Investment Analysis

and
Portfolio Management

By: Sabela A.
Chapter 1
Introduction to Investment
Contents of the chapter

1.1 What is investment?

1.2 Investment Alternatives

1.3 Securities Market

1.4 Investment companies

 1.1 What is Investment?
An investment is the current commitment of money for a period of time in order to
derive future payments that will compensate the investor for:
➔ the time the funds are committed,
➔ the expected rate of inflation, and
➔ the uncertainty of the future payments.
The “investor” can be:
● an individual,
● a government,
● a pension fund, or
● a corporation.
Why do people invest and what do they want from their
investments?

➢ People invest to earn a return from savings due to their deferred consumption
➢ They want a rate of return that compensates them for:
● The time (investment holding period),
● The expected rate of inflation during holding period, and
● The uncertainty of the return
➢ This return is known as the investor’s required rate of return.
 1.2. Investment Alternatives

Two main investment alternatives are available. These are:

1. Investing on real assets

➔ includes investments by corporations in plants and equipments
2. Investing on financial assets
➔ includes investments by individuals in stocks, bonds, commodities, or real estate
Cont’d
● Real assets of the economy includes:
❏ Land,
❏ Building
❏ Machines, and
❏ Knowledge that can be used to produce goods and services.

● Financial assets are:

❏ Stocks and
❏ Bonds
➔ Such securities are no more than sheets of paper, or do not contribute directly to
the productive capacity of the economy.
➔ These assets are the means by which individuals hold their claims on real assets.
 Cont’d

➔ Real assets generate net income to the economy, financial assets simply define
the allocation of income or wealth among investors.
➔ Companies invest on real assets; to invest on this area, they may collect capital
from individual investors through issuance of financial assets i.e. equity
securities or debt securities.
➔ In this relationship individual investors have claim on the real assets of the
companies because they are purchased by their capital.
 Taxonomy of financial assets

Financial assets are classified in to three broad categories as follows:

1. Fixed income
2. Equity, and
3. Derivatives
 1. Fixed-income or Debt securities
➔ Such securities promise either a fixed stream of income or a stream of income
that is determined according to a specified formula.
For example:
A corporate bond typically would promise that the bondholder will receive a
fixed amount of interest each year. Other so-called floating-rate bonds promise
payments that depend on current interest rates
Cont’d

★ Unless the borrower is declared bankrupt, the payments on these securities

are either fixed or determined by formula.
★ For this reason, the investment performance of debt securities typically is
least closely tied to the financial condition of the issuer.
★ Fixed-income securities are varied based on types of market they are
traded in, their maturities, and payment provisions.
 Cont’d
1. Money market
It refers to debt securities that are:
➔ Short term,
➔ Highly marketable, and
➔ Generally of very low risk
Examples:

Government treasury bills, certificates of bank deposit and the like

Cont’d

2. Capital market
It refers to a market in which long-term securities such as Treasury bonds, as well
as bonds issued by federal agencies, state and local municipalities, and corporations
traded.
 2. Common stock or Equity securities
➔ Equity security represents an ownership right or share in the corporation.
➔ Equity holders are not promised any particular payment.
➔ Equity holders receive any dividends the firm may pay and have prorated
ownership in the real assets of the firm.
➔ If the firm is successful, the value of equity will increase; if not, it will
decrease.
➔ The performance of equity investments is tied directly to the success of the
firm and its real assets.
➔ It indicates that equity investments tend to be riskier than investments in debt
securities.
 3. Derivative securities

➔ They include options and futures contracts

➔ They provide payoffs that are determined by the prices of other
assets such as bond or stock prices.
➔ Derivative securities are so named because their values are derived
from the prices of other assets. For example, the value of the call
option will depend on the price of the stock which was underlined.
 1.3 Securities Market
What is a market?

A market is the means through which buyers and sellers are brought together to
aid in the transfer of goods and/or services.
Characteristics of market:
★ First, a market does not need to have a physical location. It is only necessary
that the buyers and sellers can communicate regarding the relevant aspects of
the transaction.
Cont’d
★ Second, a market does not necessarily own the goods or services involved.
For a good market, ownership is not involved; the important criterion is
the smooth, cheap transfer of goods and services.

