INVESTMENT

Meaning:

Investment refers to purchase of financial assets. While Investment Goods

are those goods, which are used for further production. Investment implies the
production of new capital goods, plants and equipment. John Keynes refers
investment as real investment and not financial investment. Investment is a
conscious act of an individual or any entity that involves deployment of money
(cash) in securities or assets issued by any financial institution with a view to
obtain the target returns over a specified period of time.Target returns on an
investment include: Increase in the value of the securities or asset, and/or
Regular income must be available from the securities or asset.

Types of Investment:

1. Autonomous Investment:

Investment which does not change with the changes in income level, is called as
Autonomous or Government Investment. Autonomous Investment remains
constant irrespective of income level. Which means even if the income is low,
the autonomous, Investment remains the same. It refers to the investment made
on houses, roads, public buildings and other parts of Infrastructure. The
Government normally makes such a type of investment.

2. Induced Investment:

Investment which changes with the changes in the income level, is called as
Induced Investment. Induced Investment is positively related to the income
level. That is, at high levels of income entrepreneurs are induced to invest more
and vice-versa. At a high level of income, Consumption expenditure increases
this leads to an increase in investment of capital goods, in order to produce
more consumer goods.

3. Financial Investment:

Investment made in buying financial instruments such as new shares, bonds,

securities, etc. is considered as a Financial Investment. However, the money
used for purchasing existing financial instruments such as old bonds, old shares,
etc., cannot be considered as financial investment. It is a mere transfer of a
financial asset from one individual to another. In financial investment, money
invested for buying of new shares and bonds as well as debentures have a
positive impact on employment level, production and economic growth.

4. Real Investment:

Investment made in new plant and equipment, construction of public utilities

like schools, roads and railways, etc., is considered as Real Investment. Real
investment in new machine tools, plant and equipments purchased, factory
buildings, etc. increases employment, production and economic growth of the
nation. Thus real investment has a direct impact on employment generation,
economic growth, etc.

5. Planned Investment:

Investment made with a plan in several sectors of the economy with specific
objectives is called as Planned or Intended Investment. Planned Investment can
also be called as Intended Investment because an investor while making
investment make a concrete plan of his investment.

6. Unplanned Investment:

Investment done without any planning is called as an Unplanned or Unintended

Investment. In unplanned type of investment, investors make investment
randomly without making any concrete plans. Hence it can also be called as
Unintended Investment. Under this type of investment, the investor may not
consider the specific objectives while making an investment decision.

7. Gross Investment:

Gross Investment means the total amount of money spent for creation of new
capital assets like Plant and Machinery, Factory Building, etc.It is the total
expenditure made on new capital assets in a period.

8. Net Investment:

Net Investment is Gross Investment less (minus) Capital Consumption

(Depreciation) during a period of time, usually a year. It must be noted that a
part of the investment is meant for depreciation of the capital asset or for
replacing a worn-out capital asset. Hence it must be deducted to arrive at net
investment.

Features of Investment management:

1. Safety of principal
Safety of funds invested is one of the essential ingredients of a good investment
programme. Safety of principal signifies protection against any possible loss under
the changing conditions. Safety of principal can be achieved through a careful
review of economic and industrial trends before choosing the type of investment. It
is clear that no one can make a forecast of future economic conditions with utmost
precision. To safeguard against certain errors that may creep in while making an
investment decision, extensive diversification is suggested.
The main objective of diversification is the reduction of risk in the loss of capital
and income. A diversified portfolio is less risky than holding a single portfolio.
Diversification refers to an assorted approach to investment commitments.
Diversification may be of two types, namely,

i. Vertical diversification; and

ii. Horizontal diversification.
Under vertical diversification, securities of various companies engaged in different
stages of production (from raw material to finished products) are chosen for
investment. On the contrary, horizontal diversification means making investment
in those securities of the companies that are engaged in the same stage of
production. Apart from the above classification, securities may be classified
into bonds and shares which may in turn be reclassified according to their types.
Further, securities can also be classified according to due date of interest, etc.
However, the simplest diversification is holding different types of securities with
reasonable concentration in each.
2. Liquidity and Collateral value
A liquid investment is one which can be converted into cash immediately
without monetary loss. Liquid investments help investors meet
emergencies. Stocks are easily marketable only when they provide adequate
return through dividends and capital appreciation. Portfolio of liquid
investments enables the investors to raise funds through the sale of liquid
securities or borrowing by offering them as collateral security. The investor
invests in high grade and readily saleable investments in order to ensure
their liquidity and collateral value.
3. Stable income
Investors invest their funds in such assets that provide stable income.
Regularity of income is consistent with a good investment programme. The
income should not only be stable but also adequate as well.

