mba 3rd sem finance notes(bangalore university)

Module 1 :Investment AvenuesFinance specialization paper 1

Bangalore university

Investment Analysis and managements

Investment Analysis and Management 1

What investment is not

• A get rich quick scheme• A method to take on risky portfolios to get a

high return on investment’• Throwing your money into some random

event• Going to the casino• Or to the racecourse • (above two - zero beta but non zero risk)

2Investment Analysis and Management

What is an investment?

• It is a use of money to make more money• It is a means of getting capital gains• It is a way of “asset diversification” – from

cash to say gold, or even to finance accounts receivable

• Ultimately, it is a better than keeping the money in the mattress!


What is an investment?• Investopedia definition: The act of committing money

or capital to an endeavor with the expectation of obtaining an additional income or profit

• A good example is this MBA program which you are attending

• You are investing time, money and energy into this effort, in the hopes of attaining lifelong skills and earning ability till retirement

• Most of us will work for an organization so the investment will pay back periodically, hopefully at increasing levels

• Think of your investment a bond with infinite maturity paying inflation adjusted coupons until retirement


Why should one invest?

• To beat inflation• To progressively maintain quality of life• To retire comfortably• To hopefully leave something for the next

generation or two


Types of investments• Broadly, one could classify the investment types

as financial and non financial types of investment• Financial investments into capital markets

typically entail bonds, stocks derivatives or a combination of the three

• Financial investments in money markets include fixed deposits, short term treasury bills etc

• The fundamental paradigm in financial investment is the risk return tradeoff, usually measured by historical returns in the case of equities as well as derivatives


Types of investments• Non financial investments could include

precious metals, real estate • Here the hope is to get returns through

appreciation in value of asset either in their raw form or through value additions

• Risk includes downturn in these markets• Non financial investment could also include

investment in companies• Here, one is investing in the assets of a

company in the hope of capital gain in the share


Other forms of investment

• They range from stamp and coin collections to antique cars to rare baseball cards

• Some people invest in art forms – paintings, sculptors

• Coffee plantations and vineyards are long term investments as are teak and mango fields

• Education is also a lifelong investment


Other forms of investment• They range from stamp and coin collections to

antique cars to rare baseball cards• Some people invest in art forms – paintings,

sculptors• Coffee plantations and vineyards are long

term investments as are teak and mango fields

• Education is also a lifelong investment


High versus low risk

• Risk range • Risk pyramid


Personalizing the Pyramid

Not all investors are created equally. While others prefer less risk, some investors prefer even more risk than others who have a larger net worth. This diversity leads to the beauty of the investment pyramid.

Those who want more risk in their portfolios can increase the size of the summit by decreasing the other two sections, and those wanting less risk can increase the size of the base.

The pyramid representing your portfolio should be customized to your risk preference.


Personalizing the Pyramid• It is important for investors to understand the

idea of risk and how it applies to them.• Making informed investment decisions entails

not only researching individual securities but also understanding your own finances and risk profile.

• To get an estimate of the securities suitable for certain levels of risk tolerance and to maximize returns, investors should have an idea of how much time and money they have to invest and the returns they are looking for.


Risk preference

• Time horizon: if the money going to be invested is going to be required in 1 year or less for a down payment or for college tuition then stocks are not a good idea

• Bankroll: The money which one can afford to lose should be invested, otherwise it may cause liquidity issues


What is an investment philosophy?

• An investment philosophy is a structured way of thinking about markets, how they work (and sometimes do not) and the types of mistakes that you believe consistently underlie investor behavior

• An investment strategy is much narrower. It is a way of putting into practice an investment philosophy

• For lack of a better term, an investment philosophy is a set of core beliefs that you can go back to in order to generate new strategies when old ones do not work


Constituents of investment philosophy

• Step 1: All investment philosophies begin with a view on how human beings learn (or fail to learn) Underlying each philosophy is therefore is a view of human frailty – that people learn too fast, too slow, tend to crowd behavior etc….

• Step 2: From step 1, you create a view about market behavior and perhaps where they fail…. Views on market efficiency or inefficiency are the foundations for your investment philosophy

• Step 3: This step is tactical. You take your views about how investors behave and markets work (or fail to work) and try to devise strategies that reflect your beliefs


Why does one need an investment philosophy?

