Investment and Portfolio management

Investment & Portfolio Management
Active and Passive Portfolio Management
First Edition 2013
Professional “Asset Management” of various “securities” in order to meet
specified investment goals (possible returns) for the benefit of the investors
through act or practice of making Active and/or Passive investment
decisions.
This publication is recommended for;
• Masters introduction to Investment & Portfolio Management
• Undergraduate Investment Theories & exam papers
• Business model for Professional Assets Management
Official Contact:
P. O. Box 7308-40100, Mega City-Kisumu
Cell: +254 722 976 633 ; 716 455 743
Email: williamkasati@gmail.com
williamkasati@yahoo.com
2013
Author: S O William
Jaramogi Oginga Odinga University of Science & Technology
School of Business & Economics

………………..Investment & Portfolio Management………………..
For Quick Correspondence: Sati Oloo William: Digital Academic Library: Cell +254-722-976-633: williamkasati@gmail.com Page - 2 -
TABLE OF CONTENTS PAGES
CHAPTER ONE
Nature and Scope of “Investment” & “Portfolio” Management…………….…………...…...-5-
Application, Product & Project portfolio management…………………………………….….-8-
Investment Theories……………………………………………….…………………………-9-
Bernstein's Psychology of Successful Investing……………………………….……………..-10-
Castle-in-the-Air Theory…………………………………………………………...………….-11-
Diversification……………………………………………………………...………………….-11-
Efficient Market Theory……………………………………………………………………….-12-
Firm Foundation Theory………………………………………………...……………………-12-
Characteristics of Securities………………………………...…..…………………………-13-
Security Markets………………………………………………………………………………-13-
Characteristics of Financial Market Microstructure…………………………….…………..-14-
Quote-driven systems…………………………………………………...……………………..-14-
Order-driven systems…………………………………………………...……………………..-14-
Brokered systems……………………………..………………………...……………………..-15-
Hybrid systems……………………………………………………..…...……………………..-15-
Market Efficiency……………………………………….………………….…………………-17-
Risk and Return…………………….……………………………..…...……………………..-18-
Debt Security……………………………………………………….……….…………………-21-
Equity and Asset-Backed Securities…….…………………………………………………-23-
Security Market…………………………………………………..…………………………-25-
Indexes……………………………………………………….……..…….…………………-30-
Market Regulation……………………………………...……….……….…………………-31-
CHAPTER TWO
Analysis and Valuation of Investments……………………………………….………………-33-
Financial Analysis………………………………………...……….……….…………………-33-
Sources of Financial Information………………….…….……….……….…………………-33-
Analysis of Financial Statements……………………..……………...…….…………………-35-
Credit Risk………………………………………….…….…….……..…….…………………-37-
Interest Rate Risk………………………………..……………..……..…….…………………-38-
Bond Selection……………………………………...………….……..…….…………………-40-

CHAPTER THREE
Stocks and Markets…………………………………………....……..…….…………………-43-
Types of Stock for markets…………………………………….……..…….…………………-44-
Common Stock: Analysis and Strategy…………………………..…..…….…………………-50-
Buy-and-Hold Strategy……………………..………………….……..…….…………………-50-
Index Funds………..………………………………………….……..…….…………………-51-
Growth of Earnings………………………………………………….…….…………………-55-
Nonsystematic Risk…………………………………………....……..…….……….…………-62-
Assessing Risk…………..………………………..………………..……….…………………-67-
Purchasing power……………………………………..…….……..……….…………………-75-
Industry Analysis………………………………………..……….…………………-80-
Management Risk Factor………………….…………….….……..……….…………………-82-
Arbitrage Pricing Theory or APT……………………..…………..……….…………………-85-
CHAPTER FOUR
Investment Options (Call and Put)……………………………………………………………-90-
Warrants………………………………….…………...…….……..……….…………………-92-
Secondary Market…………………………………….…….……..……….…………………-94-
Types of Warrants…………………...………………..…….……..……….…………………-97-
Convertibles………………………………………………….……..……….…………………-99-
Technical and Fundamental Analysis………………..……….....……….…………………-110-
CHAPTER FIVE
Emerging issues in Investment Securities…………………………...……...………………-119-
Future Contracts………………………………..………………..……….…………………-118-
Investments in Real Assets……………………………...….….....……….…………………-120-
Capital Market Theory…………………………………………...……….…………………-122-
Capital Asset Pricing Model (CAPM)………………….………...……….…………………-123-
International Diversification……………………...……….……..……….…………………-125-
Investment Performance Evaluation…………………………….……….…………………-126-
Using Research……………………...…………………….……..……….…………………-140-
The Concept of Present Value………………………………………………………………-142-
Revision kit and Suggested Answers……………………………………..…………………-147-
References……………………………………..…………...……..……….…………………-163-

PREFACE
Aims of the book;
This publication is designed to provide a sound understanding of Investment and Portfolio
Management and is particularly relevant for;
a) Students pursuing higher level courses and undergraduates pursuing Business Studies, Finance
Institutes & Markets, Management, and any course including Investment & Portfolio
Management.
b) Students preparing themselves for professional and Academics examination.
c) Managers of Stock Securities, Investment schemes, commerce and local authorities who wish to
obtain knowledge of Investment and Portfolio Management to aid them in their investment plans.
Teaching Methodology;
This book is interactively tailored on teacher-student relationship with practical approach to
emerging issues on Investment schemes alongside their Portfolio Management and needs in the
current market. The publication has been written in standardized format with review questions,
suggested answers and summaries.
Book Objectives
The approach taken in this 1st
edition is to teach the key aspects of Investment and Portfolio
Management through realistic and relevant examples from business arenas and various
organizations. The course will also utilize the application of practical‘s needed for the
implementation of Investment and Portfolio Management. Class facilitations with lectures on
assigned topics and group discussions are essential for any academic success. The book
emphasizes on understanding the concepts in each topic. Techniques are commonly misused
because the concepts are not sufficiently understood.

Chapter One
NATURE AND SCOPE OF “INVESTMENT” & “PORTFOLIO” MANAGEMENT
Investment management is the professional “Asset Management” of various “securities” in order
to meet specified investment goals for the benefit of the investors. e.g. (real estate for assets; and
shares, & bonds for securities) Investors may be institutions (insurance companies, pension funds,
corporations, charities, educational establishments etc.) or private investors (both directly via
investment contracts and more commonly via “collective investment schemes” e.g. Mutual funds
or exchange-traded-funds.
The provision of investment management services includes elements of financial statement
analysis, asset selection, stock selection, plan implementation and ongoing monitoring of
investments. Coming under the remit of financial services. Many of the world's largest companies
are at least in part investment managers and employ millions of staff.
Portfolio management is the act or practice of making investment decisions in order to make the
largest possible returns. Portfolio management takes two basic forms: Active and Passive.
Active Portfolio Management involves using technical, fundamental, or some other analysis to
make trades on a fairly regular basis. For example, one may sell stock ‘A’ in order to buy stock B.
Then, a few days or weeks later, one may sell stock B to buy bond C.
Passive Portfolio Management, on the other hand, involves buying an index, an exchange-traded-
fund, or some other investment vehicle with securities the investor doesn’t directly choose. For
example, one may buy an exchange-traded fund that holds all the stocks on the S&P 500.
Manager
The person(s) responsible for the overall strategy and the specific buying and selling decisions for
a mutual fund (called a fund manager) or other financial institution (called a money manager).

