CHAPTER ONE

INTRODUCTION
1.1 WHAT IS AN INVESTMENT?
For most of your life, you will be earning and spending money. Sometimes, you may have more money
than you want to spend; at other times, you may want to purchase more than you can afford based on your
current income. These imbalances will lead you either to borrow or to save to maximize the long-run
benefits from your income.

When current income exceeds current consumption desires, people tend to save the excess.
They can do any of several things with these savings:
 Put the money under a mattress or bury it in the backyard until some future time when consumption desires
exceed current income.
 Give up the immediate possession of these savings for a future larger amount of money that will be
available for future consumption.

Conversely, those who consume more than their current income (that is, borrowed) must be willing to pay back
in the future more than they borrowed.

The rate of exchange between future consumption (future dollars) and current consumption (current dollars) is
the pure rate of interest. Both people’s willingness to pay this difference for borrowed funds and their desire
to receive a surplus on their savings (i.e., some rate of return) give rise to an interest rate referred to as the
pure time value of money. This interest rate is established in the capital market by a comparison of the supply
of excess income available (savings) to be invested and the demand for excess consumption (borrowing) at a
given time.

If you can exchange Br.100 of certain income today for Br. 104 of certain income one year from today, then
the pure rate of exchange on a risk-free investment (that is, the time value of money) is said to be 4 percent
(104/100 − 1).

The investor who gives up Br.100 today expects to consume Br.104 of goods and services in the
future. This assumes that the general price level in the economy stays the same. This price stability has rarely
been the case during the past several decades when inflation rates have varied from time to time: For example:

 If an investor expects a rise in prices (that is, he or she expects inflation) at the annual rate of 2 percent
during the period of investment, he or she will increase the required interest rate by 2 percent. In our
example, the investor would require Br.106 in the future to defer the Br.100 of consumption during an
inflationary period (a 6 % nominal, risk-free interest rate will be required instead of 4 %).
 If the future payment from the investment is not certain, the investor will demand an interest rate that
exceeds the nominal risk-free interest rate. The uncertainty of the payments from an investment is the
investment risk. The additional return added to the nominal, risk-free interest rate is called a risk
premium. In our previous example, the investor would require more than Br.106 one year from today
to compensate for the uncertainty. As an example, if the required amount were Br.110, Br.4 (4 percent)
would be considered a risk premium.

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1.2 INVESTMENT DEFINITION

The term ‘investing” could be associated with the different activities, but the common target in these activities
is to “employ” the money (funds) during the time period seeking to enhance the investor’s wealth.

In finance, investment is buying or creating an asset with the expectation of capital appreciation, dividends
(profit), interest earnings, rents, or some combination of these returns.

Investment is the current commitment of dollars 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 during this time period, and
 The uncertainty of the future payments.

The “investor” can be an individual, a government, a pension fund, or a corporation. Similarly, this definition
includes all types of investments, including investments by corporations in plant and equipment and
investments by individuals in stocks, bonds, commodities, or real estate. This course mostly emphasizes
investments by individual investors. In all cases, the investor is trading a known dollar amount today for
some expected future stream of payments that will be greater than the current dollar amount today.

So why people invest and what they want from their investments?

As it answered above, they invest:

 To earn a return from savings due to their deferred consumption.

 To earn a rate of return that compensates them for the time period of the investment, the expected rate
of inflation, and the uncertainty of the future cash flows.

1.3 INVESTMENT MANAGEMENT PROCESS

Investment management process is the process of managing money or funds. The investment management
process describes how an investor should go about making decisions. Investment management process can be
disclosed by five-step procedure, which includes following stages:
1. Setting of investment policy.
2. Analysis and evaluation of investment vehicles.
3. Formation of diversified investment portfolio.
4. Portfolio revision
5. Measurement and evaluation of portfolio performance.

