introduction to financial markets and investment.pdf

An Introduction to Financial Markets and Financial Investments

By

Dr. Chhiv Sok Thet

Professor of Capital Markets and Stock Exchange and Human Resource Management, Pannasastra University of Cambodia

Phnom Penh, April 22, 2014

Research Paper by Chhiv S. Thet, PhD Professor, PUC & EAU, Cambodia, April 22, 2014

An Introduction to Financial Markets and Financial Investments: Dr. Chhiv S. Thet (2014)

TABLE OF CONTENTS

Contents.................................................................................................................................2

Abstract.................................................................................................................................3

Introduction..........................................................................................................................4

Part I: Conception of Global Financial and Economic System

1.1 Function of the Global Economic System………………………………….…5

1.2 Function of the Global Financial System……………………………………..6

1.3 Function of Financial markets………………………………………………...9

1.4 Raising Funds for Investment………………………………………………...11

1.5 Model of Financial Markets…………………………………….……….……14

1.6 Types of Financial Markets…………………………………….……….…….15

1.7 Relationship between Lenders and Borrowers in the Financial Markets..........18

1.8 Key Players in the Financial Markets…............................................................18

1.9 Transactions in the Financial Markets…...........................................................21

Part II: Generalization of Financial Investment

2.1 Process of Financial Investment……………………………………..............24

2.2 Financial Assets in the Financial Markets………………………..………….26

Part III: Mathematic in Securities Investment

3.1 Calculation of Money Market Instruments………………………………….30

3.2 Calculation of Bond Price and Yield……..…………………………………32

3.3 Calculation of Stock Price and Dividend……………………………………36

3.4 Calculation of Derivative Securities…...…………………………………….….43

Part IV: Risks and Returns

4.1 Risks in Financial Investment...........................................................................48

4.2 Returns in Financial Investment.......................................................................52

4.3 Calculation of Expected Risks and Returns.....................................................54

Part V: Capital Markets ‘Analytical Tools for Economic Growth

5.1 Measure of Economic Growth..........................................................................61

5.2 Market Capitalization (%) to GDP...................................................................62

2


ABSTRACT

The financial markets performed a vital function within the global economic system.

It is the heart of global financial system which channels savings to the institutions needing

funds for business development. Moreover, it develops a mechanism for financial investment

which firms and government institutions can issue the stock, bond and other securities in

order to raise extra funds to support their investments and business development projects.

Simultaneously, the publics and investors take their money to invest the financial instruments

for their income. Hence, this mechanism provides benefits to support economic growth and

its affects to the economic and financial sector development in the country as well.

Accordingly, in order to share the significant knowledge of financial markets and

financial investment, especially, the capital market establishment in the developing countries.

I have extracted them from a part of literature review in my dissertation aiming to give this

knowledge to the students, researchers, entrepreneurs, investors, corporations and other

individual and institutions to have understanding of the concepts of financial markets, capital

markets development and financial investment in the developing countries.

The study collected the secondary data and several sources of information in order to

analyze and indicates the conception of financial markets and capital markets as well as its

transaction of financial securities. The study also demonstrates how to calculate the money

market instruments, bond price and bond yields, stock price and stock dividend and

derivative securities as well as risks and returns in financial investment and analytical tools

for economic growth.

3


Introduction

The financial market has performed a vital function within the global financial and

economic system. This market is the heart of the global financial system which mobilizes and

allocates the savings and setting the interest rates and prices of financial assets. The financial

markets were used as facilitator between lenders and borrowers or sellers and buyers of

financial instruments such as stock, bond and other securities. Besides, it channels the savings

to those businesses, individuals and institutions needing more funds for the business and

investment project expansion and meets their business spending. Thus, the financial markets

offer the support to the financial system like the financing, financial information, and equities

as well as the corporate governance and financial investment.

Accordingly, the financial market development in the country, particularly; each

nation which primarily focused on the capital markets development in the country. Then, it

created a mechanism for financial investment in that nation. This mechanism allows the

government institutions and private corporations to take opportunities to raise funds from the

capital markets through the issuance of the financial instruments such as stock, bond and

other securities to support the business and investment expansion projects.

In this regard, the investors, savers, businesspersons and securities dealers as well as

and speculators have taken their opportunities to invest or trade the financial securities of the

companies or other institutions in order to obtain their incomes from the interest rate,

dividend growth and appreciation of securities prices.

4


PART I

Conception of Global Financial and Economic System

1.1 Function of Global Economic System

The key function of global economic system is an allocation of precious resource with

the natural and laboring sources and skills as well as the capitals to produce goods and

services. In economic system, it needs to place the inputs into productions in order to receive

the goods and services for daily use, therefore, this movement created the production flow to

response to the payment flow in economy (figure 1).

Figure 1: the Global Economic System

Source: Peter S. Rose (2003); Money and Capital Markets: financial institutions and instruments in

the global marketplace; Eight Edition; Published by McGraw-Hill/Irwin, New York, USA; page 4

The economic system requires gathering all inputs such as land, natural and laboring

resources as well as management skills to place within the production in order to have goods

and services for daily consumption. We can also say that the flow in the economic system is a

movement between producing entities (companies and governments) and consuming units

(households) (see figure 2). In economy, the householders provide labors, management skills

and other resources to the corporation and government institutions in order to get back the

Flow of production

Flow of payment Goods and services sold to

the public

Land and natural resources

Labor and management skills Capital equipment

5


salary and compensation and those incomes have to pay for buying goods and services and

paying tax for daily lives, besides, just remain for savings.1 As result, it creates the flow of

incomes for enterprises to encourage them to reproduce goods and services. In conclusion,

income and production flow has mutual interdependence without ending.

Figure 2: Flow of Income, Payment, and Production in Global Economic System

Source: Peter S. Rose (2003); Money and Capital Markets: financial institutions and instruments in

the global marketplace; Eight Edition; Published by McGraw-Hill/Irwin, New York, USA; page 5

1.2 Function of Global Financial System

The financial system is very necessary for allocating all resources provided savings

from households to the business firms and government institutions to produce goods and

services for daily lives. Also, the financial system allows the people to transform the money

or the savings from the lenders to the borrowers through the financial markets. In this system,

it consists of some components such as the financial institutions, financial markets, financial

instruments, the financial services and financial transactions.

1 Peter S. Rose (2003), Money and Capital Markets, published by McGraw-Hill/Irwin New York,

USA, page 5

Producing units (business firms and

governments)

Consuming units (households)

©

Flow of expenditure for consumption and taxes

Flow of production of goods and services

Flow of productive services

Flow of incomes

6


The financial system has great important role in daily lives; there are seven basic

functions such as savings function, wealth and liquidity functions as well as credit and

payments functions, risk protection and policy functions:2

1. Saving functions: this function provides the publics with the opportunity to create

savings by investing in bonds or stocks and other financial instruments in the financial

markets to make profit. This flow provided additional cash into investments, especially for

entrepreneurs that can produce more goods and services for livelihood. For any countries that

have the savings flow decreases, in general, it will make their investments and the standard of

living of that country began to decline.

2. Wealth function: this function provides an opportunity for individuals and

companies to pick for property savings through securities investment in the capital markets

and money market. Investments of stocks, bonds and other securities did not lose their value

and generally, it has to make a profit. The risk of loss is less than the retained property in the

form of investment in objects like car, motorbike….etc. that caused to lose their great values

and risks in such an investment.

3. Liquidity function: the financial markets provide investors possibilities to transfer

their financial instruments into cash very easily and at little risk. This operation made through

the sale of securities in order to get their cash back when they need cash to expend.

4. Credit function: Besides, this system facilitated the allocation of savings from

householders and other surplus units to supply financing to corporations and government

institutions in order to expand their business, and investment.


USA, p. 9-10

7


5. Payment function: the financial system provides a mechanism to pay for goods and

services. Financial assets for settlement include currency, current accounts and credit cards

including other accounts that were used for replacing of currency.

6. Risk protection functions: the financial markets around the world has given

business firms, government institutions and householders to protect against risk who

happened to life, health, property and their income. This function requires policies, which

made by the insurance company. In addition, the companies and individuals can protect

themselves against risk through investment of their properties in the capital markets and the

money market in order to prevent losses that will occur in the future.

7. Policy function: the financial markets provided an important guideline to the

government which is implementing its policies and efforts to make the economy stable avoid

inflation and controlling of interest rates, with credit operation for expenditure and borrowing

from publics, which has an impact on the growth of production growth and job creation.

Furthermore, the financial system has created a flow for savings and investments as

following: 3

Nature of Savings: Households use their money for spending and paying tax, then

the remaining for savings. The business firms use their income left behind from tax payment,

dividend and other expenses for savings. The government institutions can do savings unless

those units have surplus income more than their current expenses.

Nature of Investment: the capital flow from financial markets can support

investment. The corporations and public institutions need capitals for constructing the

building, schools and equipment, and purchasing raw materials and goods for inventory and

3 Peter S. Rose (2003), Money and Capital Markets, published by McGraw-Hill/Irwin New York, USA, page 15

8


producing goods and services. Government institutions also need capitals for construction of

schools, hospitals, roads, and support the public services for developing productivity; labor

forces and standard of living (figure 3).

Figure 3: Global Financial System

Source: Peter S. Rose (2003); Money and Capital Markets:; 8th Edition; Published by McGraw-

Hill/Irwin, New York, USA; page 7

1.3 Function of Financial Markets

The financial markets have great significant functions in the global economic system4

and it is an engine for global financial system. The financial market participates in economic

growth for every country in the world by allocating and absorbing the savings from the

investment of financial instruments and then transforms those savings to the business firms

and other institutions needed more funds for their investment and business expansion as well

as met their expenditures5. In economy, the financial markets encourage entrepreneurs and

government for long-term investment projects for technological diffusion, capital allocation,

equities, risk management, corporate governance and human resource management, financial

services and the securities trading and financial industry. In addition, the financial markets as


USA, page 6 5 S. Kerry Cooper and Donal R. Fraser (1993), the Financial Marketplace, Fourth Edition, published

by Addison-Wesley Publishing Company, USA, page 363-4

Flows of financial services, incomes, and financial claims

Flow of savings Suppliers of funds

(Households)

Demanders of funds (Business firms and

governments)

9


a mechanism allowing publics to trade the financial instruments such as stocks, bonds and

other securities and other valuable products as energy, precious metal, gold and industrial and

agricultural products as well as other valuable products ....etc. Financial markets can help the

fund raising, the risk deduction and international trade and acting as a facilitator between the

lenders and borrowers, it means that the mobilization of saving from families, companies and

government institutions that have surplus budget given to other institutions that has budget

deficit or needs more funds to expand the business and investment projects (figure 4).