4. Capital growth
One of the important principles of investment is capital appreciation. A
company flourishes when the industry to which it belongs is sound. So, the
investors, by recognizing the connection between industry growth and
capital appreciation should invest in growth stocks. In short, right issue in
the right industry should be bought at the right time.

5. Tax implications
While planning an investment programme, the tax implications related to it
must be seriously considered. In particular, the amount of income an
investment provides and the burden of income tax on that income should
be given a serious thought. Investors in small income brackets intend to
maximize the cash returns on their investments and hence they are hesitant
to take excessive risks. On the contrary, investors who are not particular
about cash income do not consider tax implications seriously.

6. Stability of Purchasing Power

Investment is the employment of funds with the objective of earning
income or capital appreciation. In other words, current funds are sacrificed
with the aim of receiving larger amounts of future funds. So, the investor
should consider the purchasing power of future funds. In order to maintain
the stability of purchasing power, the investor should analyze the expected
price level inflation and the possibilities of gains and losses in the
investment available to them.

7. Legality
The investor should invest only in such assets which are approved by law.
Illegal securities will land the investor in trouble. Apart from being satisfied
with the legality of investment, the investor should be free from
management of securities. In case of investments in Unit Trust of India and
mutual funds of Life Insurance Corporation, the management of funds is
left to the care of a competent body. It will diversify the pooled funds
according to the principles of safety, liquidity and stability.

Nature of Investment management:

To understand the exact meaning of investment

To find out different avenues of investment

To maximize return and minimize risk

To make a programme for investment through evaluating securities,

constructing a portfolio and reviewing a portfolio
To find out a time period for investments to take place

To evaluate through various techniques to get the best return for the investor.

Importance of Investments:

1. Longer Life Expectancy

Investment decisions have become significant because statistics show that life
expectancy has increased with good medical care. People usually retire between
the ages of 60 and 65. The income shrinks at the time of retirement because the
annual inflow of earnings from employment stops. If savings are invested at the
right age and time, wealth increases if the principal sum is invested adequately
in different saving schemes. The importance of investment decisions is
enhanced by the fact that there is an increasing number of women working in
the organizations. Men and women are responsible for planning their own
investments during their working life so that after retirement they are able to
have a stable income through balanced investments.

2. Taxation

Taxation introduces an element of compulsion in a person’s savings. Every

country has different tax saving schemes for bringing down taxation levels of a
person. Since investments provide regular and stable income and also give
relief in taxation, they are considered to be very important and useful if
investments are made by proper planning.

3. Interest Rates

Interest rates vary according to the choice of investment outlet. Investors prefer
safe investments with a good return. A risk-less security will bring low rates of
return. Government securities are riskfree. However, market risk is high with
high rates of return. Before allocations of any amount, the different types of
securities must be analyzed to calculate their benefits and their disadvantages.
The investor should make his portfolio with several kinds of investments.
Stability of interest is as important as receiving a high rate of interest. This book
is concerned with determining that the investor is getting an acceptable return
commensurate with the risks that are taken.

4. Inflation
In a developing economy, there are rising prices and inflationary trends. A rise
in prices has several problems coupled with a falling standard of living. Before
funds are invested, they must be evaluated to find the right choice of
investments to tide over inflationary situations. The investor will Investment
Management – An Introduction 5 look at different investment outlets and
compare the rate of return/interest to cover the risk of inflation. Security and
safety of capital is important. Therefore, he/she should invest in those securities
that have an assured and regular return. An investor has to consider, the taxation
benefit decides the safety of capital and its continuous return.

5. Income

Investment decisions are important due the general increase in employment

opportunities and an understanding of investment channels for saving in India.
New and well paying job opportunities are in sectors like software technology;
business processing offices, call centres, exports, media, tourism, hospitality,
manufacturing sector, banks, insurance and financial services. The employment
opportunities gave rise to increasing incomes. Higher income has increased a
demand for investments and earnings above the regular income of people.
Investment outlets can be selected to make investments for supporting the
regular income. Awareness of financial assets and real assets has led to the
ability and willingness of working people to save and invest their funds for
return in their lean period leading to the importance of investments.

6. Investment Outlets

The availability of a large number of investment outlets has made investments

useful and important. Apart from putting aside savings in savings banks where
interest is low, investors have the choice of a variety of instruments. The
question to reason out is which is the most suitable channel? Which investment
will give a balanced growth and stability of return? The investor in his choice of
investment has the objective of a proper mix between high rate of return and
stability of return to get the benefits of both types of investments. Thus, the
objectives of investment are to achieve a good rate of return in the future,
reducing risk to get a good return, liquidity in time of emergencies, safety of
funds by selecting the right avenues of investments and a hedge against
inflation.

