Investment Decision and

Portfolio
Management (ACF 722)

Chapter 1 – Investment:
Introduction and over views

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 Investment defined
• Investment is defined as the commitment of current
financial resources in order to achieve higher gains in the
future.
• The “investor” can be an individual, a government, or a
corporation.
• This definition includes all types of investments,
including investments by corporations like Physical
Asset and investments in financial asset like stocks,
bonds etc.

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What do Investors Want?

¨ Investors seek current or future income or sometimes

both.
¨ Future income might be used for personal consumption at a
later date or for future generations.
¨ Aggressiveness of investor depends on risk preferences.
¨ Generally, the reasons for investments are:
 To accomplish our personal and family goals
 To have resources for retirement, education, etc.
 To grow our financial assets to serve and bless our families and
others.

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 Forms of Investment

• Two forms of investment can be defined: real and financial

– Real investment is the purchase of land, machinery, etc

– Financial investment is the purchase of a "paper" contract

• Real investments and financial investments are linked

– The share issue of a firm finances the purchase of asset

• Financial investment can provide finance for real investment

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 Financial
• There areInvestment
numerous components to financial
investment
• Markets: where assets are bought and sold, and the
forms of trade
• Securities: the kinds of securities available, their returns
and risks
• Investment process: the decision about which
securities,
and how much of each
• Financial theory: the factors that determine the
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 Markets
• A market is any organized system for connecting buyers and
sellers
• There are many security markets
• Markets may have a physical location
– The New York Stock Exchange

• Or exist only as computer networks

– Nasdaq

• Markets vary in the securities that are traded and in the

way securities are traded
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Characteristics of Markets
• There are a number of ways to classify markets

Primary/Secondary
– Primary markets are security markets where new issues
of securities are traded.
– A secondary market is a market where securities are
resold.

• Most activity on stock exchanges is in the

secondary market.
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 Characteristics of
• TradesMarkets
on the primary market raise capital for firms
• Trades on the secondary market do not raise
additional capital for firms
• The secondary market is still important
– It gives liquidity to primary issues. New securities would
have a lower value if they could not be subsequently
traded
– It signifies value. Trading in assets reveals information
and provides a valuation of the assets. This helps to
guide investment decisions. 8
 Characteristics of Markets
• Markets can also be characterized by the lifespan of the
assets
traded

Money/Capital
– Money market: for assets with a life of less than 1 year

– Capital market: for assets with a life greater than 1 year

• Some assets, such as most bonds, have a fixed lifespan

• Common stock have an indefinite lifespan

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Continued…

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 Brokers
• A broker is a representative appointed by an individual
investor
• Brokers have two conflicting roles

– An advisor: a broker can offer investment advice and

information
– A sales person: brokers are rewarded through
commission and have an incentive to encourage trade

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 Brokers...Con’d
• A full service broker is a brokerage house that can
offer a full range of services including investment
advice and portfolio management
• A discount broker offers a restricted range of services
at a lower price
 To complete a trade additional brokers are needed
• A floor broker is located on the floor of the
exchange and does the actual buying and selling

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 Securities

• The standard definition of a security is:

"A legal contract representing the right to

receive
future benefits under a stated set of conditions"
• The piece of paper defining the property
rights held by the owner is the security

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 Securities…Cont’d
• Money market securities

– Short-term debt instruments sold by governments,

financial institutions and corporations
– They have maturities of one year or less

• 1. Treasury Bills

– Treasury Bills are the least risky and the

most marketable of all money markets
instruments
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 Securities…Cont’d
• T -bills
– An active secondary market with very low transaction
costs for trading it.
– T-bills are sold at a discount from face value and pay
no explicit interest payments.
• T-bills are considered to have no risk of default, have
very short-term maturities, and have a known return.
• T-bills are the closest approximations that exist to a risk-
free investment.

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 Securities…Cont’d
• Capital market securities
– Instruments having maturities greater than one year
and those having no designated maturity at all.

• 1. Fixed income securities

– Fixed income securities have a specified payment
schedule
– Bonds promise to pay specific amounts at specific times

– Failure to meet any specific payment puts the bond

into default with all remaining payments.

