FIN 548

CHAPTER 1
Introduction to Investment

Overview

Introduction

Financial Market

Definition

Money market

Types of Asset

Capital Market

Market Participants

Investment
Process

Five (5)/Seven (7)

basic steps

INTRODUCTION
Definition
commitment of current resources with the expectation
of receiving a larger amount of resources in the future.
the sacrifice of current money with the hope of
receiving a larger amount in the future. Investment
involves both the elements of risk and time, where the
investor forgoes consumption now for a much larger
consumption later.
However, the later consumption is not guaranteed, it
may or may not be larger in the future. Thus, there is
an element of risk involved in investment: some
instruments may have larger risk than others.

Types Of Investors
Investors can be classified as either :
Individual investors
The individuals that manage their personal
funds in order to achieve their financial goals.
Institutional Investors
Investment professionals who are paid to
manage other peoples money. These
professionals
trade
large
volumes
of
securities for individuals, businesses and
government. Institutional investors includes
financial institutions ( banks, life insurance
companies, mutual funds and pension funds)

PROVIDER
OF FUNDS

MARKET
PARTICIPANT
FINANCIAL
INTERMEDIARIES

USER OF
FUNDS

1. Providers of fund
They are usually the households who, in
general, earn more than they can
consume. They are net savers and will
purchase securities issued by firms (which
needed funds).
These are the investors and can be further
classified as either retail or institutional.
Retail investors are individuals
Institutional investors are provident,
pension funds, investment companies,
insurance companies and banks.

2. Users of fund
2. Usually business firms and the government.
.Eg: government (major user of funds) compared
to the private sector which comprises of
corporations.
.However, since 1993 private sector took over as
the major user after the privatisation and
corporatisation plans
.The government can either act as a lender or a
borrower depending on its fiscal policy.
.Lender - when its budget surplus, total revenues
> total expenditures.
.Borrowers when total revenues < total
expenditures.

3. Financial intermediaries
Who are financial intermediaries?
i. Institutions that bring lenders and borrowers
together. Savers with excess funds will deposit
funds with financial intermediaries then lend the
deficit units.
. Eg: commercial banks, insurance companies, and
investment companies.
. Financial intermediaries can be regarded both as
a provider and as a user of funds.
ii. Institutions who provide investment banking
(eg:investment bank).
. Frequently, companies may need to obtain large
amounts of funds direct from the public. This
involve issues of securities, either in the form of
debt or equity.

 The banker is directly involved in floating

new securities to the public besides
providing
advice
and
underwriting
services.
When a banker underwrites an issue , it
means that any shares not bought by
investors will be bought by the banker.
The underwritings function:
To ensures that the corporation receives the
total amount of funds it wants to raise.

Overview of
Financial market
Functions of
Financial market
Transfer
financial resources
Information
Dissemination
Price
Setting Mechanism

Offer Liquidity

Types of
Financial Market

Money market

Capital market

Primary Market

Secondary market

Overview of Financial Market

Introduction
Financial market refers to the means by
which financial resources are transferred
from fund surplus units to fund deficit units.
It enables fund deficit units (eg: government
and business entities) to raise funds for
investment purpose and facilitate growth.
the financial market is also used for buying
and selling of securities from one investor to
another.

Functions of the financial

market
1. Transfer
financial
resources
through time
. An investor with surplus funds may buy
securities for the time being and
liquidate them later when they need
money.
. Thus, consumption of the surplus fund
can be delayed by buying instruments
in the financial markets.

2.Information Dissemination

information on instruments traded in

the market available to all buyers and
sellers.

In trading of financial assets, buyers

and sellers carry out transaction
through the information provided by
the financial market without meeting
at a physical location

Functions Of The Financial

Market
3. Price Setting Mechanism
The financial market receive buys and
sells orders which reflect the amount of
supply and demand for securities.
By matching orders, the market is able to
determine the price at which individual
securities should sell for.

4. Offers liquidity
it easy to buy and sell securities. Liquidity
refers to how easy it is to buy or sell any
securities without causing a great
reduction in prices.
Liquidity of markets can be measured by
looking at the depth, breadth and
resiliency of transactions.

Types of financial market

1. Money market
It provides trading facilities for
individuals and institutions with
temporary
surpluses
and
or
shortages.
It deals with marketable securities
or money market instruments that
matures within 1 year or less. These
types of securities have low default
risks, short maturities, high liquidity
and high marketability.

2. Capital market
It deals with transactions of longterm securities.
The
main
types
of
financial
instruments
traded
are
bonds,
common stocks, preferred stocks
convertibles issues.
Why capital market exist? It is an
important channel for businesses to
raised needed capital to finance the
business growth and expansions to
achieve its goals.