Figure 4: Diagram of Funds Flow in the Global Financial System

Source: Rose and Marquise (2006); Money and Capital Markets, McGraw Hill International,

Singapore and Securities Commission Malaysia (2009), Introduction to

Islamic Capital Market, Printed in Malaysia, by Dolphin Press Sdn Bhd

Financing Financing

Fina

ncin

g Fina

ncin

g

Deficit Units

(Borrowers)

-Corporations

-Government Units

-Households

-Foreigners

Surplus Units

(Lenders)

-Business Firms

-Government Units

-Individuals

-Foreigners

Financial Intermediaries

Financial Markets

Direct Financing

Indirect Financing

Fina

ncin

g

10


1.4 Raising Funds for Investment Development

The financial market facilitates between the companies and other institutions that

need more funds for investment expansion besides the banking system. Although commercial

banks as a source of credit, but banks is financial intermediaries receiving deposits from the

savers, and then provided those savings to the borrowers that need loans in short or medium

or long terms for buying home or car or for operating small or medium businesses. Generally,

commercial banks take less attention on long-term loan, so, the entrepreneurs or businessmen

have used both options to find financing to support the business based on their possibilities.

But, loans processes in the financial market is more complicated than loans in the banking

system, generally, it requires corporations and institutions needing funds for investment must

issues stock, bond and other securities and sell them to the publics. Whereas securities issued

by those institutions were traded from one hand to another in the secondary market (Figure 4).

Currently, the United States relied profoundly on fund raising in the financial markets,

especially, issuance of securities such as stock and bond through the capital markets.

The financial markets help the business firms and government units to raise funds for

the investment and business expansion, besides the banking system. If there are no financial

markets, the business individuals or entrepreneurs and institutions are really met difficulties

in finding the lenders themselves.

John Gurley and Edward Shaw (1960), economists pointed out that each business

firm, household, and government were active in the financial system and must conform to the

following identity6:

6 John Gurley and Eward Shaw (1960) and Peter S. Rose (2003), Money and Capital Markets:

financial institutions and instruments in the global marketplace, 8th Edition, Published by McGraw-

11


o (E) Current expense

o (R) current income

o (∆FA) building up holdings of financial assets

o (∆D) paying off some outstanding debt and equities.

Accordingly, economic units must fall into one of three groups as following:

• Deficit budget unit (DBU): E>R; and so ∆D>∆FA => borrower of funds

• Surplus budget unit (SBU): R>E; and so ∆FA>∆D => lenders of funds

• Balance budget unit (BBU): R=E and so ∆D=∆FA=> neither lender and borrower

This context showed that the financial market has great important functions in

transforming savings into the financial investment for strengthening the health and strength of

national economic. If households and investors did not use their savings within investment,

so, the national economic strength was shorten and revenue begin to fall down in the future

and then leading to reduce expenditure of consumption and living standard also begins to

decline. This may cause reduction of the workforce needs in the economy. As result, the rate

of employment may start falling and also, unemployment rate will start increasing.7

Hill/Irwin, New York, USA, page 33 7 Peter S. Rose (2003), Money and Capital Markets: financial institutions and instruments in the

global marketplace, 8th Edition, Published by McGraw-Hill/Irwin, USA

Current income receipt – Expenditures

out of current income

R – E = ∆FA - ∆D

Change in holding of financial assets – Change

in debt and equity outstanding =

12


The opinion of economists also realized that the role of financial system as a

momentum of long-term economic growth and, it develops a significant improvement in the

recent years. The financial system has been recognized as a system, which impact on the

economic growth through mobilization and allocation of capital inflows.8 For the countries

that have a better financial system, the system can provide the benefits to those countries with

the long-term growth potential. Merton (2003) also determined that the economic problems

recently happened in Asia, because they did not entirely rely on the financial markets, they

counted on this market a little. As a result, their economic growth dropped dramatically and

rapidly. He also claimed that the development of an efficient financial market as well as its

relevant institutions meaning that those countries can reduce the most reliance on financing

of banking system for the economic growth, in particular, in the developing countries today.

Currently, most of Asian countries have the advanced economic growths, but their capital

markets are not created properly yet, they are still heavily depending on the banking system

to finance their economic development. He also added that the U.S. economy in the 20th

century reduced the reliance on the banking system by developing the financial markets and

relevant institutions separately in order to fulfill the different functions. Doing like this in

order to increases an efficiency of capital allocation process of the United States and reduce

the suffering, fragility of the credit occurred in the history of the United States. In contrast,

Japan's economy did not reduce the reliance on the banking system. He has still used both

The banking systems and the capital markets and also takes an effort to solve the bank

concerns. The reliance on banking system is not just to make an instable economy of the

8 Merton Milller (2005), Financial Markets and Economic Growth, Article first published by Journal

of Applied Corporate Finance, volume 11, issue 3

13


country but also affect to the neighboring countries as well9. A number of Asian countries

have almost implemented as Japan by using the financing systems, both the banking system

and the capital markets in order to support the stable financial system and sustainable

economic growth.

1.5 Model of Financial Markets

The model of financial markets used in the study is “Brownian models for financial

markets” based on the work of Robert C. Merton and Paul A. Samuelson, as extensions to

the one-period market models of Harold Markowitz and William Sharpe, and are concerned

with defining the concepts of financial assets and markets, portfolios, gains and wealth in

terms of continuous-time stochastic processes. Under this model, these assets have

continuous prices evolving continuously in time and are driven by Brownian motion

processes. This model requires an assumption of perfectly divisible assets and a frictionless

market (i.e. that no transaction costs occur either for buying or selling). Another assumption

is that asset prices have no jumps that is; there are no surprises in the market. This last

assumption is removed in jump diffusion models.10

Consideration of a financial market consisting of N + 1 financial asset, where one of

these assets, called a bond or money-market, is risk free while the remaining N assets,

called stocks, are risky. A financial market is defined as:11

1. A probability space

2. A time interval

9 Economy Watch (November 2010), Types of Financial Market, http://www.economywatch.com 10 Tsekov, Roumen (2010). Brownian Markets, October 13, 2010 11 Karatzas, Ioannis, Shreve, Steven E. (1991), Brownian Motion and Stochastic Calculus, New York

14

http://en.wikipedia.org/wiki/Financial_markets


http://en.wikipedia.org/wiki/Robert_C._Merton

http://en.wikipedia.org/wiki/Paul_A._Samuelson

http://en.wikipedia.org/wiki/Harold_Markowitz

http://en.wikipedia.org/wiki/William_Forsyth_Sharpe

http://en.wikipedia.org/wiki/Assets


http://en.wikipedia.org/wiki/Portfolio_%28finance%29

http://en.wikipedia.org/wiki/Gains

http://en.wikipedia.org/wiki/Wealth

http://en.wikipedia.org/wiki/Stochastic_processes

http://en.wikipedia.org/wiki/Frictionless_market

http://en.wikipedia.org/wiki/Frictionless_market

http://en.wikipedia.org/wiki/Jump_diffusion

http://en.wikipedia.org/wiki/Bond_%28finance%29

http://en.wikipedia.org/wiki/Money-market

http://en.wikipedia.org/wiki/Risk

http://en.wikipedia.org/wiki/Stocks

http://arxiv.org/ftp/arxiv/papers/1010/1010.2061.pdf


3. D-dimensional Brownian process adapted to the

augmented filtration

4. A measurable risk-free money market rate process

5. A measurable mean rate of return process .

6. A measurable dividend rate of return process .

7. A measurable volatility process such

8. A measurable, finite variation, singularly continuous stochastic

9. The initial conditions given by

A financial market M is said to be standard if: (i) it is viable, (ii) the number of stocks

is not greater than the dimension D of the underlying Brownian motion process W(t), (iii)

the market price of risk process satisfies: , almost surely and the

positive process is a martingale.

1.6 Types of Financial Markets

The financial markets consist of the capital markets, money market and foreign

currency exchange, commodity and derivative markets. Although, financial markets have

many categories; but their main functions are different and also financial instruments are

dissimilar, and the capital markets and money market classified as the most important

markets in the global financial system.12 The capital markets: there are two main markets,

which provided long-term financing, or more than one year that consisting of stock exchange

and bond market. Stock exchange allows the corporations to issue shares or equity securities

in order to finance the investment projects and business expansion. Then, those securities

12 Peter S. Rose (2003), Money and Capital Markets, 8th Edition, Published by McGraw-Hill/Irwin, USA, page 12-13

15

http://en.wikipedia.org/wiki/Martingale_%28probability_theory%29


brought to trade since then. Bond market issues bond or debt securities of corporations and

government institutions in order to finance the investment projects and business enlargement.

Then, those securities traded in the public since then.

The money market is a market that provides short-term financing or less than a year

and securities issued by government, large corporations and financial institutions in order to

support investment projects and expand their business. The short-term securities as treasury

notes, certificate of deposit, commercial paper, banker’s acceptance, repos, and reverses.

The foreign exchange market (FOREX) is a market that allows trading of foreign

currencies in order to facilitate imports and exports, as well as international investors who are

investing and purchasing of foreign goods or they want to take profit from speculation of the

exchange rate volatility or access to the market in order to exchange their currency for

investment needs or buy other currencies to take profits or protect themselves from losses and

reduce the risk which can be happened by exchange rate fluctuations.

The commodities market is a market trading products or raw materials as precious

metals (gold, silver, platinum and other precious metals), agriculture (corn, beans, wheat,

sugar, cotton, cocoa, and coffee), energy (crude, gas, ethanol, and gasoline), industry (iron,

copper, lead, zinc, tin, aluminum, and nickel), animals and meat (animals as life animals,

food, pork, beef). Those products traded in form of a standardized contract or also called a

futures contract, which both selling and purchasing parties want to protect them from risk of

loss, which will happen in the future was caused by rising or falling prices in the market.

The derivative market is a market where trading of derivative products such as the

futures contract, forewords, options and swaps. Derivative is a kind of securities whose its

16


value based on or derived from the underlining assets. Those assets conclude stocks, bonds,

currency, interest rates and market indexes.

Among the main compositions of financial markets, the capital markets and money

market are most important; both markets are divided into the primary market and secondary

market.13 For the initial public offering (IPO) or new issue (public offering) was traded in the

primary market that those activities held between issuers and underwriters. The securities

issued in the primary market were traded in the secondary market that held between investors

and investors. This means that investors hold securities in hand and intend to sell securities

called sellers and investors who wish to buy or invest securities called buyer (Figure 5).