Asset
Any item of economic value owned by an individual or corporation, especially that which could
be converted to cash. Examples are cash, securities, accounts receivable, inventory, office
equipment, real estate, a car, and other property. On a balance sheet, assets are equal to the sum of
liabilities, common stock, preferred stock, and retained earnings. From an accounting perspective,
assets are divided into the following categories: current assets (cash and other liquid items), long-
term assets (real estate, plant, equipment), prepaid and deferred assets (expenditures for future
costs such as insurance, rent, interest), and intangible assets (trademarks, patents, copyrights,
goodwill).
Mutual fund
An open-ended fund operated by an investment company which raises money from shareholders
and invests in a group of assets, in accordance with a stated set of objectives. Mutual funds raise
money by selling shares of the fund to the public, much like any other type of company can sell
stock in itself to the public. Mutual funds then takes the money they receive from the sale of their
shares (along with any money made from previous investment) and use it to purchase various
investment vehicles, such as stocks, bonds and money market instruments. In return for the money
they give to the fund when purchasing shares, shareholders receive an equity position in the fund
and, in effect, in each of its underlying securities. For most mutual funds, shareholders are free to
sell their shares at any time, although the price of a share in a mutual fund will fluctuate daily,
depending upon the performance of the securities held by the fund. Benefits of mutual funds
include diversification and professional money management. Mutual funds offer choice, liquidity,
and convenience, but charge fees as often require a minimum investment. A closed-end fund is
often incorrectly referred to as a mutual fund, but is actually an investment trust.
There are many types of mutual funds, including aggressive growth fund, asset allocation fund,
balance fund, blend fund, bond fund, capital appreciation fund, clone fund, closed fund, crossover

fund, equity fund, fund of funds, global fund, growth fund, growth and income fund, hedge fund,
income fund, index fund, international fund, money market fund, municipal bond fund, prime rate
fund, regional fund, sector fund, specialty fund, stock fund, and tax-free bond fund.
Monitoring
The systematic process of observing, tracking, and recording activities or data for the purpose of
measuring program or project implementation, and its progress towards achieving objectives.
Information gathered through monitoring is used to analyze, evaluate all of the components of a
project or a department in order to measure its effectiveness and adjust inputs where necessary.
A good way to begin understanding what portfolio management is (and is not) may be to define
the term portfolio. In a business context, we can look to the mutual fund industry to explain the
term's origins. Morgan Stanley's Dictionary of Financial Terms offers the following explanation:
If you own more than one security, you have an investment portfolio. You build the portfolio by
buying additional stocks, bonds, mutual funds, or other investments. Your goal is to increase the
portfolio's value by selecting investments that you believe will go up in price.
According to modern portfolio theory, you can reduce your investment risk by creating a
diversified portfolio that includes enough different types, or classes, of securities so that at least
some of them may produce strong returns in any economic climate.
Note that this explanation contains a number of important ideas:
• A portfolio contains many investment vehicles.
• Owning a portfolio involves making choices that is, deciding what additional stocks, bonds, or
other financial instruments to buy; when to buy; what and when to sell; and so forth. Making such
decisions is a form of management.
• The management of a portfolio is goal-driven. For an investment portfolio, the specific goal is to
increase the value.
• Managing a portfolio involves inherent risks.

Over time, other industry sectors have adapted and applied these ideas to other types of
"investments," including the following:
Application portfolio management. This refers to the practice of managing an entire group or
major subset of software applications within a portfolio. Organizations regard these applications
as investments because they require development (or acquisition) costs and incur continuing
maintenance costs. Also, organizations must constantly make financial decisions about new and
existing software applications, including whether to invest in modifying them, whether to buy
additional applications, and when to "sell" -- that is, retire -- an obsolete software application.
Product portfolio management. Businesses group major products that they develop and sell into
(logical) portfolios, organized by major line-of-business or business segment. Such portfolios
require ongoing management decisions about what new products to develop (to diversify
investments and investment risk) and what existing products to transform or retire (i.e., spin off or
divest).
Project or initiative portfolio management. An initiative, in the simplest sense, is a body of
work with:
• A specific (and limited) collection of needed results or work products.
• A group of people who are responsible for executing the initiative and use resources, such as
funding.
• A defined beginning and end.
Managers can group a number of initiatives into a portfolio that supports a business segment,
product, or product line. These efforts are goal-driven; that is, they support major goals and/or
components of the enterprise's business strategy.
Managers must continually choose among competing initiatives (i.e., manage the organization's
investments), selecting those that best support and enable diverse business goals (i.e., they
diversify investment risk). They must also manage their investments by providing continuing

oversight and decision-making about which initiatives to undertake, which to continue, and which
to reject or discontinue.
INVESTMENT THEORIES
Once the American humorist Will Rogers (1879 - 1935) had remarked "I'm more concerned about
the return of my money than with the return on my money". And, he was certainly correct. We all
attempt to enhance our wealth and it is an intuitive and natural instinct of human beings. However,
we should do so in a fashion and style that does not put our wealth, savings, and investments to
undue and undesirable risk. Perhaps, there is always some element of risk and speculation inherent
in most of investments, yet with a prudent and informed approach such risks may be contained to
a large extent (though not always). Over a period of time, are pancakes, the desire of management
of finance has resulted into many styles of personal investing (as also general and other investing),
and these styles have given rise to a number of theories of investments.
These Investment Theories try to explain and support particular type of Investment Strategies.
Some of the major and popular Investment Theories are:
1. Bernstein’s Psychology of Successful Investing
2. Top Down Investing
3. Bottom Up Investing
4. Buy the Rumour & Sell the Fact
5. Castle-in-the-Air Theory
6. Constant Stock-Bond Ratio Theory
7. Cybernetic Analysis
8. Diversification Theory
9. Efficient Market Theory
10. Firm Foundation Theory
11. Life Cycle Investment Theory

12. Markowitz Portfolio Selection Theory
13. Selling Theory
14. The 10 Percent Rule
15. The Windbag Theory
Few words about these theories of Investments, and related concepts and ideas are briefly outlined
below. The relevant details pertaining to these theories are also presented in separate write-ups
relating to these theories.
Bernstein's Psychology of Successful Investing
How Personality Traits Affect Successful Financial Investments;
You'll earn a higher return on investments if you know a little "money psychology." Here are four
ways personality traits affect your thoughts and behaviors about money;
- Knowing the psychology behind your financial investments
- How personality traits affect your investment portfolio
- Can change the way you invest in low-risk mutual funds, medium-to-high risk stocks and bonds
Bottom up Investing
Bottom up Investing is an investment theory which takes a dramatically different view of investing
if compared to Top Down Investing. It takes a micro approach and starts analyzing the individual
securities and the firms, moves on to have an idea of the industry. Thereafter, it still moves forward
to look deeply into the position of the stock market and the economy in its totality. If positive
indications emerge, the investor buys the stocks with which he/she had started the analysis.

