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Q1. Define Investment. Give
difference between investment and specula-
tion.

Ans.pInvestment is the commitment of money

or capital to purchase financial instruments or
other assets in order to gain profitable returns
in form of interest, income, or appreciation of
the value of the instrument. It is related to sav-
ing or deferring consumption.

Difference between investment and specula-

tion:

INVESTMENT:

1. the investor invest for long term gain pur-

pose

2. the investor hold securities for long period.

3. risk is less as compare to speculation

4. the rate of return is less as compare to

speculation
SPECULATION:

1. the investor invest for short term gain pur-

pose

2. the investor hold securities very short pe-

riod say 1 or 2 days

3. risk is high

4. rate of return is more

5. it invole buying and silling of securities.

Q2. What do you mean by Risk and Returns and

how will we measure Risk and Return.

Ans. Return:

The expected returns or benefits an invest-

ment generates come in the form of cash flow,
not accounting profits, is the relevant variable
in measuring returns.
Continue to remember that future cash flows,
not the reported earnings figure, determine the
investor's rate of return.

Risk:

Risk is the potential variability in future cash

flows. The wider the range of possible events
that can occur, the greater the risk.

If we diversify our investments across different

securities rather than invest in only one stock,
the variability in the returns of our portfolio
should decline.

The reduction in risk will occur if the stock re-

turns within one portfolio do not move precise-
ly together over time-not correlated.The reduc-
tion occurs because some of the volatility in
the returns of a stock are unique to that secu-
rity. The uniqueness of a single stock tends to
be countered by the uniqueness of another se-
curity. However, we should not expect to elim-
inate all risk from our portfolio.
Measuring of risk and return:

Risk

There are two ways to measure risk. One is by

using modern portfolio theory and the capital
asset pricing model and the second is to look
at the various risk factors which affect a busi-
ness.

1)p Capital Asset Pricing Model

We will not discuss in detail this theory of as-

set pricing as it requires you (the reader) to
have a working knowledge of first or second
year university level statistics and finance.
Since this is an introductory article, readers
who are interested to learn more about the
CAPM and Modern portfolio theory are encour-
aged to attend a course in finance or seek ad-
vice from a qualified advisor.
Basically, the CAPM makes some major as-
sumptions about investors and their prefe-
rences. In order to use the CAPM to find the
proper discount rate, one must know three
things: a stock's beta, the nominal risk free
rate, and the expected return on the market.
Stock's with betas greater than one are more
risky than the market and betas of less than
one are less risky. For example, a stock with a
beta of 1.5 is expected to gain 1.5% when the
market rises 1%.

Modern portfolio theory is also where the main

ideas about diversification come from. We will
look at this concept in more detail later. For
now, we can define a diversified portfolio as
containing securities which have little or no
correlation to other securities in a portfolio or
the market. These securities are then placed
in a portfolio in such a way as to minimize the
volatility of the portfolio.

You may be scratching your head by now but

this is essentially the basic concept of diversi-
fication and minimizing risk. There are a lot of
disadvantages and advantages to using the
CAPM and MPT. One assumption of the CAPM I
will mention is that there are two types of risk.
Market risk and firm specific risk. The CAPM
assumes that investors only get a premium re-
turn for taking on market risk because the firm
specific risk can be entirely eliminated through
diversification. Thus, beta only measures mar-
ket or nondiversifiable risk.

2)p Second Way to Measure Risk:

The second way to measure risk is to start by

taking a nominal risk free rate. How do you do
this? Well you take the yield that is currently
offered on US Government bonds that match
your investment horizon. For example, if you
plan to invest for 5 years, you should use the
yield on 5yr U.S. bonds. Now add to this the
premium for risk and voila-you have your re-
quired return or discount rate. You may be ask-
ing, what makes up the risk premium? Well,
remember from lesson there are five things: fi-
nancial, business, liquidity, foreign exchange,
and political risk.

a)p Financial Risk:

Financial risk involves a company's capital

structure. What is their debt/equity? What is
their current ratio? etc. We will look into how
to assess financial risk in greater detail later
in lessons on accounting and financial
statements analysis.

b)p Business Risk:

This involves the economics of the firm you are
looking at. Ask yourself, how will this company
look ten years from now? Do they have barriers
to entry? (ie patents, economies of scale etc.
more on this in the economics lessons).

