Chapter 1

Investment ScenarioSavings and Investment – Two sides of a coin

What is Investment?

• Investment is the employment of funds on assets with the aim of earning income or capital appreciation

• Investment has 2 attributes – Time – Risk

• Present consumption is scarified to get a return in the future• Investment is a placement of capital in expectation of deriving

profit

speculation

• Involves buying & selling activities with the expectation of getting profit from the price fluctuations.

• Interested in getting abnormal return• Speculator is more interested in the market

action & its price movement• Line b/w speculation & investment is very thin

Gambling

• Game of chance• Very short term investment, time horizon is

shorter than speculation • People gamble as a way to entertain themselves,

earning income would be the secondary factor.• No risk & return trade off in the gambling &

negative outcomes are expected.• Financial analysis does not reduce the risk

proportion involved.

INVESTMENT VS. SPECULATION

INVESTOR SPECULATOR

• PLANNING LONG SHORT HORIZON

• RISK MODERATE HIGH DISPOSITION

• RETURN MODEST HIGH EXPECTATION

• BASIS FOR FUNDAMENTAL TECHNICAL DECISIONS

• LEVERAGE NO HIGH

INVESTMENT VS. Gambling

INVESTOR Gambler

Planning Long Very Short

Risk Disposition Moderate Very High

Return Expectation Modest Very High

Basis for decision Fundamental Perceptions

Leverage No Very High

Investment Objectives• Main objective are increasing the Rate of return & reducing

the Risk• Liquidity

– Investment could be converted into cash without much loss of time

– It depends on marketing & trading facility• Hedge against inflation

– Rate of return should ensure a cover against the inflation• Safety

– Investment avenue should be under the legal & regulatory frame work along with the safety of the principal

INVESTMENT CONSTRAINT

• Liquidity

• Age

• Need for regular income

• Time horizon

• Risk Tolerance

• Tax Liability

Security is a generic term that refers to a debt or equity IOU issued by a borrower or issuer.

- Debt security or bond – an IOU promising periodic payments of interest and/or principal from a claim on the issuer's earnings

- Equity or stock – an IOU promising a share in the ownership and profits of the issuer

Stocks & Shares• Interchangeably used, but there is a diff

• Share– Share capital of a company is divided into a no of small units of equal

values called shares

• Stock– Is the aggregate of a members fully paid up shares of equal value

merged into one fund.

• Equity shares have certain advantages– Capital appreciation– Limited liability– Free tradeability– Hedge against inflation

Investment Classification

Investment

Financial Investment Real Investment

Fixed income Variable income

Real assets are tangible, material thing such as buildings, automobiles etc

Financial assets are pieces of paper representing an indirect claim to real assets held by some one else

Money market instruments

• Treasury Bill

• Certificate of deposit

• Commercial Paper

• Treasury Bills

• Commercial bills

• Repo & Reverse Repo

Certificate of Deposit Introduced in 1989 in India. Fixed interest rates and fixed tenure instruments issued by

banks and financial institutions. Can be issued by Scheduled Commercial Banks and

Selected Financial Institution (Permitted by RBI within the umbrella limit fixed by RBI).

Maturity: Min. 7 days to Max. 12 Months (for Banks) Min. 1 Year to Max. 3 Years (For Financial Institutions)

Issued in denominations of 1 Lacs and multiples of 1 lacs thereafter.

Can be issued to individuals, corporations, companies, trusts, associations.

NRIs can also subscribe on non–repatriable basis.

Commercial PaperCommercial Paper (CP) is an unsecured money market

instrument issued in the form of a promissory note.CP is a short term unsecured loan issued by a corporation

typically financing day to day operation. CP is very safe investment because the financial situation

of a company can easily be predicted over a few months. Only company with high credit rating can issue CP’s.Maturities on commercial paper rarely range any longer

than 270 days.The debt is usually issued at a discount, reflecting

prevailing market interest rates.

Eligibility for issue of CP a)The tangible net worth of the company, as per the

latest audited balance sheet, is not less than Rs. 4 crore;

b)The working capital (fund-based) limit of the company from the banking system is not less than Rs.4 crore and the borrowable account of the company is classified as a Standard Asset by the financing bank/s.

Meaning of Repo It is a transaction in which two parties

agree to sell and repurchase the same security. Under such an agreement the seller sells specified securities with an agreement to repurchase the same at a mutually decided future date and a price

The Repo/Reverse Repo transaction can only be done at Mumbai between parties approved by RBI and in securities as approved by RBI (Treasury Bills, Central/State Govt securities).

Repurchase agreement (Repos)Repo is a form of overnight borrowing and is used by those who deal in government securities.

They are usually very short term repurchases agreement, from overnight to 30 days of more.

The short term maturity and government backing usually mean that Repos provide lenders with extreamly low risk.

Repos are safe collateral for loans.

Repo Rates and Reverse Repo RatesRBI uses Repo and Reverse repo as instruments for liquidity adjustment in the system

It helps banks to invest surplus cash

It helps borrower to raise funds at better rates

An SLR surplus and CRR deficit, bank can use the Repo deals as a convenient way of adjusting.

Call Money Market

The call money market is an integral part of the Indian Money Market, where the day-to-day surplus funds (mostly of banks) are traded. The loans are of short-term duration varying from 1 to 14 days. The money that is lent for one day in this market is known as "Call Money", and if it exceeds one day (but less than 15 days) it is referred to as "Notice Money".

