ch 1 investmnt

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What is a security?

Security is an investment instrument, other than an insurance policy or

fixed annuity, issued by a corporation, government, or other

organization which offersevidence ofdebt or equity.

A security is a fungible, negotiable instrument representing financial

value. Securities are broadly categorized into debt securities (such as

banknotes, bonds and debentures) and equity securities, e.g., common

stocks; and derivative contracts, such as forwards, futures, options and

swaps. The company or other entity issuing the security is called the

issuer.

What is Investment?

Investment means sacrificing some money value in the present with the

expectation of making gains in the future. The two important features of

an investment are current sacrifice and future benefit.

When we postpone consumption, sacrifice takes place in the present and

is certain whereas the benefits occur in future and are certain.

Therefore, risk and expected return from the investments are the two

key determinants of investment process.

Forms of investment:1) R buys 200 shares of X ltd @ Rs.150 per share

2) K buys a piece of land with the aiming of selling it in future.

3) T buys a plant for 20 lacs for its factory.

4) S buys ticket of Play wind with the aim of winning it.

5) L deposits 10000 in post office time deposit a/c.

An act of investment has the following dimensions-

Element of sacrifice

Element of futurity

Risk

Expectation of gain

1) Element of sacrifice: as soon as commitment of some money value

is made either in buying shares, land, plant etc, it entails an

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element of sacrifice current consumption of money value. By

investing the money in present, utility of money is being postpone,

which otherwise have been derived through current consumption.

This sacrifice is one of the basis of expectations in investment.

2) Element of Futurity: Every investment is made with the aim of

holding it for a certain time period. Few investors hold it for a few

days, whereas others hold it for a certain months or years. The

holding period is generally classified into three types- short term,

medium term and long term. Expected returns are always higher

for a long duration investment as compared to short duration

ones. This can be attributed to the uncertainty of future.

3) Risk: since every investment activity has an element of futurity

and the future is always uncertain, it induces the risk factor. Riskmeans the chances of having adverse or low returns in contrast to

the expected high returns by the investor.

Some risks arise due to system wide factors, which cannot be

avoided, whereas others arise due to specific performance of the

investment avenue that can be minimized through diversification.

4) Expectations of gains: The element of sacrifice of current utility of

money value, futurity and the risk of monetary loss put together

makes the basis for expecting gains from the invested money. Thegains expected by the investors are nothing but the compensation

for:

a) waiting

b) loss in purchasing power

c) risk premium

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Investment Process:

The investment process comprises of 5 steps which are as under-

1) Determining investment objectives and policy: the investor

should evolve a policy considering the amount of wealth at his

disposal. The investors objectives should be defined in terms of risk

and return.

At this point it is important to determine the category of financial

assets that an investor is interested in. This in turn would depend

upon the objectives, amount of wealth and the tax structure of the

investor.

2) Security analysis: this step would include examining the riskreturn characteristics of individual securities. The aim is to ascertain

the worth of a security before acquiring it for portfolio. This depends

upon the extent to which a security is MISPRICED.

There are two approaches to identify the mispriced status of a

security-

i) Technical Analysis: in this the past movements of price of

a security are studied, to determine the trends and

patterns that repeat themselves. Then recent trends are

studied to identify emerging trends. Then the two areintegrated to predict if a given trend will repeat in

future. The current market price is compared with the

predicted price to calculate the level of mispricing.

ii) Fundamental analysis: in it the intrinsic value of a

security is determined and it is compared with the

current market price. The intrinsic value is the present

value of all future cash flows expected during and at the

end of the holding period. This entails first forecasting

the cash flows, for which a forecast of earnings of thecompany and its payout ratios is required. Forecast of

the price of the security at the end of the holding period

is also needed. These are then discounted at an

appropriate rate which corresponds with the investors

required ROR. The intrinsic value is compared with the

current market price. If the current price is more then

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the intrinsic value, the shares are overvalued and vice

versa. It is noted that cases of mispricing are eventually

corrected by the market, which implies that the prices of

undervalued shares will increase and those of overvalued

shares will decline.

3) Portfolio Construction: this includes the specific securities in

which to invest and the proportion of wealth to be invested in each.