Figure 5: Structure of the Global Financial Markets

Sources: S. Kerry Cooper and Donal R. Fraser (1993); Financial Marketplace; Fourth Edition, USA; page 18-20 and Invest Korea; Korea Financial System; Korea’s Financial Market Structure, Seoul,

www.investkorea.org/

13 Peter S. Rose (2003), Money and Capital Markets: financial institutions and instruments in the

global marketplace, Eight Edition, published by McGraw-Hill/Irwin, New York, USA, page 12

Financial Markets

FOREX

Derivatives Market

Commodities Market

Money Market Capital Markets

Primary

Secondary

IPO (initial Public Offerings)

Securities or issued securities

Stock Exchange

Bond Market

17


1.7 Relationship between Borrowers and Lenders in the Financial Markets

Lender

Financial institutions

and intermedaries Financial markets Borrowers

Individuals,

Household,

Business firms

Other institutions

Commercial bank

Insurance companies

Retirement funds

Mutual funds or

Investment firms

Securities firms

Stock exchange

Money market

Bond market

Forex market

Derivative market

Corporations

Government

Other institutions

Source: Peter S. Rose (2003); Money and Capital Markets; and Wikipedia; Financial Market

1.8 Key Players in the Financial Markets

1. Lenders in the financial market: (a) almost individuals can provide loans through

deposit the savings in their bank account and/or participate in the pension program and pay a

premium to insurance companies as well as investment in stock of companies, and corporate

and government bonds, (b) All companies and institutions remaining the surplus budget or

exceed at any period could use their budget for short-term investments in the money market.

For companies with surplus budget always invest in stock, bond or repurchasing of their

outstanding stock from the market.

2. Borrowers in the financial market: each individual can borrow money through

banks for short-term needs or long-term financing for mortgage. Corporations can also find

credits in order to support their cash flow or financing for corporation modernization or to

expand their business in the future. The government institutions can borrow money to support

their expenses on the industrial and agriculture sector development and subsidize other public

institutions as well as various public services.

18


3. Financial intermediary is a financial institution acts as a facilitator between lenders

and borrowers in the financial system. That means that savers take their money to deposit at

the bank, and then bank uses those savings to provide loan for individuals or business units

needing funds for business and investment. Financial intermediary consist of14: depository

institutions: commercial banks and non-depository institutions like saving and credit union

and saving bank, contractual institutions: insurance companies and pension funds, investment

institutions: investment companies, money market funds and real estate investment trust.

4. The U.S.’s financial institutions are institutions that provide main financial services

to customers or its members and act as financial intermediaries being responsible in

providing or transferring funds from investors, companies and government units to

corporations and institutions that need more funds for investment development15. Financial

institution receives deposits from customers who deposit in bank account and provide interest

rates to savers directly and indirectly, and then, provide loans to customers or companies that

need funds. Sometimes, financial institutions act as service providers to customers and charge

commission from them. In addition, there are some institutions used savings to invest in the

real estate or stock and bonds and other institutions do both. Major financial institutions in

the U.S. economy comprising of commercial banks, savings and loan association banking

credit union, saving banks, insurance companies, mutual funds and private pension funds.

These institutions attract funds from individuals, companies and government units to

mobilize funds to provide loans to companies and institutions.16 These institutions comprise

14 Cooper, S. Kerry and Fraser, Donal R. (1993): Financial Marketplace, 4th Edition, Addison-

Wesley Publishing, pp.216-242 and Rose, Peter S. (2003), Money and Capital Markets, 8th

Edition, published by McGraw-Hill, page 41 15 Gitman, Lawrence J. (2003), Principle of Managerial Management, 10th edition, Pearson, pp. 21 16 ibid., pp. 22

19


of the financial companies, money market funds and real estate investment funds.17 Financial

companies provide loans to business firms and consumers to fill short-term capital flows and

long-term investment needs. Investment companies or mutual funds mobilize funds from

contributions of thousands savers and investors from sale of the company’s shares and then

used those funds to invest in securities and sell them when the market open and as

representative of financial intermediaries that has rapid progress in recent years. Money

market funds are kind of specialized-investment companies receiving saving account from

individuals and companies and brought those funds to invest short-term quality securities in

the money market. Real estate investment funds are small members of financial institutions

involving to investment companies on housing and commercial property. Besides, there is

another mortgage institution to facilitate providing credit for construction of new home and

new business.

Financial intermediaries and financial institutions have significant differences in each

national financial system as measured by total financial assets. In the U.S, commercial banks

have occupied over entire U.S. financial system comprising of financial assets more than

US$6 trillion18 occupied by banks of America and represents 1/4 of total wealth of U.S.

financial institutions. Some financial intermediaries as commercial banks, savings and loan

associations, saving banks and credit unions, if those institutions were totally combined can

create assets of 1/3 of total wealth of U.S. financial institutions, whereas, number of financial

assets remaining was divided into each part. Financial institutions have been actively

participated within financial markets and act as supplier of funds and as demander funds for

investment as well.

17 Peter S. Rose (2003), Money and Capital Markets: financial institutions and instruments in the

global marketplace, Eight Edition, Published by McGraw-Hill/Irwin, New York, USA, Page 44 18 Kerry Cooper and Donald R. Fraser (1993), Financial marketplace, Fourth Edition 9, Page 216-17

20


1.9 Transactions in the Financial Markets

The enterprises, companies and government institutions can choose sources of

financing to support their investment projects and business expansion through banks or

financing from public sources. Therefore, source of financing from bank is an indirect

finance. Whereas, financing sources from the publics as the direct finance (figures 6, 7 and 8).

Today, in the financial system, there is a sequence evolution from direct-finance source to

semi-direct finance as a newborn form, which just appeared in the recent time in the trades of

financial instrument. Hence, the transfer of funds from savers to demanders of funds in the

financial markets, at least, must meet the following three ways19: (A) direct finance, (B)

semi-direct finance and (C) indirect finance:

A. Direct Finance is an operation that occurred when lenders provide loan directly to

borrowers through issuance of securities like bond, stock and other securities as contracts for

evidence of debt which it has borrowed.

B. Semi-Direct Finance is an operation that occurred when lenders provide loan

directly to borrowers with help of financial service providers and market-makers that helped

sell IPOs/PO to the investors and providing services for securities trading as well.

A and B above show that direct finance and semi-direct finance encouraged

developing a source of the indirect finance. The activity was participated and supported from

the financial intermediaries and institutions.

C. Indirect Finance is an operation that occurred when lenders provide loan to the

borrowers through financial intermediaries like commercial banks, insurances and financial

companies. In this case, the borrowers have to issue a debt contracts to the loan providers.

19 Peter S. Rose (2003), Money and Capital Markets, 8th Ed., published by McGraw-Hill, NY, pp. 40

21


PART II

Generalization of Financial Investment

First, the study focuses on the viewpoint of investment. Usually, investment has

general meaning and related sectors such as the investment in the field of macroeconomic,

investment in the field of business administration and investment in the financial sector and

real estate. But this study has significantly focused on "financial investment" as a part of the

investment in the financial sector. A number of dictionaries and economic articles have

defined the word of "Financial Investment" as "Money Investing" or "Investment in

Finance"20. Accordingly, financial investment was defined that is the current commitment of

money and other resources in the expectation of gathering future benefits. As individuals

purchase shares of companies and anticipates that they will make earnings in the future from

appreciation of stock prices. The transaction identifies about time, money and risk in

investment which were tied up.21 Timothy (1978) defined that financial investment involves

expectation of some positive rate of returns that can be reasonably expected after sufficient

analysis has been made. Traditionally, it engages a known degree of risk, which dictates that

the principal and future income value be relative certain.22

Several financial experts defined that “the financial investment is relevance to the

profitable level which properly received by expectation after doing sufficient analysis on this

investment. Investment usually comes with risk that might be known and related to the real

20 World Economic Watch, Financial Investment & Investing Money, www.economic.com/investment 21 Zvi Bodie , Alex Kane, and Alan J Marcus (2008), Essentials of Investments, 7th Edition,

published by McGraw Hill International, Singapore, pp. 2 22 Timothy E. Johnson (1978), Investment Principles, published by Prentice-Hall, USA, pp. 3

22


profits and principals”23. There are some articles were defined that “the financial investment

is placing of money into investment with expectation, especially, use of funds to purchase

financial instruments in order to take profit in the forms of dividend, interest rate and

appreciation of stock prices” 24 . Whereas Cambodian economists also described about

investment that " Enterprises borrow money from the families to finance their investment

projects through the issuance of stock and bond or borrow from other financial institutions,

whereas cost was paid to lenders is the interest rate"25.

In addition, financial investment is that when investors or individuals give their

money to the issuing companies (issuers) and then those companies have used those funds to

generate the profit for the individuals or investor as their shareholders. Whereas investors

the company. For Individuals who give money to the investment projects or investment

companies in order to take the profit, it is able to consider as “financial investment” the

projects used those funds to create profits for all individuals as their members. Also, those

members do not need to monitor the business activities of investment projects. Whereas

individuals who use their money to buy real estate or gold or buy the license, financial

service providers can create profits for those individuals, but this action is not considered as

financial investments because the profits are not created by the financial investment.26

However, the Australia Corporate Law defined that the financial investment is when

inventors and individuals offer their money to invest in corporations and then the companies

use those funds for increasing incomes for individuals and investors. In this regards, investors

23 ibid., pp. 33 24 Arthur O, Steven M. (2003), Economics: Principles in Action, 1st edit. Prentice Hall, USA, pp. 2 25 HANG Chuon Naron (2009), Macroeconomics, published by Preah Vihear, 1st edition, pp. 76 26 Timothy E. Johnson, (1978), Investment Principle, published by Prentice-Hall, USA, pp. 1-5

23


and individuals clearly known that the funds was used for generating income for individuals

participating in the corporation. For individual who invested their money into the investment

funds or investment companies in order to receive benefits was also considered as “financial

investment” and corporations used those money to create more income for individuals who

are their members who those are not required to control any business of company.27 Based on

definitions of financial investment defined in the Australia Corporate Law and Peter S. Rose

(2003) showed about its mechanism relating between lenders and borrowers in the financial

markets. Accordingly, lenders always are the surplus-budget units and individuals want to

invest their money through stock and bond. Whereas, borrowers are the deficit-budget units

such as the business firms, government and other institutions, which are seeking to raise

funds for their business and investment in the capital markets.

2.1 Process of Financial Investment

Individuals must clearly understand process of financial investment and mechanism of

whole market with relationship in the industry, economy and also between brokerage firms

and investors, when they are seeking to invest the financial instruments for a profit taking.