1. Setting of investment policy: - is the first and very important step in investment management process. It
includes setting of investment objectives that should have the specific objectives regarding the investment
return requirement and risk tolerance of the investor. For example, the investment policy may define that
the target of the investment average return should be 15 % and should avoid more than 10 % losses.
Identifying investor’s tolerance for risk is the most important objective, because it is obvious that every
investor would like to earn the highest return possible. But because there is a positive relationship between
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 risk and return, it is not appropriate for an investor to set his/ her investment objectives as just “to make a
lot of money”. Investment objectives should be stated in terms of both risk and return.
2. Analysis and evaluation of investment vehicles.
When the investment policy is set up, investor’s objectives defined and the potential categories of
financial assets for inclusion in the investment portfolio identified, the available investment types can be
analyzed. For example, if the common stock was identified as investment vehicle relevant for investor, the
analysis will be concentrated to the common stock as an investment. There are many different approaches
how to make such analysis. Most frequently two forms of analysis are used:
i. Technical analysis: it the analysis of market prices in an attempt to predict future price movements
for the particular financial asset traded on the market based on examining of trends of historical
prices.
ii. Fundamental analysis: its simplest form is focused on the evaluation of intrinsic value of the
financial asset. This valuation is based on the assumption that intrinsic value is the present value of
future flows from particular investment. By comparison of the intrinsic value and market value of
the financial assets those which are underpriced or overpriced can be identified. Fundamental
analysis will be examined in later chapter.
3. Formation of diversified investment portfolio is the next step in investment management process.
Investment portfolio is the set of investment vehicles (short- term investment vehicles; fixed-income securities;
common stock; speculative investment vehicles; other investment tools), formed by the investor seeking to
realize its’ defined investment objectives. In the stage of portfolio formation, the issues of selectivity,
timing and diversification need to be addressed by the investor.

4. Portfolio revision. This step of the investment management process concerns the periodic revision of the
three previous stages. This is necessary, because over time investor with long-term investment horizon
may change his / her investment objectives and this, in turn means that currently held investor’s portfolio
may no longer be optimal and even contradict with the new settled investment objectives, prices of the
assets change, meaning that some assets that were attractive at one time may be no longer be so. Investor
should form the new portfolio by selling some assets in his portfolio and buying the others that are not
currently held. Individual investor managing portfolio must perform portfolio revision periodically as
institutional investors do.

5. Measurement and evaluation of portfolio performance. This the last step in investment management
process involves determining periodically how the portfolio performed, in terms of not only the return
earned, but also the risk of the portfolio. For evaluation of portfolio performance appropriate measures of
return and risk and benchmarks are needed. The benchmark may be a popular index of appropriate
assets – stock index, bond index. The benchmarks are widely used by institutional investors evaluating
the performance of their portfolios.

1.4 INVESTMENT ALTERNATIVES

There are financial and physical investments, and they have some characteristics that differentiate them from
one another. Even if we analyze only financial investment there is a big variety of financial
investment vehicles (alternatives)
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 The main types of financial investment vehicles are:
 Short term investment vehicles;
 Fixed-income securities;
 Common stock;
 Speculative investment vehicles;
 Other investment tools.
I. Short - term investment vehicles are all those which have a maturity of one year or less. Short term
investment vehicles often are defined as money-market instruments, because they are traded in the money
market which presents the financial market for short term (up to one year of maturity) marketable financial
assets. The risk as well as the return on investments of short-term investment vehicles usually is lower than
for other types of investments.
The main short term investment vehicles are:
 Certificates of deposit
 Treasury bills;
 Commercial paper;
 Bankers’ acceptances;
 Repurchase agreements.
 Certificate of deposit is debt instrument issued by bank that indicates a
specified sum of money has been deposited at the issuing depository institution.
Certificate of deposit bears a maturity date and specified interest rate and can be issued
in any denomination. Most certificates of deposit cannot be traded and they incur
penalties for early withdrawal. For large money-market investors financial institutions
allow their large-denomination certificates of deposits to be traded as negotiable
certificates of deposits.
 Treasury bills
 Are securities representing financial obligations of the government
 They have maturities of less than one year.
 They are issued at a discount from their nominal value and the difference between nominal value
and discount price is the only sum which is paid at the maturity for these short term securities
because the interest is not paid in cash, only accrued.
 They are treated as risk-free a security, which was rare in developed countries, the T-bill will
pay the fixed stated yield with certainty.
 Bills can be traded before the maturity, while their market price is subject to change with changes
in the rate of interest.
 T-Bills are regarded as high liquid assets.
 Commercial paper is a name for short-term unsecured promissory notes issued by corporation.
 It is a means of short-term borrowing by large corporations.
 It is cheaper than relying solely on bank loans.
 It is issued either directly from the firm to the investor or through an intermediary.
 It, like T-bills is issued at a discount with most common maturity range of 30 to 60 days or less.
 It is riskier than T-bills, because there is a larger risk that a corporation will default.

