Chapter One
INTRODUCTION TO INVESTMENT
1.1. Definition of 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. They can 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. 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.
Those who give up immediate possession of savings (that is, defer consumption) expect to receive
in the future a greater amount than they gave up. 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.
An 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. This
course emphasizes 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.
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1.2. Investment Alternatives
A. Assets:
Assets are things that people own. The two kinds of assets are financial assets and real assets. The
distinction between these terms is easiest to see from an accounting viewpoint.
A financial asset: carries a corresponding liability somewhere. If an investor buys shares of stock,
they are an asset to the investor but show up on the right side of the corporation’s balance sheet.
A financial asset, therefore, is on the left-hand side of the owner’s balance sheet and the right-hand
side of the issuer’s balance sheet.
A real asset: does not have a corresponding liability associated with it, although one might
Be created to finance the real asset. Financial assets have a corresponding liability but real assets
do not.
B. 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 the 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
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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:
Derivative assts have received a great deal of attention in the 1990s. A derivative asset 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. These building blocks of risk management programs are used
by all large investment houses and commercial banks.
1.3. Investment Companies
An investment company is a financial service organization that sells shares in it to the public and
uses the funds it raises 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.
A regulated investment company can elect to pay no federal taxes on any distribution of dividends,
interest, and realized capital gains to its shareholders. The investment company acts as a conduit,
"flowing through" these distributions to stockholders who pay their own marginal tax, rates on
them. In effect, fund shareholders are treated as if they held the securities in the fund's portfolio.
Shareholders pay the same taxes they would pay if they owned the shares directly.
Fund taxation is unique with income taxed only once when it is received by its shareholders. A
funds short-term gains and other earnings are taxed to shareholders as ordinary income, whereas
its long-term capital gains are taxed to shareholders as" long-term, capital gains.
Tax-exempt income received by a fund is generally tax exempt to the shareholder.
Investment companies are required by the Investment Company Act of 1940 to register with the
Securities and Exchange Commission (SEC). This detailed regulatory statute contains numerous
provisions designed to protect shareholders. Both federal and state laws require appropriate
disclosures to investors.
It is important to note that investment companies are not insured or guaranteed by any government
agency or by any financial institution from which an investor may obtain shares. These are risky
investments, losses to, investors can and do occur (just think 2000 to 2002), and investment
companies' promotional materials state this clearly.
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Types of Investment Companies:
All investment companies begin by selling shares in themselves to the public. The proceeds are
then used to buy a portfolio of securities. 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 types, we
focus on mutual funds, the most popular type of investment company by far for the typical'
individual investor.
Unit Investment Trusts:
An alternative form of. Investment Company that deviates from the normal managed type is the
unit -investment trust, (OIT), 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 either equities or tax-exempt securities.
The assets are almost always 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 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 purchase of securities by (he 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
Closed-End Investment Companies:
One of the two types of managed investment companies, the closed-end investment company,
usually sells no additional shares of its own 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) broker age commissions.
Open-End Investment Companies (Mutual Funds):
Open-end 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-end investment company is continually
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.
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Mutual funds typically are purchased either:
1. Directly from a fund company, using mail or telephone, or at the company's 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 either corporations or business trusts 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.
Some mutual funds use a sales force to reach investors, with shares being available from brokers,
insurances agents, and financial planners. In an alternative form of distribution called direct
marketing, the company uses advertising and direct mailing to appeal to investors. About 60
percent of all stock, bond; and income fund sales are made by funds using a sales force.
Mutual funds can be subdivided into:
1. Load funds (those that charge a sales fee)
2. No-load funds (those that do not charge a sales fee)
Major Types of Mutual Funds:
The general range of mutual funds arrayed along a return-risk spectrum. As we can see', money
market funds are on the lower end; and bond funds and balanced funds (which hold both bonds
and stocks) are in the middle. Stock funds are on the upper-end of the risk-return spectrum.
There are two major types of mutual funds:
1. Money market mutual funds
2. Stock (also called equity) funds and bond & income funds
These types of funds parallel of money markets and capital markets. Money market funds
concentrate on short-term investing by holding portfolios of money market assets, whereas stock
funds and bond & income funds concentrate on longer term investing by holding mostly capital
market assets. We will discuss each of these two types of mutual funds in turn.
Money Market Funds:
A major innovation in the investment company industry has been the creation, and subsequent
phenomenal growth, of money market funds (MMFs), which are open-end investment companies
whose portfolios consist of m6ney market instruments. Created in 1974, when interest rates were
at record-high levels, MMFs grew rapidly as investors sought to earn these high short-term rates.