Distinction between Investment and Speculation:

 Investment Speculation
Time Horizon Long-term time Short-term planning
framework beyond holding assets even for
12 months one day.
Risk It has limited risk. High Returns though risk
of loss is high.
Return It is consistent and There are high profits
moderate over a long and gains as well as
period high losses. It is not
consistent
Use of funds The investor uses his Speculation is through
own funds through own and borrowed funds
savings
Decisions Safety, liquidity, Market behaviour
profitability and stability information, judgments
considerations and on movement in the
performance of stock market, haunches
companies and beliefs

Types of Investment:

Stocks:

Buying shares of stock gives the buyer the opportunity to participate in the
company’s success via increases in the stock’s price and dividends that the
company might declare. Shareholders have a claim on the company’s assets in
the event of liquidation, but do not own the assets. Holders of common stock
have voting rights at shareholders’ meetings and the right to receive dividends if
they are declared. Holders of preferred stock don’t have voting rights, but do
receive preference in terms of the payment of any dividends over common
shareholders. They also have a higher claim on company assets than holders of
common stock.

Bonds:

Bonds are debt instruments whereby an investor effectively is loaning money to

a company or agency (the issuer) in exchange for periodic interest payments
plus the return of the bond’s face amount when the bond matures. Bonds are
issued by corporations, the federal government plus many states, municipalities
and governmental agencies. A typical corporate bond might have a face value of
$1,000 and pay interest semi-annually. Interest on these bonds is fully taxable,
but interest on municipal bonds is exempt from federal taxes and may be
exempt from state taxes for residents of the issuing state. Interest on Treasuries
is taxed at the federal level only. Bonds can be purchased as new offerings or on
the secondary market, just like stocks. A bond’s value can rise and fall based on
a number of factors, the most important being the direction of interest rates.
Bond prices move inversely with the direction of interest rates.

Mutual funds:

A mutual fund is a pooled investment vehicle managed by an investment

manager that allows investors to have their money invested in stocks, bonds or
other investment vehicles as stated in the fund’s prospectus. Mutual funds are
valued at the end of trading day and any transactions to buy or sell shares are
executed after the market close as well. Mutual funds can passively track stock
or bond market indexes such as the S&P 500, the Barclay’s Aggregate Bond
Index and many others. Other mutual funds are actively managed where the
manager actively selects the stocks, bonds or other investments held by the
fund. Actively managed mutual funds are generally more costly to own. A
fund’s underlying expenses serve to reduce the net investment returns to the
mutual fund shareholders. Mutual funds can make distributions in the form of
dividends, interest and capital gains. These distributions will be taxable if held
in a non-retirement account. Selling a mutual fund can result in a gain or loss on
the investment, just as with individual stocks or bonds. Mutual funds allow
small investors to instantly buy diversified exposure to a number of investment
holdings within the fund’s investment objective. For instance, a foreign stock
mutual might hold 50 or 100 or more different foreign stocks in the portfolio.
An initial investment as low as $1,000 (or less in some cases) might allow an
investor to own all the underlying holdings of the fund. Mutual funds are a great
way for investors large and small to achieve a level of instant diversification.

ETFs:

ETFs or exchange-traded funds are like mutual funds in many respects, but are
traded on the stock exchange during the trading day just like shares of stock.
Unlike mutual funds which are valued at the end of each trading day, ETFs are
valued constantly while the markets are open. Many ETFs track passive market
indexes like the S&P 500, the Barclay’s Aggregate Bond Index, and the Russell
2000 index of small cap stocks and many others. In recent years, actively
managed ETFs have come into being, as have so-called smart beta ETFs which
create indexes based on “factors” such as quality, low volatility and momentum.

Alternative investments:

Beyond stocks, bonds, mutual funds and ETFs, there are many other ways to
invest. We will discuss a few of these here. Real estate investments can be
made by buying a commercial or residential property directly. Real estate
investment trusts (REITs) pool investor’s money and purchase properties.
REITS are traded like stocks. There are mutual funds and ETFs that invest in
REITs as well. Hedge funds and private equity also fall into the category of
alternative investments, although they are only open to those who meet the
income and net worth requirements of being an accredited investor. Hedge
funds may invest almost anywhere and may hold up better than conventional
investment vehicles in turbulent markets. Private equity allows companies to
raise capital without going public. There are also private real estate funds that
offer shares to investors in a pool of properties. Often alternatives have
restrictions in terms of how often investors can have access to their money. In
recent years, alternative strategies have been introduced in mutual fund and ETF
formats, allowing for lower minimum investments and great liquidity for
investors. These vehicles are known as liquid alternatives.

