Investment And Portfolio Management

Investment and Portfolio Management

WEEK 1 September 2, 2009 Prepared by Mrs.Mahlaqa

Lecture Contents I. II. III.

Investment defined Importance of Investments. Investment Alternatives.

Learning Objectives 

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To appreciate the scope of investment decisions and the operating environment in which they are made. Understand the basics of two derivative securities, options and futures and how they fit into the investor's choice. Appreciate the importance of indirect investing (the use of investment companies and exchange-traded funds) to individual investors. Understand exchange-traded funds, a bridge between direct and indirect investing.

1. Definitions: 

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Investment is an activity that commits funds in any financial/physical form in the present with an expectation of receiving additional return in the future. The commitment of funds to one or more assets that will be held over some future time period. In its broadest sense, “an investment is a sacrifice of current money or other resources for future benefits”.

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We can still define investment as; investment is the current commitment of dollars for a period of time in order to derive future payments that will compensate the investor for:

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The time the funds are committed The expected rate of inflation The uncertainty of the future payments

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Investments can be classified as financial investments or economic investments. The financial investment is the commitment of funds to derive future income in the form of interest, dividend, premium or pension benefits et. Examples: purchase of shares, debentures and insurance policies Economic investment is an expectation of increasing the current economy's capital stock that consists of goods and services. Example: Capital Stock

Investment as a Profession:       

Investment Bankers Bond Traders Security Analyst Portfolio Managers Stock Brokers Financial Planners Chartered Financial Analyst (CFA)

3. Investment Alternatives. There are two forms of investing:  Direct Investing: It involves securities that investors not only buy and sell themselves but also have direct control over.  Indirect Investing: It refers to the buying and selling of the shares of investment companies that, in turn, hold portfolios of securities.

Direct Investing

A. B. C. D.

We can divide direct investing into the following broad categories: Nonmarketable Money Market Capital Market Derivatives Market

A. Nonmarketable Financial Assets 

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Those assets which represent personal transactions between the owner and the issuer e.g. bank account etc. These are “safe” investments, occurring at insured financial institutions or issued by the U.S. government. At least some of these assets offer the ultimate in liquidity.

Types of Nonmarketable Financial Assets 1. 2. 3. 4.

Savings Accounts Nonnegotiable Certificates of deposit Money market deposit accounts U.S. government savings bonds

1. Savings Account 

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Savings accounts are held at commercial banks or at “thirft” institutions such as savings and loan associations and credit unions. Savings accounts in insured institutions offer a high degree of safety on both the principal and the return on that principal.

2. Nonnegotiable Certificates of deposit (CDs) 

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Commercial banks and other institutions offer a variety of savings certificates known as certificates of deposit. These certificates are available for various maturities, with higher rates offered as maturity increases. In effect, institutions are free to set their own rates and terms on most CDs.

3. Money Market Deposit Accounts (MMDAs) 

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Financial institutions offer money market deposit accounts with no interest rate ceilings. Money market “investment” accounts have a required minimum deposit to open, pay competitive money market rates and are insured.

4. U.S. Government Savings Bonds 

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The nontraded debt of the governments, savings bonds, are nonmarketable, nontransferable, and nonnegotiable, and cannot be used for collateral. They are purchased from the Treasury, most often through banks and savings institutions.

B. Money Market Securities 

Money markets include short-term, highly liquid, relatively low risk instruments sold by governments, financial institutions, and corporations to investor with temporary excess funds to invest.

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This market is dominated by financial institutions, particularly banks, and governments.

Major Money Market Securities

1. 2. 3. 4. 5. 6.

Following are the major money market securities: Treasury bills Negotiable Certificates of Deposit (CDs) Commercial Paper Eurodollars Repurchase Agreement (RPs) Banker’s Acceptance

1. Treasury Bills 

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The premier money market instrument, a fully guaranteed, very liquid IOU from the government treasury. They are sold on an auction basis every week at a discount from face value, therefore, the discount determines the yield. The greater the discount at time of purchase, the higher the return earned by investors.

2. Negotiable Certificates of Deposit (CDs) 

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Issued in exchange for a deposit of funds by most banks, the CD is a marketable deposit liability of the issuer, who usually stands ready to sell new CDs on demand. The deposit is maintained in the bank until maturity, at which time the holder receives the deposit plus interest.

3. Commercial Paper 

A short-term unsecured promissory note issued by large, well-known and financially strong corporations.

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It is usually sold at a discount either directly by the issuer or indirectly through a dealer, with rates comparable to CDs.

4. Eurodollars 

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Dollar-denominated deposits held in foreign banks or in offices of U.S. banks located abroad. Although this market originally developed in Europe, dollar-denominated deposits can now be made in many countries, such as those of Asia.

5. Repurchase Agreement (RPs) 

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An agreement between a borrower and a lender to sell and repurchase government securities. The borrower initiates an RP by contracting to sell securities to a lender and agreeing to repurchase these securities at a prespecified price on a stated date.