Castle-in-the-Air Theory
The Castle-in-the-Air Theory, one of the Investment Theories, is rather opposite in its postulations
compared to the Firm Foundation Theory. The Firm Foundation Theory believes and tries to
understand the intrinsic value of any stock or other asset. The castle-in-the-air theory delves deep
into another aspect of investing behavior - it tries to unravel and understand the psychic values and
behavior of the group of investors. This theory was made popular in 1936 by John Maynard
Keynes, a famous economist (as also an investor) and the theory postulates that the investors try
to build a sort of castles in the air and think of the probable price rise in the future than estimating
the intrinsic values of stocks. Once the investor has estimated this, he/she tries to beat the crowd
by building positions in the preferred stocks before the crowds (read other investors) start buying
those stocks and the price surges ahead.
Diversification
Diversification is one of the long standing and widely prevalent Investment Theories to reduce the
Investment Risks relating to holding and investing in stocks and other financial assets.
Diversification may be practiced in different ways; one or more of these ways may be combined
to create a diversified portfolio. Generally, diversification of a portfolio may be achieved by:
• Stock Diversification
• Geographical Diversification
• Strategy Diversification
• Asset Diversification

Efficient Market Theory
Efficient Market Theory is one of the Investment Theories, and the theory postulates that at any
given point of time the prices of securities being traded in a stock market or any other financial
market fully reflects all available information and data. People buy securities thinking that the
price shall move up, and they sell securities thinking that the price shall go down. Now, according
to Efficient Market Theory, as the prices fully reflect all the available information, any price
movement upward or downward is a matter of luck. However, like many Investment Theories, the
Efficient Market Theory has also its plus and negative points.
Firm Foundation Theory
The Firm Foundation Theory is one of the important Investment Theories. It postulates that any
financial asset like a stock or real estates like a piece of property has an intrinsic value. The
condition in the market either keeps the price below the intrinsic value or above the intrinsic value
- it rarely remains at or around the intrinsic value. This position offers the investor a choice - in
case, he/she is able to buy the stock or the real estate below its intrinsic value, he/she shall make
profits when the price goes above the intrinsic value.
Modern portfolio theory (MPT) is a theory of investment which tries to maximize return and
minimize risk by carefully choosing different assets. Although MPT is widely used in practice in
the financial industry and several of its creators won a Nobel prize for the theory, in recent years
the basic assumptions of MPT have been widely challenged by fields such as behavioral
economics, and many companies using variants of MPT have gone bankrupt in various financial
crisis.
MPT is a mathematical formulation of the concept of diversification in investing, with the aim of
selecting a collection of investment assets that has collectively lower risk than any individual asset.

This is possible, in theory, because different types of assets often change in value in opposite ways.
For example, when the prices in the stock market fall, the prices in the bond market often increase,
and vice versa. A collection of both types of assets can therefore have lower overall risk than either
individually
MPT was developed in the 1950s through the early 1970s and was considered an important
advance in the mathematical modeling of finance. Since then, much theoretical and practical
criticism has been leveled against it. These include the fact that financial returns do not follow a
Gaussian distribution and that correlations between asset classes are not fixed but can vary
depending on external events (especially in crises). Further, there is growing evidence that
investors are not rational and markets are not efficient
Perhaps the most spectacular example of MPT's shortcomings was the failure of Long Term
Capital Management in 1998.
CHARACTERISTICS OF SECURITIES
Basic Concepts and Definitions in Financial Market Microstructure
Security Markets
Security Markets are places where traders gather to trade securities (e.g. Forex Market). Trading
is a search process, where buyers or sellers try to find counter-party. Price, Quantity and Time to
the trade are key factors. Dealers or brokers help people trade. Dealers; are willing to take the other
side of a trade on demand. They quote a bid (buy) price and offer (ask) price and profit from the
spread. Dealers acquire their clients’ positions and then try to trade for them at a profit. Brokers
are agents who help traders search for counter parties; they profit through commissions.
Security markets are designed to reduce counterparty search cost. Key elements which make
markets work are: asymmetric information between informed and uninformed traders; order flow
externalities “trade attracts trade!”

Trading rules; communication and trading technology; arbitrage between assets in different
markets; principal-agent issues1; trustworthiness and creditworthiness; and the legal and
institutional framework.
Characteristics of Financial Market Microstructure
Three main characteristics define the financial market structure;
a) Trading sessions (time intervals at which trades take place),
b) Execution systems (matches buyers with sellers), and
c) Information systems (bring information into and out of the market.
Trading sessions differ across different types of markets. Continuous markets arrange trades
continuously as orders arrive. Call markets collect orders for batch processing. Markets are usually
classified by their execution systems (the procedures for matching buyers and sellers), these
include:
Quote-driven systems: are primarily organized by dealers (e.g. NASDAQ, London International
Stock Exchange (SEAQ), OTC Bond markets, Forex markets). In a pure quote-driven market,
dealers supply all liquidity. Dealers quote their bid and ask prices. Better prices and larger quotes
for larger sizes may be obtained through negotiation.
Brokers or buy-side traders choose which dealer they trade with. Narrow spreads provide a
measure of fairness;
Order-driven systems: (auction markets): are organized by exchanges and follows order
precedence trading rules to match buyers and sellers and a set of pricing rules. Agents may not act
in the best interests of the principal; brokers may not work as hard as you may want them to. Since
traders cannot choose with whom they trade, order-driven markets require clearing houses;

Brokered systems: are organized by brokers who actively search for matching buyers and seller.
Brokered markets usually arise when the item traded is somehow unique and when dealers are
unwilling to hold inventories. Brokered market examples include block trading market, market for
ongoing concerns (businesses) and real estate market.
Hybrid systems: Is a mixture of order driven, quote driven and brokered market. Hybrid systems
are order-driven auction markets in which the specialist must provide liquidity under some
circumstances. Many US stock and options exchanges have specialist systems.
Information Systems collect, organize, present, store, and transmit information about orders,
quotes and trades.
Electronic trading systems facilitate collection of information from market participant.
Order routing systems, order presentation systems, and order books are used to transmit,
present, and manage standing orders.
Electronic order routing systems transmit standardized orders with great accuracy at low cost.
These systems may be maintained by brokers, dealers or exchanges. Complex orders are often
communicated by telephone. On some exchanges, hand signals may be used to send an order from
an order clerk to a floor trader. An example of Order Routing System is NYSE’s Super Dot. In
open outcry auctions (oral auctions), traders sell out their bids and offers on the floor of an
exchange.
Screen-based trading systems, orders are presented on computer screens.
Board-based trading systems, orders are written on a big board. Order books hold orders that
have not yet been executed. An order book may be an electronic database or a box of trading
tickets.
Brokers, exchanges and dealers may all maintain order books. Collected information is distributed
to member traders. Market data systems report trades and quotes to the public. Price and sale feeds