★ In most financial markets, those who establish and administer the market
do not own the assets but simply provide a physical location or an
electronic system that allows potential buyers and sellers to interact.
 Characteristics of a Good Market

1. Timely and accurate information about the price and volume of past transactions is
available
2. It is liquid, meaning an asset can be bought or sold quickly at a price close to the
prices for previous transactions (has price continuity), assuming no new
information has been received.
3. Transactions entail low costs, including the cost of reaching the market, the actual
brokerage costs, and the cost of transferring the asset.
4. Prices rapidly adjust to new information
 Organization of the Securities Market
Securities market is organized as:
1. Primary financial markets, and
2. Secondary financial markets

Primary financial markets

These are a means through which new issues of:
➢ Bonds,
➢ Preferred stock, and/or
➢ Common stock are sold by government units, municipalities, or
companies to acquire new capital
 CONT’D
Government Bond Issues
These are subdivided into three segments based on their original maturities as
follows:
● Treasury bills are negotiable, non-interest-bearing securities with original
maturities of one year or less.
● Treasury notes have original maturities of 2 to 10 years.
● Treasury bonds have original maturities of more than 10 years
Cont’d
New municipal/ government bond issues are sold by one of three methods:

1. Competitive bid
➔ sales typically involve sealed bids. The bond issue is sold to the bidding
syndicate of underwriters that submits the bid with the lowest interest cost
in accordance with the stipulations set forth by the issuer
 Cont’d
2. Negotiation
➔ Involves contractual arrangements between underwriters and issuer wherein
the underwriter helps the issuer prepare the bond issue and set the price and
has the exclusive right to sell the issue
3. Private placement

➔ Involves the sale of a bond issue by the issuer directly to an investor or a

small group of investors (usually institutions).
Corporate Bond Issues

● Corporate bond issues are almost always sold through a negotiated arrangement
with an investment banking firm that maintains a relationship with the issuing
firm.
● As a result, the expertise of the investment banker can help reduce the issuer’s
cost of new capital.
 Corporate Stock Issues
For corporations, new stock issues are typically divided into two groups:
1. Seasoned equity issues
➔ These issues are new shares offered by firms that already have stock
outstanding
For example: Assume Dashen Bank collected Bir 1,000,000 additional capital after
5 years from its formation by issuing additional its new common stock for further
business expansion purpose. This stock issuance is considered as seasoned stock
issue.
Cont’d

2. Initial public offerings (IPOs)

➔ Such issues involve a firm selling its common stock to the public for the
first time. At the time of an IPO offering, there is no existing public
market for the stock, that is, the company has been closely held.
For example : Currently betoch Bank issues stock to form a real-estate bank
for the first time in Ethiopia. This issuance is an initial public offering.
 CONT’D
➔ New issues (seasoned or IPOs) are typically underwritten by investment
bankers, who acquire the total issue from the company and sell the securities to
interested investors.
➔ The underwriter gives advice to the corporation on the general characteristics
of the issue, its pricing, and the timing of the offering. The underwriter also
accepts the risk of selling the new issue after acquiring it from the corporation
 Secondary Financial market

● Secondary market is a means by which stocks or bonds that are already sold to
the public are traded between current and potential owners.

● The proceeds from a sale in the secondary market do not go to the issuing unit
(the government, or company) but, rather, to the current owner of the security
Why Secondary Markets Are Important

➔ They provide liquidity to the individuals who acquired these securities

➔ The primary market benefits greatly from the liquidity provided by the
secondary market because investors would hesitate to acquire securities in
the primary market if they thought they could not subsequently sell them
in the secondary market.
Cont’d
➔ Without an active secondary market, potential issuers of stocks or bonds
in the primary market would have to provide a much higher rate of return
to compensate investors for the substantial liquidity risk.
➔ New issues of outstanding stocks or bonds to be sold in the primary
market are based on prices and yields in the secondary market.
➔ Even forthcoming IPOs are priced based on the prices and values of
comparable stocks or bonds in the public secondary market
 Third Market
● The term third market describes OTC (over the counter) trading of shares listed
on an exchange.
● this involves trading listed shares out of the formal secondary market
(exchange)
● This market is critical during the relatively few periods when trading is not
available on the exchange either because trading is suspended or the exchange
is closed.
Fourth Market
● The term fourth market describes direct trading of securities between two
parties with no broker intermediary. In almost all cases, both parties involved
are institutions.
● Investors typically buy or sell stock through brokers because it is faster and
easier. Also, you would expect to get a better price for your stock because the
broker has a good chance of finding the best buyer. You are willing to pay a
commission for these liquidity services.
Cont’d