6. Banker’s Acceptance 

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A time draft drawn on a bank by a customer, whereby the bank agrees to pay a particular amount at a specified future date. These are negotiable instruments because the holder can sell them for less than face value in the money market. It is normally used in international trade.

C.

Capital Market Securities

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Capital Market: The market for long-term securities such as stocks and bonds.

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There are two types:  Fixed Income Securities 

Equity Securities

Fixed Income Securities 

All of these securities have a specified payment schedule, such as bond. In most cases the amount and date of each payment are known in advance. Some of these securities deviate from the traditional bond format, but all fixed-income securities have a specified payment or repayment schedulethey must mature at some future date.

Types of Fixed-Income Securities 1. 2. 3. 4.

Federal Government Securities Government Agency Securities Municipals Securities Corporates

Bonds 

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Bonds can be described as long-term debt instruments representing the issuer’s contractual obligation, The buyer of a newly issued coupon bond is lending money to the issuer who, in turn, agrees to pay interest on this loan and repay the principal at a stated maturity date. Specified interest payment and the principal repayment. Bonds are Fixed-income securities

Bond Characteristics   

Coupon Bonds Zero Coupon Bond Call Provision: The right to call in a security and retire it by paying off the obligation.

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Non Callable Bonds Legal Liability to pay interest and repay principal amount.

1. Federal Government Securities 

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The govt. in the course of financing its operation through the Treasury Department, issues numerous notes and bonds with maturities greater than one year. Treasury Bonds: Traditionally have maturities of 10 to 30 years. They are sold at competitive auctions and are sold at face value. Treasury-Inflation-Indexed Securities: Protect investors against losses resulting from inflation. Based on the Consumer Price Index (CPI), the value of the bond is adjusted upward every six months by the amount of inflation.

2. Government Agency Securities 

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The federal government has created various federal agencies designed to help certain sectors of the economy through either direct loans or guarantee of private loans. These various credit agencies compete for funds in the marketplace by selling government agency securities.

Types of Govt. Agency Securities 

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Federal Agencies: Legally, federal agencies are part of the federal govt. and their securities are fully guaranteed by the Treasury. Federally Sponsored Credit Agencies: These are privately owned institutions that sell their own securities in the marketplace in order to raise funds for their specific purposes.

3. Municipals Securities 

Bonds sold by states, counties, cities and other political entities (e.g., airport authorities, school districts) other than the federal government and its agencies are called municipal bonds. The risk varies widely, as does marketability.

4. Corporates 

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Long-term debt securities of various types sold by corporations. The typical corporate bond matures in 20 to 40 years, pays semiannual interest, is callable, and is sold originally at a price close to par value.

What is an Investment Company Investment Company is a financial company that sells shares in itself to the public and uses these funds to invest in a portfolio of securities. Types of Investment Companies:  Unit Investment Trusts  Closed-End Investment Companies  Open-End Investment Companies or Mutual Funds 

Unit Investment Trusts 

Unit Investment Trust is an Unmanaged form of Investment company, typically holding fixed income securities, offering investors diversification and minimum operating costs.

Closed-End Investment Company 

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An investment company with a fixed capitalization whose shares trade on exchange markets It is a type of managed investment company

Open-End Investment Company 

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An investment company whose capitalization constantly changes as new shares are sold and outstanding shares are redeemed. Open-End Investment Company is the managed company and are popularly referred as Mutual Funds Mutual Funds are the popular name for an Open-End Investment Company

Equity Securities 

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Equity securities represent an ownership interest in a corporation. These securities provide a residual claim There are two types:  

Preferred Stock Common Stock

Preferred Stock It is known as hybrid security An equity security with an intermediate claim Cumulative & noncumulative Variable-rate preferred Stock Auction-rate preferred Stock Convertible into Common Stock Mandatory Convertibles

Common Stock An equity security representing the ownership interest in a company “Closely held” and “go public” Par Value and Book Value Market Value & Aggregate Market Value Dividends

Derivative Securities 

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Securities that derive their value in whole or in part by having a claim on some underlying security. Their value is derived from their connected underlying security.

Two types of Derivatives:  

Options Futures Contract

Options 

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Options means the rights to buy or sell a stated number of shares of stock within a specified period at a specified price. The word options refers to puts and calls. Options are created not by corporations but by investors seeking to trade in claims on a particular common stock.

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Put: An option to sell a specified number of shares of stock at a stated price within a specified period. Call: An option to buy a specified number of shares of stock at a stated price within a specified period. Leaps: Puts and calls with longer maturity dates of up to two years.

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Buyers of calls are betting that the price of the underlying common stock will rise, making the call option more valuable. Put buyers are betting that the price of the underlying common stock will decline, making the put option more valuable.

Futures Contracts 

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Future Contract is a commitment to buy or sell at a specified future settlement date a designated amount of a specific commodity or asset. Future contracts have been available on commodities such as corn and wheat for a long time. Now they are also available for financial instruments, including stock market indexes, currencies, Treasury bill & bonds, bank certificates of deposits. Agreement providing for the future exchange of a particular asset at a currently determined market price.