(ticker tapes) report trade prices and sizes. Trade information is sold to various data vendors who
repackage it for distribution to the public.
A market is transparent when complete information is reported to the public quickly. A market is
liquid when traders can trade when they want to without much impact on price.
Orders are instructions traders give to brokers and/or exchanges explaining how their trades should
be arranged. Traders use orders to communicate their intentions. The order submission strategy
affects trading profits and liquidity.
Different types of order can be issued, these affect market liquidity and execution price; while
market orders are the instructions given to brokers to trade at the best price currently available,
limit orders are instructions to broker to trade at the best price available but to not violate the limit
price.
▪ Stop orders: activate only after price reaches some threshold called stop price.
▪ Market if touched orders: are traded at the market price if it touches some preset price.
▪ Tick sensitive orders: specify tick conditions for trade execution.
Different type of instruction can be associated with an order:
▪ Validity Instructions indicate how long the order remains (Good-till-cancel orders remain open
indefinitely; Good-until orders specify an expiration date; Day orders expire at day end;
Immediate-or-cancel, good-on-sight orders and fill-or-kill orders expire immediately following
presentation)
▪ Quantity instructions indicate how large orders can be broken into small trades. All or none
orders must be completely filled.
▪ Timing instructions restrict the execution window (Market-on-close orders are traded at closing
prices; Market-on-open orders are traded on open prices)

▪ Execution instructions tell the broker how to arrange the trade (Market-not-held is a market order
that the broker need not immediately execute or expose. The broker is expected to use discretion
to find the best price).
A tick is a change in price within trades. An up-tick is an increase in price; down-tick is a decrease
in price.
MARKET EFFICIENCY
Market efficiency is an important concern for both academics and practitioners. In academic
research models efficient markets are prototyped, and tests for efficiency in different markets are
undertaken. The efficient market hypothesis (EMH) introduced by Fama (1970 and 1991) is one
of the central ideas in modern finance. There are different versions of the market efficiency
hypothesis according to the information set that is assumed to be contained in market prices: Weak
form efficiency in current market prices reflects all information on past prices, while Semi-strong
form efficiency in current market prices reflects all publicly available information and Strong form
efficiency in current market prices reflects both public and private information. Malkiel (1996)
stated that a capital market is efficient if it fully and correctly reflects all relevant information in
determining security prices. This implies that it is impossible to make economic profits on the
basis of that information set.
All the empirical research on the theory of efficient markets has been concerned with whether
prices fully reflect particular subsets of available information. Weak form tests were conducted
with the information subset of interest being past price histories. Weak form tests include serial
correlation, runs, trading rules, and variance ratio tests.
The semi-strong form efficiency test of the adjustment of prices to public announcements is
conducted using an event study methodology.
The test for private information (whether specific investors have information not in market prices)
is used to test the strong form of efficiency.

In practice, investors are highly concerned about getting fair prices and achieving high returns.
Market efficiency implies also an optimal allocation of resources in the economy. Three types of
market efficiency are identified;
Operational efficiency: A financial market is operationally efficient if it works smoothly, with
limited delays (orders can be transmitted from all parts of the world to a market very quickly, and
are quickly executed and confirmed). Markets should carry out their operations at the lowest
possible cost. Competition among markets is an ingredient in increasing operational efficiency.
Technology is also an important factor in achieving operational efficiency. A market may be
operationally efficient, however, without being information-ally efficient.
Allocation efficiency: Resources in the economy are scarce, and it is important to allocate
resources in a way to achieve optimum productivity. An efficient market should channel the fund
to help in the growth of different industries.
Trading Cost
Haynes (2000) subdivided trading cost into a visible and hidden part. The visible part includes
Taxes, commission, and spread, while the hidden part of the trading cost includes market impact
and delay.
Straight Through Processing
The five time steps to execute the three stages of the trading process in the old trading model
T + 0 T + 1 T + 2 T + 3 T + 4 T + 5
RISK AND RETURN
The Risk - Return Relationship
Another fundamental relationship in the study of finance is the relationship between expected
return and the expected level of associated risk. The nature of the relationship is that as the level
of expected risk increases, the level of expected return also increases. The opposite is true as well.
Lower levels of expected risk are associated with lower expected returns.

This RISK-RETURN RELATIONSHIP is characterized as being a direct relationship or a positive
relationship.
Business firms operate and invest in risky environments. Since these risks impact the level of
returns from business investments, they directly affect the economic value of both individual
investment projects and the firm as a whole. Because of this, the potential risks associated with
project investments must be taken into account when making investment decisions.
The "expectational" nature of the relationship.
It should be noted that the risk-return relationship is stated in expectational terms. That is, it
focuses on expected risk and expected returns. When an investment decision is made, the decisions
reflect expectations about future performance. After the investment has been made, actual returns
and actual risks may be different from what was originally anticipated. The important point,
however, is that when investment decisions are made, greater levels of expected risk should be
compensated for by greater expected returns on the investment.
A general definition of risk.
In its most general definition, risk is nothing more than the possibility of something unexpected
happening. These unexpected occurrences could either have a positive or a negative effect on our
personal financial well-being or the financial well-being of our company. In its broadest sense,
then, risk is essentially the unknown or uncertainty. Finance related risks can then be thought of
as the impact of the unknown on an individual’s economic wealth or a business firm’s economic
value. Note that risk of the unknown could work either in your favor (upside risk) or against you
(downside risk). Risk = the possibility of something unexpected happening
or
Risk = the possibility of an unexpected outcome occurring
Expected Return Expected Risk
Expected Return Expected Risk

The importance of the risk-return relationship
The risk-return relationship has implications for many of the areas of finance. If, for example, two
different alternative investments are being considered by a business, the existence of the risk-return
relationship dictates that the comparison of alternative investments has to take both expected risks
and expected returns into account. The decision cannot be made solely on the basis of the expected
return. If two investments have differing risk levels associated with their future cash flows, the
risk must be accounted for in the investment decision process. There are a number of different
methods that can be used to incorporate risk into the project investment decision. These are
covered in the advanced Capital budgeting modules.
The risk-return relationship also has implications for the pricing of various financial assets. If two
sets of identical cash flows with the same risk levels are available, the risk-return relationship
dictates that the two investments must have the same market value and market price. If the prices
differ, the opportunity exists for arbitrage activities and the earning of riskless profits. This aspect
of the risk-return relationship is the basis of one of the fundamental asset pricing concepts in
finance and economics; the Law of one Price.
Risk is a fundamental, underlying, concept that has to be taken into account during any financial
decision making process.
Risk Aversion.
Risk aversion refers to the aspect of human nature that causes people to avoid unnecessary risk.
In general, people tend to be risk averse. In order to overcome this risk aversion, the investor must
be adequately compensated. This concept of risk aversion carries over into the business and
financial world as well. In business, people also tend to be risk averse. If they choose to expose
themselves to higher levels of risks, they do so only if they are going to be compensated in some
financial way for taking on the additional risk.