Factors influencing investment decision:

Capital investment decisions are not governed by one or two factors, because
the investment problem is not simply one of replacing old equipment by a new
one, but is concerned with replacing an existing process in a system with
another process which makes the entire system more effective.

1. Management Outlook

lf the management is progressive and has an aggressively marketing and growth

outlook, it will encourage innovation and favor capital proposals which ensure
better productivity on quality or both. In some industries where the product
being manufactured is a simple standardized one, innovation is difficult and
management would be extremely cost conscious. In contrast, in industries such
as chemicals and electronics, a firm cannot survive, if it follows a policy of
‘make-do’ with its existing equipment. The management has to be progressive
and innovation must be encouraged in such cases.

2. Competitor’s Strategy
Competitors’ strategy regarding capital investment exerts significant influence
on the investment decision of a company. If competitors continue to install
more equipment and succeed in turning out better products, the existence of the
company not following suit would be seriously threatened. This reaction to a
rival’s policy regarding capital investment often forces decision on a company’

3. Opportunities created by technological change:

Technological changes create new equipment which may represent a major

change in process, so that there emerges the need for re-evaluation of existing
capital equipment in a company. Some changes may justify new investments.
Sometimes the old equipment which has to be replaced by new equipment as a
result of technical innovation may be downgraded to some other applications. A
proper evaluation of this aspect is necessary, but is often not given due
consideration. In this connection, we may note that the cost of new equipment is
a major factor in investment decisions. However the management should think
in terms of incremental cost, not the full accounting cost of the new equipment
because cost of new equipment is partly offset by the salvage value of the
replaced equipment. In such analysis an index called the disposal ratio becomes
relevant.

Disposal ratio = (Salvage value, Alternative use value) / Installed cost

4. Market forecast

Both short and long run market forecasts are influential factors in capital
investment decisions. In order to participate in long-run forecast for market
potential critical decisions on capital investment have to be taken.

5. Fiscal Incentives

Tax concessions either on new investment incomes or investment allowance

allowed on new investment decisions, the method for allowing depreciation
deduction allowance also influence new investment decisions.

6. Cash flow Budget

The analysis of cash-flow budget which shows the flow of funds into and out of
the company may affect capital investment decision in two ways. First, the
analysis may indicate that a company may acquire necessary cash to purchase
the equipment not immediately but after say, one year, or it may show that the
purchase of capital assets now may generate the demand for major capital
additions after two years and such expenditure might clash with anticipated
other expenditures which cannot be postponed. Secondly, the cash flow budget
shows the timing of cash flows for alternative investments and thus helps
management in selecting the desired investment project.

7. Non-economic factors

New equipment may make the workshop a pleasant place and permit more
socializing on the job. The effect would be reduced absenteeism and increased
productivity. It may be difficult to evaluate the benefits in monetary terms and
as such we call this as non-economic factor. Let us take one more example.
Suppose the installation of a new machine ensures greater safety in operation. It
is difficult to measure the resulting monetary saving through avoidance of an
unknown number of injuries. Even then, these factors give tangible results and
do influence investment decisions.

Risk and Returns:

Returns are the gains or losses from a security in a particular period and are
usually quoted as a percentage. What kind of returns can investors expect from
the capital markets? A number of factors influence returns.

Risk: In the investing world, the dictionary definition of risk is the chance that
an investment's actual return will be different than expected. Risk means you
have the possibility of losing some, or even all, of your original investment.
Low levels of uncertainty (low risk) are associated with low potential returns.
High levels of uncertainty (high risk) are associated with high potential returns.
The risk/return trade-off is the balance between the desire for the lowest
possible risk and the highest possible return. Investment risks can be divided
into two categories: systematic and unsystematic.

Systematic Risk: Also known as "market risk" or "un-diversifiable risk",

systematic risk is the uncertainty inherent to the entire market or entire market
segment. Also referred to as volatility, systematic risk is the the day-to-day
fluctuations in a stock's price. Volatility is a measure of risk because it refers to
the behavior, or "temperament," of your investment rather than the reason for
this behavior. Because market movement is the reason why people can make
money from stocks, volatility is essential for returns, and the more unstable the
investment the more chance there is that it will experience a dramatic change in
either direction. Interest rates, recession and wars all represent sources of
systematic risk because they affect the entire market and cannot be avoided
through diversification. Systematic risk can be mitigated only by being hedged.