Capital Market can be divided

by:
i. Primary Market

Whenever firms need to raise funds, they will

issue common shares, bonds and other
securities to the investing public.
Funds from investors will flow to the company
concerned, which, will then be able to invest
the money for its investment purpose.
The firm which sells new securities is known
as the issuer while the NEWLY ISSUED
SECURITIES are the primary issue.
In the primary market, both seasoned and
unseasoned issues are sold

ii. Secondary Market

Deals with securities previously
issued.
involves the buying and selling of
shares and bonds from one investor
to another. The proceeds of selling
securities go to the seller, i.e. the
current owner.
The original issuer of the securities
does not get the proceeds.
It provides the means of liquidity to
investors to acquire and dispose

TYPESOF
OFASSETS
ASSETS
TYPES

FINANCIAL
FINANCIALASSET
ASSET

EQUITY
EQUITY

REAL
REALASSET
ASSET

REAL
REALESTATE
ESTATE

FIXED
FIXEDINCOME
INCOME
SECURITIES
SECURITIES

REAL
REALPROPERTY
PROPERTY

DERIVATIVES
DERIVATIVES

TANGIBLE
TANGIBLEPERSONAL
PERSONAL
PROPERTY
PROPERTY

Types of Assets
1. Financial assets - refer to claims on real assets or
on the income they generate. Eg: stocks and bonds.

For investment purpose, an investor can use his

funds either to buy real assets or financial assets.

If buy common stocks, it means that they have

financial assets on hand.

The company which receive his fund can then

use it to buy real assets such as machines and
equipment, and use them to generate profits.

Thus, return to investors from the income

produced by real assets - financed by funds
obtained from selling financial assets.

2.
.

Real assets
Real assets are those which contribute
directly to the productive capacity of an
economy.
. Assets which are used to produce goods and
services of a nation are considered as real
assets.
. Can either be tangible or intangible.

tangible assets are land, buildings and

machines

intangible asset is knowledge. Notice that

these are all used directly to produce
goods and services.

Types of Financial Assets

There are (3) three broad classes of financial
assets:
1. Equity - An equity or a common stock is
considered as ownership share in a company.
The holder of common stock:
is part-owner and is entitled to receive
dividends the company may declare.
Is the last to claim on the company's
assets in case of liquidation.
The performance of equity security
depends on the success of the firm and
the income generated by its real assets.
Consider - quite risky investment.

2. Fixed income security - promises a certain

amount of return on a regular basis.
This return can either be a constant amount
or it can vary depending on the terms
agreed upon.
Has a fixed maturity date when the
principal amount will be paid by the issuer
(i.e. the company).
3. Derivative security - is an asset where its
value is determined by, or derived from, the
value of another investment. Examples
(options, futures, swaps and forwards). A
derivative security is used to transfer risk to

Short Term Instruments

Or called Money Market Instruments
maturity usually of I year or less.
Example:- deposit accounts, treasury bills,
certificate of deposits, commercial papers,
bankers acceptance, money market, mutual
funds.
carry little risk
provide liquidity (can be converted into
cash quickly and with little or no loss)
Popular among conservative investors wishes to earn returns on temporarily on
idle funds

Long Term Instruments

Also called as Capital Market Instruments
These are long term instruments with longer
maturities or no maturities at all
a) Common Stock - most popular equity investment
that represent ownership in the company.
Returns comes from either of the 2 sources:
i) Dividends periodic payment made by firm to
the shareholders from its current and past
earnings.
ii) Capital gain result of selling the stock at a price
above that of originally purchase price ( P 1 P0)
riskier than fixed-income securities.

b) Fixed Income Securities

Bonds Debt instruments requiring the issuer to

repay to the lender/investor the amount borrowed
plus interest over a specified period of time.

Investors may be able to buy and sell bond prior

to maturity.
c) Preferred Stock is a Hybrid securities because it
has the features of common stock and bond.

like a stock it represents an ownership interest in

a corporation.

It has a stated dividend rate. Payment of dividend

is give preference over common stock dividends.

Claims on income and assets is prior to common

stockholders
(in case of companys liquidation)

d) Convertible Securities

special type of fixed-income obligations (convertible

bond and convertible preferred stock) which
permitting the investor to convert it into a specified
number of shares of common stock.

Benefits - in term of interest (bond), priceappreciation and dividend (preferred stock).

e) Mutual Funds and Unit Trust Funds

Unit Trust Funds collective form of investment

whereby the financial resources of individuals and
corporate investors are POOLED for the purpose of
making large scale investments in a selected
portfolio of securities.