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 Securities…Cont’d
– Fixed income securities differ from each other in
promised return for several reasons
• The maturity of the bonds
• The creditworthiness of the issuer
• The taxable status of the bond

– Income (interest in this case) and capital gains are

taxed differently in many countries
– Bonds are designed to exploit these differences
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 Securities…Cont’d
1. Treasury notes , Treasury bonds and treasury Inflation-Protected
Securities (TIPS)
 Both notes and bonds usually pay interest twice a year and repay
principal on the maturity date
 Treasury notes mature in more than a year, but not more than 10 years
from their issue date.
 Bonds mature in more than 10 years from their issue date.
 The principal value of TIPS is adjusted to reflect inflation or deflation as
measured by the Consumer Price Index
 With TIPS, the semi-annual interest payments and maturity payment
are calculated based on the inflation-adjusted principal value of the
security
2. Corporate bonds
– These promise to pay interest at periodic intervals and to return
principal at a fixed date
– These bonds are issued by business entities and thus have a risk of
default 18
Securities…Cont’d

2. Common stock (shares, equity)

– Common stock represents an ownership claim on the
earnings and assets of a corporation
– After holders of debt claims are paid, the management of
the company can either pay out the remaining earnings to
stockholdings in the form of dividends or reinvest part or all
of the earnings
– The holder of a common stock has limited liability

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 Securities…Cont’d
3. Derivative instruments
– Derivative instruments are securities whose value derives
from the value of an underlying security or basket of
securities
– The instruments are also known as contingent claims, since
their values are contingent on the performance of
underlying assets
Uses
Risk management
– Hedging (e.g. farmer with corn forward)
Speculation
– Essentially making bets on the price of something
Reduced transaction costs
– Sometimes cheaper than manipulating cash portfolios
Regulatory arbitrage 20
 Securities…Cont’d
1. A forward contract is a private agreement between two
parties giving the buyer an obligation to purchase an
asset (and the seller an obligation to sell an asset) at a
set price at a future point in time.

2. A future is the obligation to buy or sell a particular

security or bundle of securities at a particular time for
a stated price
– A future is simply a delayed purchase or sale of a
security
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 Securities…Cont’d
3. An option on a security gives the holder the right to either
buy (a call option) or sell (a put option) a particular asset at a
future date or during a particular period of time for a specified
price
4. A swap is a derivative in which two counterparties exchange
cash flows of one party's financial instrument for those of the
other party's financial instrument. The benefits in question
depend on the type of financial instruments involved.

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 Types of a Derivative

Futures The owner of a future has the OBLIGATION to sell or

buy something in the future at a predetermined price.

The owner of a forward has the OBLIGATION to sell or

Forwards
buy something in the future at a predetermined price.
The difference to a future contract is that forwards are
not standardized.

Options The owner of an options has the OPTION to buy or sell

something at a predetermined price and is therefore
more costly than a futures contract.

Swaps A swap is an agreement between two parties to exchange

a sequence of cash flows.
 Securities…Cont’d
5. Indirect investing
– The purchase of a shares of an investment
portfolio
• mutual fund

• Unit trusts

• Investment trusts

• Hedge funds

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 Securities…Cont’d
• Mutual funds are a type of investment that take money

from many investors and uses it to make investments on

financial markets based on a stated investment

objective.

– Each shareholder in the mutual fund participates

proportionally (based upon the number of

shares owned) in the gain or loss of the fund.

– They are open ended, well diversified, 25

 Securities…Cont’d
• A unit trust is a form of collective investment constituted under a trust

deed. It pools investors money into a single fund, which is managed by a

fund . It is unincorporated mutual fund structure that allows funds to hold

assets and provide profits that go straight to individual unit.

• Unit trusts are also referred to as open-ended funds, because they will

always accept more cash from investors.

– They just become bigger to accommodate the demand.

– If there are more sellers than buyers, the fund will become smaller.
– They are open ended, invests on smaller diversified portfolio

of securities , with passive strategy and defined life funds

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 Securities…Cont’d

• Investment trusts are form of collective investment found

mostly in Uk. They are known as closed- ended funds, as
they tend to raise a set amount of cash, then invest it.

– They do not create new shares

whenever someone wants to buy them.
– They are listed on stock market

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 Securities…Cont’d
• Hedge fund is investment fund that pooled capitals from
accredited individuals and institutional investors and invest in
variety of Assets.
• It is investment pools that are relatively unconstrained
in what they do; relatively unregulated; charge very
high fees.
• The primary aims of most hedge funds is to reduce
volatility and risk, while attempting to preserve
capital, and deliver positive returns under all market 28
 Key Participants in Investment
• Process
Government
– Federal, state and local

– Typically net demanders of funds

• Business

– Investments in production of goods and services

– Typically net demanders of funds but can also be

suppliers

• Individuals

– Some need for loans (house, auto)

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– Typically net suppliers of funds 2
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 Types of
• Investors
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
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