In finance, since risk and return are positively related, the taking on of greater expected levels of
risk is always associated with a higher expected financial return. This is the basis for the direct
risk-return relationship.
DEBT SECURITIES
Debt securities are a type of financial platform in which an issuer, also known as a creditor,
provides assets to a borrower with the intention of receiving a repayment of the funds. Basically,
it is some form of contract that represents money owed to another party. Examples of this include
different types of bonds, documents such as debentures, or even paper money issued by a bank or
government. These debt securities are usually backed by some sort of legal standing; however,
some countries do not regulate the practice and allow creditors to issue statements privately.
Private Debt
Private debt is money owed by individual people, households, and businesses. It excludes money
owed by governments, which is known as public debt. There are many different kinds of private
debt, including mortgages, credit cards, student loans, and commercial loans. While taking on debt
may be unavoidable in some situations, mishandling debt obligations can lead to dire financial
consequences, including bankruptcy and foreclosure.
Most forms of private debt work as a guarantee against future income. If a person doesn't have the
money to buy a home or open a business outright, he may be able to secure a loan or credit card
that is repaid over time with regular income. If all goes well, he or she will be able to make timely
payments to the point where the debt is fully repaid, thereby fully owning the initial purchase.
Unfortunately, a variety of factors can intercede to interrupt this ideally smooth repayment process.
One factor that must be considered when opting to accept any form of private debt is interest.

This is a fee tacked on to most loans or credit lines, which allows the process to be profitable for
the lender. Without interest, a bank would only be able to lend out what is paid out, without any
money generated for expansion, investment, or operations.
While private debt can stimulate new businesses, pay for education, or finance the purchase of the
home, it is a serious risk that requires careful consideration. Consumers must be fully aware of the
obligation they undertake by shouldering private debt; it is an obligation that may last years, if not
decades.
Some financial experts warn of a growing consumer and commercial debt problem in developed
countries, where inflation and cost of living increases have lead many individuals to rely more and
more on private debt. Many economists also decry governmental regulations on consumer debt,
suggesting that they are often all but written by lobbyists for the debt industry, and may be designed
to obscure important facts that might influence consumers.
The concept of a debt security is important to the continued function of most of the worldwide
economy. Those institutions with capital provide individuals and companies in need of funding
with the ability to purchase goods and services on credit. The creditor then issues some sort of
binding document designed to symbolize the debt accrued. These documents are considered to be
worth a certain value, requiring the individual or group to repay the debt according to the terms of
the agreement.
Debt securities can be traded much like goods, allowing them to represent potential economic
value. In this way, a bank or private entity can issue some sort of credit, create a debt security
document, and then sell it to another source for the right to collect the repayment value. Debt
securities therefore essentially equate to the exchange of money. Within the debt securities market,
a number of different types of credit-based documents can be issued.
Private debt securities are issued to a private entity by some sort of organization with the purpose
of eventually being paid off with the addition of interest, such as a credit card account.

Corporate debt securities are those which are issued to a company and represent a certain portion
of that company's assets. Governments of all levels, from municipal to federal, issue debt securities
in the form of bonds. These are essentially promissory notes, which guarantee a repayment with
interest to individuals after a certain period of time.
One of the most prevalent examples of a debt security is simply the currency issued by a federal
government. In the United States, each piece of money represents a certain amount of debt held by
the Federal Reserve. The centralized bank issues finances to the people of the United States
through its government, specifically the Treasury department. These finances are represented by
the paper and digital money that is transferred in exchange for goods and services by the private
sector. Essentially, each dollar bill is equal to one dollar of debt held by the Federal Reserve, with
the intention of accepting repayment by the people at some point in the future.
EQUITY AND ASSET-BACKED SECURITIES
Asset backed securities, also called ABS, are pools of loans that are packaged and sold as
securities, a process known as “securitization”. The type of loans that are typically securitized are
credit card receivables, auto loans, home equity loans, student loans, and even loans for boats or
recreational vehicles.
Here’s how it works: when a consumer takes out a loan, their debt becomes an asset on the balance
sheet of the lender. The lender, in turn, can sell these assets to a trust or “special purpose vehicle,”
which packages them into an asset backed security that can be sold in the public market. The
interest and principal payments made by consumers “pass through” to the investors that own the
asset backed securities. Typically, individual securities will represent loans with similar maturities
and delinquency risk.

The benefit for the issuer of an ABS is that the issuer removes these items from its balance sheet,
thereby gaining both a source of new funds as well as greater flexibility to pursue new business.
The benefit to the buyer - usually institutional investors - is that they can pick up additional yield
relative to government bonds and augment their portfolio diversification.
The ABS market first developed in the 1980s, and it has since grown to be a significant component
of the U.S. debt market. The U.S. ABS Index was created in 1992, at which point the asset class
was added to the Lehman U.S. Aggregate Bond Index - the benchmark for investment-grade bonds
that is now called the Barclays U.S. Aggregate Bond Index. During the past decade, asset backed
securities have made up anywhere from 2.5% to 7% of the index.
Only the most sophisticated individual investor would by individual asset backed securities
directly, since a great deal of research is necessary to evaluate the underlying loans. However, if
you own a bond mutual fund, particular an index fun, there’s a good chance that the portfolio has
a modest weighting in ABS. Currently, no exchange-traded fund are dedicated solely to asset
backed securities.
The maturity of the loans represented in asset backed securities is relatively short, so ABS typically
are less affected by interest rate movements than other bonds with similar maturities. ABS do carry
prepayment risk, which is the chance that investors will experience reduced cash flows caused by
borrowers paying back their loans early. This, in turn, would reduce the cash flow to the owner of
the ABS. Asset backed securities typically carry high credit rating due to legal protection set up
around the issuing entity, which helps shield investors from defaults among the original borrowers
of the underlying loans or the failure of the issuing corporations. As a result, the ABS market held
up very well during the financial crisis of 2008.

SECURITY MARKET
The global securities market has been constantly evolving over the years to serve the needs of
traders. Traders require markets that are liquid, with minimal transaction and delay costs, in
addition to transparency and assured completion of the transaction. Based on these core
requirements, a handful of securities market structures have become the dominant trade execution
structures in the world.
Quote-Driven Markets
Also called dealer markets, quote-driven markets are those in which the buyers and sellers engage
in transactions with market makers, or dealers. The market makers post the bid and ask quotes for
an inventory of stocks that they are willing to buy from, and sell to traders. Only certain dealers
are allowed to perform the market making function and in return, they receive privileges, such as
the right to post quotes, the ability to get information on the order flow and book, and generally
lower or no fees paid to the exchange.
Quote-driven markets are common in over-the-counter (OTC) markets such as bond markets, the
forex market and some equity markets. The Nasdaq and London SEAQ are two examples of equity
markets that have their roots as a quote-driven market. It should be noted that the Nasdaq structure
also contains aspects of an order driven market.
The advantages of a quote driven market are typically best seen in illiquid markets. In securities
that are thinly traded (low volume), dealers can step in to improve liquidity for traders, by
maintaining an inventory of the security. In exchange for providing this liquidity, dealers make
money from the spread between the bid and ask quotes.
To generate profits, dealers will attempt to buy low (at the bid) and sell high (at the ask) and have
high turnover.
Order Driven Markets