Unsystematic Risk: Also known as "specific risk," "diversifiable risk" or

"residual risk," this type of uncertainty comes with the company or industry you
invest in and can be reduced through diversification. For example, news that is
specific to a small number of stocks, such as a sudden strike by the employees
of a company you have shares in, is considered to be unsystematic risk.

Credit or Default Risk: Credit risk is the risk that a company or individual will
be unable to pay the contractual interest or principal on its debt obligations. This
type of risk is of particular concern to investors who hold bonds in their
portfolios. Government bonds, especially those issued by the federal
government, have the least amount of default risk and the lowest returns, while
corporate bonds tend to have the highest amount of default risk but also higher
interest rates. Bonds with a lower chance of default are considered to be
investment grade, while bonds with higher chances of default are considered to
be junk bonds. Bond rating services, such as Moody's, allows investors to
determine which bonds are investment-grade and which bonds are junk

Country Risk: Country risk refers to the risk that a country won't be able to
honor its financial commitments. When a country defaults on its obligations it
can harm the performance of all other financial instruments in that country as
well as other countries it has relations with. Country risk applies to stocks,
bonds, mutual funds, options and futures that are issued within a particular
country. This type of risk is most often seen in emerging markets or countries
that have a severe deficit.

Foreign-Exchange Risk: When investing in foreign countries you must

consider the fact that currency exchange rates can change the price of the asset
as well. Foreign-exchange risk applies to all financial instruments that are in a
currency other than your domestic currency. As an example, if you are a
resident of America and invest in some Canadian stock in Canadian dollars,
even if the share value appreciates, you may lose money if the Canadian dollar
depreciates in relation to the American dollar.

Interest Rate Risk: Interest rate risk is the risk that an investment's value will
change as a result of a change in interest rates. This risk affects the value of
bonds more directly than stocks
Political Risk: Political risk represents the financial risk that a country's
government will suddenly change its policies. This is a major reason why
developing countries lack foreign investment.

Some additional factors that influence actual returns are as follows:

Taxes:

Different types of investments are taxed differently. The type of account an

investment is held in and a taxpayer's tax bracket also affect the amount by
which taxes diminish investment returns. For example, the interest paid on
municipal bond investments is generally not taxable, and gains on investments
held in a retirement account like an IRA or 401(k) are not taxable until the
money is withdrawn.

Fees: Investors pay brokerage fees to buy and sell certain investments. They
also pay management fees. These fees diminish investment returns

Compounding: As we discussed in Section 4, the frequency with which your

investment returns are reinvested and able to earn additional returns can
significantly impact your total returns. The more frequently earnings are
compounded, the better. Daily compounding is better than annual compounding.
Now that we understand the major factors that influence returns, let's look at the
historical returns, average returns and variability of returns from investing in the
stock and bond markets.

FINANCIAL MARKETS

People and organizations wanting to borrow money are brought together with
those having surplus funds in the financial markets. Note that “markets” is
plural; there are a great many different financial markets in a developed
economy such as ours. We briefly describe the different types of financial
markets and some recent trends in these markets.

Types of Markets

Different financial markets serve different types of customers or different parts

of the country. Financial markets also vary depending on the maturity of the

securities being traded and the types of assets used to back the securities.

For these reasons it is often useful to classify markets along the following
dimensions:

1.Physical asset versus financial asset mark.ets

Physical asset markets (also called “tangible” or “real” asset markets) are those
for products such as wheat,autos, real estate, computers, and machinery.
Financial asset markets, on the other hand, deal with stocks, bonds, notes,
mortgages, and other claims on real assets, as well as with derivative securities
whose values are derived from changes in the prices of other assets. A share of
Ford stock is a “pure financial asset,” while an option to buy Ford shares is a
derivative security whose value depends on the price of Ford stock.

2. Spot versus futures markets.

Spot markets are markets in which assets are bought or sold for “on-the-spot”
delivery (literally, within a few days).Futures markets are markets in which
participants agree today to buy or sell an asset at some future date. For example,
a farmer may enter into a futures contract in which he agrees today to sell 5,000
bushels of soybeans six months from now at a price of $5 a bushel. On the other
side, an international food producer looking to buy soybeans in the future may
enter into a futures contract in which it agrees to buy soybeans six months from
now.

3. Money versus capital markets.

Money markets are the markets for short-term, highly liquid debt securities.
The New York, London, and Tokyo money markets are among the world’s
largest. Capital markets are the markets for intermediate- or long-term debt and
corporate stocks. The New York Stock Exchange, where the stocks of the
largest U.S. corporations are traded, is a prime example of a capital market.
There is no hard and fast rule on this, but when describing debt markets, “short
term” generally means less than 1 year, “intermediate term” means 1 to 10
years, and “long term” means more than 10 years.