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  It is not easily bought and sold after it is issued, because the issues are relatively small compared
with T-bills and hence their market is not liquid.
 Bankers acceptances are the vehicles created to facilitate commercial trade transactions.
 Bank accepts the responsibility to repay a loan to the holder of the vehicle in case the debtor fails
to perform.
 They (Bankers acceptances) are short-term fixed-income securities that are created
by non-financial firm whose payment is guaranteed by a bank.
 This short-term loan contract typically has a higher interest rate than similar short –term securities
to compensate for the default risk.
 Repurchase agreement (often referred to as a repo) is the sale of security with a commitment by the
seller to buy the security back from the purchaser at a specified price at a designated future date.
 It is a collectivized short-term loan, where collateral is a security (repo may be a Treasury
security, other money-market security).
 The difference between the purchase price and the sale price is the interest cost of the loan.
 The length of maturity of repo is usually very short. If the agreement is for a loan of funds for
one day, it is called overnight repo; if the term of the agreement is for more than one day, it is
called a term repo.
II.Fixed-income securities are those which return is fixed, up to some redemption date or indefinitely. The
fixed amounts may be stated in money terms or indexed to some measure of the price level. This type of
financial investments is presented by two different groups of securities:
 Long-term debt securities
 Preferred stocks.
1. Long-term debt securities:
 They are debt instruments representing the issuer’s contractual obligation.
 It has maturity longer than 1 year.
 The buyer (investor) of these securities is lending money to the issuer, who undertake obligation
periodically to pay interest on this loan and repay the principal at a stated maturity date.
 They are traded in the capital markets.
 From the investor’s point of they can be treated as a “safe” asset. But in reality the safety of
investment in fixed –income securities is strongly related with the default risk of an issuer.
 The major types of these securities are bonds, but today there are a big variety of different kinds of
bonds, which differ not only by the different issuers (governments, municipals, companies, agencies,
etc.), but by different schemes of interest payments.
2. Preferred stocks:
 Is equity security, which has infinitive life and pay dividends.
 It is attributed to the type of fixed-income securities, because the dividend for preferred stock is fixed in
amount and known in advance.
 Paid after the debt securities holders but before the common stock
holders in terms of priorities in payments of income and in case of liquidation of the
company.
 Usually same rights to vote in general meetings for preferred stockholders are suspended.

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 3. The common stock:
 It is the other type of investment vehicles which is one of most popular among investors with
long-term horizon of their investments.
 It represents the ownership interest of corporations or the equity of the stock holders.
 Holders has a right to attend and vote at a general meeting of shareholders, to receive declared
dividends and to receive their share of the residual assets, if any, if the corporation is bankrupt.
 The issuers of these securities are the companies which seek to receive funds in the market and
though are “going public”.
4. Speculative investment vehicles following the term “speculation” could be defined as investments with a
high risk and high investment return. Using these investment vehicles speculators try to buy low and to sell
high, their primary concern is with anticipating and profiting from the expected market fluctuations. The
only gain from such investments is the positive difference between selling and purchasing prices.

1.5 .MEASURES OF RETURN AND RISK

Following the presentation of measures of historical rates of return and risk, we turn to
estimating the expected rate of return for an investment.

1.5.1 Investment return

With most investments, an individual or business spends money today with the expectation of earning even
more money in the future. The concept of return provides investors with a convenient way to express the
financial performance of an investment. To illustrate you buy ten shares of stocks for Br.1, 000. The stock
pays no dividends, but at the end of one year, you sell the stock for Br. 1,100. What is the return on your Br.
1,000?

On way to express an investment return is in dollar/Birr Terms. The dollar return is simply the total dollars
received from the investment less the amount invested.

Br.