However, all individuals and investors must have appropriate knowledge and experiences in

the financial investment, if they have less experience in financial investments or nothing, they

will face more difficulties to use their funds to properly for investment.28

Generally, individuals or investors who wish to invest in the securities market. First,

they have to create a proper own capital for investment. Then, just think about planning and

investment process, with various risks associated with their investment. Another new risk is

27 Australian Corporation Acts 2001, SECTION 763 B 28 Economy Watch (2010), Securities Investment and Speculation, http://www.economywatch.com

24


"Personality" of investors who first encounter within their initial investment. Usually, the

investors used their emotion more than analysis and evaluating securities. Meanwhile, the

investors have to strongly understand about the analytical methods and investment process, if

they don’t have the investment knowledge, they cannot be successful in investment. Whereas,

the economic conditions must be appropriate to the investment and analyze industries, is it

proper to the current economic conditions? After analyzing of economies and industries,

investors will consider to choose a worthy corporation with better industrial situation, strong

financial position, quality market improvement and products as well as proper production

facilities. Accordingly, investors can determine which corporation is strong enough for them

to invest. Another main fact is that analysis on securities and potential profit forecast of the

corporation and level of risk that can make the profits vary and uncertain expectations. No

any factor is better than analysis on securities and the potential of the company's profits.29

Therefore, in order to prepare the investment in a good process, first, investors must

allocate their financial assets into investment portfolio and then sell the existing securities

when its price is head up and purchase new securities cheaper than in order to take profit

from that operation or additionally increase their funds to make a larger investment portfolio

or sell all securities to reduce investment portfolio.30 Financial assets are classified as stocks,

bonds, currencies and other financial products to create the securities investment portfolio. To

make the financial asset allocation, each person who has a deposit at the bank, has to transfer

the money from banks into the investment portfolio, then they can select securities such as

stock and bonds....etc. if an investor purchase common stock from large companies which

provides annual average profit 12 percent, whereas, treasury bills provide only 4.8 percent,

29 Timothy E. Johnson, (1978), Investment Principle, published by Prentice-Hall, USA, pp. 10 30 ibid., pp. 12

25


which securities the investors decide to invest? First, investors must understand that stock is

equity securities with high risk, issued in the stock exchange, whereas, Treasury bill is a debt

securities with no risk, issued in the money market. In addition, they do analysis and

evaluation of the two securities which securities are valued to be most attractive? Both

securities were evaluated that they are very attractive to investors, but the common stock

price are much fluctuated depend on the situations and conditions of issuers.31

2.2 Financial Assets in the Financial Markets

Financial assets are usually defined as financial obligations or debt contract issued by

debtors to investors. Financial assets are issued by private and government institutions.

Generally, the private and government institutions issued both securities, debt and equity

securities. Debt securities like the bonds and money market instruments were issued by major

corporations and government institutions in order to raise funds from the public, whereas

fund demanders have an obligation to pay interest rates to investors. The money market

instruments are non-interest rate securities sold by discounted price at the over-the-counter

market (OTC) with maturity ranging from 28 days (4 weeks/1 month), 91 days (13 weeks/3

months) and 182 days (26 weeks/6 months) up to 364 days (52 weeks/1 year)32.

Whereas, the bonds have normal maturity from 1 year to 10 years, but in the United

States the bonds have maturity up to 30 years. The borrowers in the bond market must pay

the interest rates to lenders or investors every 6 months or 2 times a year and repay the

principal when to get maturity. The government and corporate bonds can issue for long and

31 Economy Watch (2010), the Securities Investment and Speculation, http://www.economywatch.com 32 Zvi Bodie , Alex Kane, and Alan J Marcus (2008), Essentials of Investments, 7th Edition,

published by McGraw Hill International, Singapore, pp. 5

26


short terms.33 The government bonds issue to the public in order to raise funds for supporting

the excess spending on general education, health cares, roads, public transportations and

other public services. Whereas, the corporate bonds issued by the large corporations in order

to finance their businesses development and investment projects. On the other hand, the

corporate bonds always provide higher-interest rates than the government bonds because it

has a tendency towards higher risk than the government bonds.

The equity securities or stock was issued by the major enterprises and corporations,

their securities are representing a part of ownership in the corporations and provide their right

to shareholders to get dividends. Stock ownership is very important aspect to the financial

investment for the free economy of country; first; it is a source of important capital that

financing from external origin of institution, and second; is a financial flow for corporations

to expand their businesses and investments.34

The commodity market instrument is a future contract range of products such as

energy, precious metals, agricultural products and industrial products. These products are

traded in the form of standardized contracts and usually called the futures contracts and they

are traded in the organized exchange.35

33 Timothy E. Johnson (1978), Investment Principles, published by Prentice-Hall, USA, Page 1-5 34 Stephen A. Ross, Randolph W.Westerfield and Bradford D. Jordan (2000), Fundamentals of

Corporate Finance, 5th Edition, 4th International Edition, McGraw-Hill Company, USA, pp. 217 35 E-how money, Commodities Market Instruments, retrieved from

http://www.ehow.com/info_8024407_traded- instrument-commodity-market.html

27


The currency market instrument is a contract and foreign currency, which are traded

in the Foreign Exchange Market (FOREX). The foreign currencies are traded in two forms;

the first form is a future contract and second form is a trade between currencies and other

currencies. Investors who want to purchase the future contracts and currencies; they always

wish to protect themselves from losses due to the exchange rate changes or demanding of the

foreign currency for purchasing the foreign goods and services and also speculate to gain a

profit from the exchange rate fluctuation.

The derivatives market is a part of financial markets for derivatives, where their

products are derived from other forms of underlying assets. The derivative instrument is a

contract was traded in the organized derivative market and the over-the-counter market. The

contracts are standardized and non-standardized contracts such as future contracts, forwards,

options and swaps. The cost of contracts needs to rely on the underlining assets meaning that

when volatility of original asset price, it can make the price of derivatives change as well. So

investors who come into this market is intended to protect them from the risk will be coming

from the rise or drop of the original asset prices.

28


Table 2: Financial Instruments Traded in the Financial Markets

Financial

markets

Financial

instruments Issuers Investors

Money market

Treasury bills

Banks and

financial institutions

Publics, individuals

and business firms,

government and other

institutions

Certificates of deposit

Commercial papers

Bankers’ acceptance

Repos and reverses

Stock market Common stocks

Preferred stocks

Corporations and

public institutions


and business firms,


institutions

Bond market

Treasury bond and notes

Municipal bond

Corporate bond

Corporations and

government

institutions


and business firms,


institutions

Foreign Exchange

Market (Forex)

Foreign currencies

Currency contracts Brokers and traders

Publics, individuals and

other institutions

Derivatives

Market

Future contract

Forward contract

Swap and Option

Producers, consumers,

brokers and traders

Publics, individuals and

other institutions

Source: Zvi Bodie , Alex Kane, Alan J Marcus(2008); Essentials of Investments; Seventh Edition;

McGraw Hill International; Singapore, Page 24-33, and S. Kerry Cooper and Donal R. Fraser

(1993); Financial Marketplace; Fourth Edition; USA; page 16-18

29


PART III

Mathematics of Financial Securities Investment

The securities investment is an activity relating to trading in financial instruments,

such as shares, bonds and contracts, currencies and other securities are dealt and speculated in

the financial markets and want to make the profits from the transaction.36 Normally, the

securities transactions held by brokerage firms and investment advisors who facilitate buying

and selling securities and recommend buying shares of companies with long-

lasting value and expect to have profits in the future. Besides, investors can buy and sell

securities on their own by internet without use of brokerage firm. The differentiation in the

investment securities is relevant to the proper time adjustment

of the investors in order to buy cheap securities and sell them costly in the future. Commonly,

both institutional and individual investors always find the ways to make more profits through

the savings in the securities investment. However, securities investment also created the

opportunities and risks as well. Moreover, the investors must have the basic capability to

calculate the prices, risks and returns of financial securities and able to analyze all situations

and opportunities of the investment. 37 Based on Brownian model for financial markets

defined the financial assets where one of the assets called bonds or money-market

instruments (N+1) are free risk, so, its price S0(t)>0 with S0(0)=1, while the remaining assets

(N) called stocks are risky.38

36 Kathy Kristof (2000), Investing 101, First Edition, Bloomberg Press Princeton, USA, page 12 37 Pat Dorsey (2004), Successful Stock Investing: Morningstar’s Guide to Building Wealth and

Winning in the Market, Morningstar, USA, page 30 38 Tsekov, Roumen (2010). Brownian Markets, October 13, 2010

30

http://arxiv.org/ftp/arxiv/papers/1010/1010.2061.pdf


3.1 Calculation of Money Market Instruments

The money market instruments are most marketable, liquid and free risk and safe.

They are financial market assets involved in short-term borrowing and lending. Buying and

selling them with original maturities within one year or less. Trading in the money markets is

done in the over-the-counter market (OTC). The market interest rate creates differentiation

between the purchase and selling prices of securities when they get at maturity. When the

loan is repaid, borrower retrieves securities and returns the fund to the lenders.

① Formula to calculate the current price of money market asset:39

The Treasury bill was trading in the form of discounted price from the face value, based on

360 days per year. Therefore, in order to calculate the value of bills, the above formula has

been applied. If T-bill with a face value of US$1,000 and maturity of 26 weeks and now, the

bill was sold for discounted price at 3.80%. In order to calculate the current price of T-bill,

we have to applied this way P = 1,000 (1 - 0.038 x 182) 360 = 980.80. So, the price of T-bill

is US$980.80 and got US$19.20 discount off the face value which will pay US$1,000 on

maturity in four weeks.

Table 3: Calculation of Money Market Instruments

Maturity Date Day to

Maturity

Purchasing

price

Selling

Price

Change Yields

01 February 2007 27 4.70% 4.69% -0.06 4.77

29 March 2007 83 4.88% 4.87% -0.02 4.99

05 April 2007 90 4.91% 4.90% -0.01 5.03

Source: the Wall Street Journal Online, T-Bills Listing on January 4, 2007

39 Zvi Bodie, Alex Kane, Alan J Marcus (2008), Essentials of Investments, Bank Discount Method

Calculation, Seventh Edition, International Edition, Singapore, Page 27

−= YieldDiscount x

360MaturitytoDays

1 x ValueFacePriceCurrent

31


According to the above T-bills listing, the Investment Bank intends to sell the T-bills

with a face value of US$10,000 at a rate of 4.90% and maturity date is in 90 days. So, the

price of bill (P) = 10,000 x [1- 0.0490 x (90/360)] = 9,877.50 and this bill was purchased for

US$ 9,877.50. On the other hand, the formula of bank discount yield was applied this way

Bank discount yield = (D/F) x (360/t) x 100% = (122.50/10,000) x (360/90) x 100% = 4.90%.

② Formula to calculate the yield of money market assets:

Holding-Period Yield (HPY) = (P1 - P0 + D1)/P0

P0 = Purchase price P1 = price at maturity D1 = cash distribution at

maturity

If we invest the T-bill with a face value of US$50,000 and the current market price

was sold at US$49,700 and maturity date in 100 days. What is the HPY of the bill? So, the

HPY was calculated this way, HPY = (50,000 - 49,700+0)/49,700*100% = 0.60%.

3.2 Calculation of Bond Price and Yields

The bond is a debt securities in which issued by the government institutions and large

corporations (issuers) through underwriter in the primary market and then, those securities

are sold to the securities firms or the investment banking and then sold continuously to the

investors in the secondary market. The bond investment is a fixed-income investment and

less risk than stock. The bond investors can hold the securities until the maturity to get both

the interest and principal, or sell the bonds before maturity when the market opens. When the

government institutions and large corporations need to raise the capital from the investors by

issuing the bond and have an obligation to pay interest and repay the principal at maturity

date. Additionally, in order to attract the potential investors in the market, the issuers always

issue the bond price or the face value with appropriate value, terms and a fixed interest rate.