● The fourth market evolved because of the substantial fees charged by

brokers to institutions with large orders. At some point, it becomes
worthwhile for institutions to attempt to deal directly with each other and
bypass the brokerage fees.
Cont’d
For example:
● Assume xyz comp issued 100,000 shares of birr 10 par directly to ABC
investment fund in a total of Birr 1,500,000 and saved 10 cents per share
commission payment for intermediaries. How much is saved in total from
issuance of 100,000 share
Solution
= 100,000 shares * 0.1 birr
= birr 10,000. is saved
 1.4 Investment companies
● Investment company refers to a mutual fund, that owns a portfolio of individual
stocks, bonds, or a combination of the two
● An investment company sells shares in itself and uses the proceeds of this sale to
acquire bonds, stocks, or other investment instruments. As a result, an investor
who acquires shares in an investment company is a partial owner of the investment
company’s portfolio of stocks or bonds.

● Such companies can be distinguished by the types of investment instruments they

acquire as follows:
Cont’d

1. Money Market Funds

2. Bond Funds
3. Common Stock Funds
4. Balanced Funds
5. Index Funds
6. Exchange-Traded Funds
7. Real Estate Investment Trusts
Money Market Funds

★ These are investment companies that acquire high quality, short-term

investments like:
➔ T-bills
➔ High quality commercial paper from various corporations
➔ Certificates of bank deposit from the major money center banks
Cont’d

★ The yields on the money market portfolios always exceed those on normal bank CDs
because the investment by the money market fund is larger and the fund can commit to
longer maturities than the typical individual. In addition, the returns on commercial
paper are above the prime rate.
★ You can always withdraw funds from your money market fund without penalty
(typically by writing a check on the account), and you receive interest to the day of
withdrawal.
★ They provide yields above what is available on most savings accounts, and the funds
are readily available
Bond Funds

● Bond funds generally invest in various long-term government, corporate,

or municipal bonds. They differ by the type and quality of the bonds
included in the portfolio as assessed by various rating services

● The expected rate of return from various bond funds will differ, with the

low-risk government bond funds paying the lowest returns and the
high-yield bond funds expected to pay the highest returns.
Common Stock Funds

● They include different investment styles, such as growth or value, and

concentrate in alternative-sized firms, including small-cap, mid-cap, and
large capitalization stocks.
● These funds are diversified within a sector or an industry, but are not
diversified across the total market.
 Balanced Funds

● Balanced funds invest in a combination of bonds and stocks of various sorts

depending on their stated objectives.

● Index funds are mutual funds created to equal the performance of a market index
● Such funds appeal to passive investors who want to simply experience returns
equal to some market index either because they do not want to try to “beat the
market” or they believe in efficient markets and do not think it is possible to do
better than the market in the long run.
Exchange-Traded Funds (ETFs)

● Mutual funds in general and index funds in particular are only priced daily
at the close of the market and all transactions take place at that price.

● As a result, if you are aware of changes taking place for the aggregate
market due to some economic event during the day and want to buy or sell
to take advantage of this, you can put in an order but it will not be executed
until the end of the day at closing prices.
Cont’d

● An exchange-traded fund is created the above problem, ETF—that could

be traded continuously because the prices for the 500 stocks are updated
continuously so it is possible to buy and sell this ETF like a share of stock.
Real Estate fund

● A real estate investment trust is an investment fund designed to invest in

various real estate properties. It is similar to a stock or bond mutual fund,
except that the money provided by the investors is invested in property and
buildings rather than in stocks and bonds.
● There are several types of REITs.
Cont’d
➔ Construction and development trusts: lend the money required by builders
during the initial construction of a building.
➔ Mortgage trusts: provide the long-term financing for properties.
Specifically, they acquire long-term mortgages on properties once
construction is completed.
➔ Equity trusts: own various income-producing properties, such as office
buildings, shopping centers, or apartment houses.

● Therefore, an investor who buys shares in an equity real estate investment

trust is buying part of a portfolio of income-producing properties.
Cont’d

★ Direct Real Estate Investment: The most common type of direct real
estate investment is the purchase of a home, which is the largest
investment most people ever make.
★ Land Development: Land development can involve buying raw land,
dividing it into individual lots, and building houses on it. Alternatively,
buying land and building a shopping mall would also be considered land
development.
Cont’d

★ Raw Land: Another direct real estate investment is the purchase of raw
land with the intention of selling it in the future at a profit.
★ Rental Property: Many investors with an interest in real estate investing,
acquire apartment buildings or houses with low down payments, with the
intention of deriving enough income from the rents to pay the expenses of
the structure, including the mortgage payments.
THE END OF THE CHAPTER

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