However,-with- the deregulation of the thrift institutions, competition has increased dramatically
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for investors' short-term savings. Money market deposit accounts (MMDAs) pay competitive
money market rates and are insured, and therefore have attracted large amounts of funds.
Investors in higher tax brackets should carefully compare the taxable equivalent yield on tax-
exempt money market funds with that available on taxable funds because the tax-exempt funds
often provide an edge.
Taxable MMFs hold assets such as Treasury bills, negotiable certificates of deposit (CDs), and
prime commercial paper. Some funds hold only bills, whereas others hold various mixtures.
Commercial paper typically accounts for 40 to 50 percent of the total assets held by these funds,
with Treasury bills, governmental agency securities, domestic and foreign bank obligations, and
repurchase agreements rounding out" the portfolios. The average maturity of money market
portfolios ranges from approximately one to two months. SEC regulations limit the maximum
average maturity of money funds to 90 days.
Stock Funds and Bond A Income Funds:
The board of directors (trustees) of an investment company must specify the objective that the
company will pursue in its investment policy! The companies try to follow a consistent investment
policy according to their specified objective. Investors purchase mutual funds on the basis of their
objectives.
The Investment Company Institute, a well-known organization that represents the investment
company industry, uses multiple major categories of investment objectives, most of which are for
equity and bond, & income funds (the remainder are-for money market funds as previously
explained).
Measures of Fund Performance for Investment company:
Throughout this text we will use total return to measure the return from any financial asset,
including a mutual fund. Total return for a mutual fund includes reinvested dividends and capital
gains, and therefore includes all of the ways investors make money from financial assets. It instated
as a percentage or a decimal, and can cover any time periods-one month, one year, or multiple
years.
A cumulative total return measures the actual cumulative performance over a stated period of
time, such as the past 3, 5 and 10 years. This allows die investor to assess total performance over
some stated period of time.
Investing Internationally Through Investment Companies:
The mutual fund Industry has become a global industry. Open-end funds around the world have
grown rapidly, including emerging market economies. About 42 percent of worldwide mutual
future assets were invested in equity funds and another 26 percent in money market funds.
Aggregate mutual fund assets in Europe amount to about one-third of the world total. .In
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Latin America, roughly one of every 200 people owns a mutual fund (compare to one in three in
the United States). In Japan, mutual fund assets approximate one-half trillion dollars.
Funds that specialize in international securities have become both numerous and well known in
recent years.
1. So-called international funds tend to-concentrate primarily on international stocks. In one
recent year, Fidelity Overseas Fund was roughly one-third invested in Europe and one-third in
the Pacific Basin, whereas Kemper International had roughly one sixth of its assets in each of
three areas, the United Kingdom, Germany, and Japan.
2. Global funds tend to keep a minimum of 25 percent of their-assets in the United States. For
example, in one recent year, Templeton World Fund had over 60 percent of its assets in the
United States and small positions in Australia and Canada.
Most mutual funds that offer "international" investing invest primarily in non U.S. stocks, thereby
exposing investors to foreign markets, which may behave differently from U.S. markets. However;
investors may also be exposed to currency risks. An alternative approach to international investing
is to seek international exposure by investing in U.S. companies with strong earnings abroad,
which is a natural extension of the globalization concept.
1.4. Securities market
Securities market is a component of the wider financial market where securities can be bought
and sold between subjects of the economy, on the basis of demand and supply. Securities markets
encompasses equity markets, bond markets and derivatives markets where prices can be
determined and participants both professional and non professionals can meet.
Securities markets can be split into below two levels. Primary markets, where new securities are
issued and secondary markets where existing securities can be bought and sold. Secondary markets
can further be split into organized exchanges, such stock exchanges and over-the counter where
individual parties come together and buy or sell securities directly. For securities a holder knowing
that a secondary market exists in which their securities may be sold and converted into cash
increases the willingness of people to hold stocks and bonds and thus increases the ability of firms
to issue securities.
There are a number of professional participants of a securities market and these include;
brokerages, broker-dealers, market makers, investment managers, speculators as well as those
providing the infrastructure, such as clearing houses and securities depositories.
A securities market is used in an economy to attract new capital, transfer real assets in financial
assets, determine price which will balance demand and supply and provide a means to invest
money both short and long term.