32


① Formula to calculate the bond price

The price or value of bond is determined by discounting the bond's expected cash

flows to the present using the appropriate discount rate. The relationship is expressed for a

semiannual and annual coupon bonds by the following formulas. Now, looking at the cash

flow of a semiannual bond with face value $1000, a 10% coupon rate, and 15 years remaining

until maturity and annual bond is $100 which is calculated by multiplying the 10% coupon

rate times the $1000 face value. Thus, the periodic coupon payments equal $50 every six

months. Frequently, most of bonds pay interest semiannually. However, the corresponding

equations for annual and semiannual coupon bonds are provided on the bond equations:40

Bond Cash Flows

40 Business Finance Online, retrieved from http://www.zenwealth.com/BusinessFinanceOnline/BV/

BondValuation.html

Where:

B0 – Bond Price

C – Coupon

r – Interest rate

F – Face Value

t – Years/Period

33


A bond has maturity in 20 years with the face value US$1,000 and coupon rate of 5%

and has a yield of 6%. Using the annual formula above to calculate the market bond price:

==>

In the case of calculation of a semiannual bond price with a face value $1,000 with 10%

coupon rate, and 15 years remaining until maturity and the required return is 12%.

Additionally, the calculation of the bond value is able to apply in the excel formula:

1.Annual bond value: PV (rate,nper,pmt,fv,type) => B0 = (6%,20,50,1000) = $885.30

2. Semiannual bond value: PV (rate,nper,pmt,fv) => B0=(0.06,30,50,1000) = $862.35

② Formula to calculate the bond yields

The yield to maturity (YTM) on a bond is the rate of return that the investors would

earn if they bought the bond at its current market price and held it until maturity. This is

illustrated by the following equation:

B0 = $885.32

B0 = $862.35

Where: B0 = the bond price, C = the annual coupon payment, F = the face value of the bond, YTM = the yield to maturity on the bond, and t = the number of years remaining until maturity

34


A semiannual bond with a face value of $US1000 and has a 10% coupon rate, and 15

years remaining until maturity that given the bond price is $862.35. Find the yield to maturity

(YTM) on this bond:

In addition, the calculation of the YTM is able to apply in the excel formula:

=RATE (nper,pmt,pv,fv)*2 => YTM = (30,50,-862.35,1000)*2*100% = 12%

Whereas, the yield to call (YTC) is the rate of return that the investors would earn if

they bought a callable bond at its current market price and held it until the call date that

given the bond was called on the call date. This is illustrated by the following equation:

A semiannual bond with a face value of US$1,000 and has a 10% coupon rate, 15

years remaining until maturity that given the bond price is US$1,175 and it can be called 5

years from now at a call price of US$1,100. Find the yield to call (YTC) on this bond:

YTM = 12%

Where: B0 = the bond price, C = the annual coupon payment, CP = the call price, YTC = the yield to call on the bond, and CD = number of years remaining until the call date

YTC = 7.43%

35


Moreover, the calculation of the YTM is able to apply in the excel formula:

RATE (nper,pmt,pv,fv*(1+CP))*2 => YTC = (10,100,-1175,11)*2*100% = 7.43%

Whereas, the Hold-Period Yield (HPY/HPR) is a slight modification of YTM formula,

the situation is that the investors hold a financial asset for a time, and then sells it to another

investor before maturity. The HPY on a bond, you would simply take the difference between

what you purchased and its current value. This is illustrated by the following equation:

A 30-year semi-annual bond with face value of US$1,000 and has a coupon rate 8%

and now the bond is selling at US$1050. What is the HPY of this bond?

HPY = 80 + 1050− 1000

1000= 0.13 𝐼𝐼𝑟 13%

In this case, the current yield is falling at the market that it makes the bond price

increases to $1050.

3.3 Calculation of Stock Price and Dividend

Stock is equity securities that represents or evidences a part of ownership claim in a

corporation or enterprise and entitles investors or shareholders to be part of the proportional

share of the total number of share issued by the corporation and earnings and assets of the

corporation. Thus, the equity securities indicate an institutional aspect of a private enterprise

and resource of holding wealth, and a source of new capital funds for corporations. Equity

securities are of great significance to the saving-investment process in a market economy for

two reasons. First is that new issues of stock are often an important source of external capital

funds and second is the basic role of equity securities in the financing flows of corporations.

Pt+1 = Current price or price you sell/buy

t = Time or years to mature

Pt = Price of face value

36


The equity securities are riskier than bond because there is no fixed commitment for

payments to the stockholders, but offer the possibility of higher returns. There are two types

of equity securities are common stock and preferred stock:

1. Common stock is a form of corporate equity ownership and distinguishes from

preferred stock. It represents ownership in a corporation. Holders of common stock exercise

control by election. Common stockholders are on the bottom of the priority ladder for

ownership structure. It is usually voting shares and the holders are able to influence the

corporation through votes on establishing the corporate’s objectives and policy and electing

the company's board of directors. Some holders of common stock also receive preemptive

rights, which enable them to retain their proportional ownership in a company. There is no

fixed dividend paid out to the common stockholders and so their returns are uncertain. If the

company goes bankrupt, the common stockholders will not receive their funds until the

creditors, bondholders and preferred shareholders have received their respective share of the

leftover assets. The amount of the dividend on common stock unlike the amount of dividend

on preferred stock is known before the stock is purchased. This makes common stock riskier

than debt securities or preferred shares.

2. Stock Splits: the stock split is an action to increase the number of shares of the

common stock outstanding. For a 2 for 1 split, for example, the number of shares of common

stock is doubled. Once the firm decides to make a distribution to the investors, it has two

primary means of doing so. The first is through cash dividends and the second is through

stock repurchases. Many firms also declare stock splits and stock dividends that they wish the

investors to consider valuable. Effect of stock split or stock dividend on the corporation as

following:

37


2.1. Before stock split or stock dividend

o Common stock (one million shares outstanding) $2,550,000

o Retained earning $4,450,000

o Total shareholders’ equity $7,000,000

2.2 After 2 for 1 stock split

o Common stock (two million shares outstanding) $2,550,000

o Retained earning $4,450,000

Total shareholders’ equity $7,000,000

In this case, we conclude that the shareholders will receive two benefits:

(a) Number of shares and dividends increased and

(b) Expectation from appreciation of stock price

3. Preferred stock also known as preferred shares. It generally has a dividend that

must be paid out before dividends to the common stockholders and commonly does not have

voting rights. Also unlike common stock, a preferred stock pays a fixed dividend that does

not fluctuate, although the company does not have to pay the dividend if it lacks the financial

ability to do so. The main benefit to owning preferred stock is that the investor has a greater

claim on the company's assets than common stockholders. Preferred shareholders always

receive their dividends first and, in the event of the company goes bankrupt, preferred

shareholders are paid off before common stockholders. However, the best way to think

of preferred stock is as a financial instrument that has characteristics of both debts (fixed

38


dividends) and equity (potential appreciation). Similar to bonds, preferred stocks are rated by

the major credit rating companies and receive fixed dividend, however, they do not carry the

same guarantees as interest payments from bonds. Like common stock, preferred stocks

represent partial ownership in a company, although preferred stock shareholders do not enjoy

any of the voting rights of common stockholders.

4. Stock Valuation Equations:

o Equation for Constant Growth Stock Price:

According to this formula, besides the calculation of bond price (P0), it could be

calculated to find the current and next dividends and grow rate in dividend and the required

return on the stocks. Thus, this formula can create the following equations:

r = D0(1+ g)/P0 + g D0 = P0(r - g)/ (1 + g)

D1 = P0(r - g) g = (r - D1)/P0

The corporation expects to pay the current dividend of $2.50 per share in the initial period,

the discount rate of stock associate with 12%, and dividends are expected to grow at a rate of

6% each year. So, we have D0 =$2.50, r = 0.12, g = 0.06.

P0 = the stock price at time 0, D0 = the current dividend

D1 = the next dividend at time 1

r = the required return (expected return) on the stock

g = the expected growth rate of dividend in future (g<r)

39


To find the stock price (P0), this formula has been applied as following:

o Equation for Non-constant Growth Stock Price:

Where:

P0 = the stock price at time 0

Dt = the expected dividend at time t

T = the number of years of non-constant growth

g = the long-term constant growth rate in dividends

r = the required return on the stock, and r> g

The current dividend on a stock is $2 per share and the investors require a rate of

return of 12%. Dividends are expected to grow at a rate of 20% per year over the next three

years and then at a rate of 5% per year from that point on. There are 3 years of non-constant

growth, thus, we have T = 3, the expected grow rate = 20% and r 12%, D0 = 2, gc = 5%. In

order to find this stock price (P0), we have to calculate the expected dividends for year one

through year four (D1 to D4) using the expected growth rates and apply the following

equations:

D1 = D0 (1+g) = 2(1 + 20) = $2.40

D2 = D1 (1+g) = 2.40(1 + 20) = $2.88

D3 = D2 (1+g) = 2.88(1 + 20) = 3.456

D4 = D3 (1+g) = 3.456(1 + .05) = 3.6288

P0 =2.40

(1 + .12)1 +2.88

(1 + .12)2 +3.456

(1 + .12)3 +3.6288

(. 12 + .05) (1 + .12)−3 = $43.80

40


o Equation for Required Return Calculation on Stock:

A stock that given the next dividend is $5.71 per share, the growth rate in dividends is

3.08%, and the stock price is $96.45 per share. In order to find the required return on stock,

this formula has been applied r = D0 (1+ g)/P0 + g. Thus, we have D1 = $5.71, g = 3.08% and

P0 = $96.45, the required return is calculated as follows:

r = D1

P0

+ g = 5.71

96.45

+ 0.0308 = 0.09 = 9%

o Equation for Calculation of Dividend Growth Rate for Stock:

A stock that given the next dividend is $1.64 per share, the required return is 13.1%,

and the stock price is $37.02 per share. In order to find the dividend growth rate for stock,

this formula has been applied this way, g = (r - D1)/P0. So, we have D1 = $1.64, g = 13.1%

and P0 = $37.02, the Dividend Growth Rate is calculated as follows:

g = r - D1

P0

= 0.131 - 1.64

37.02

= 0.0867 = 8.67%

o Equations for Calculation of Holding-Period Return (HPR) for Stock:

If your stock investment has the following returns in the four quarters of a given year

which has quarterly prices as $98, $101, $102 and $99 and also quarterly dividends as $1, $1,

$1.5 and $1.5. Looking at the table below to calculate the quarterly rates and an annual HPR,

The following formulas have been applied.