c)p Liquidity Risk:

It has been shown through various studies that

firms which are private or thinly traded are
sold at a significant discount to their value
compared with similar firms with active mar-
kets. Firm's which can be easily bought or sold
with little transaction costs are called liquid or
marketable. The lack of liquidity can occur if
the stock you are researching is not widely fol-
lowed. It can also happen if you plan to liqui-
date a large block of stock. Your transaction
could bring down the price significantly.

d)p Foreign Exchange/Political Risk:

This involves firms which derive significant
portions of their sales oversees. For example,
many exporters to Asia have been affected by
weaker demand for their goods. Foreign Ex-
change/Political risk can also happen because
the company you are looking into is heavily re-
stricted by the government. Finally, different
countries have different accounting rules so
you should be aware of this when investing in
foreign stocks.

When investing in foreign stocks, you also run

the risk of the U.S. appreciating. To adjust for
this, you should restate your foreign returns to
U.S. returns.

Returns

We measure the financial impact of the busi-

ness results realised at level 4. The most popu-
lar way of expressing this impact is as a return
on investment (ROI).

ROI is calculated as follows:

% ROI = benefits x 100 costs

ROI relates to a specified period of time, typi-

cally a year or two years. First you measure all
of the costs associated with the particular
training programme over this period:

1.p analysis, design and development costs

2.p promotional costs
3.p admin costs
4.p tutor costs
5.p learner costs (time, expenses, lost
productivity)
6.p equipment and facilities costs
7.p evaluation costs
Then you measure the financial benefits ob-
tained over the same period:

1.p labour savings

2.p productivity increases
3.p cost savings

Then you can calculate the ROI.

Let's imagine you have been running an online

management training programme and want to
calculate the ROI over the first year. You
measure the costs as $100,000 and the bene-
fits as $130,000. Your ROI is 130,000 / 100,000
x 100, or 130%.
Q3. Explain Harry Markowitz Model and criti-
cally examine the assumptions and limitations.

Ans. A model for portfolio diversification based

on the mean and variance of expected return
and a key development in the theory of diversi-
fication and asset allocation. The model as-
sumes that expected returns on a security can
be defined by their mean and variance; when
two or more securities are combined in a port-
folio, the sum of the two returns depends on
the covariance or correlation between the se-
curities' returns. Given suitable combinations
of securities, Harry Markovitz demonstrated
that by combining securities into portfolios, in-
vestors could obtain either significantly higher
returns for the same risk or the same return
with significantly lower risk. His insights led to
the development of a theory of asset price
formation, the Capital Asset Pricing Model, al-
though the original Markowitz model made no
assumptions about equilibrium prices.
The Markowitz framework(Markowitz 1952) is
often generically known as the mean-variance
framework.

The assumptions of this model are:

1.p Investors base their decisions on ex-

pected risk and return, as measured by
the mean and variance of the returns on
various assets.
2.p All investors have the same time horizon.
In other words, they are concerned only
with the utility of their terminal wealth,
and not with the state of their portfolio
beforehand, and this terminal time is the
same for all investors.
3.p All investors are in agreement as to the
parameters neccesary, and their values,
in the investment decision making
process, namely, the means, variances
 and correlation of returns on various in-
vestments.
4.p Financial assets are arbitrarily fungible.
5.p All investors are risk averse.

Procedure for choosing the optional portfolio of

risky assets:

Markowits designed a mathematical formula

through the use of variables like return, stan-
dard deviation, coefficient of variation and cor-
relation to draw relationships between differ-
ent securities. He established relationships be-
tween two securities, three securities and ¶N·
number of securities. According to him, all se-
curities lying on the efficient frontier should be
preferred to the securities which are not domi-
nated by the efficient frontier.

Markowitz model is tedious and can be used

only through a computer.

Limitations of this model:

3p
p
1.p Assumes that deviations both above and
below the level of expected return are
equally undesirable
p
p
2.p Assumes that the only investment ob-
jectives are the acquisition of return
and the avoidance of risk.
²Type of returns (dividends vs. capital
gains) are important
²Timing of realization of income is important

3.3Assumes that historical returns will be re-

peated in the futurep
²The decision is how long a time period to in-
clude in the data set is an important one.

p
p