The issue of selectivity will have to be based upon micro level

forecast of expected cash flows from the shares and debentures ofdifferent companies. Timing of investment will have to be

determined by observing forecasted price movement of shares

relative to debentures at macro level. Efforts will be made to

minimize risk for a given expected level of average returns. This

would happen when the returns of shares and debentures that

comprise a portfolio are not positively co related. The resultant

portfolio will be a DIVERSIFIED PORTFOLIO.

4)Portfolio Revision: securities once included in the portfolio arenever attractive for ever. New securities with different risk return

considerations emerge. Therefore it becomes necessary to review the

portfolio. Unattractive securities should be liquidated and funds so

acquired should be invested in new securities. While doing so

transaction cost incurred in buying and selling activities should be

considered.

5) Portfolio performance evaluation: portfolio should be examined

constantly for average return and risk.

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Investment vs Speculation vs Gambling:

Pure Investment: financial investments are exchange of

financial claims i.e. buying of shares, debentures, investingmoney in post office or banks etc. While investing the money,

an investor has certain objectives in mind, which forms the

basis of his investment decisions. Generally, pure investment

is-

Carefully thought of

Well planned

Based on the study of fundamental factors about

investment avenues Meant for a reasonable time horizon

Expected returns commensurate with risk assumed

Low risk

Something in which investors do not tend to borrow

money for investment

Investments are made with a future end date in mind. A

financial asset purchased with a very short holding period inmind probably in not an investment- it is a gamble or

speculation.

Speculation: It starts where investment ends. It is an act of

investing money on the basis of market wide information

about the investment avenue. Such information may include

trends of share prices or traded volume of shares. While

speculating, the investor tends to take more risk ascompared to pure investment activity and accordingly, the

returns expected are also comparatively higher. It is-

for a relatively short duration

based on market related information

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an act in which the investor has an attitude to assume

risk rather than to avoid it

the tendency of a speculator to sometimes borrow

money for investment, with the expectation of gaining

more than the cost of borrowing

a positive attitude towards losses, in case of adverse

happenings

ready to book losses

The way brokers/ investors Speculate: speculation on the

stock market can be done by adopting any of the

following mechanism- Jobbing: it is an activity in which a broker tries to

square up his position by the end of the settlement

or the same trading day. The main purpose of

jobbing is to gain profit from the price difference

between the bid and ask price, as specified by the

jobber. A broker who regularly does the jobbing is

identified as the jobber- he always gives two way

quotations for scrip. Lower quotation is the bid rateand higher quotation is the ask rate. A jobber is

ready to buy or sell any quantity at the bid and ask

price quoted by him. The aim of a jobber is to

derive benefits from the spread of bid and ask

price. Usually, jobber specializes in one or two

scrips.

Speculation using Jobbing: At 10.10 am A purchases 500 shares of wipro @

Rs.230 and he expects the price to rise within the

same day and plans to sell it by the end of the same

trading session.

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During the day, he hears from his broker that

shares of TISCO will decline from the level of

Rs.190 and he sells 200 shares of TISCO @ Rs.190

with the hope of buying it back by the end of the

days trading.

At 12.10 pm, price of Wipro increases to Rs.246 and

he sells 500 shares and books the profit.

At 3.20 pm price of TISCO has become Rs.200 in

contrast to his expectations and he covers (buys)

200 shares of TISCO at Rs.200 and books a loss.

Badla/ carry forward: when one buys or sellssecurities, the transaction is to be settled i.e. the buyers

need to pay for it and the seller needs to deliver the

securities sold as per the settlement program of the

exchange. When a buyer does not have money to pay

for the transaction and is hopeful about the future

scenario and hence is not willing to square up his

position, then the next alternate is badla (to forward

the transaction for the next settlement). Badla is thepostponement of the settlement of a transaction from

one settlement to another. Similarly, when a seller is

not willing to settle a transaction, he can carry

forward his sales position to the next settlement. Badla

of a transaction can be done in every settlement for a

maximum of 90 days. As soon as badla is done, the

following charges are paid by the client-

Badla charges Badla margin

A badla transaction has the following features-

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Badla charges: it is charge t be paid by the client who

carries forward his transaction. This is like interest

compensation for the delayed period and is to be paid

over and above the price of the transaction. This can be of

two types: (a) contango and (b) backwardation charges.When a purchaser pays badla charges for carrying

forward his purchase, it is called contango/sidha badla.