Mutual funds - A company that raises money from

sale of its shares and invest in and professionally
manages a diversified portfolio of securities.

e.g. Money market mutual funds are mutual funds

that invest solely in short-term investment vehicles.

f) Derivative Securities
Derivative securities are neither debt nor
equity. The value of derivative securities
depends on (is derived from) the value of an
underlying security such as common stock
They posses high level of risk, because of
the returns are uncertain due to unstable
market value. These instruments have high
levels of expected return.
There are two (2) types of derivatives:
i) Options Options provide the investor
with an opportunity to sell or buy another
security or asset at a specific price over a
given period of time. Three types of options
Puts, Calls and Warrants.

ii) Futures Futures are legally binding

obligations that the sellers of such
contracts will make delivery and the buyer
of the contracts will take delivery of
specified commodity or financial instrument
at some specific date in the future at a
price agreed upon at the time the contract
is sold.
E.g. commodities Gold futures, crude
palm oil futures, USD CPO Crude Palm Oil
Kernel.
Financial Futures 3 month KLIBOR
futures, 3 year MGS, 5 Year MGS, FBM
KLCI Futures.
high level of expected return
high level of risk
unstable market value

Types of Real Assets

generally less liquid than financial assets, because
they are heterogeneous, often adopted for specific
use. They are in the form of:
a) Real Estate
i) Real Property e.g. land, building-permanently
affixed to the land.
Advantages:
may offer an opportunity on an inflation hedge
offer as a good collateral
personal satisfaction.
Disadvantages:
absence of liquid and efficient market.
a lot of paperwork, middleman, commission
returns on real assets are frequently more
difficult to measure accurately owing to the
absence of broad, ready and active markets.

ii) Tangible personal property or personal chattel e.g. gold, precious metal, artwork, antiques,
collectables coins, stamps.
Advantages:
purchase in an anticipation of price increase
during possession may also provide investor
with psychological aesthetic enjoyment
provide psychic pleasure to the owner
Disadvantages:
difficult in valuing need expertise to determine
quality
high transaction costs
require secured storage
high initial capital
low liquidity

Types of Investment
Direct

Indirect

Foreign

investor buys
stock/bond/real
estate to earn
income/ preserve
value

an investment
make in portfolio
or group of
securities/properti
es.
e.g: purchase a
share of mutual
fund -diversified
portfolio of
securities issued
by various firms.

when a company/
individual from
one nation invests
in asset of a
company based in
another nation.
As increased
globalization in
business has
occurred, it's
become very
common for big
companies to
branch out and
invest money in
companies
located in other
countries.

Refer text book Gitman pg 12

seven(7) steps

The investment process involves five

(5) basic steps:
i. setting investment objectives
ii. establishing investment policy
iii. selecting a portfolio strategy
iv. selecting the assets
v. measuring and evaluating
performances.

Five (5) Basic Steps in Investment

process
June 2013 ( 1c)

setting
investment
objectives

establishing
investment
policy

selecting
the assets

measuring
and
evaluating
performanc
es

Not: Refer text book Gitman pg 12 seven(7) steps

selecting a
portfolio
strategy

i) Setting investment
objectives
What is the investors goals of investment?
eg type of return, investment horizon and the
amount of risk
Risk tolerance safety of principal, stable
income (low risk)
interested in high return and can undertake
(high risks)
Objectives
must
be
reasonable
and
attainable. Some objectives are impossible,
for example, wanting high return and safety
of principle.

ii) Establishing Investment

Policy
Is a written document which the asset
allocation decision and the constraints of
the investor
Asset allocation decision refers to
determine the proportion of funds to be
invested in stocks, bonds and real assets.
Some investors face constraints that will
affect their asset allocation decision.
For example, life insurance companies
can only invest about 10% of their
portfolio in the stock market.

iii) Selecting a Portfolio

strategy
This strategy can either be active or
passive.
An active strategy - the investor actively
manages the investments by changing the
proportions of assets in the portfolio.
Investor is always searching for new
information in an attempt to identify
undervalued securities (current market
price <expected price or intrinsic value)

Contd
Too active strategy not good, may
diminish the amount of returns after
considering transaction costs.
A passive strategy - investors invest in a
well-diversified portfolio without trying to
find mispriced securities.
Some investors believe this is a better
strategy as time is not wasted in trying to
"beat the market" and transaction costs
will be minimised.

iv) Selecting Assets

selecting securities within each asset
class for the investor's portfolio after
done several security analysis.
Most common is fundamental analysis
which requires analysis of the economy,
industry and company's financial position.
Security valuation follows with the
intention
of
identifying
mispriced
securities that will provide investors with
a higher level of return.

v) Monitoring and Evaluating

Performance
The return on the portfolio is measured
and compared against a benchmark.
This benchmark can be the return on any
broad-based index like the FTSE Bursa
Malaysia KLCI, Industrial Index and
sectorial indices