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Investment

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SAPM – Unit I

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Investment

• Investment is the employment of funds with the aim of achieving additional income or growth in value.

• Qualities/attributes of Investment

• Waiting for reward

• Long-term commitment of resources

• Put away from current consumption

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Meaning

• Financial : Allocation of monetary resources to various assets through which return or yield can be generated over the period of time.

• Economist : Net additions to the economy’s capital stock which consists of assets through which other goods & service

• capital formation

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Investment & Speculation

• …?????

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Investment & SpeculationTime

Risk

Return

Tax

Long-Term (>12 months)

Limited

Consistent and moderate return

Long-term Capital Gain

Short- term(Even intra-day)

Compared to investment is high

High volatility persist.

Short term capital Gain

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Investment and Speculation

Decisions Safety,

Liquidity

Profitability

Stability

Performance

Are considered while investment.

Depends on Market information, judgment, movement in the stock markets

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Real Assets

• Land & Building, f&f

• Tangible, movable,immovable

• Used for production of Goods & Services

Financial Assets

• Securities,derivatives,

fixed deposits, bills,

loans• Called as paper

securities• Financial claims

represented by securities

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Why Invest….

Longer Life ExpectancyTaxationInterest ratesInflationSurplus Income

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Factors Favourable for ….

1. Legal Safeguards

2. A stable currency

3. Existence of financial institutions and services

4. Forms of business organisation

5. Plenty choice of investment

6. Risky and Risk-less option available

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Investment Media

• Direct Invest. Alternatives

• Fixed Principal Investment

• Savings Account

• Savings Certificate

• Government Bonds

• Corporate Bonds and Debentures

• Indirect Invest. Alternatives

• Pension Fund• Provident Fund• Insurance• Invest. Companies• UTI and Other trust

funds

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Invest. Media

• Variable Principle Securities

• Equity Shares• Convertible

Debentures or • Preference Securities

• Non-Security Investment

• Real Estate• Mortgages• Commodities• Art, Antiques and

other valuables

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Investment Process / Stages in investment

1. Investment Policy

2. Investment Analysis

3. Valuation of Securities

4. Portfolio Construction

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1. Investment policy

ObjectivesFinancial affairsLiquidityIdentification of assets

This is the stage of considering various investment features.

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2. Investment Analysis

• Security Analysis

• Kind of security

• Behaviour of Stock prices

• Risk

• Return

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3. Valuation of Securities

• Comparison of the VALUE with the current market price of the asset

• Determination of the relative attractiveness of the asset.

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4. Portfolio Construction

1. Determination of diversification level

2. Selection of investment assets

3. Allocation of investible wealth to assets

4. Timing of the investment

5. Evaluation of portfolio for feedback

6. Dynamic Reconstruction

Risk

Concept of Risk

Uncertainty is the inability to forecast the future events and Risk is the expected deviation in the outcome from the plan of action. It is expressed in terms of variability of return.

Types of risks:Systematic riskUnsystematic risk

Systematic Risk

It is the risk that is caused by external factors such as Economic, Political and Sociological conditions. It affects the functioning of the entire market. Otherwise known as External or Non-diversible or Uncontrollable risk.

1. Market risk

2. Interest rate risk

3. Purchasing power risk

1.Market Risk

Market risk as that portion of the total variability of returns that is caused by investor attitude which leads to bull and bear markets.

Tangible events: Earthquake, war, political uncertainty and decrease in the value of money are some of the examples of tangible events.

Intangible events: It is related to market psychology, expectations and market sentiments.

2. Interest Rate Risk

It is the risk caused by the variations in the market interest rates. Prices of debentures, bonds, etc. are mainly affected by the interest rate risk.

Causes of interest rate risk

Changes in the government’s monetary policyChanges in the interest rate of treasury bills

Changes in the interest rate of government bonds

3. Purchasing Power Risk

Variations in returns are caused by the loss of purchasing power of currency.

Demand-pull inflation: The demand for goods and services remains higher than the supply.

Cost-push inflation: There is a rise in price due to the increase in the cost of production.

Nominal future valueReal future value = ------------------

1 + Inflation Rate 1 + r

Real Rate of Return = -------- - 1

1 + IR

where r = rate of return and IR = Inflation Rate

Unsystematic Risk

Unique, specific and related to a particular industry.

Managerial inefficiency, changes in preferences of the consumers,

Availability of raw material, labour problems, etc.

1. Business risk2. Financial risk

1. Business Risk

It is the risk that is caused by the inefficiency of a company to manage its growth or stability of earnings.

It can be classified as: Internal business risk: It is the risk that is associated

with the operational efficiency of a company.External business risk: It is the risk that is the result

of operating conditions imposed on the firm by the external environment.

2. Financial Risk

It is associated with the capital structure of the company, which consists of equity and borrowed funds. A financial risk can be avoided by analyzing the capital structure of the company.

The financial risk considers the risk between EBIT and EBT.

Risk Measurement

An efficient measurement of risks provides an appropriate quantification of risk.

Standard deviation is used as a tool for measuring the risk, which is a measure of the variables around its mean.

The following formula is used to calculate standard deviation:

N

2

1i=1

σ = P r -E(r)

Beta

Beta is the sensitivity of the scrip return in relation to market index return. Beta describes the relationship between the stock return and index return. Negative beta indicates that the stock return and the market move in opposite directions. Beta is the slope of the regression line.

Beta = +1.0. One per cent change in index return causes one per cent change in stock return.

Beta = +0.5. One per cent change in index return causes 0.5 per cent change in stock return.

CAPM

• Introduced by Jack Treynor (1961, 1962)

• William Sharpe (1964)

• John Lintner (1965a,b) and Jan Mossin (1966) independently

• Sharpe, Markowitz and Merton Miller jointly received the Nobel Memorial Prize in Economics for this contribution to the field of financial economics.

Meaning - CAPM

• Capital Asset Pricing Model

• A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities.

• The general idea behind CAPM is that investors must be compensated in two ways: time value of money and risk.

Formula