Another major dominant market structure type is an order-driven-market. In this type of market,
the exchange matches buyers and sellers with each other and there is no middle man, like there is
with quote driven markets. Price discovery is determined by the limit order of traders in the
particular security. Most order-driven markets are based on an auction process, where buyers are
looking for the lowest prices and sellers are looking for the highest prices. A match between these
two parties results in a trade execution.
The biggest benefit of an order driven market in liquid markets is the large number of traders
willing to buy and sell the security. Generally, the larger the number of traders in a market, the
more competitive the prices become; this theoretically translates into better prices for traders. The
downside to this type of market is that in securities with few traders, the liquidity can be poor. An
example of an order-driven market is the Toronto Stock Exchange (TSE) in Canada.
In addition, there are two main types of order driven markets, a call auction and a continuous
auction market. In a call auction market, orders are collected during the day and at specified times
an auction takes place, to determine the price. On the other hand, a continuous market, as the name
suggests, operates continuously during trading hours and trades are executed whenever a buy and
sell order match up.
Hybrid Markets
A third popular market structure, a category in which the New York Stock Exchange (NYSE) falls
in, is the hybrid market, also known as a mixed market structure. The hybrid market combines
features from both a quote-driven market and an order driven market. Although dominantly an
order driven market that matches buyers and sellers, the NYSE also utilizes dealers to provide
liquidity, in the event of low liquidity periods. In addition to being a hybrid market, the NYSE is
also a continuous auction market.

Brokered Markets
In this market, brokers are the middle men who find counterparties for trades. When a client asks
their broker to fill an order, the broker will search their network for a suitable trading partner.
Often, brokered markets are only used for securities that have no public market; these are generally
unique or illiquid securities, or both. Common uses of the brokered markets are for large block
trades in bonds or illiquid stocks.
The direct real estate market is also a good example of a brokered market. This market contains
assets that are relatively unique and illiquid. Clients generally require the assistance of real estate
brokers to find buyers for their home. In these types of markets, a dealer wouldn't be able to hold
an inventory of the asset, like in a quote-driven market, and the illiquidity and low frequency of
transactions in the market would make an order-driven market infeasible, as well.
The Bottom Line
There are different types of market structures simply because traders have different needs. The
type of market structure can be very important in determining overall transaction costs of a large
trade and can affect the profitability of a trade. In addition, if you are developing trading strategies,
sometimes the strategy may not work well across all market structures. Knowledge of these
different market structures can help you determine the best market for your trades. (For additional
study, take a look at The NYSE and NASDAQ on how they work.)
Securities markets are organized to help bring buyers and sellers together, so that both parties to
the transaction will be satisfied that a fair transactions price, close to the true equilibrium price,
has been arranged. There are three main types of market organization that facilitate the actual
purchase and sale of securities: an auction market, a brokered market, and a dealer market. In each
case, the aim is to match up buyers and sellers.
Primary versus Secondary Markets:

Before detailing the nature of trading in securities markets, it is important to emphasize the
distinction between primary markets and secondary markets. Most of the popular markets, such as
the New York Stock Exchange and the Tokyo Stock Exchange, are secondary markets where
existing securities are exchanged between individuals and institutions, while the primary markets;
are markets for newly issued securities that are much less well known.
In the United States, for example, new issues of stocks or bonds to raise funds for General Motors,
General Electric, or General Mills are not sold to saver-lenders on the floor of the New York Stock
Exchange, the American Stock Exchange, or even the Midwest Stock Exchange in Chicago.
Rather, the matchmaking takes place behind closed doors, aided by Wall Street’s investment
banks.
Efficiency of Secondary Market Trading
As we indicated at the beginning of the chapter, secondary markets work well if they bring together
buyers and sellers of securities so that they transact at prices close to the true equilibrium price.
Markets that accomplish this objective have low transactions costs and are considered liquid. One
measure of the liquidity costs of a market is the spread between the bid price and the offer (or
asked) price quoted by a dealer who “makes a market” in the particular security. In order to
understand how the dealer’s bid-asked spread measures liquidity costs, let’s begin with a market
that operates as an auction and then introduce dealers as participants.
The equilibrium price that we identify with the intersection of supply and demand curves emerges
from the following type of auction. At a prearranged point in time, buyers and sellers interested in
a particular security gather before an auctioneer. The auctioneer announces a price for the security
(perhaps the price from the previous auction) and asks buyers and sellers to submit quantities they
want to buy or sell at that price.
If the quantity supplied exceeds what is demanded, the auctioneer announces a lower trial price
and asks market participants to resubmit orders to buy or sell. If at the new lower price there are

more buyers than sellers the auctioneer tries a slightly higher price and asks for still a new set of
orders. This iterative “reconstructing” process continues until a price emerges at which buying and
selling interest are equal. At that point, the auctioneer instructs buyers to tender cash and sellers to
tender the securities, and the exchange takes place at what has been established as the equilibrium
price. This auction is known as a Walrasian auction, after Leon Walras, a nineteenth-century
French economist who conceptualized the auction underlying the determination of equilibrium
prices in this way. There is, in fact, one very real marketplace that operates as a Walrasian auction;
namely, the twice-daily London gold fixing, where the price of gold bullion is determined.
Key Terms:
- For a person to remain in the marketplace to provide the service of continuously bidding for
securities that investors want to sell and offering securities those investors want to buy. This
person acts as a dealer (also called market-maker)
- Unlike brokers; dealers commit capital to the process of bringing buyers and sellers together
and take on the risk of price changes in the securities they hold in inventory. Dealers expect to
earn a profit, because they always quote a bid price (at which they buy) that is below their offer
price (at which they sell).
- Many securities trade in dealer markets, including government bonds, corporate bonds, and
equities traded in the so-called over-the-counter (OTC) market.
- There are usually many dealers in each security. They are linked together either by telephone or
by computer hookup. In fact, many over-the-counter stocks trade in a partially automated
electronic stock market called; National Association of Securities Dealers Automated
Quotation (NASDAQ) system.
- On the New York Stock Exchange, the specialists who are the designated auctioneers also quote
bids and offers in their capacity as dealers. Thus trading on the New York Stock Exchange is a
cross between a dealer market and an auction market.