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A securities market is a system of interconnection between all participants (professional and
nonprofessional) that provide effective conditions:
to attract new capital by means of issuing new security (securitization of debt)
to transfer real asset into financial asset
to invest money for short or long term periods with the aim of deriving profitability
commercial function (to derive profit from operation on this market)
price determination (demand and supply balancing, the continuous process of prices
movements guarantees to state correct price for each security so the market corrects
mispriced securities)
informative function (market provides all participants with market information about
participants and traded instruments)
regulation function (securities market creates the rules of trade, contention regulation,
priorities determination)
Transfer of ownership (securities markets transfer existing stocks and bonds from
owners who no longer desire to maintain their investments to buyers who wish to
increase those specific investments
Insurance (hedging) of operations though securities market (options, futures, etc.)
Levels of securities market
Primary market
The Primary Market is that part of the capital markets that deals with the issue of new securities.
Companies, governments or public sector institutions can obtain funding through the sale of a new
stock or bond issue. This is typically done through a syndicate of securities dealers. The process
of selling new issues to investors is called underwriting. In the case of a new stock issue, this sale
is a public offering. Dealers earn a commission that is built into the price of the security offering,
though it can be found in the prospectus. Primary markets create long term instruments through
which corporate entities borrow from capital market...
Features of primary markets are:
This is the market for new long term equity capital. The primary market is the market where
the securities are sold for the first time. Therefore, it is also called the new issue market
(NIM).
In a primary issue, the securities are issued by the company directly to investors.
The company receives the money and issues new security certificates to the investors.
Primary issues are used by companies for the purpose of setting up new business or for
expanding or modernizing the existing business.
The primary market performs the crucial function of facilitating capital formation in the
economy.
The new issue market does not include certain other sources of new long term external
finance, such as loans from financial institutions. Borrowers in the new issue market may
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be raising capital for converting private capital into public capital; this is known as "going
public."
Secondary market
The secondary market, also known as the aftermarket, is the financial market where previously
issued securities and financial instruments such as stock, bonds, options, and futures are bought
and sold. The term "secondary market" is also used to refer to the market for any used goods or
assets, or an alternative use for an existing product or asset where the customer base is the second
market (for example, corn has been traditionally used primarily for food production and feedstock,
but a "second" or "third" market has developed for use in ethanol production).
Stock exchange and over the counter markets. With primary issuances of securities or financial
instruments, or the primary market, investors purchase these securities directly from issuers such
as corporations issuing shares in an IPO or private placement, or directly from the federal
government in the case of treasuries. After the initial issuance, investors can purchase from other
investors in the secondary market.
The secondary market for a variety of assets can vary from loans to stocks, from fragmented to
centralized, and from illiquid to very liquid. The major stock exchanges are the most visible
example of liquid secondary markets - in this case, for stocks of publicly traded companies.
Exchanges such as the New York Stock Exchange, Nasdaq and the American Stock Exchange
provide a centralized, liquid secondary market for the investors who own stocks that trade on those
exchanges. Most bonds and structured products trade “over the counter,” or by phoning the bond
desk of one’s broker-dealer. Loans sometimes trade online using a Loan Exchange.
Over-the-counter market
Over-the-counter (OTC) or off-exchange trading is to trade financial instruments such as stocks,
bonds, commodities or derivatives directly between two parties. It is contrasted with exchange
trading, which occurs via facilities constructed for the purpose of trading (i.e., exchanges), such as
futures exchanges or stock exchanges. In the U.S., over-the-counter trading in stock is carried out
by market makers that make markets in OTCBB and Pink Sheets securities using inter-dealer
quotation services such as Pink Quote (operated by Pink OTC Markets) and the OTC Bulletin
Board (OTCBB). OTC stocks are not usually listed nor traded on any stock exchanges, though
exchange listed stocks can be traded OTC on the third market. Although stocks quoted on the
OTCBB must comply with United States Securities and Exchange Commission (SEC) reporting
requirements, other OTC stocks, such as those stocks categorized as Pink Sheets securities, have
no reporting requirements, while those stocks categorized as OTCQX have met alternative
disclosure guidelines through Pink OTC Markets. An over-the-counter contract is a bilateral
contract in which two parties agree on how a particular trade or agreement is to be settled in the
future. It is usually from an investment bank to its clients directly. Forwards and swaps are prime
examples of such contracts. It is mostly done via the computer or the telephone. For derivatives,
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these agreements are usually governed by an International Swaps and Derivatives Association
agreement. This segment of the OTC market is occasionally referred to as the "Fourth Market."
The NYMEX has created a clearing mechanism for a slate of commonly traded OTC energy
derivatives which allows counterparties of many bilateral OTC transactions to mutually agree to
transfer the trade to ClearPort, the exchange's clearing house, thus eliminating credit and
performance risk of the initial OTC transaction counterparts..