• To protect themselves against hoaxes, to be able to convince oneself about ideas rather than rely solely on others and mainly to have a core set of beliefs

• Lowering transaction costs by not shifting from investment strategies in a sporadic or non structured manner

• Adopting a strategy which suits your risk/return profile or if you are a portfolio manager, developing a portfolio for your client which suits their risk return profile


The investment process

Market

Timing

1. How much risk did portfolio mgr take?

2. What return did portfolio manager make?

3. Did the portfolio manager under/out perform?

Stock

selection

Asset allocationAsset classesCountries

Stocks Bonds Real Assets

Domestic International

Views on

Inflation Rates growth

Private

information

Trading

speed

Security selection

Which stocks/bonds/real assets?

Views on

markets

Valuation basis

Cash flows/comparables/charts & indicators

Trading costs,

Commissions

Bid/Ask spread

Price impact

Execution

How often do you trade?

How large are your trades?

Use of derivatives to manage risk?

Performance evaluation

Portfolio manager’s job

Utility functions Risk

tolerance/AversionInvestment Horizon Tax status

Tax code

The client

Risk and return

Mkt

efficiency

Trading

systems

Risk models CAPM APT


Categories of investment philosophies

• Market timing versus asset selection: Market timing bets on movement of entire market – for financial as well as real assets while in asset selection timing is not important and you focus on picking good investments within each market

• Activist Investing versus Passive Investing: With passive investing, you take positions in companies and hope that the market corrects its mistakes. With activist investing, you play a role (or provide the catalyst) in correcting market mistakes.

• Time Horizon: Some philosophies require that you invest for long time periods. Others are based upon short holding periods.


Investment constraints

Constraints are hindrances or obstacles which has an impact on investment action. The constraints reduces the chances of achieving the investment objectives. A rationale investor should identify these constraints and take them into account while selecting the securities

19Investment Analysis and Management Dr.Triveni P.

Investment constraints

The investment constraints are:

• Liquidity

• Tax shelter

• Time horizon

• Portfolio risk level

• Allowed securities

• Diversification


Investment strategies

Investment strategy is a set of rules, behaviour or procedures, designed to guide an investor’s selection of an investment portfolio.

The strategy is designed around investor’s risk return tradeoff, some investors will prefer to maximise expected returns by investing in risky assets, others will prefer to minimise risk , but most will select a strategy somewhere in between.


Investment strategies

Active portfolio strategy

Strives to earn superior risk adjusted returns. It is based on the premise that the capital market is characterised by the inefficiencies and it is followed by investment professionals and aggressive investors.


Active portfolio strategies

There are five dimensions of active portfolio strategies:

• Market timing

• Sector rotation

• Security selection

• Use of specialised concepts

• Combination of above


Passive portfolio strategies

It is based on the assumption that the capital market is informally inefficient. An investor should create a well diversified portfolio at a predetermined level of risk exposure and hold the portfolio of stocks that relatively is unchanged over time till it becomes inadequately diversified or inconsistent with the unique risk-return preferences.


Investment verses Speculation

• Investment involves employment of funds with the expectation of earning additional income or capital appreciation or both.

• Speculation involves buying and selling of securities or other asset, in the hope of making profit from anticipated change in the prices.



• Investment is long term in nature.

• Speculation is a short term activity.

• Investment has less degree of risk.

• Speculation involves a high degree of risk.



• Marketable asset is not necessary for investment.

• Marketable asset is necessary for speculation.

• The person who indulges in investment activity is called investor.

• The person who indulges in speculation activity is called speculator.



• Greater emphasis is laid on the fundamental factors and attempts a careful evaluation of the firm’s prospects.

• Heavily relies on technical charts and market psychology.


Arbitrage and Gambling

• Arbitrage refers to the simultaneous purchase and sale of securities/assets in two different markets to take advantage of price differentials. It involves making profits from the differences in the prices prevailing in two markets.


Gambling

• Gambling is a high risk venture, not only for higher returns but also for associated excitement. It is unplanned and unscientific activity with the knowledge of risk involved.