- The organizational structure of a market, the existence of brokers, dealers, exchanges, as well as
the technological paraphernalia, such as quotation screens, computer terminals, and
telecommunications, are all mobilized to keep transactions prices as close to true (but unknown)
equilibrium prices as is economically feasible. Easy access to a trading forum, with many
potential buyers and sellers, means that a security can be bought or sold quickly with little
deviation from its equilibrium value. That is what is meant by marketability a catch-all term
indicating small deviations of actual transaction prices about the true equilibrium.
- Good marketability implies that a security can be sold, liquidated, and turned into cash very
quickly without triggering a collapse in price. Because a highly marketable security is more
desirable to investors, its equilibrium price will be higher, and its return lower, relative to less
marketable securities.
- A vast literature has developed during the past twenty years based on a relatively straightforward
proposition: The current price of a security fully reflects all publicly available information. Put
somewhat differently: There is no unexploited publicly available information that would lead to
superior investment performance. If securities prices fully reflect all available information, the
capital market is called efficient.
INDEXES
An index is an imaginary portfolio of securities representing a particular market or a portion of it.
In the case of financial markets, it’s a statistical measure of change in an economy or a securities
market. Each index has its own calculation methodology and is usually expressed in terms of a
change from a base value.
Thus, the percentage change is more important than the actual numeric value. Stock and bond
market indexes are used to construct index mutual funds and exchange-traded funds (ETFs) whose
portfolios mirror the components of the index.

The Standard & Poor's 500 is one of the world's best known indexes, and is the most commonly
used benchmark for the stock market. Other prominent indexes include the DJ Wilshire 5000 (total
stock market), the MSCI EAFE (foreign stocks in Europe, Australasia, Far East) and the Lehman
Brothers Aggregate Bond Index (total bond market).
Because, technically, you can't actually invest in an index, index mutual funds and exchange-
traded funds (based on indexes) allow investors to invest in securities representing broad market
segments and/or the total market.
MARKET REGULATION
A regulated market or controlled market is the provision of goods or services that is controlled
by a government appointed body. The regulation may cover the terms and conditions of supplying
the goods and services and in particular the price allowed to be charged and/or to whom they are
distributed. It is common for a regulated market to control natural monopolies such as aspects of
telecommunications, water, gas and electricity supply. Often regulated markets are established
during the partial privatization of government controlled utility assets.
Market regulation is a medium for the exchange of goods or services over which a government
body exerts a level of control. This control may require market participants to comply with
environmental standards, product-safety specifications, information disclosure requirements and
so on.
A variety of forms of regulations exist in a regulated market. These include controls, oversights,
anti-discrimination, environmental protection, taxation and labor laws. In a regulated market, the
government regulatory agency may legislate regulations that privilege special interest, known as
regulatory capture.
The market for both prescription and over-the-counter drugs is an example of a regulated market.
The Food and Drug Administration (FDA), a federal government body, tightly controls what drugs

may be sold on the market, how they may be advertised, for what conditions they may be
prescribed and more.
Regulated markets provide obvious protection for consumers. However, some argue that the
formal regulation of markets is unnecessary and imposes inefficiencies and unnecessary costs on
markets and on taxpayers. These people argue that there are plenty of ways for markets to self-
regulate.
Chapter Two

ANALYSIS AND VALUATION OF INVESTMENTS
Introduction-Financial Analysis
The process of evaluating businesses, projects, budgets and other finance-related entities to
determine their suitability for investment. Typically, financial analysis is used to analyze whether
an entity is stable, solvent, liquid, or profitable enough to be invested in. When looking at a specific
company, the financial analyst will often focus on the income statement, balance sheet, and cash
flow statement. In addition, one key area of financial analysis involves extrapolating the company's
past performance into an estimate of the company's future performance.
One of the most common ways of analyzing financial data is to calculate ratios from the data to
compare against those of other companies or against the company's own historical performance.
For example, return on assets is a common ratio used to determine how efficient a company is at
using its assets and as a measure of profitability. This ratio could be calculated for several similar
companies and compared as part of a larger analysis.
Sources of Financial Information
Financial information is sourced from diverse spectrum of books of original entries depending on
the mode of operation of the firm or company under review, the nature of information depends on
source-department e.g. marketing, accounts, vendors etc; the information focuses on the monetary
and equivalent values flowing in and out of the operation, and what they represent in respect to
investment and growth. Balance sheet, Income statement, statement of cash flows is some of the
source documents for any financial information. Key sources for obtaining financial, industry, and
company information are leveled into three phases; Primary, Secondary & Tertiary sources of
information.
i. Primary: Organization’s website, Annual reports, Profit & Loss reports, Balance sheet, Cash
books are some of the primary source documents.

ii. Secondary: Published investment records, Performance Index reports, Research reports, Journal,
Advertisements, Organization’s web and media publications.
iii. Tertiary or Industry: Industry data is also available from a number of different websites. When
analyzing a company or industry, it is a good idea to read through other company’s profile in the
same industry to help get a better feel for competition and the requirements for the industry i.e.
Quarterly financial reports.
Annual Reports
The Annual Report to Shareholders is the principal document used by most public companies to
disclose corporate information to shareholders. It is usually a state-of-the-company report
including an opening letter from the Chief Executive Officer, financial data, and results of
continuing operations, market segment information, new product plans, subsidiary activities and
research and development activities on future programs. Annual Reports are probably the best
single source of information on public companies. Keep in mind that annual reports are written by
the companies themselves and used as a public relations tool. Although there are guidelines,
companies do have a fair amount of freedom in preparing the reports. The amount of information
included will vary greatly from company to company, and you often have to read between the lines
or consult other resources to obtain a truly accurate view of a companies include annual reports,
or portions of the reports, on their websites.
SEC Filings
Securities and Exchange Commission (SEC) regulations require that companies which sell stock
(public companies) file a number of financial reports with the Commission. These reports are
public and provide a wealth of information. Listed below are some of the key, common reports
used in company research.

An SEC filing containing more detailed financial information than annual reports; text may
include products, markets, distribution channels, research and development, patent, and
environmental safety information.
Proxy Statements
A report to stock holders issued prior to the annual meeting or a vote on significant changes. The
proxy statement is intended to provide security holders with the information necessary to enable
them to vote in an informed manner. Two important pieces of information which often appear in
proxy statements are ownership information and salaries of company executives.
Note: Many resources take the information from corporate financial reports and repackage it in
various ways. Some will condense the information. Most will provide the information in a uniform
manner facilitating comparisons amongst companies. Some provide additional information or
analysis.
Analysis of Financial Statements
Whether you watch analysts on media or read articles, you'll hear experts insisting on the
importance of "doing your homework" before investing in a company. In other words, investors
should dig deep into the company's financial statements and analyze everything from the auditor's
report to the footnotes.
What are Financial Statements?
Financial Statements, or financials as they're sometimes called, are a set of accounting reports--
• Balance Sheet – Financial report showing the financial position of the Organization in terms of;
its assets, liabilities, and equity at a given point in time.
• Income Statement - The monetary summary of company showing gross income, expenditure and
net margin at any given financial period.
• Cash Flow Statement - The inflow and outflow of cash is the lifeblood of a business. The cash
flow statement reflects the entry and exit of cash from the operations.

