the default risk. Since bankers’ acceptances are not standardized, there is no active trading of these securities.

 

Repurchase agreement (often referred to as a repo) is the sale of security with a commitment by the seller to buy the security back from the purchaser at a specified price at a designated future date. Basically, a repo is a collectivized short-term loan, where collateral is a security. The collateral in a repo may be a Treasury security, other money-market security. The difference between the purchase price and the sale price is the interest cost of the loan, from which repo rate can be calculated. Because of concern about default risk, the length of maturity of repo is usually very short. If the agreement is for a loan of funds for one day, it is called overnight repo; if the term of the agreement is for more than one day, it is called a term repo. A reverse repo is the opposite of a repo. In this transaction a corporation buys the securities with an agreement to sell them at a specified price and time. Using repos helps to increase the liquidity in the money market. Our focus in this course further will be not investment in short-term vehicles but it is useful for investor to know that short term investment vehicles provide the possibility for temporary investing of money/ funds and investors use these instruments managing their investment portfolio.

 

Fixed-income securities are those which return is fixed, up to some redemption date or indefinitely. The fixed amounts may be stated in money terms or indexed to some measure of the price level. This type of financial investments is presented by two different groups of securities:

• Long-term debt securities

• Preferred stocks.

 

Long-term debt securities can be described as long-term debt instruments representing the issuer’s contractual obligation. Long term securities have maturity longer than 1 year. The buyer (investor) of these securities is lending money to the issuer, who undertake obligation periodically to pay interest on this loan and repay the principal at a stated maturity date. Long-term debt securities are traded in the capital markets. From the investor’s point of view these securities can be treated as a “safe” asset. But in reality the safety of investment in fixed –income securities is strongly related with the default risk of an issuer. The major representatives of long-term debt securities are bonds, but today there are a big variety of different kinds of bonds, which differ not only by the different issuers (governments, municipals, companies, agencies, etc.), but by different schemes of interest payments which is a result of bringing financial innovations to the long-term debt securities market. As demand for borrowing the funds from the capital markets is growing the long-term debt securities today are prevailing in the global markets. And it is really become the challenge for investor to pick long-term debt securities relevant to his/ her investment expectations, including the safety of investment.

 

Preferred stocks are equity security, which has infinitive life and pay dividends. But preferred stock is attributed to the type of fixed-income securities, because the dividend for preferred stock is fixed in amount and known in advance. Though, this security provides for the investor the flow of income very similar to that of the bond. The main difference between preferred stocks and bonds is that for preferred stock the flows are forever, if the stock is not callable. The preferred stockholders are paid after the debt securities holders but before the common stock holders in terms of priorities in payments of income and in case of liquidation of the company. If the issuer fails to pay the dividend in any year, the unpaid dividends will have to be paid if the issue is cumulative. If preferred stock is issued as noncumulative, dividends for the years with losses do not have to be paid. Usually same rights to vote in general meetings for preferred stockholders are suspended. Because of having the features attributed for both equity and fixed-income securities preferred stocks is known as hybrid security. A most preferred stock is issued as noncumulative and callable. In recent years the preferred stocks with option of convertibility to common stock are proliferating.

 

The common stock is the other type of investment vehicles which is one of most popular among investors with long-term horizon of their investments. Common stock represents the ownership interest of corporations or the equity of the stock holders. Holders of common stock are entitled to attend and vote at a general meeting of shareholders, to receive declared dividends and to receive their share of the residual assets, if any, if the corporation is bankrupt. The issuers of the common stock are the companies which seek to receive funds in the market and though are “going public”.

The issuing common stocks and selling them in the market enables the company to raise additional equity capital more easily when using other alternative sources. Thus many companies are issuing their common stocks which are traded in financial markets and investors have wide possibilities for choosing this type of securities for the investment.

 

Speculative investment vehicles the term “speculation” could be defined as investments with a high risk and high investment return. Using these investment vehicles speculators try to buy low and to sell high, their primary concern is with anticipating and profiting from the expected market fluctuations. The only gain from such investments is the positive difference between selling and purchasing prices. Of course, using short-term investment strategies investors can use for speculations other investment vehicles, such as common stock, but here we try to emphasize the specific types of investments which are more risky than other investment vehicles because of their nature related with more uncertainty about the changes influencing their price in the future.

 

Financial markets

Financial markets are the other important component of investment environment. Financial markets are designed to allow corporations and governments to raise new funds and to allow investors to execute their buying and selling orders. In financial markets funds are channeled from those with the surplus, who buy securities, to those, with shortage, who issue new securities or sell existing securities. A financial market can be seen as a set of arrangements that allows trading among its participants.

 

Other investment tools:

• Various types of investment funds;

• Investment life insurance;

• Pension funds;

• Hedge funds.

 

1.3 INVESTMENT ALTERNATIVES:

Assets:

Assets are things that people own. The two kinds of assets are financial assets and real assets.