• It is based on blind chance without any rational basis. A gambler could lose all his capital in the trading process based on his emotions


Types of investors

Individual investors/Retail investors

Institutional investors

Investment Analysis and Management Dr.Triveni P. 31

Individual investors/Retail investors• Individual investors are large in number.

• Investible resources available with them are low.

• They lack the skills required to carry out extensive analysis and evaluation before investing.

• They may manage their own investments without investment managers, directly investing through a brokerage account, bank savings account, government savings bonds or certificate of deposits. If they do, utilize investment managers for investing in pooled investment vehicles such as mutual funds.


Individual investors/Retail investors

• They do not have enough time and resources to engage in such an analysis to find out the intrinsic worth of investments.

• They have a difficult time while determining their portfolio.

• Investment selection becomes almost a hit and run mechanism for them.

• They depend on other sources of information within their reach to arrive at investment decision.



• They are the institutions/organisations with surplus funds who indulge themselves in investment activities. Ex: NBFC’s, Investment companies, Mutual funds, Insurance companies etc.

• They are few in number compared to individual investors.

• They engage professionals to carry out critical analysis and evaluation of wide investment avenues available.



• They carry out their investment activity on a realistic and systematic manner.

• They have a great advantage over the average individual investors in managing their investment portfolio.


Summary

We discussed:• Investment constraints• Investment strategy• Investment verses speculation• Arbitrage• Gambling• Types of investors• Investor behaviour


Debenture

Debentures includes debenture stock, bonds and any other securities of a company, whether constituting a charge on the assets of the company or not.

A debenture is an instrument issued by a company under its common seal, acknowledging its debt to the holder, and containing an undertaking to repay the debt on or after a specified period and to pay interest on the debt at a fixed rate at regular intervals usually half yearly, until the debt is repaid.


warrants

A warrant is a security issued by a company, granting a specified number of shares, at a specified price, any time prior to an expirable date. they may be issued with a debentures of equity shares. they specify the number of shares entitled, the expiration date,along with the stated price.


Equity shares

Equity shares represent an ownership position in a corporation. It is a residual claim, in the sense that creditors and preference shareholders must be paid before shareholders can receive any payment. In the event of liquidation, equity shareholders are entitled to assets remaining only after all prior claimants have been satisfied. Thus the risk is highest with equity shares and so must be its expected return. When investors buy equity shares, they receive certificates of ownership as proof of their being part owners of the company which states the number of shares purchased and their value.


Advantages of Equity shares

• Potential for profit

• Limited liability

• Hedge against inflation

• Free transferability

• Share in growth

• Tax advantage


Form of equity capital

• Authorised capital

• Issued capital

• Paid-up capital


Nature of equity shares

• Evidence of ownership

• Maturity of equity shares

• Par value

• Financial analysis and accounting data

• Pre-emptive right

• Voting right


Valuation of rights

Rights issue is made to expand the capital. It is

priced below the current market price to attract the existing shareholders which will be generally between 10 to 20 percent lower than the current market price. When right issue is announced, all the existing shareholders have the right to subscribe for new shares and so there are rights attached to the existing shares.They are also called “cum rights”(rights attached) and are traded cum rights


Classification of equity shares in the market parlance

• Growth shares

• Blue chip shares

• Income shares speculative shares

• Cyclical shares

• Defensive shares


Classification of equity shares according to Peter Lynch

Slow growers

Stalwarts

Fast-growers

Cyclicals

Turnarounds

Asset oppurtunities


Preference shares

• Preference shares are those shares which carry with them preferential rights for their holders, i.e, preferential right as to fixed rate of dividend & as to repayment of capital at the time of winding up of the Company.


Characteristics

• Fixed rate of dividend.

• Priority as to payment of dividend.

• Preference as to repayment of capital during liquidation of the Company.

• Generally preference shareholders do not have voting rights.

• According to The Companies (Amendment) Act, 1988, the preference shares are redeemable & the maximum period for which they can be issued is 10 years.


Kinds of Preference SharesKinds of Preference Shares

On the basis of cumulation of dividend : Cumulative Preference Shares:

They are those shares on which the dividend at a fixed rate goes on cumulating till it is all paid. Non Cumulative Preference Shares:

These are those shares on which the dividend does not cumulate.



