INVESTMENT ENVIRONMENT
INVESTMENT ENVIRONMENT
The term ‘investing” could be associated with different activities, but the common
target in these activities is to “employ” the money (funds) during the time period
seeking to enhance the investor’s wealth.
Funds to be invested come from assets already owned, borrowed money and savings.
By foregoing consumption today and investing their savings, investors expect to
enhance their future consumption possibilities by increasing their wealth.
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.
INVESTMENT ENVIRONMENT
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.
INVESTMENT ENVIRONMENT
Together with the investment the term speculation is frequently used. Speculation
can be described as investment too, but it is related with the short-term
investment horizons and usually involves purchasing the salable securities with
the hope that its price will increase rapidly, providing a quick profit.
Speculators try to buy low and to sell high, their primary concern is with anticipating
and profiting from market fluctuations. But as the fluctuations in the financial
markets are and become more and more unpredictable speculations are treated
as the investments of highest risk. In contrast, an investment is based upon the
analysis and its main goal is to promise safety of principle sum invested and to
earn the satisfactory risk.
INVESTMENT ENVIRONMENT
It is useful to make a distinction between real and financial investments. Real
investments generally involve some kind of tangible asset, such as land,
machinery, factories, buildings etc. Financial investments involve contracts in
paper or electronic form such as stocks, bonds, financial derivatives etc.
It is also important to distinguish individual investors from institutional investors.
Individual investors are individuals who are investing on their own. Sometimes
individual investors are called retail investors. Institutional investors are entities
such as investment companies, commercial banks, insurance companies,
pension funds and other financial institutions.
INVESTMENT ENVIRONMENT
Whether individual or institutional investors, 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, borrow) must be willing to pay back in the future more
than they borrowed.
The rate of exchange between future consumption (future dollars) and current
consumption (current dollars) is the pure rate of interest. Both people’s
willingness to pay this difference for borrowed funds and their desire to receive a
surplus on their savings give rise to an interest rate referred to as the pure time
value of money.
This interest rate is established in the capital market by a comparison of the supply of
excess income available (savings) to be invested and the demand for excess
consumption (borrowing) at a given time.
INVESTMENT ENVIRONMENT
Example:
If you can exchange $100 of certain income today for $104 of certain income one
year from today, then the pure rate of exchange on a risk-free investment (that is,
the time value of money) is 4 percent.
That is (104 - 100/100)*100 = 4%
The investor who gives up $100 today expects to consume $104 of goods and
services in future. This assumes that the general price level in the economy stays
the same. This price stability has rarely been the case during the past several
decades when inflation rates have varied drastically.
That is (106 - 100/100)*100 % = 6%
INVESTMENT ENVIRONMENT
When investors expect a change in prices, they will require a higher rate of return to
compensate for it.
Example:
If an investor expects a rise in prices (that is, he or she expects inflation) at the rate of
2 percent during the period of investment, he or she will increase the required
interest rate by 2 percent.
In this case, the investor would require $106 in the future to defer the $100 of
consumption during an inflationary period (a 6 percent nominal, risk-free interest
rate will be required instead of 4 percent).
INVESTMENT ENVIRONMENT
Further, if the future payment from the investment is not certain, the investor will
demand an interest rate that exceeds the pure time value of money plus the
inflation rate.
The uncertainty of the payments from an investment is the investment risk. The
additional return added to the nominal, risk-free interest rate is called a risk
premium.
In the previous example, the investor would require more than $106 one year from
today to compensate for the uncertainty.
As an example, if the required amount was $110, $4, or 4 percent, would be
considered a risk premium.
That is (110 - 100/100)*100 = 10 – 6%
INVESTMENT ENVIRONMENT
To recapitulate therefore, we can define investment as the current commitment of
dollars for a period of time in order to derive future payments that will
compensate the investor for; the time the funds are committed, the expected rate
of inflation, and the uncertainty of the future payments.
The “investor” can be an individual, a government, a pension fund, or a corporation.
This definition includes all types of investments classified and real assets and
financial assets. They include stocks, bonds, commodities, real estate among
others.
Individual and institutional investors 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. That return
is referred to as required rate of return.
FINANCIAL SYSTEM
The financial system comprises the financial markets, financial intermediaries and
other financial institutions that execute the financial decisions of individual and
institutional investors.
The
scope of the financial system is global. Extensive international
telecommunication networks link financial markets and intermediaries so that the
trading of securities and transfer of payments can take place 24 hours a day.
The financial system has four elements that interact continually namely: Lenders
(surplus economic units) and borrowers (deficit economic units); Financial
institutions; Financial instruments; and Financial markets.