On the contrary, when a seller pays badla charges for

carrying forward his sales transaction, it is called

backwardation/undha badla.

Badla margin: it is to be deposited by the party doing

badla. This margin money is either refunded or adjustedwhen transaction is either squared up or settled. Under

the traditional system of badla, there was a fixed

percentage of margin, but under the new system it is

calculated on a progressive basis- margin percentage

increases for a transaction, which is in carry forward for

a longer duration.

Eligible scrips: this facility is available for scrips in Acategory, which are called specified shares. Shares are

categorized in A category on the basis of certain factors

like profitability, traded volume, frequency of trades,

number of trades etc.

Badla Financer: When an original party does not agree to

carry forward, it is the badla financer who bails out the

party willing to enter into badla. A badla financer is a

broker, who specializes in providing scrips for the carryforward of the sales transaction and money to carry

forward the purchase transaction. These are provided by

the financer with the understanding that these will be

returned to him at the end of the settlement. He asks

badla charges for it.

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Regulated by the stock exchange: all badla transactions

are regulated by the stock exchange. The exchange

specifies eligible scrips, margin and other related aspects.

A tool to speculate: It is a tool to speculate because it

provides ways in which an investor can avail the

opportunity to gain form price fluctuations. He can keep

his position open till it becomes favorable for him. With

the help of Badla transactions artificial demand and

supply is created for the scrips. For entering into a badla

transaction, a speculator only pays margin and hence he

can enter into transactions of higher value by paying onlymargin. This leads to the creation of artificial demand

and supply, depending upon the type of Badla.

A tool to hedge the risk: Hedging means

counterbalancing or minimizing risk. With the help of

Badla, losses arising due to adverse price movement can

be set off.

Gambling: It is like betting for an uncertain outcome. In it, the

investor is always ready to take high degree of risk. Gambler

expects higher gains in a very short time horizon due to high

level of risk assumed. Gambling is entirely based upon rumors,

hunches and tips.

Therefore, it can be said that every speculation is an

investment but every investment is not speculation. Speculation

starts where investment ends and gambling starts wherespeculation ends.

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Difference Between Investment and Speculation:

Basis Investor Speculator

PlanningHorizon

An investor has along time horizon.His holding periodis usually at least ayear.

A speculator has ashort planninghorizon. His holdingperiod may be a fewdays or months.

Risk

Investors do notlike to assumemore risk.

Speculators areready to assumehigher risk.

ReturnExpected

Investors seekmoderate rate ofreturn which iscommensurate withthe limited riskassumed by him.

Speculators assumehigher rate ofreturns as theyassume more risk.

Basis fordecisions

Investor attacheshigher significanceto fundamentalfactors

Speculator relies ontechnical charts andmarket psychology

Leverage

Uses his own fundsand avoids andborrowed funds

Normally restores toborrowings

Investment Objectives:

Safety: This means protection against losses. Investor

would always ensure full safety of his investment. This

can be done by investing in an avenue where risk- default

risk, market risk, interest rate risk, inflation risk,

political risk etc. is minimum and return is maximum.

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Arbitrage: it means buying in a market where prices are

low and selling in the market where prices are high.

Investors also at times invest to take advantage of

differences in same share prices across different stock

exchanges.

Investment Attributes:

For evaluation of investment avenues, the following

attributes are relevant:

1) Returns

2) Capital Appreciation Conservative

Aggressive Growth

Speculation

Form of return

Periodic cash receipts

Capital Gain

Safety and security of funds

Risk

Liquidity

Tax Consideration

Conceal ability

Adequate Liquidity and Collateral Value

Stability of Income

Types of Investors:

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Contrarians- They buy when rest of the world sells.

Trend Followers- They are conservative and tend to invest in

products such as bank deposits.

Hedgers and Holders- They are small investors who want high

return and low risk.

Measured Investor- They start investing early, enjoys investing

and is happy with his current financial situation. He regularly

rebalances portfolio and avoids concentration in a single

investment.

Reluctant Investor- They do not enjoy investing and spends a little

investment on investments. They are assured of a comfortable

retirement. They do not invest regularly and neither rebalances

their portfolio.

Competitive Investor- They invest regularly and remain

optimistic about the future.

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ch 1 investmnt

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