On the basis of participation : Participating Preference shares:

This type of shares are allowed to participate in surplus profits during the lifetime of the company & surplus assets during winding up. Non Participating Shares:

These shares are not entitled to participate in surplus profit. Dividend at fixed rate is given.



On the basis of conversion : Convertible preference shares:The owners of these shares have the option to convert their preference shares into equity shares as per the terms of issue. Non-convertible preference shares:The owners of these shares do not have any right of converting their shares into equity shares.

On the basis of redemption: Redeemable preference shares:These are to be purchased back by the company after a certain period as per the terms of issue. Irredeemable preference shares:These are not to be purchased back by the company during its lifetime.


Status of Preference Shares, if Articles of Association are silent

• Preference shares will be presumed to be:

Cumulative Non-Participating Irredeemable and Non-Convertible.


Deferred Shares

• Deferred shares are those shares on which the payment of dividend and capital (at the time of winding up of a company) is made after money is paid in full on preference shares and equity shares.

• As per the provisions of the COMPANIES ACT,1956, no public company can issue deferred shares.


Factors to be considered for analysing the preference shares

• High quality preference shares

• Stability

• Security

• Rights of dividend

• Investment


Characteristics

• Rate of dividend is not fixed. It depends upon the availability of profits & the discretion of the Board of the Directors.

Dividend is paid after payment of dividend on equity & preference shares.

At the time of liquidation, capital on these shares is returned after capital is repaid on both preference & equity shares.


Real Estate• Residential House

• Sources of Housing Finance

• Features of Housing Loans

• Guidelines for Buying a Flat

• Commercial Property

• Agricultural Land

• Suburban Land

• Time Share in a Holiday Resort


Commodity market

• A bulk good such as an agricultural product, food, natural resource or metal that is traded on an exchange in bulk quantities.

• A commodity is any homogenous item which may be freely bought and sold. The term typically refers to products such as coffee, cocoa and soyabeans (soft commodities) or gold, aluminium and platinum (hard commodities).


Commodity market

• Commodities typically are bought and sold in futures markets where producers combine with manufacturers and speculators to create a smoothly functioning market.


Module2:Investment AvenuesFinance specialization paper 1

Bangalore university

Investment Analysis and managements


Session topics

• Investment Avenues• Bonds and debentures• Preference shares• Equity shares• Real estate• Commodity markets• Bank deposits• Insurance• Mutual funds• Foreign exchange• Money market instruments• Derivatives-Forward , Futures ,Options , Swaps


What is a bond?

• Defn: A bond is a tradable instrument that represents a debt owed to the owner by the issuer.

• Most commonly, bonds pay interest periodically (usually semiannually) and then return the principal at maturity


A bond certificate


A bond certificate


•This bond certificate from the Mansfield and Framingham Railroad Co. (incorporated in Massachusetts) is complete with a coupon in the lower-left corner. •Note that the face value of the bond is printed in pink, written, and also in the graphic in the upper-left of the picture. •This bond has been canceled as is evidenced by the cancellation holes over the signatures of the president and secretary (lower-right) and the “Cancelled” stamp in two locations.•In the upper-right, you can see that the bond is number 26.•Finally, note the ornate artwork which is to discourage counterfeitin

Advantages of bonds over stocks

• Bonds, while a more conservative investment than stocks, can offer certain investors some very attractive features:– Safety– Reliable income– Potential for capital gains– Diversification (especially for an otherwise all-

equity portfolio)– Tax advantages


Safety of bonds

• The safety of bonds derives mainly from two things:– Bondholders are in line ahead of both preferred and

common stockholders for payment. Thus, if a firm falls on hard times, it must first pay its bondholders while stockholders may see dividends cut.

– In the event that a company skips a payment or violates covenants of the indenture, the creditors may force it into bankruptcy to protect the value of their investment. Stockholders have no such right.