FINANCIAL SYSTEM
FINANCIAL SYSTEM
Investors can use direct or indirect type of investing.
Direct investing is realized using financial markets and indirect investing involves
financial intermediaries.
The primary difference between these two types of investing is that applying direct
investing investors buy and sell financial assets and manage individual
investment portfolio themselves.
Consequently, investing directly through financial markets investors take all the risk
and their successful investing depends on their understanding of financial
markets, its fluctuations and on their abilities to analyze and to evaluate the
investments and to manage their investment portfolio.
FINANCIAL SYSTEM
Using indirect type of investing investors are buying or selling financial instruments of
financial intermediaries (financial institutions) which invest large pools of funds in
the financial markets and hold portfolios.
Indirect investing relieves investors from making decisions about their portfolio. As
shareholders with the ownership interest in the portfolios managed by financial
institutions (investment companies, pension funds, insurance companies,
commercial banks) the investors are entitled to their share of dividends, interest
and capital gains generated and pay their share of the institution’s expenses and
portfolio management fee.
FINANCIAL SYSTEM
The risk for investor using indirect investing is related more with the
credibility of chosen institution and the professionalism of portfolio
managers.
In general, indirect investing is more related with the financial institutions
which are primarily in the business of investing in and managing a
portfolio of securities (various types of investment funds or investment
companies, private pension funds).
By pooling the funds of thousands of investors, those companies can offer
them a variety of services, in addition to diversification, including
professional management of their financial assets and liquidity.
FINANCIAL SYSTEM
Investors can “employ” their funds by performing direct transactions, bypassing both
financial institutions and financial markets (for example, direct lending). But such
transactions are very risky, if a large amount of money is transferred only to one’s
hands, following the well known proverb “don't put all your eggs in one basket”.
Direct financing can only occur if lenders’ requirements in terms of risk, return and liquidity
exactly match borrowers’ needs in terms of cost and term to maturity. Direct financing
usually involves the use of a financial market broker who acts as a conduit between
lenders and borrowers in return for a commission.
Financial intermediaries perform indirect financing by making markets in two types of
financial instruments – one for lenders and one for borrowers. To lenders they offer
claims against themselves – termed indirect securities - tailored to the risk, return and
liquidity requirements of the lenders. In turn they acquire claims on borrowers known
as primary securities. Thus the surplus funds of lenders are invested with financial
intermediaries that then re-invest the funds with borrowers.
FINANCIAL SYSTEM
Lenders and borrowers
Lenders are the ultimate providers of savings while borrowers are the ultimate users
of those savings. Both are non-financial entities and are referred to as surplus
and deficit economic units respectively.
Lenders and borrowers can be categorized into four sectors: household; business or
corporate; government; and foreign. The household sector consists of individuals
and families. It also includes private charitable, religious and non-profit bodies as
well as unincorporated businesses such as farmers and professional
partnerships. The corporate sector comprises all non-financial companies
producing and distributing goods and services. The government sector consists of
central and provincial governments as well as local authorities. The foreign sector
encompasses all individuals and institutions situated in the rest of the world.
FINANCIAL SYSTEM
Usually the household sector is a net saver and thus a net provider of loanable or
investable funds to the other three sectors. While the other three sectors are net
users of funds they also participate on an individual basis as providers of funds.
For example a business with a temporary excess of funds will typically lend those
funds for a brief period rather than reduce its indebtedness i.e., repay its loans.
Similarly while the household sector is a net provider of funds, individual
households do borrow funds to purchase homes and cars.
The excess funds of surplus units can be transferred to deficit units either through
direct financing or indirectly via financial intermediaries.
Financial intermediaries are financial institutions that expedite the flow of funds from
lenders to borrowers. Types of financial intermediaries include banks, insurance
companies, pension and provident funds, unit trusts, mutual funds.
FINANCIAL SYSTEM
Banks accept deposits from lenders and on-lend the funds to borrowers. Insurers and
pension and provident funds receive contractual savings from households and reinvest the funds mainly in shares and other securities such as bonds. In addition
insurers perform the function of risk diversification i.e., they enable individuals or
firms to distribute their risk amongst a large population of insured individuals or
firms.
A unit trust invests funds subscribed by the public in securities such as shares and
bonds and in return issues units that it may repurchase.. A mutual fund pools the
funds of many small investors and re-invests the funds in shares, bonds and other
financial claims with each investor having a proportional claim on the assets of
the fund. Both unit trusts and mutual funds play a risk diversification role in that
they are large enough to spread their investments widely i.e., they can spread the
risk by investing in number of different securities.