If you received at the end of the year you sell the stock for Br. 900, your return will be Br. -100(900-1000)
(negative return). Although expressing returns in dollars is easy, two problems arise to make meaningful
judgment about the return:
1. What is the scale (size) of investment? i.e. this Br. 100 return comes from Br.1,000 or from Br. 10,000
investment?
2. What is the timing of the return? i.e. this Br. 100 return is obtained after one year or twenty years?
So the solution to this problem is to express investment results as rates of return, or percentage of returns.
For example, the rate of return on the one-year stock investment, when Br. 1,100 is received after one year,
is 10%:

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 =

The rate of return calculation “standardizes” the return by considering the annual return per unit of
investment. Although this example has only one outflow and one inflow, the annualized rate of return can
easily be calculated in situations where multiple cash flows occur over time by using time value of money
concepts.

1.5.2 Measures of Historical Rates of Return

When you are evaluating alternative investments for inclusion in your portfolio, you will often be comparing
investments with widely different prices or lives. When we talk about a return on an investment, we are
concerned with the change in wealth resulting from this investment. This change in wealth can be either due
to cash inflows, such as interest or dividends, or caused by a change in the price of the asset (positive or
negative).

If you commit Br. 200 to an investment at the beginning of the year and you get back Br. 220 at
the end of the year, what is your return for the period? The period during which you own an
investment is called its holding period, and the return for that period is the holding period
return (HPR). In this example, the HPR is 1.10, calculated as follows:

This HPR value:

 Always, it can never be a negative value. So:

 > 1, an increase in your wealth, which indicate a positive rate of return during the period
 No change in value of investment, i.e. no loss no gain.
 Decline in wealth, which indicates a negative return during the period.


Although HPR helps us express the change in value of an investment, investors generally evaluate returns
in percentage terms on an annual basis. This conversion to annual percentage rates makes it easier to
directly compare alternative investments that have markedly different characteristics.

1.5.3 Holding Period Yield

The first step in converting an HPR to an annual percentage rate is to derive a percentage return, referred
to as the holding period yield (HPY).

or an alternative formula for the HPY is:

in the case of stock holder investor’s and for the bond investor’s the same formula is applied except the
interest is calculated over it.
In our example: HPY = 1.10 − 1 = 0.10 or 10%
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To derive an annual HPY, you compute an annual HPR and subtract 1.

Annual HPR is found by:

Where:
n = number of years the investment is held
Consider an investment that cost Br.250 and is worth Br. 350 after being held for two years:

= 1.1832 = 1.1832 − 1 =0.1832 or 18.32% or

If you experience a decline in your wealth value, the computation is as follows:

HPY = HRP-1 = 0.80 – 1.00 = −0.20 = −20%

1.5.4 Computing Mean Historical Returns

Over a number of years, a single investment will likely give high rates of return during some years and low
rates of return, or possibly negative rates of return, during others.

Given a set of annual rates of return (HPYs) for an individual investment, there are two summary measures of
return performance. The first is the arithmetic mean return; the second is the geometric mean return.

i. Arithmetic mean

To find the arithmetic mean (AM), the sum (Σ) of annual HPYs is divided by the number of years (n) as
follows:

AM   HPY/n
where :

 HPY  the sum of annual

holding period yields

n =number of years

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 ii. Geometric Mean

The geometric mean (GM), is the nth root of the product of the HPRs for n years minus one. To check that you
understand the calculations, determine the annual HPY for a three-year HPR of 1.50. (Answer: 14.47 percent.)
Compute the annual HPY for a three-month HPR of 1.06. (Answer: 26.25 percent.)

A Portfolio of Investment

The mean historical rate of return for a portfolio of investments is measured as the weighted average of the
HPYs for the individual investments in the portfolio.
No of Begin Beginning Ending Ending Market Wtd.
shares
Price Mkt. Value Price Mkt. Value HPR HPY Wt. HPY
Stock

A 100,000 $ 10 $ 1,000,000 $12 $ 1,200,000 1.20 20% 0.05 0.010

B 200,000 $ 20 $ 4,000,000 $21 $ 4,200,000 1.05 5% 0.20 0.010

C 500,000 $ 30 $15,000,000 $33 $16,500,000 1.10 10% 0.75 0.075

Total $20,000,000 $21,900,000 0.095

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 HPR 21,900,000 = 1.095
= $20,000,000

HPY = 1.095 - - 1 = 0.095 or 9.5%

As shown, above the HPY is the same (9.5 percent) whether you compute the weighted average return using
the beginning market value weights or if you compute the overall percent change in the total value of the
portfolio.
Although the analysis of historical performance is useful, selecting investments for your portfolio requires you
to predict the rates of return you expect to prevail.