4. Primary versus secondary markets.

Primary markets are the markets in which corporations raise new capital. If GE
were to sell a new issue of common stock to raise capital, this would be a
primary market transaction. The corporation selling the newly created stock
receives the proceeds from the sale in a primary market transaction. Secondary
markets are markets in which existing, already outstanding, securities are traded
among investors. Thus, if Jane Doe decided to buy 1,000 shares of GE stock,
the purchase would occur in the secondary market. The New York Stock
Exchange is a secondary market because it deals in outstanding, as opposed to
newly issued, stocks and bonds. Secondary markets also exist for mortgages,
various other types of loans, and other financial assets. The corporation whose
securities are being traded is not involved in a secondary market transaction
and, thus, does not receive any funds from such a sale. Spot Markets The
markets in which assets are bought or sold for “on-the-spot” delivery. Futures
Markets The markets in which participants agree today to buy or sell an asset at
some future date.Money Markets The financial markets in which funds are
borrowed or loaned for short periods (less than one year). Capital Markets The
financial markets for stocks and for intermediate- or longterm debt (one year or
longer). Primary Markets Markets in which corporations raise capital by issuing
new securities. Secondary Markets Markets in which securities and other
financial assets are traded among investors after they have been issued by
corporations.

5. Private versus public markets.

Private markets, where transactions are negotiated directly between two parties,
are differentiated from public markets, where standardized contracts are traded
on organized exchanges. Bank loans and private debt placements with insurance
companies are examples of private market transactions. Because these
transactions are private, they may be structured in any manner that appeals to
the two parties. By contrast, securities that are issued in public markets (for
example, common stock and corporate bonds) are ultimately held by a large
number of individuals. Public securities must have fairly standardized
contractual features, both to appeal to a broad range of investors and also
because public investors do not generally have the time and expertise to study
unique, nonstandardized contracts. Their wide ownership also ensures that
public securities are relatively liquid. Private market securities are, therefore,
more tailor-made but less liquid, whereas publicly traded securities are more
liquid but subject to greater standardization. Other classifications could be
made, but this breakdown is sufficient to show.

FINANCIAL INSTITUTIONS

Direct funds transfers are more common among individuals and small
businesses, and in economies where financial markets and institutions are less
developed. While businesses in more developed economies do occasionally rely
on direct transfers, they generally find it more efficient to enlist the services of
one or more financial institutions when it comes time to raise capital.

1. Investment banking houses

such as Merrill Lynch, Morgan Stanley, Goldman Sachs, or Credit Suisse Group
provide a number of services to both investors and companies planning to raise
capital. Such organizations (a) help corporations design securities with features
that are currently attractive to investors, (b) then buy these securities from the
corporation, and (c) resell them to savers. Although the securities are sold twice,
this process is really one primary market transaction, with the investment
banker acting as a facilitator to help transfer capital from savers to businesses.

2. Commercial banks,

such as Bank of America, Wells Fargo, Wachovia, and J. P. Morgan Chase, are
the traditional “department stores of finance” because they serve a variety of
savers and borrowers. Historically, commercial banks were the major
institutions that handled checking accounts and through which the Federal
Reserve System expanded or contracted the money supply. Today, however,
several other institutions also provide checking services and significantly
influence the money supply. Conversely, commercial banks are providing an
ever-widening range of services, including stock brokerage services and
insurance.

3. Financial services corporations

It is a large conglomerates that combine many different financial institutions

within a single corporation. Examples of financial services corporations, most
of which started in one area but have now diversified to cover most of the
financial spectrum, include Citigroup, American Express, Fidelity, and
Prudential.

4. Savings and loan associations (S&Ls)

Traditionally served individual savers and residential and commercial mortgage

borrowers, taking the funds of many small savers and then lending this money
to home buyers and other types of borrowers. In the 1980s, the S&L industry
experienced severe problems when (a) short-term interest rates paid on savings
accounts rose well above the returns earned on the existing mortgages held by
S&Ls and (b) commercial real estate suffered a severe slump, resulting in high
mortgage default rates. Together, these events forced many S&Ls to merge with
stronger institutions or close their doors.

5. Mutual savings banks,

which are similar to S&Ls, operate primarily in the northeastern states,

accepting savings primarily from individuals, and lending mainly on a long-
term basis to home buyers and consumers.

6. Credit unions are cooperative associations

whose members are supposed to have a common bond, such as being

employees of the same firm. Members’ savings are loaned only to other
members, generally for auto purchases, home improvement loans, and home
mortgages. Credit unions are often the cheapest source of funds available to
individual borrowers.