Call Money MarketBanks borrow in this market for the following

purpose To fill the gaps or temporary mismatches in

funds To meet the CRR & SLR mandatory

requirements as stipulated by the Central bank To meet sudden demand for funds arising out of

large outflows.

Banker's AcceptanceA banker’s acceptance (BA) is a short-

term credit investment created by a non-financial firm.

BA’s are guaranteed by a bank to make payment.

Acceptances are traded at discounts from face value in the secondary market.

BA acts as a negotiable time draft for financing imports, exports or other transactions in goods.

This is especially useful when the credit worthiness of a foreign trade partner is unknown

Treasury Bills

A treasury bills nothing but promissory note issued by the Government under discount for a specified period stated therein.

The Government promises to pay the specified amount mentioned therein to the bearer of the instrument on the due date.

The period does not exceed a period of one year.

It is purely a finance bill since it does not arise out of any trade transaction.

It does not require any ‘grading’ or’ endorsement’ or ‘acceptance’ since it is clams against the Government.

Treasury bill are issued only by the RBI on behalf of the Government.

Treasury Bills

Treasury bills are issued for meeting temporary Government deficits.

They are issued with three-month, six-month and one-year maturities.

T-bills are purchased for a price that is less than their par(face) value; when they mature, the government pays the holder the full par value.

Gilt edged securities The term government securities

encompass all Bonds & T-bills issued by the Central Government, and state governments. These securities are normally referred to, as "gilt-edged" as repayments of principal as well as interest are totally secured by sovereign guarantee.

Bills of Exchange The bill of exchange (B/E) is a trade related instrument. A written, unconditional order by one party (the drawer) to

another (the drawee) to pay a certain sum, either immediately (a sight bill) or on a fixed date (a term bill), for payment of goods and/or services received.

The drawee accepts the bill by signing it, thus converting it into a post-dated check and a binding contract.

An accepted draft or bill of exchange can be sold for early payment to a bank or credit institution at less than face value after the bank deducts fees and applicable interest charges. Which is called as bill discounting.

The bank or credit institution then collects full value on the draft or bill of exchange when payment comes due.

Equity Shareholders

• They are the owners of the company, sharing its risks, profits, and losses.

• They have a residual claim on the earnings and assets of a company.

• They are paid their share of the company’s profits after all other claims are met, and in the event of the liquidation of the company they share whatever is left of the company after all its creditors have been paid.

• They enjoy limited liability, i.e., liability only to the extent of their shareholding.

• Only equity shareholders are entitled to vote at the company’s meetings, thus controlling the management.

• If the company prospers, it is the equity shareholders who is the greatest gainer.

CLASSIFICATION OF EQUITY SHARES

• BLUE-CHIP SHARES

• GROWTH SHARES

• INCOME SHARES

• CYCLICAL SHARES

• DEFENSIVE SHARES

• SPECULATIVE SHARES

•SWEAT EQUITY sweat equity shares means such equity shares has are issued by a company to its directors or employees at a discount or for consideration, other than cash, for providing their know-how or making available rights in the nature of intellectual property rights or value additions

FINANCIAL DERIVATIVES

A derivative is an instruments whose value depends on the

value of some underlying asset.

Futures A futures contract is an agreement between two

parties to exchange an asset for cash at a predetermined

future date for a price that is specified today.

Options An option gives its owner the right to buy or sell

an underlying asset on or before a given date at a

predetermined price.

MUTUAL FUND SCHEMES

• Mutual Funds— A mutual fund represents a vehicle for collective investment. When an investor invests in a scheme he becomes owner to the extent of the units held by him.

• Classified as

•Open ended & closed ended

•On basis of objective classified as

•Growth schemes & income scheme

•Equity Schemes

• Balanced Schemes

• Debt Schemes

REAL INVESTMENT

Land and House Property

Residential House

Commercial Property

Agricultural Land

Suburban Land

Gold and Silver

Precious Stones

Art Objects

Economic vs financial investment FinanciaI investment

A financial investment allocates resources into a financial asset, such as a bank account, stocks, mutual funds, foreign currency and derivatives.

Financial investments are purchases of financial claims. This type of investment may or may not yield a return.

Economic Investment An economic investment puts resources in something that may

yield benefits in excess of its initial cost. Though these resources still include money, investments can also

be made in time, asset creation assistance and mentoring. An economic investment may include buying or upgrading

machinery and equipment or adding to a labor force.

Investment process

1- Setting the Investment Objectives:- The first and the basic step for investment is that the investor

should set his investment objectives. These investment objectives vary from person to person.

2- Establishing Investment Policy:- Establishing investment policy refers to the allocation of asset

amongst the major allocated assets in the capital market. The range of allocated asset is from equities, debt, fixed income

securities, real estate, foreign securities to currencies. Restraint of environment and that of investor should be kept in

mind while establishing the investment policy.

Investment process

4- Selecting the Assets:-The assets to be placed in the portfolio have to be selected by the investor. This is the

point where real creation of portfolio will take place after the selection of assets in which to invest by the manager or investor. That asset will be selected which will give best return in available resources and which involves lowest risk. The assets can be shares, stocks, art objects, securities, gold, property etc.

5- Measuring and Evaluating Performance:-» In this step the performance of the portfolio will be measured in

comparison to the realistic benchmark or the standard set by the investor. Risk and return will be evaluated by the manager. Measuring and evaluating the portfolio will give the feedback to the investor and will in turn help the investor to improve the quality as well as the performance of the portfolio of investment.