1.5.5 Scenario Analysis and Probability Distribution

Risk is the uncertainty that an investment will earn its expected rate of return. In contrast, an investor who is
evaluating a future investment alternative expects or anticipates different possibilities of outcomes or scenarios.
 Certain returns, which indicates for risk free return
 Probability of return that is it lays between certain (100%) to complete uncertain (0%) chance of return.

An investor determines how certain the expected rate of return on an investment is by analyzing estimates of
possible returns. To do this, the investor assigns probability values to all possible returns. These probability
values range from zero, which means no chance of the return, to one, which indicates complete certainty that
the investment will provide the specified rate of return. Using this information along with future expectations
regarding the economy, one can derive an estimate of what might happen in the future. The expected return
from an investment is defined as:-

Certain Return Case

Let us begin our analysis of the effect of risk with an example of perfect certainty wherein the investor is
absolutely certain of a return of 5 percent. Perfect certainty allows only one possible return, and the probability
of receiving that return is 1.0. Few investments provide certain returns and would be considered risk-free
investments.

In the case of perfect certainty, there is only one value for Pi Ri:

E(Ri) = (1.0) (0.05) = 0.05 = 5%

In an alternative scenario, suppose an investor believed an investment could provide several different rates of
return depending on different possible economic conditions. The investor might estimate probabilities for
each of these economic scenarios based on past experience and the current outlook as follows:

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 Economic Conditions Probability Rate of Return

Strong economy, no inflation 0.15 0.20

Weak economy, above-average inflation 0.15 −0.20

No major change in economy 0.70 0.10

This set of potential outcomes can be visualized as shown in above. The computation of the expected rate of
return [E(Ri)] is as follows: ERiPi:

Obviously, the investor is less certain about the expected return from this investment than about the return
from the prior investment with its single possible return.

A third example is an investment with 10 possible outcomes ranging from −40 percent to 50 percent with the
same probability for each rate of return. In this case, there are numerous outcomes from a wide range of
possibilities. The expected rate of return [E(Ri)] for this investment would be:

The expected rate of return for this investment is the same as the certain return discussed in the first example;
but, in this case, the investor is highly uncertain about the actual rate of return. This would be considered a
risky investment because of that uncertainty. We would anticipate that an investor faced with the choice
between this risky investment and the certain (risk-free) case would select the certain alternative. This
expectation is based on the belief that most investors are risk averse, which means that if everything else is the
same, they will select the investment that offers greater certainty (i.e., less risk).

1.5.6 Measuring the Risk of Expected Rates of Return

Statistical measures allow you to compare the return and risk measures for alternative investments directly.
Two possible measures of risk (uncertainty) have received support in theoretical work on portfolio theory: the
variance and the standard deviation of the estimated distribution of expected returns.

The formula for variance is as follows:

Variance: The larger the variance for expected rate of return, the greater the dispersion of
expected returns and the greater the uncertainty, or risk, of the investment.

The variance for the perfect-certainty (risk-free) example would be:

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=

=1.0(0.0) = 0

Note that in perfect certainty, there is no variance of return because there is no deviation from expectations and,
therefore, no risk or uncertainty.

The variance for the second example would be:-

= [0.002535 + 0.010935 + 0.00063} = 0.0141

Standard Deviation The standard deviation is the square root of the variance:

For the second example, the standard deviation would be:

=
= 0.11874 or 11.87%

Therefore, when describing this investment example, you would contend that you expect a return of 7 percent,
but the standard deviation of your expectations is 11.87 percent.