Reliability of income• Most bonds are “fixed-income” securities. As such,

they promise a fixed set of interest payments and the return of the principal at maturity

• Investors can count on receiving their interest payments in full and on time, except in the event of severe financial distress. Common stockholders can never be sure of the exact amount (and sometimes the exact timing) of dividends

• Bonds that are callable (most corporates and some Treasuries issued before 1985) do not offer as much reliability, though it is still far better than stocks. As interest rates decline, the probability of a call increases


Potential for capital gains

• Investors who do not hold a bond to maturity may enjoy capital gains or suffer capital losses:

– When interest rates fall, bond prices rise. Thus an investor who buys when rates are high, and sells after rates fall will earn a capital gain. The rate decrease may be due to general market conditions or improvement in the company’s creditworthiness


Potential for capital gains

– When interest rates rise, bond prices fall. Thus an investor who buys when rates are low, and sells after rates rise will suffer a capital loss. The rate increase may be due to general market conditions or a decrease in the company’s creditworthiness

– All other things being equal, as the bond moves through time to maturity, the price must move towards its face value. Thus, bonds purchased at a discount will rise in price, and those purchased at a premium will decline in price


Diversification

• Bonds, when added to an equity portfolio, can lower risk while lowering returns slightly (depending on the percentage of the portfolio allocated to bonds).

• While bond prices may be quite volatile, due to the stability of the income that they provide bond total returns tend to have low correlation with stock returns.

• The following slide shows the effect of adding bonds to a stock portfolio.


Tax advantages of bonds

• Interest paid on corporate bonds:

– Firms offering bonds are tax exempt on their interest expense paid

– The higher the tax savings the greater is the firm’s earnings

– The value of the firm is enhanced to the extent of their debt (MM theorem) owing to this tax shield on interest expense


Types of Bonds

Pure Discount or Zero-Coupon Bonds Pay no coupons prior to maturity. Pay the bond’s face value at maturity.

Coupon Bonds Pay a stated coupon at periodic intervals prior to

maturity. Pay the bond’s face value at maturity.

Perpetual Bonds (Consols) No maturity date. Pay a stated coupon at periodic intervals.


Types of Bonds

• Floating rate bonds

• Bonds with call/put option

• Capital indexed bonds

• RBI Relief Bonds

• Public Sector Undertaking Bonds


Bond Issuers

• Government• Financial Institutions• Countries• Corporations


Government Bonds

Treasury Bills (Gilts) No coupons (zero coupon security) Face value paid at maturity Maturities up to one year

Treasury Notes Coupons paid semiannually Face value paid at maturity Maturities from 2-10 years


Government Bonds

Treasury Bonds Coupons paid semiannually Face value paid at maturity Maturities over 10 years The 30-year bond is called the long bond.


Government Bonds

• No default risk. Considered to be riskfree.• Exempt from state and local taxes.• Sold regularly through a network of primary

dealers.• Traded regularly in the over-the-counter

market.


Corporate Bonds

• Secured Bonds (Asset-Backed) Secured by real property Ownership of the property reverts to the

bondholders upon default.

• Debentures General creditors Have priority over stockholders, but are

subordinate to secured debt.


Bond Ratings

Moody’s S&P Quality of Issue

Aaa AAA Highest quality. Very small risk of default.

Aa AA High quality. Small risk of default.

A A High-Medium quality. Strong attributes, but potentiallyvulnerable.

Baa BBB Medium quality. Currently adequate, but potentiallyunreliable.

Ba BB Some speculative element. Long-run prospectsquestionable.

B B Able to pay currently, but at risk of default in thefuture.

Caa CCC Poor quality. Clear danger of default .

Ca CC High specullative quality. May be in default.

C C Lowest rated. Poor prospects of repayment.

D - In default.

Fixed income securities

Fixed income securities are investments where the cash flows are according to a predetermined amount of interest. paid on a fixed schedule. Fixed interest rate securities are those in which the interest payable is fixed beforehand. Credit quality, yield and maturity are the key components of fixed securities.


Basic bond valuation

• The intrinsic value of a bond, like stocks, is the present value of its future cash flows

• Bonds, however, have much more predictable cash flows and a finite life

• The cash flows promised by a bond are:– A series of (usually) constant interest payments

– The return of the face value of the bond at maturity


Basic bond valuation (cont.)

• The value of a bond is determined by four variables:

– The Coupon Rate – This is the promised annual rate of interest. It is normally fixed at issuance for the life of the bond. To determine the annual interest payment, multiply the coupon rate by the face value of the bond. Interest is normally paid semiannually, and the semiannual payment is one-half the annual total payment

– The Face Value – This is nominally the amount of the loan to the issuer. It is to be paid back at maturity


Basic bond valuation (cont.)