7. Pension funds are retirement plans

funded by corporations or government agencies for their workers and

administered primarily by the trust departments of commercial banks or by life
insurance companies. Pension funds invest primarily in bonds, stocks,
mortgages, and real estate.

8. Life insurance companies

It is savings in the form of annual premiums; invest these funds in stocks,

bonds, real estate, and mortgages; and finally make payments to the
beneficiaries of the insured parties. In recent years, life insurance companies
have also offered a variety of tax-deferred savings plans designed to provide
benefits to the participants when they retire.

9. Mutual funds

It is a corporations that accept money from savers and then use

these funds to buy stocks, long-term bonds, or short-term debt instruments

issued by businesses or government units. These organizations pool funds and

thus reduce risks by diversification. They also achieve economies of scale in
analyzing securities, managing portfolios, and buying and selling securities.
Different funds are designed to meet the objectives of different types of savers.
Hence, there are bond funds for those who desire safety, stock funds for savers
who are willing to accept significant risks in the hope of higher returns, and still
other funds that are used as interest-bearing.

Structure of financial markets:

A financial market is a broad term describing any marketplace where buyers

and sellers participate in the trade of assets such as equities, bonds, currencies
and derivatives. Financial markets are typically defined by having transparent
pricing, basic regulations on trading, costs and fees, and market forces
determining the prices of securities that trade.

Financial markets can be found in nearly every nation in the world. Some are
very small, with only a few participants, while others - like the New York Stock
Exchange (NYSE) and the forex markets - trade trillions of dollars daily.

Investors have access to a large number of financial markets and exchanges

representing a vast array of financial products. Some of these markets have
always been open to private investors; others remained the exclusive domain of
major international banks and financial professionals until the very end of the
twentieth century.

Capital Markets

A capital market is one in which individuals and institutions trade financial

securities. Organizations and institutions in the public and private sectors also
often sell securities on the capital markets in order to raise funds. Thus, this type
of market is composed of both the primary and secondary markets.

Any government or corporation requires capital (funds) to finance its operations

and to engage in its own long-term investments. To do this, a company raises
money through the sale of securities - stocks and bonds in the company's name.
These are bought and sold in the capital markets.

Stock Markets

Stock markets allow investors to buy and sell shares in publicly traded
companies. They are one of the most vital areas of a market economy as they
provide companies with access to capital and investors with a slice of ownership
in the company and the potential of gains based on the company's future
performance.
This market can be split into two main sections: the primary market and the
secondary market. The primary market is where new issues are first offered,
with any subsequent trading going on in the secondary market.

Bond Markets

A bond is a debt investment in which an investor loans money to an entity

(corporate or governmental), which borrows the funds for a defined period of
time at a fixed interest rate. Bonds are used by companies, municipalities, states
and U.S. and foreign governments to finance a variety of projects and activities.
Bonds can be bought and sold by investors on credit markets around the world.
This market is alternatively referred to as the debt, credit or fixed-income
market. It is much larger in nominal terms that the world's stock markets. The
main categories of bonds are corporate bonds, municipal bonds, and U.S.
Treasury bonds, notes and bills, which are collectively referred to as simply
"Treasuries."

Money Market

The money market is a segment of the financial market in which financial

instruments with high liquidity and very short maturities are traded. The money
market is used by participants as a means for borrowing and lending in the short
term, from several days to just under a year. Money market securities consist of
negotiable certificates of deposit (CDs), banker's acceptances, U.S. Treasury
bills, commercial paper, municipal notes, eurodollars, federal funds and
repurchase agreements (repos). Money market investments are also called cash
investments because of their short maturities.

The money market is used by a wide array of participants, from a company

raising money by selling commercial paper into the market to an investor
purchasing CDs as a safe place to park money in the short term. The money
market is typically seen as a safe place to put money due the highly liquid
nature of the securities and short maturities. Because they are extremely
conservative, money market securities offer significantly lower returns than
most other securities. However, there are risks in the money market that any
investor needs to be aware of, including the risk of default on securities such as
commercial paper.

Cash or Spot Market

Investing in the cash or "spot" market is highly sophisticated, with opportunities
for both big losses and big gains. In the cash market, goods are sold for cash and
are delivered immediately. By the same token, contracts bought and sold on the
spot market are immediately effective. Prices are settled in cash "on the spot" at
current market prices. This is notably different from other markets, in which
trades are determined at forward prices.

The cash market is complex and delicate, and generally not suitable for
inexperienced traders. The cash markets tend to be dominated by so-called
institutional market players such as hedge funds, limited partnerships and
corporate investors. The very nature of the products traded requires access to
far-reaching, detailed information and a high level of macroeconomic analysis
and trading skills.