𝐻𝐻𝐻𝐻𝐻𝐻𝑛𝑛 = 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 + (𝐻𝐻𝑛𝑛+1 − 𝐻𝐻𝑛𝑛) 𝐻𝐻𝑛𝑛 This is HPR Equation ==>

41


The Holding-Period Return (HPR) is calculated as follows:

HPR1 = ($98 – $100 + $1)/$100 = -1% HPR3 = ($102 – $100 + $3.5)/$100 = 5.5%

HPR2 = ($101 – $100 + $2)/$100 = 3% HPR4 = ($99 - $100 + $5) / $100 = 4%

This is Annual HPR Equation =>1+HPR= (1+HPR1) (1+HPR2) (1+HPR3) (1+HPR4)

HPR = [(1 -0.01) x (1 + 0.03) x (1 + 0.055) x (1 + 0.04)] - 1 = 11.8%

o Equation for Calculation of Preferred Stock Price:

The preferred stock can be valued as a constant growth stock with a fixed-preferred

dividend growth rate equal to zero. Thus, the price of a preferred stock can be determined

using the following equation:

The share of preferred stock that given the par value is $100 per share, the preferred-

stock dividend rate is 8%, and the required return is 10%. This formula has been applied to

calculate the price of a share of preferred stock. P0 = .08 x 100

.01 = $80

Description 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter

Dividends $1 $1 $1.5 $1.5

Stock Prices $98 $101 $102 $99

Quarterly Rates -1% 3% 5.5% 4%

Annual Rate 11.8%

Where:

Pp = the preferred stock price,

Dp = the preferred dividend, and

r = the required return on the stock

Pp =Dp

r

42


3.4 Calculation of Derivative Securities

Derivatives are securities whose prices are derived from the underlying assets and its

value is determined by the fluctuations in the underlying assets. Underlying assets are most

commonly stocks, bonds, currencies, interest rates, commodities and market indices. Most

common derivatives are the future contracts, forward contracts, options and swaps and

generally used to hedge risk and speculative purpose.

Currency future contracts are traded in order to hedge the risk of exchange rate

fluctuation while holding the financial assets like stock and other securities. Let’s say if the

European investor purchases shares of American Corporations from American Exchange by

using the U.S. dollars. Thus, in order to lock in a specified exchange rate for future stock sale

and currency conversion back into Euro, the investor can buy a currency future contract. If,

the investor purchase a 90-day future contract, amount of Euro 125,000 and base on the

current market quote, one Euro is US$1.23354 or EUR/USD 1.23354, so, investor has to pay

$154,192.50 to buy the contract and calculated this way 125,000 x 1.23354 = US$154,192.50.

Moreover in the Forex market, the foreign currencies are traded as well. The traders buying

and selling the foreign currencies in the market and make thousands of trades daily. Trading

in the Forex may be used for varied purposes such as the import and export needs, the direct

foreign investment and speculation for profit from the short-term fluctuation in exchange

rates including management of existing positions or need to buy foreign goods and services

and financial assets. Let's say EUR/USD 1.3675 is purchased that means that you are buying

one Euro and selling US D 1.3675 at the same time.

Whereas, forward contracts are very similar to the futures contracts, except they are

not traded on the organized exchange. Although the settlement price and the delivery date are

43


the same, but there is a difference between the gains and losses under the two contracts. The

the gains or losses of future contracts are realized day by day because of the daily settlement

and the gains or losses of the forward contracts are realized on maturity. Let’s say traders

agree to accept payment in British Pound for the next three months, they may purchase the

British Pound-future contract in order to guarantee that when those Pound can be sold for a

specific U.S. dollar amount. Thus, trader can buy a 90-day contract at GBP100,000 at the

over-the-counter that one Pound is equal to US$ 1.55665 or GBP/USD 1.55665. Then, trader

has to pay 100,000 x 1.55665 = US$155,665 for that contract. One month later, the 90-day

contracts rise from US$ 1.55665 to US$ 1.6500 per GBP, then trader decides to sell that

contract in order to realize a profit. However, usually, this earning isn’t realized day by day

like the future contract, it will make the same gain but on maturity, that is on the 90th day.

Options are the contracts that give the buyer or owner the right, but not the obligation,

to buy (call option) or sell (put option) an underline asset or instrument at a specified strike

price on or before a specified date. The option contract also specifies a maturity date and has

an expiration date. When an option expires, it no longer has value and no longer exists. The

primary types of the financial options are exchange-traded derivatives which are settled

through a clearing house with guaranteed by the exchange and OTC options are traded

between two private parties, and not listed on an exchange. The strike price is price of the

underlying security can be bought or sold as detailed in the option contract and also identify

the month they expire. Date of all options expires on the third Friday of the month unless that

Friday is a holiday, then the options expire on Thursday. Options are quoted in per share

prices, but it sold in the 100 share lots. A coption might be quoted at $2, but you would pay

$200 because the option contracts are always sold in the 100-share lots.

44

http://en.wikipedia.org/wiki/Option_(finance)


A call option is a financial contract between two parties, the buyer and the seller of

this type of option. The buyer of the call option has the right, but not the obligation, to buy an

agreed quantity of a particular commodity or financial instrument from the seller of option at

a certain time for a strike price. The seller or writer is obligated to sell the commodities or

financial instruments to the buyer. The buyer pays a fee (a premium) for this right. When you

buy a call option, you are buying the right to buy a stock at the strike price and before the

expiration date. Let’s say a stock trades at $50 right now and you buy a call option with a $50

strike price, you have the right to purchase that stock for $50, even if the stock rises to $100,

you still have the right to buy that stock for $50 before the call option expired. On the other

hand, if the stock falls to below $50, the buyer will never exercise the option, since he would

have to pay $50 per share when he can buy the same stock for less. If this occurs, the option

expires worthless and the option seller keeps the premium as profit. Base on above instance,

the current price of stock is $50 per share, and investor expects it will go up significantly.

Then he buys a call contract from the call writer/seller. The strike price for the contract is $50

per share, and investor pays a premium $5 per share, or $500 total. If the stock does not go up,

investor/buyer does not exercise the contract, then he has lost $500. Subsequently, the stock

goes up to $60 per share before the contract expires. Then, buyer/investor exercises the call

option to sell the stock on the market at market price for a total of $6,000. Thus, he has a net

profit of $500 = (1000–500). However, if the stock price drops to $40 per share by the time

the contract expires, the investor will not exercise the option and loses his premium of $500.

Accordingly, If you take a “XYZ October 26 Call” it would be a call option on XYZ stock

with a strike price of $26 that expires in October. So, you have a right to buy 100 shares of

XYZ at $26 per share. If you are right, the stock rises from $26 to $30 per share before option

expires, you could exercise your option and sell them for an immediate profit of $4 per share.

45


If you are wrong, the stock fell from the original $26 per share to $24 per share, you

would simply let the option expire and suffer.

A put option is a financial contract between two parties and gives the right to the

buyer to sell the underlying assets at a certain price on or before a certain date and becomes

more valuable as the price of the underlying assets depreciates relative to the strike price.

Let’s say a buyer thinks the price of a stock will decrease. He pays a premium which he will

never get back, unless it is sold before it expires. The buyer has the right to sell the stock at

the strike price to the writer and writer receives a premium from the buyer. If the buyer

exercises his option, the writer will buy the stock at the strike price. If the buyer does not

exercise his option, the writer's profit is the premium. Let’s say "Buyer A" purchases a put

contract to sell 100 shares to "Seller B" for $50 per share. The current price is $55 per share,

and “Buyer A” pays a premium of $5 per share. If the price of stock falls to $40 a share

before expiration, then “Buyer A” can exercise the put option by buying 100 shares for

$4,000 from the stock market, then selling them to “Buyer B” for $5,000. Buyer A's total

earnings can be calculated at $500. It is the same calculation, if you buy one Sept 13 Taser

10 put, you have the right to sell 100 shares of Taser at $10 until September 2013. If the

shares fall to $5 and you exercise the option at $10, then you can purchase 100 shares for $5

in the market and sell the shares to the option's writers for $10 each, which means that you

make a profit $500 on the put option and also calculated this way = (100 x ($10-$5)) = $500.

Swaps are contracts to exchange the cash flows on or before a specified future date

based on underlying assets of currencies/exchange rates, bonds/interest rates, commodities,

stocks or other assets. Unlike most standardized and nonstandardized contracts as options,

forwards and futures contracts, swaps are not exchange-traded instruments. Instead, swaps

46

http://en.wikipedia.org/wiki/Swap_(finance)


are customized contracts that are traded in the over-the-counter (OTC) market between

private parties. Firms and financial institutions dominate the swaps market, with few (if any)

individuals ever participating. Because swaps occur on the OTC market. Now, let’s say that

company A and company B enter into a five-year swap and company A pays company B an

amount equal to 6% per annum on a notional principal of US$20 million. Company B pays

Company A an amount equal to one-year LIBOR + 1% per annum on a principal of US$20

million. In order to calculate the cash flows of payment between both parties, a following

figure has been applied annually based on one-year LIBOR41:

Fixed Rate: 6%

Floating Rate: LIBOR + 1%

Let's assume that the two parties exchange the payments annually on December 31.

Thus, company A pays company B this way, $20,000,000 x 6% = US$1,200,000. Therefore,

company B will pay company A like this, $20,000,000*(5.33% + 1%) = $1,266,000. Lastly,

the company B has to pays $66,000 and company A pays nothing.

41 London Interbank Offered Rate, British Bankers Association - BBA

Company A

Company B

47


PART IV

Risks and Returns

4.1 Risks in Financial Investment

Risk is the potential of loss resulting from an action, activity or inaction. This idea

indicates that a choice having influence on the outcome sometimes exists. Possible losses

may be called "risks". Any human endeavor carries some risk, but some are much riskier than

others.

The investors do not fully appreciate the

risks in the securities investment and they are

difficult to obtain the result while individuals

consider investing their money, and then were

immediately faced with the conflict between their desire for safety of principal and future

return. The investors are not always willing to accept the risks associated with high returns.

The risk in holding securities is that the actual returns might be less than the expected returns.

The investors attempt to secure the largest rate of returns at the high risk that are willing, but

risk is uncertainty about the size of future returns. So, there is a positive relationship between

amount of risks assumed and amount of expected returns. That is, the greater the risk, larger

the expected returns and the larger the chance of a substantial loss. One of more difficult

problems for investors is to estimate the highest level of risk that is able to assume42.