– Term to Maturity – This is the remaining life of the bond, and is determined by today’s date and the maturity date. Do not confuse this with the “original” maturity which was the life of the bond at issuance

– Yield to Maturity – This is the rate of return that will be earned on the bond if it is purchased at the current market price, held to maturity, and if all of the remaining coupons are reinvested at this same rate. This is the IRR of the bond


Basic bond valuation example

• Suppose that you are interested in purchasing a 3-year bond with a 10% semiannual coupon rate and a face value of Rs 1,000. If your required return is 7%, what is the intrinsic value of this bond?

• Here is a timeline showing the cash flows:

0 1 2 3 4 5 6

50 50 50 50 50 501000


Basic bond valuation example (cont.)

• Note that the cash flows of the bond consist of:– An annuity, the interest payments, paid every six

months. This is calculated as:

– A lump sum which is the return of the face value of the bond at the end of its life. This payment is made at the same time as the last interest payment

502

100010.0

2

FVCRPmt


Basic bond valuation example (cont.)

• We can find the intrinsic value of these cash flows by finding the present value of the interest payments and then adding the present value of the face value:

• Note that the first term is the present value of an annuity, and the second is the present value of a lump sum

• Do the math, and you’ll find that the bond is worth Rs. 1,079.93. Note that this value must decline until it reaches Rs. 1,000 at maturity

6

207.01

1000

207.0

207.0

1

11

501

1

11

6

N

dd

Nd

Bk

FV

k

kPmtV


Bond valuation notes

• A few things of note with regard to the example:– The interest is paid semiannually, so we first

calculated the annual interest and the divided it by two. If interest was paid, say, quarterly, we would have divided the annual amount by four

– Similarly, we must convert the number of years to maturity (3) into the total number of periods (6)


Bond valuation notes

– Finally, we also must adjust your annual required return (7%) to a semiannual return (3.5%)

– These three variables must always be stated on a per period basis

– Nearly all bonds (in the U.S.) pay interest more often than annually. Most often this is semiannually, but it could also be quarterly or monthly


Valuing bonds between coupon dates

• The bond valuation formula just presented has one major flaw: It only works on a coupon date

• Since coupon dates (interest payment dates) usually only occur twice per year, chances are (~ 99.45%) you’ll buy (or sell) a bond between coupon dates

• In this case, we must deal with accrued interest, and the increase in the bond value since the last coupon date


Valuing bonds between coupon dates (cont.)

• Imagine that we are halfway between coupon dates. We know how to value the bond as of the previous (or next even) coupon date, but what about accrued interest?

• Accrued interest is assumed to be earned equally throughout the period, so that if we bought the bond today, we’d have to pay the seller one-half of the period’s interest

• Bonds are generally quoted “flat,” that is, without the accrued interest. So, the total price you’ll pay is the quoted price plus the accrued interest (unless the bond is in default, in which case you do not pay accrued interest, but you will receive the interest if it is ever paid)



• The procedure for determining the quoted price of the bonds is:– Value the bond as of the last payment date

– Take that value forward to the current point in time This is the total price that you will actually pay

– To get the quoted price, subtract the accrued interest

• We can also start by valuing the bond as of the next coupon date, and then discount that value for the fraction of the period remaining



• Let’s return to our original example (3 years, semiannual payments of Rs 50, and a required return of 7% per year).

• As of period 0 (today), the bond is worth Rs 1,079.93. As of next period (with only 5 remaining payments) the bond will be worth Rs 1,067.73. Note that:

• So, if we take the period zero value forward one period, you will get the value of the bond at the next period including the interest earned over the period

50035.193.107973.1067 1

P1 P0 Interest earned



• Now, suppose that only half of the period has gone by. If we use the same logic, the total price of the bond (including accrued interest) is:

• Now, to get the quoted price we merely subtract the accrued interest:

• If you bought the bond, you’d get quoted Rs. 1,073.66 but you’d also have to pay Rs 25 in accrued interest for a total of Rs. 1,098.66

66.1098035.193.1079 5.0

66.10732566.1098 QP


mba 3rd sem finance notes(bangalore university)

Documents