Main financial instruments
Bond, Promissory note, Cheque – a security contains requirement to make full payment to the
bearer of cheque, Certificate of deposit, Bill of Lading (a Bill of Lading is a “document evidencing
the receipt of goods for shipment issued by a person engaged in the business of transporting or
forwarding goods." ), Stock.
Promissory note
A promissory note, referred to as a note payable in accounting, or commonly as just a "note", is a
contract where one party (the maker or issuer) makes an unconditional promise in writing to pay
a sum of money to the other (the payee), either at a fixed or determinable future time or on demand
of the payee, under specific terms. They differ from IOUs in that they contain a specific promise
to pay, rather than simply acknowledging that a debt exists.
Certificate of deposit
A certificate of deposit or CD is a time deposit, a financial product commonly offered to consumers
by banks, thrift institutions, and credit unions. CDs are similar to savings accounts in that they are
insured and thus virtually risk-free; they are "money in the bank" (CDs are insured by the FDIC
for banks or by the NCUA for credit unions). They are different from savings accounts in that the
CD has a specific, fixed term (often three months, six months, or one to five years), and, usually,
a fixed interest rate. It is intended that the CD be held until maturity, at which time the money may
be withdrawn together with the accrued interest.
Bond
Bond - an issued security establishing its holder's right to receive from the issuer of the bond,
within the time period specified therein,
its nominal value
and the interest fixed therein on this value or other property equivalent.
The bond may provide for other property rights of its holder, where this is not contrary to
legislation.
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Stocks (shares)
Common shares represent ownership in a company and a claim (dividends) on a portion of profits.
Investors get one vote per share to elect the board members, who oversee the major decisions made
by management. Over the long term, common stock, by means of capital growth, yields higher
returns than almost every other investment. This higher return comes at a cost since common stocks
entail the most risk. If a company goes bankrupt and liquidates, the common shareholders will not
receive money until the creditors, and preferred shareholders are paid.
Preferred share represents some degree of ownership in a company but usually doesn't come with
the same voting rights. (This may vary depending on the company.) With preferred shares
investors are usually guaranteed a fixed dividend forever. This is different than common stock,
which has variable dividends that are never guaranteed. Another advantage is that in the event of
liquidation preferred shareholders are paid off before the common shareholder (but still after debt
holders). Preferred stock may also be callable, meaning that the company has the option to
purchase the shares from shareholders at any time for any reason (usually for a premium). Some
people consider preferred stock to be more like debt than equity.
Professional participants
Professional participants in the securities markets - legal persons, including credit organizations,
and also citizens registered as business persons who conduct the following types of activity:
Brokerage shall be deemed performance of civil-law transactions with securities as agent or
commission agent acting under a contract of agency or commission, and also under a power
(letter) of attorney for the performance of such transactions in the absence of indication of the
powers of agent or commission agent in the contract.
Dealer activity shall be deemed performance of transactions in the purchase and sale of
securities in one's own name and for one's own account through the public announcement of
the prices of purchase and/or sale of certain securities, with an obligation of the purchase and/or
sale of these securities at the prices announced by the person pursuing such activity.
Activity in the management of securities shall be deemed performance by a legal person or
individual business person, in his own name, for a remuneration, during a stated period, of trust
management of the following conveyed into his possession and belonging to another person,
in the interests of this person or of third parties designated by this person:
1. securities;
2. monies intended for investment in securities;
3. monies and securities received in the process of securities management.
Clearing activity shall be deemed activity in determining mutual obligations (collection,
collation and correction of information on security deals and preparation of bookkeeping
documents thereon) and in offsetting these obligations in deliveries of securities
Depositary activity shall be deemed the rendering of services in the safekeeping of
certificates of securities and/or recording and transfer of rights to securities
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Activity in the keeping of a register of owners of securities shall be deemed collection,
fixing, processing, storage and provision of data constituting a system of keeping the
register of security owners
Provision of services directly promoting conclusion of civil-law transactions with
securities between participants in the securities market shall be deemed activity in the
arrangement of trading on the securities market.
Some Reasons for investing
People choose to invest to supplement their income, to earn gains, and to experience the excitement
of the investment process.
1) Income: Some people invest in order to provide or supplement their income. Investments
provide income through the payment of dividends or interest.
2) Appreciation: Other individuals, especially those in their peak working years, may be
more interested in seeing the value of their investments grow rather than in receiving any
income from investment. Appreciation is an increase in the value of an investment.
3) Excitement: Investing is frequently someone’s hobby. Investing is not inherently an end
in itself; it is a means to an end. Ultimately, the investment objective involves improved
financial standing. If an active investor makes frequent trades but only breaks even in the
process, only the stockbroker will benefit materially.
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