Timothy Johnson (1978) and other economists determined that there were many types

of risk such as purchasing-power risk, credit risk, market risk, interest rate risk, business and

operational risks, equity and financial risks. Thus, the investors must be aware all types of

42 Timothy E. Johnson (1978), Investment Principles, Published by Prentice-Hall,, USA, Page 17

Figure: 10

Figure 9: Risk and Return

48

http://www.google.com.kh/url?sa=i&rct=j&q=&esrc=s&frm=1&source=images&cd=&cad=rja&docid=YFzLo-uiuP75oM&tbnid=mmXWRXlz1ljiCM:&ved=&url=http://www.scielo.org.co/scielo.php?pid=S0120-56092008000100011&script=sci_arttext&ei=VDtpUfP8C8norQfvkIDwAQ&bvm=bv.45175338,d.bmk&psig=AFQjCNGNEmMyskDMsGVRyO9MVzhF4g0SyA&ust=1365937364671897





systematic risks and unsystematic risks. Therefore, the investors must know how to measure

and manage the investment risk.

In finance, there are different types of risk can be classified under two main groups:

1. Systematic risk

2. Unsystematic risk

The Systematic risk is due to the influence of external factors, which are normally

uncontrollable from an organization's point of view. Systematic risk is a macro in nature as it

affects a large number of organizations operating under a similar stream or same domain. It

cannot be planned by the organization. Types of risk under systematic risk are listed below:

o Interest rate risk

o Market risk

o Purchasing power or Inflationary risk

The Interest-rate risk arises due to variability in the interest rates from time to time. It

particularly affects debt securities as they carry the fixed rate of interest. The interest-rate risk

is further classified into the price risk reinvestment rate risk. The Market risk is associated

with consistent fluctuations seen in the trading price of any particular shares or securities.

That is, it is a risk that arises due to rise or fall in the trading price of listed shares or

securities in the stock market. The market risk is further classified into the absolute risk,

relative risk, directional risk, non-directional risk, basis risk and volatility risk. Whereas, the

purchasing power risk is also known as inflation risk. It is so, since it originates from the fact

that it affects a purchasing power adversely. It is not desirable to invest in securities during an

inflationary period. The purchasing power or inflationary risk is classified into demand

inflation risk and cost inflation risk.

49


The Unsystematic risk is due to the influence of internal factors prevailing within the

organizations. Such factors are normally controllable from an organization's point of view.

The Unsystematic risk is a micro in nature as it affects only a particular organization. It can

be planned, so that necessary actions can be taken by the organization to mitigate (reduce the

effect of) the risk. The types of risk under unsystematic risk are below:

o Business or liquidity risk.

o Financial or credit risk.

o Operational risk.

The Business risk is also known as the liquidity risk. It is so, since it originates from

the sale and purchase of securities affected by the business cycles, technological changes, etc.

The business or liquidity risk is classified into the asset liquidity risk and funding liquidity

risk. Whereas, the financial risk is also known as credit risk and arises due to change in the

capital structure of the organization. The capital structure mainly comprises of three ways by

which funds are sourced for the projects. The financial/credit risk classified into the exchange

rate risk, recovery rate risk, credit event risk, non-directional risk, sovereign risk and

settlement risk. Whereas, the operational risks are the business process risks failing due to

human errors. This risk will change from industry to industry. It occurs due to breakdowns in

the internal procedures, people, policies and systems. The operational risk is classified into

the model risk, people risk, legal risk and political risk.

The professionals have two common ways to measure risk:

(1) Beta model

(2) Variance and Standard deviation model

50


Beta model is a measure of the volatility, or systematic risk of securities or portfolios

in comparison to the overall market movements. Beta is used in the capital asset pricing

model (CAPM), is a model that calculates the expected return of an asset based on its beta

and expected market returns. Beta is an indicator of how risky a particular stock is and it is

used to evaluate its expected rate of return. Beta is one of the fundamentals that stock

analysts consider when choosing stocks for their portfolios, along with price-to-earnings

ratio, shareholder's equity, debt-to-equity ratio, and other factors. Therefore, in order to

calculate the risk and return of your portfolio investment, this formula has been applied:

Beta = (Cov(ra,rb)) or (Covariance of Market Return with Stock Return)

(Var)(rb) or Variance of the Stock Market Return

Or Expected Rate of Return = R = Rf + B (rm - rf) ==> Beta = (R - Rf) / (Rm - Rf)

Let’s say we have the market rate 30.32%, risk-free return rate 0.26% and beta 2.147. In

order to calculate the expected of return, this formula has been applied, R = Rf + B (rm - rf) =

E(r) = 0.26% + 2.147(30.32 – 0.26%) = 64.82%.

This is the rate of return an investor could expect on an investment in which his/her

money is not at risk, such as U.S. T-Bills for investments in U.S. dollars and EU Government

Bills for investments that trade in euros. This figure is normally expressed as a percentage.

o Risk-free rate = 2%

o Stock’s rate of return = 7%

o Market rate of return = 8%

R = Expected Rate of Return, Rf = Risk-Free Interest Rate

Rm = Expected Market Return, B = Stock Beta

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Using a simple equation to calculate the Beta:

o 7% - 2% = 5%

o 8% - 2% = 6%

o 𝛽 = 56

= 0.833

𝛽 < 1 => beta of less than 1 means that the security will be less volatile than the market

𝛽 > 1 => beta of greater than 1 show that the price of securities will be more volatile than

the market.

𝛽 = 1 => beta of 1 indicates that the price of securities will move with the market

𝛽 < 0 => beta of less than 0 means that the stock is losing money while the market is

gaining.

If a stock's beta is 1.2, it's theoretically 20% more volatile than the market. Many utilities

stocks have a beta of less than 1. Conversely, most high-tech, Nasdaq-based stocks have a beta of

greater than 1, offering the possibility of a higher rate of return, but also posing more risk.

4.2 Returns in Financial Investment

Standard Deviation is a unit of measurement expressed as a percentage and sheds

light on historical volatility and is the real key to understanding the risk of your investment

portfolio. Standard deviation describes the probability of the distribution of a series of data. If

a volatile stock will have a high standard deviation while the deviation of a stable blue chip

stock will be lower. A large distribution tells us how much the return on the fund is deviating

from the expected normal returns. Thus, risk reflects the chance that the actual return on an

investment may be very different than the expected return. One way to measure risk is to

calculate the variance and standard deviation of the distribution of returns. Consider the

probability distribution for the returns on stocks A and B provided below.

52


State Probability Return on Stock A Return on Stock B

1 20% 5% 50%

2 30% 10% 30%

3 30% 15% 10%

4 20% 20% -10%

The expected returns on stocks A and B were calculated below. The expected return

on stock A was found to be 12.5% and the expected return on stock B was found to be 20%.

In order to calculate the expected returns of asset, this formula can be applied:

E [R] = �piRiN

i=1

Where: N = the number of states, pi = the probability of state i,

Ri = the return on the stock in state i, and E[R] = the expected return on the stock

Stock A: E [RA] = 0.20(5%) + 0.30(10%) + 0.30(15%) +0.25(20%) = 12.5%

Stock B: E [RB] = 0.20(50%) + 0.30(30%) + 0.30(10%) +0.25(-10%) = 20%

As the result, the calculation shows that the Stock B offers a higher expected return

than Stock A or E [RB] > E [RA]. However, that is only part of the investment; they haven't

yet considered risk. Thus, in order to compute the measure risk, the standard deviation and

Variance has been determined as expected value of square deviation as below formula:

𝑉𝑎𝑟[𝐻𝐻] = 𝜎2 = �𝑝𝑖 (𝐻𝐻1

𝑁

𝑖=1

− 𝐸[𝐻𝐻])2

53


σA2 = 0.20(0.50 − 0.125)2 + 0.30(0.10 − 0.125)2 + 0.30(0.15 − 0.125)2

+ 0.20(0.20 − 0.125)2 = 0.00263 ==> σA2 = √0.00263 = 0.0512 = 5.12%

σB2 = 0.20(0.50 − 0.20)2 + 0.30(0.30 − 0.20)2 + 0.30(0.10 − 0.20)2

+ 0.20(−0.10 − 0.20)2 = 0.04200 ==> σB2 = √0.04200 = 0.2049 = 20.49%

As result, though Stock B offers a higher expected return than Stock A E[RB]>E[RA],

but it also is riskier since its variance and standard deviation are greater than Stock A. Most

investors choose to hold securities as part of a diversified portfolio.

4.3 Calculation of Expected Risks and Returns

Let’s see the table below and calculate the expected rate of risks (σ) and expected rate

of returns E(r) on portfolio investment alternatives:

4.3.1 Calculation of Expected Returns on Each Alternative

E(r) AA = 0.10(-22%) + 0.20(-2%) + 0.40(20%) + 0.20(35%) + 0.10(50%) = 17.4%

E(r) BB = 0.10(28%) + 0.20(14.7%) + 0.40(0%) + 0.20(-10%) + 0.10(-20%) = 1.7%

E(r) CC = 0.10(10%) + 0.20(-10%) + 0.40(7%) + 0.20(45%) + 0.10(30%) = 13.8%

E(r) DD = 0.10(-13%) + 0.20(1%) + 0.40(15%) + 0.20(29%) + 0.10(43%) = 15.30%

Economy Probability T-Bill AA BB CC DD

Recession 0.10 8% -22% 28% 10% -13%

Below average 0.20 8% -2% 14.7% -10% 1%

Average 0.40 8% 20% 0.0 7% 15%

Above average 0.20 8% 35% -10% 45% 29%

Boom 0.10 8% 50% -20% 30% 43%

1.00 (100%)

54


4.3.2 Calculation of Expected Risks on Each Alternative

σ T-bills = 0.0%

σAA = [(-22 - 17.4)20.10 + (-2 - 17.4)20.20 + (20 - 17.4)20.40 + (35 - 17.4)20.20

+ (50 - 17.4)20.10)]1/2 = 20.0%

σBB = [(28 – 1.7)20.10 + (14.7 – 1.7)20.20 + (0 – 1.7)20.40 + (-10 – 1.7)20.20

+ (-20 – 1.7)20.10)]1/2 = 13.4%

σCC = [(10 – 13.8)20.10 + (-10 – 13.8)20.20 + (7 – 13.8)20.40 + (45 – 13.8)20.20

+ (30 – 13.8)20.10)]1/2 = 18.8%

σDD = [(-13 – 15)20.10 + (1 – 15)20.20 + (15 – 15)20.40 + (29 – 15)20.20

+ (43 – 15)20.10)] 1/2 = 15.3%

Securities Expected Returns Expected Risks

AA 17.4% 20.0%

BB 15.0% 15.3%

CC 13.8% 18.8%

DD 1.7% 13.4%

T-bills 8.0% 0.0%

Base on the result shows that the risk of stock AA (20%) is higher than its return

(17.4%) and the risk of stock BB (15.3%) is higher than its return (15%). Whereas, the risk of

stock CC (18.8%) is higher than its return (13.8%) and the risk of stock DD (13.4%) is higher

than the return (1.7%) and the T-bills is free risk (8.0%). Thus, the calculation is estimated

that this portfolio provides average return smaller than higher risk.