A Relative Measure of Risk In some cases, an unadjusted variance or standard deviation

can be misleading. If conditions for two or more investment alternatives are not similar—that is, if there are
major differences in the expected rates of return—it is necessary to use a measure of relative variability to
indicate risk per unit of expected return. A widely used relative measure of risk is the coefficient of variation
(CV), calculated as follows:

This measure of relative variability and risk is used by financial analysts to compare alternative investments
with widely different rates of return and standard deviations of returns. As an illustration, consider the
following two investments:-

Comparing absolute measures of risk, investment B appears to be riskier because it has a standard deviation of
7 percent versus 5 percent for investment A. In contrast, the CV figures show that investment B has less
relative variability or lower risk per unit of expected return because it has a substantially higher expected rate
of return:

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1.6 RELATIONSHIP BETWEEN RISK AND RETURN
The following graphs the expected relationship between risk and return. It shows that investors
increase their required rates of return as perceived risk (uncertainty) increases. The line that
reflects the combination of risk and return available on alternative investments is referred to
as the security market line (SML). The SML reflects the risk-return combinations available
for all risky assets in the capital market at a given time. Investors would select investments
that are consistent with their risk preferences; some would consider only low-risk investments,
whereas others welcome high-risk investments.

Fundamental risk
• Business risk: Uncertainty of income flows caused by the nature of a firm’s business. Sales volatility
and operating leverage determine the level of business risk.

• Financial risk: Uncertainty caused by the use of debt financing. Borrowing requires fixed payments
which must be paid ahead of payments to stockholders. The use of debt increases uncertainty of
stockholder income and causes an increase in the stock’s risk premium.

• Liquidity risk: Uncertainty is introduced by the secondary market for an investment.

 How long will it take to convert an investment into cash?

 How certain is the price that will be received?

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 • Exchange rate risk: Uncertainty of return is introduced by acquiring securities denominated in a
currency different from that of the investor. Changes in exchange rates affect the investors return when
converting an investment back into the “home” currency

• Country risk: Political risk is the uncertainty of returns caused by the possibility of a major change in
the political or economic environment in a country. Individuals who invest in countries that have
unstable political-economic systems must include a country risk-premium when determining their
required rate of return

Risk premium

The variation from the expected return by either of the following risks: That is fundamental risk (unsystematic
risk which is subject to elimination) or systematic risk (market risk, which may difficult to minimize).

f (Business Risk, Financial Risk, Liquidity Risk, Exchange Rate Risk, Country Risk)

Or

• f (Systematic Market Risk)

Risk Premium and Portfolio Theory

An alternative view of risk has been derived from extensive work in portfolio theory and capital
market theory by Markowitz (1952, 1959) and Sharpe (1964). Markowitz and Sharpe indicated that
investors should use an external market measure of risk. Under a specified set of assumptions, all
rational, profit-maximizing investors want to hold a completely diversified market portfolio of
risky assets, and they borrow or lend to arrive at a risk level that is consistent with their risk
preferences. Under these conditions, they showed that the relevant risk measure for an individual asset
is its co-movement with the market portfolio. This co-movement, which is measured by
an asset’s covariance with the market portfolio, is referred to as an asset’s systematic risk, the
portion of an individual asset’s total variance that is attributable to the variability of the total
market portfolio. In addition, individual assets have variance that is unrelated to the market
portfolio (the asset’s nonmarket variance) that is due to the asset’s unique features. This nonmarket
variance is called unsystematic risk, and it is generally considered unimportant because
it is eliminated in a large, diversified portfolio. Therefore, under these assumptions, the risk premium
for an individual earning asset is a function of the asset’s systematic risk with the aggregate market
portfolio of risky assets. The measure of an asset’s systematic risk is referred to as its beta:

Risk Premium = f (Systematic Market Risk)

In equilibrium, all assets and all portfolios of assets should plot on the SML. That is, all assets should be priced
so that their estimated rates of return, which are the actual holding period rates of return that you anticipate, are
consistent with their levels of systematic risk. Any security with an estimated rate of return that plots above the
SML would be considered undervalued because it implies that you forecast receiving a rate of return on the
security that is above its required rate of return based on its systematic risk. In contrast, assets with estimated
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rates of return that plot below the SML would be considered overvalued. This position relative to the SML
implies that your estimated rate of return is below what you should require
based on the asset’s systematic risk.

In an efficient market, you would not expect any assets to plot off the SML because, in equilibrium, all stocks
should provide holding period returns that are equal to their required rates of return. Alternatively, a market
that is not completely efficient may misprice certain assets because not everyone will be aware of all the
relevant information.

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