FINANCIAL SYSTEM
Financial instruments or claims can be defined as promises to pay money in the
future in exchange for present funds i.e., money today. They are created to satisfy
the needs of financial system participants and as a result of financial innovation
in the borrowing and financial intermediation processes, a wide range of financial
instruments and products exists.
Financial claims can be categorized as indirect or primary securities. Within these two
categories, financial instruments can be characterized as marketable or nonmarketable. Marketable instruments can be traded in secondary markets while
non-marketable instruments cannot. To recover their investment, holders of nonmarketable financial instruments have recourse only to the issuers of the claims.
Non-marketable claims generally involve the household sector while marketable
claims are usually issued by the corporate and government sectors.
FINANCIAL SYSTEM
Financial markets can be defined as the institutional arrangements, mechanisms and
conventions that exist for the issuing and trading of financial instruments. A financial
market is not a single physical place but millions of participants, spread across the world
and linked by vast telecommunications networks that brings together buyers and sellers of
financial instruments and sets prices of those instruments in the process.
Financial market participants include:
• Borrowers: the issuers of securities;
• Lenders: the buyers of securities;
• Financial intermediaries: issuers and buyers of securities and other debt instruments;
and
• Brokers: act as conduits between lenders and borrowers in return for a commission.
Financial market terminology includes terms such as cash and derivatives markets; spot
and forward markets, primary and secondary markets; financial exchanges and over-thecounter markets.
THE INVESTMENT PROCESS
Five steps:
 Set investment policy
 Perform security analysis
 Construct a portfolio
 Revise the portfolio
 Evaluate performance
STEP 1: INVESTMENT POLICY
 Identify investor’s unique objective
 Determine amount of investable wealth
 State objectives in terms of risk and return
 Identify potential investment categories
STEP 2: SECURITY ANALYSIS
 Using potential investment categories,
find mispriced securities
 Using fundamental analysis
 Intrinsic value should equal discounted present value
 Compare current market price to true market value
 Identify undervalued securities
STEP 3: CONSTRUCT A PORTFOLIO
Identify specific assets and proportion of wealth in which to invest
Address issues of
 Selectivity
 Timing
 Diversification
STEP 4: PORTFOLIO REVISION
Periodically repeat step 3
Revise if necessary
 Increase/decrease existing securities
 Delete some securities
 Add new securities
STEP 5: PORTFOLIO PERFORMANCE
EVALUATION
Involves periodic determination of portfolio performance with respect to risk and
return
Requires appropriate measures of risk and return
FINANCIAL MARKET RATES
There are essentially three financial market rates: Interest rates; Exchange rates; and Rates of return.
An interest rate is the price, levied as a percentage, paid by borrowers for the use of money they do not own and
received by lenders for deferring consumption or giving up liquidity.
Factors affecting the supply and demand for money and hence the interest rate include:
•
Production opportunities: potential returns within an economy from investing in productive, cash-generating
assets;
•
Liquidity: lenders demand compensation for loss of liquidity. A security is considered to be liquid if it can be
converted into cash at short notice at a reasonable price;
•
Time preference: lenders require compensation for saving money for use in the future rather than spending
it in the present;
•
Risk: lenders charge a premium if investment returns are uncertain i.e., if there is a risk that the borrower
will default. The risk premium increases as the borrowers’ creditworthiness decreases. Sovereign debt generally
has no risk premium within a country. A country risk premium may apply outside a country’s borders;
•
Inflation: lenders require a premium equal to the expected inflation rate over the life of the security.
FINANCIAL MARKET RATES
The exchange rate is the price at which one currency is exchanged for another currency.
The actual exchange rate at any one time is determined by supply and demand
conditions for the relevant currencies with the foreign exchange market.
Rates of return
Interest rates are promised rates i.e., they are based on contractual obligation. However
other assets such as property, shares, commodities and works of art do not carry
promised rates of return. The return from holding these assets comes from two
sources:
•
Price appreciation (depreciation) i.e., any gain (loss) in the market price of the asset;
•
Cash flow (if any) produced by the asset e.g., cash dividends paid to shareholders,
rental income from property.
FINANCIAL MARKET RATES
 Calculating the RATE OF RETURN :
R = (p1 - p0)/ p0
where
R = the rate of return
P0 =
the beginning price
P1 = the ending price
FINANCIAL MARKET RATES
Examples:
Assume at the beginning of the year a share is bought for $50. At the end of the year
the share pays a dividend of $2.50 and its price is $55. Compute the Return,
Capital gain and Current yield.
Assume a painting is purchased at the beginning of the year for $2,000. At an auction
at the end of the year, the painting is sold for $3,000. Compute the Return,
Capital gain and Current yield.
THE END