The material wealth of a society is determined ultimately by the productive capacity of its economy—the goods and services that can be provided to its members. This productive capacity is a function of the real assets of the economy: the land, buildings, knowledge, and machines that are used to produce goods and the workers whose skills are necessary to use those resources. Together, physical and “human” assets generate the entire spectrum of out- put produced and consumed by the society. In contrast to such real assets are financial assets such as stocks or bonds. These assets, by itself, do not represent a society’s wealth. Shares of stock are no more than sheets of paper or more likely, computer entries, and do not directly contribute to the productive capacity of the economy. Instead, financial assets contribute to the productive capacity of the economy indirectly, because they allow for separation of the ownership and management of the firm and facilitate the transfer of funds to enterprises with attractive investment opportunities. Financial assets certainly contribute to the wealth of the individuals or firms holding them. This is because financial assets are claims to the income generated by real assets or claims on income from the government.                                              

When the real assets used by a firm ultimately generate income, the income is allocated to investors according to their ownership of the financial assets, or securities, issued by the firm. Bondholders, for example, are entitled to a flow of income based on the interest rate and par value of the bond. Equity holders or stockholders are entitled to any residual income after bondholders and other creditors are paid. In this way the values of financial assets are derived from and depend on the values of the underlying real assets of the firm. Real assets produce goods and services, whereas financial assets define the allocation of income or wealth among investors. Individuals can choose between consuming their current endowments of wealth today and investing for the future. When they invest for the future, they may choose to hold financial assets. The money a firm receives when it issues securities (sells them to investors) is used to purchase real assets. Ultimately, then, the returns on a financial asset come from the income produced by the real assets that are financed by the issuance of the security. In this way, it is useful to view financial assets as the means by which individuals hold their claims on real assets in well-developed economies.

Most of us cannot personally own auto plants (a real asset), but we can hold shares of General Motors or Ford (a financial asset), which provide us with income derived from the production of automobiles. Real and financial assets are distinguished operationally by the balance sheets of individuals and firms in the economy. Whereas real assets appear only on the asset side of the balance sheet, financial assets always appear on both sides of balance sheets. Your financial claim on a firm is an asset, but the firm’s issuance of that claim is the firm’s liability.

 

Securities:

A security is a legal document that shows an ownership interest. Securities have historically been associated with financial assets such as stocks and bonds, but in recent years have also been used with real assets. Securitization is the process of converting an asset or collection of assets into a more marketable forum.

Security Groupings:

Securities are placed in one of three categories: equity securities, fixed income securities, or derivative assets.

 

1) Equity Securities:

The most important equity security is common stock. Stock represents ownership interest in a corporation. Equity securities may pay dividends from the company’s earnings, although the company has no legal obligation to do so. Most companies do pay dividends, and most companies try to increase these dividends on a regular basis.

 

2) Fixed Income Securities:

A fixed income security usually provides a known cash flow with no growth in the income stream. Bonds are the most important fixed income securities. A bond is a legal obligation to repay a loan’s principal and interest, but carries no obligation to pay more than this. Interest is the cost of borrowing money. Although accountants classify preferred stock as an equity security, the investment characteristics of preferred stock are more like those of a fixed income security. Most preferred stocks pay a fixed annual dividend that does not change overtime consequently. An investment manager will usually lump preferred shares with bonds rather than with common stocks.

Conversely, a convertible bond is a debt security paying a fixed interest rate. It has then added feature of being convertible into shares of common stocks by the bond holders. If the terms of the conversion feature are not particularly attractive at a given moment, the bonds behave like a bond and are classified as fixed income securities. On the other hand, rising stock prices make the bond act more like the underlying stock, in which case the bond might be classified as an equity security. The point is that one cannot generalize and group all stock issues as equity securities and all bonds as fixed income securities. Their investment characteristics determine how they are treated. For investment purposes, preferred stock is considered a fixed income security.

 

3) Derivative Assets:

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.

 

1.4 Investment vs Speculation

A speculator can be defined as someone that seeks to buy and sell in order to take advantage of market price fluctuations. An investor is someone who holds on to securities that provide a good income or capital gain by virtue of them being based on something of real and increasing value.

The most realistic distinction between the investor and the speculator is found in their attitude toward stock-market movements. The speculator's primary interest lies in anticipating and profiting from market fluctuations. The investor's primary interest lies in acquiring and holding suitable securities at suitable prices. Market movements are important to him in a practical sense, because they alternately create low price levels at which he would be wise to buy and high price levels at which he certainly should refrain from buying and probably would be wise to sell.

 

Difference between Speculation and Investment

Basis	Speculation	Investment
Meaning	• A message expressing an opinion based on incomplete evidence	• The investing of money
Types of contract	• Speculator is a owner of the speculation	• Investor is a creditor of the Investment
Length commitment	• In the case speculation the length of commitment is a short term only	• In the case of investment the length of commitment is a long term
Source of Income	• The source of income is fluctuated and changes in market price	• The source of income is earning from the enterprise
Quantity of Risk	• Quantity of risk is the high	• Quantity of risk is the Low
Stability of Income	• Income is uncertain and erratic	• Income is very stable
Psychological attitude of Participants	• Speculator psychological attitude is a daring and careless	• Investor psychological attitude is a cautious and conservative
Reasons for Purchase	• It is unscientific analysis of intrinsic worth	• It is scientific analysis of intrinsic worth
Planning Horizon	• A speculator has a very short planning horizon. His holding may be a few to a days to a few months	• An investor has a relatively longer planning horizon. His holding period is usually at least one year
Risk Disposition	• A speculator risk is high	• An investor risk is less
Return Expectation	• A speculator looks for a high rate of return	• An investor usually seeks moderate rate of return
Basis for Decisions	• A speculator relies more on hear say, technical charts and market psychology	• An investor attaches greater significance to fundamental factors and attempts a careful evaluation of the growth of the enterprise
Leverage	• A speculator normally takes to borrowings, which can be very substantial, to supplement his personal resources.	• An investor uses his own funds avoid borrowed funds