Derivatives Markets

The derivative is named so for a reason: its value is derived from its underlying
asset or assets. A derivative is a contract, but in this case the contract price is
determined by the market price of the core asset. If that sounds complicated, it's
because it is. The derivatives market adds yet another layer of complexity and is
therefore not ideal for inexperienced traders looking to speculate. However, it
can be used quite effectively as part of a risk management program.

Examples of common derivatives are forwards, futures, options, swaps and

contracts-for-difference (CFDs). Not only are these instruments complex but so
too are the strategies deployed by this market's participants. There are also
many derivatives, structured products and collateralized obligations available,
mainly in the over-the-counter (non-exchange) market, that professional
investors, institutions and hedge fund managers use to varying degrees but that
play an insignificant role in private investing.

Forex and the Interbank Market

The interbank market is the financial system and trading of currencies among
banks and financial institutions, excluding retail investors and smaller trading
parties. While some interbank trading is performed by banks on behalf of large
customers, most interbank trading takes place from the banks' own accounts.
The forex market is where currencies are traded. The forex market is the largest,
most liquid market in the world with an average traded value that exceeds $1.9
trillion per day and includes all of the currencies in the world. The forex is the
largest market in the world in terms of the total cash value traded, and any
person, firm or country may participate in this market.

There is no central marketplace for currency exchange; trade is conducted over

the counter. The forex market is open 24 hours a day, five days a week and
currencies are traded worldwide among the major financial centers of London,
New York, Tokyo, Zürich, Frankfurt, Hong Kong, Singapore, Paris and Sydney.

Until recently, forex trading in the currency market had largely been the domain
of large financial institutions, corporations, central banks, hedge funds and
extremely wealthy individuals. The emergence of the internet has changed all of
this, and now it is possible for average investors to buy and sell currencies
easily with the click of a mouse through online brokerage accounts.

Primary Markets vs. Secondary Markets

A primary market issues new securities on an exchange. Companies,

governments and other groups obtain financing through debt or equity based
securities. Primary markets, also known as "new issue markets," are facilitated
by underwriting groups, which consist of investment banks that will set a
beginning price range for a given security and then oversee its sale directly to
investors.

The primary markets are where investors have their first chance to participate in
a new security issuance. The issuing company or group receives cash proceeds
from the sale, which is then used to fund operations or expand the business.

The secondary market is where investors purchase securities or assets from

other investors, rather than from issuing companies themselves. The Securities
and Exchange Commission (SEC) registers securities prior to their primary
issuance, then they start trading in the secondary market on the New York Stock
Exchange, Nasdaq or other venue where the securities have been accepted for
listing and trading.

The secondary market is where the bulk of exchange trading occurs each day.
Primary markets can see increased volatility over secondary markets because it
is difficult to accurately gauge investor demand for a new security until several
days of trading have occurred. In the primary market, prices are often set
beforehand, whereas in the secondary market only basic forces like supply and
demand determine the price of the security.

Secondary markets exist for other securities as well, such as when funds,
investment banks or entities such as Fannie Mae purchase mortgages from
issuing lenders. In any secondary market trade, the cash proceeds go to an
investor rather than to the underlying company/entity directly.

The OTC Market

The over-the-counter (OTC) market is a type of secondary market also referred

to as a dealer market. The term "over-the-counter" refers to stocks that are not
trading on a stock exchange such as the Nasdaq, NYSE or American Stock
Exchange (AMEX). This generally means that the stock trades either on the
over-the-counter bulletin board (OTCBB) or the pink sheets. Neither of these
networks is an exchange; in fact, they describe themselves as providers of
pricing information for securities. OTCBB and pink sheet companies have far
fewer regulations to comply with than those that trade shares on a stock
exchange. Most securities that trade this way are penny stocks or are from very
small companies.

Third and Fourth Markets

You might also hear the terms "third" and "fourth markets." These don't concern
individual investors because they involve significant volumes of shares to be
transacted per trade. These markets deal with transactions between broker-
dealers and large institutions through over-the-counter electronic networks. The
third market comprises OTC transactions between broker-dealers and large
institutions. The fourth market is made up of transactions that take place
between large institutions. The main reason these third and fourth market
transactions occur is to avoid placing these orders through the main exchange,
which could greatly affect the price of the security. Because access to the third
and fourth markets is limited, their activities have little effect on the average
investor.

Financial institutions and financial markets help firms raise money. They can do
this by taking out a loan from a bank and repaying it with interest, issuing bonds
to borrow money from investors that will be repaid at a fixed interest rate, or
offering investors partial ownership in the company and a claim on its residual
cash flows in the form of stock.