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The techniques to manage risk:

The individual investors can use several methods to help reduce the risk and volatility

in their portfolios. These include diversification, asset allocation, Dollar cost averaging

Portfolio rebalancing.

1. Diversification is a technique that reduces the unsystematic risk by allocating

investments among various financial instruments, industries and other categories. It aims to

maximize return by investing in different areas that would each react differently to the same

event. Most investment professionals agree that, although it does not guarantee against loss,

diversification is the most important component of reaching long-range financial goals while

minimizing risk. Generally, investors confront two main types of risk when investing.

Diversifiable risk is associated with every company and also known as "systematic risk" or

"market risk". Causes are things like inflation rates, exchange rates, political instability, war

and interest rates. This type of risk is not specific to a particular company or industry, and it

cannot be eliminated, or reduced, through diversification; it is just a risk that investors must

accept. Whereas, diversifiable risk also known as "unsystematic risk" and it is specific to a

company, industry, market, economy or country; it can be reduced through diversification.

The most common sources of unsystematic risk are business risk and financial risk. Thus, the

aim is to invest in various assets so that they will not all be affected the same way by market

events. Now, let's say you have a portfolio of only airline stocks. If it is publicly announced

that airline pilots are going on an indefinite strike, and that all flights are canceled, share

prices of airline stocks will drop. Your portfolio will experience a noticeable drop in value. If,

however, you counterbalanced the airline industry stocks with a couple of railway stocks,

only part of your portfolio would be affected. In fact, there is a good chance that the railway

stock prices would climb, as passengers turn to trains as an alternative form of transportation.

56


But, you could diversify even further because there are many risks that affect both rail and

air, because each is involved in transportation. An event that reduces any form of travel hurts

both types of companies. Statisticians would say that rail and air stocks have a strong

correlation. Therefore, to achieve superior diversification, you would want to diversify, not

only different types of companies but also different types of industries. The more

uncorrelated your stocks are better. Thus, diversification can help investors to manage risk

and reduce the volatility of an asset's price movements or can reduce risk associated with

individual stocks, but general market risks affect nearly every stock, so it is important to

diversify also among different asset classes. The key is to find a medium between risk and

return; this ensures that you achieve your financial investment goals.

2. Asset allocation is an investment strategy that attempts to balance risk versus

reward by adjusting the percentage of each asset in an investment portfolio according to the

investor's risk tolerance, goals and investment time frame.43There is no simple formula that

can find the right asset allocation for every individual. However, the consensus among most

financial professionals is that asset allocation is one of the most important decisions that

investors make. In other words, your selection of individual securities is secondary to the way

you allocate your investment in stocks, bonds, and cash, real estate, and equivalents, even

insurance investments, commodities, collectibles, and other categories count, which will be

the principal determinants of your investment results. This method establishes and adheres to

a base policy mix as a proportional combination of assets based on expected rates of return

for each asset class. For example, if stocks have historically returned 10% per year and bonds

have returned 5% per year, a mix of 50% stocks and 50% bonds would be expected to return

7.5% per year. Let’s see the Harvard Asset Allocation as of June 30, 2008 used as an

43 Asset Allocation Definition (2011), retrieved from Investopedia

57


investment strategy to attempt to balance of risk versus return by adjusting the percentage of

each asset in an investment portfolio. Thus, the Harvard has allocated their assets such as the

absolute return, fixed income, and domestic, foreign and private equities as well as real assets

and cash to put in the investment portfolio = 19% + 16% + 12% + 22% + 12% + 24% +

(-5%) = 100%.

3. Dollar cost averaging (DCA) is an

investment strategy for reducing the impact

of volatility on large purchases of financial

assets such as equities. DCA reduces the

risk of incurring a substantial loss resulting

from investment in the market. DCA is not

always the most profitable way to invest a

large sum, but it minimizes downside risk. 44 Let’s say that more shares are purchased when

prices are low, and fewer shares are bought when prices are high. Eventually, the average

cost per share of the security will become smaller and smaller. Dollar-cost averaging lessens

the risk of investing a large amount in a single investment at the wrong time. For example,

you decide to purchase $1,000 worth of XYZ each month for three months. In January, XYZ

is worth $3, so you buy 100 shares. In February, XYZ is worth $5, so you buy 100 additional

shares and then in March XYZ share is worth $10, so you buy 100 shares. Finally, in April,

XYZ share is worth $4, so you buy 100 shares. In total, you purchased 400 shares for an

average price of approximately $5.5 each. The cost average has been calculated in the

following table:

44 Dollar Cost Averaging: A Technique that Drastically Reduces Market Risk. Retrieved 2009-03-22

Picture 10: the Harvard Asset Allocation

58


4. Portfolio rebalancing is a powerful risk-control strategy. As a portfolio’s different

investments produce the altered returns, the portfolio drifts from its target asset allocation,

acquiring risk and return characteristics that may be inconsistent with an investor’s goals and

preferences. A rebalancing strategy addresses this risk by formalizing guidelines about how

frequently the portfolio should be monitored, how far an asset allocation can deviate from its

target before it’s rebalanced, and whether periodic rebalancing should restore a portfolio to its

target or to some intermediate allocation. The objective of portfolio rebalancing is to maintain

a consistent mix of asset classes, most commonly equities and fixed income in order to

control risk at the level desired by the investors. This is accomplished by transferring funds

from higher-performing classes to lower-performing classes. When asset classes deviate from

their target by a certain dollar amount, the investors have to find the way to rebalance. For

instance, if you have a $10,000 portfolio investment and hold $5,000 in equities (50%) and

$4,000 in the fixed income (40%) and 1,000 in the real estate (10%) on January 31, 2011,

after the market takes action a few months up to March 30, 2011 and your portfolio has

changed 45% equities, 35% bonds and 20% real estate. Thus, you would rebalance your

portfolio in order to balance your current holdings of $5,000 equities (50%), and $4,000

fixed-income (40%) and $1,000 real estate (10%).

Date Price per Share Shares Cost

January 15 $3 100 $300

February 15 $5 100 $500

March 15 $10 100 $1,000

April 15 $4 100 $400

Total 400 $2,200

Average Price per Share $5.50

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PART V

Capital Markets ‘Analytical Tools for Economic Growth

According to the previous research findings showed that the development of capital

markets in the country, it provided chances and benefits to the economic growth, particularly,

its mechanism offers opportunities for companies and institutions seeking financing beside

banking system in order to expand their investment and business projects in the future.

Moreover, this mechanism also gave choices to investors and publics to participate in this

investment activity.

Moreover, beside the benefits to economic growth, this mechanism

can help country's financial integration into the global financial system and strengthen the co

untry's financial sector more robust including keeping the macroeconomic stability. In the

findings of University of Science Economics of Romania showed that development of capital

markets helped boost the economic growth of the country during 2000 to 2006,

accompanied by the development of the financial system and

the variables used for measuring in the study are the variables of market capitalization size

and listed stocks including of trading volume. 45 Whereas Nieuwerberg, Buelens and

Cuyvers also

said the development of the capital markets in Belgium to help promote national economic gr

owth during 1873-1935 as measured by the variables of market capitalization size and

numbers of listing stocks. Whereas, Harry Garresten, Robert Lensink and Elmer Sterken

showed relationship between

45 Laura, Victor, Delia, Andreas (2008): correlation between capital market and economic growth, pp. 8

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the economic growth and development of the capital markets when economic growth

has impetus 1% it determines that the market capitalization ratio increase 0.4%.

5.1 Measure of Economic Growth

To analyze on the economic growth and capital market development is

used a classical model is a total production function that

has a relationship between the quantities of outputs and inputs. Depend

on the following equation shows the relationship between the inputs and outputs to determine

the economic growth as measured by the production function Y = AF (K, N).46To facilitate

the calculation, we assume key inputs, which comprise (N) labor (K) as capital. Therefore,

this equation showed that the outputs (Y), which depends on the level of inputs and

technology. If technology (A) higher, they can produce more item by item. Thus, the equation

above shows the contribution of inputs through the productivity formation to increase the

outputs. Accordingly, the labor and capital contribute to the economic growth (outputs). The

improvement of technology is the productivity development of the workforce.

According to the function of production “Cobb and Douglas” showed relationship

between the vital inputs and outputs to the economic growth that economists always used the

function of production, which found by Wicksell (1851-1926) and was taken to verify the

data by Charles Cobb and Paul Douglas in 1928. This function can write a formula Y =

ALαKβ or Y = A x Lα x Kβ which represented by (Y) = is the production, (L) = labor input

and (K) = capital input and (A) = total factor productivity. α and β = is the constancy of labor

and capital. The two values are determined by the appropriate technology. If α = 0.15, and

46 Hang Choun Naron (2009), Macroeconomics, first edition, Phnom Penh, pp. 162

61


labor force growth at 1%, will lead to increase of 0.15%. If α + β = 1, will lead to the

production function has constantly increased. If L and K increased 20% Y also increased by

20%. If α + β <1, the profit from the investment will be dropped. If α + β>1, the profits from

the investment will be increased. This growth model showed a close relationship between a

living standard of people and key factors such as savings rates, population growth and the

progress of technology. The evolutions of economic growth and its impetus including the

motive force to the slow economic countries will step up to the advance economic countries.

Solow’s economic growth model described that there is an interaction or relationship

to the five macroeconomic equations: (1) the function equation of macro production (2) the

equation of GDP (3) the equation of savings (4) the equation of capital transformation and (5)

the equation of transformation of labor.47 Solow growth model was used for calculation and

analysis of the amount of all the products and services that each nation produces and uses.

Especially domestic product equation or called gross domestic product or was called GDP.

Thus, GDP is the value of all finished products and services that produced in an economy at a

time, whereas, the value of goods and services are identified depending on the market price.

The GDP is calculated by three methods:

(1) Method of productions

(2) Method of expenses and

(3) Method of incomes

As said by the theory, the equation of GDP can be determined as follows:

GDP = C + G + I + (X-M) ==> Y = GDP = C + G + I + (NX)

47 Solow–Swan growth model, the economic growth models, the framework of neoclassical growth

models

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When GDP increases, the gross products as outputs (Y) increase because of the investments

and total incomes increase for improving the domestic products and services as well as the

total expenditure and consumption for reduction of the import and improve the export.

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5.2 Market Capitalization (%) to GDP

Additionally, the model of the World Bank (2011) has been used for calculation to

find out the market capitalization of listed companies (% of GDP). The market capitalization

is the share price times the number of shares outstanding and divided by the nominal GDP

and time 100%. The following formula has applied in the U.S. markets and the world markets

as well. A ratio used to determine whether an overall market is undervalued or overvalued.

Market Capitalization to GDP = Stock Market Capitalization

Nominal GDPx 100

Source: ACEMAXX-ANALYTICS: US-Börsen: Marktkapitalisierung versus BIP

2010, https://www.chartstore.com

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