Financial Ratios
Financial Ratios are pillars of Financial Statement analysis derived from financial statements.
These ratios help to make it easier to understand and absorb reports as categorized in three strata’s
below:
1. Part 1 focuses on defining Financial Ratios and covers - Liquidity and Asset Turnover ratios.
2. Part 2 covers Leverage and Operating Performance/Profitability ratios.
3. Part 3 concludes the series with a detailed discussion on Valuation ratios.
Pro-forma Financial Statements
These are financial statements that are usually prepared before a major event like a merger,
significant capital investment, new product line, etc. They focus on the future instead of the past
and are based upon forecasts instead of hard facts.
Interest Rate Risk Factor
All companies that lend or borrow money are subject to Interest Rate Risk (IRR). A company faces
interest rate risk when interest rates change, affecting the company's bottom line. Each loan or
borrowing a company is involved with has its own interest rate risk, but the overall risk to the
company of changing interest rates can be affected by many variables that should be analyzed and
minimized.
Length of Loan Terms
One of the largest determinants of the interest rate risk a company is exposed to is its loan terms,
on its borrowings and on the loans it issues. Even the majority of small businesses may face this
problem if they offer terms to their customers. For example, if the business charges a fixed interest
rate on its accounts receivable and short-term interest rates increase, it may find its bottom line
dropping if it has to refinance its bank demand debt without any corresponding increases in what
it charges customers. If interest rates on trade receivables are kept in sync with interest rates on a
company's borrowings, the overall interest rate risk for the business is reduced.

Credit Risk
A company's credit risk is, in part, determined by its debt to equity ratio. As interest rates rise,
equity falls because the company is paying out more interest. This increases the overall credit risk
of the company, which, in turn, causes lenders to raise interest rates on new borrowings. The more
debt exposure a company has, the higher is its overall interest rate risk.
Overall Economic Climate
The wider economic markets can have an impact on a company's interest rate risk. In times of
economic decline or recession, a company can find refinancing and new borrowing more difficult
and interest rates higher. This is often a time when revenues decline as fewer customers are
financing purchases. The uncertainty of incoming cash flow coupled with the increased outgoing
cash flow from interest payments increases the company's exposure to interest rate risk.
Foreign Exchange Rates
The strength of the U.S. dollar against other foreign currencies, such as the Shillings, pound or the
yen, can impact a company's interest rate risk if it is paying interest on foreign debt. For example,
if Tri-Star Export Company manufacturing clothing is taking credit terms from its local supplier
in shillings, that debt becomes more expensive if the U.S. dollar weakens. The company's revenues
are still coming in U.S. dollars but its debt is now a larger drag on the bottom line.
Interest rate risk affects the value of bonds more directly than stocks, and it is a major risk to all
bondholders. As interest rates rise, bond prices fall and vice versa. The rationale is that as interest
rates increase, the opportunity cost of holding a bond decreases since investors are able to realize
greater yields by switching to other investments that reflect the higher interest rate. For example,
a 5% bond is worth more if interest rates decrease since the bondholder receives a fixed rate of
return relative to the market, which is offering a lower rate of return as a result of the decrease in
rates.

Default Risk Factor
There are typically five types of interest rate risk on bonds and debt instruments as follows:
i. Bond prices and their yields are inversely related. Thus, if an interest rate increases the bond price
falls or drops to a discount, and if the interest rate drops the bond prices rises or is considered at a
premium. The fluctuation in the market is an interest rate risk that must be accounted for
accordingly when investing.
ii. The longer the maturity the more sensitive a bond or debt instrument is to interest rate changes.
As a bond comes closer to its maturity the price fluctuates less and less from changes in the market.
This means that a shorter term security has less interest rate risk.
iii. An increase in interest rates will yield a much larger change in a bond than a decrease of the same
amount. This means that a bond has the ability to lose its overall value in price than it does in
gaining or selling at a premium.
iv. Prices of low coupon bonds are much more sensitive to market yield changes than the prices of
higher coupon bonds.
v. A bond or debt instrument's price is much more sensitive if that particular bond has a lower yield
to maturity. Thus, the higher the yield to maturity the less sensitive the bond price.
Note: None of these factors matter if a person plans on holding a bond or debt instrument until its
maturity. If a person holds a bond until its maturity the fact that interest rates fluctuate is irrelevant
because all bonds pay coupons and finally the face value at maturity. This means that this person
will automatically make the desired return and therefore need not worry about interest rate risk
measures.
Interest Rate Risk
Chuck wants to invest in a debt instrument, and comes across some lucrative bonds. He has
narrowed the search down to two, and is trying to decide between bond A and bond B. Both bonds
pay a coupon of 8% and have a current yield to maturity of 6%.

The only large difference between them is that the maturity for bond A is 5 years and B has a
maturity of 30 years. After consulting with a close friend Chuck decides to buy bond A because
his friend tells him there is less interest rate risk inherent in bond A.
Common Factors in Default Risk Across Countries and Industries
Global economic crises appear to strongly affect corporate bankruptcy rates. However, several
prior studies indicate that changes in default risk are strongly negatively related to equity returns,
which in turn depend predominately on country-specific factors. This suggests that country effects
– and not global effects should dominate changes in default risk.
To analyze this issue, we decompose changes in default risk, changes in the fundamental
determinants of default risk and equity returns into global, country and industry effects. We proxy
for default risk through Merton (1974) default risk estimates and CDS rates.
Our evidence reveals that changes in default risk always depend most strongly on global and
industry effects. However, the magnitude of country effects in equity returns correlates positively
with economic stability, rendering it dependent on the sample period.
Recent experience during the 2008–2009 ‘credit crunch’ suggests vividly that default risk has an
important global component. However, even before these extreme events credit analysts
recognized that default (or bankruptcy) risk is strongly correlated across, we are grateful to an
anonymous referee, and seminar participants at the 2008 Annual Meeting of the Campus-for-
Finance Research Conference in Vallendar, the 2007 Annual Meeting of the European Finance
Association in Ljubljana, the 2007 EIASM Workshop on Default Risk and Financial Distress in
Rennes and a Virtual Laboratory Research Meeting at Old Mutual Asset Management in London.
Bond Selection

Bonds are touted for their minimal risk and frequent interest payments, but you still have to be
careful. Investors tend to view bonds as the safe portion of their portfolio. And while bonds are
usually less volatile than stocks, they aren't foolproof. Like many other investments, bonds also
require investors to take greater risk for greater returns.
Most individual bonds are bought and sold in an over the counter market, which you can access
through an investment adviser or directly through a broker. There are a handful of bonds that trade
on an exchange. One key thing to understand about bonds: price and yield have an inverse
relationship. Price is the amount you pay for the bond. Yield, or current yield, refers to the amount
the bond pays monthly, quarterly or semi-annually, as a percent of the price you paid for the bond.
Yields fall as prices move higher and vice versa.
Here are some tips for choosing the right bond.
• Treasury bonds provide steady payments. Because they are backed by the government,
Treasury bonds have little risk of default. But that safety also means yields are going to be lower
than those of riskier bonds, such as corporate bonds.
• Take more risk if you need higher yields. Investment- grade corporate bonds, those issued by
companies rated BBB/Baa or higher from bond rating firms like Moody's, Fitch Ratings or
Standard & Poor's, pay more than Treasury’s because they have a slightly higher risk of default.
Even riskier high-yield or "junk" bonds, rated below BBB, have higher yields still -- and have an
even higher risk the issuing company will default on its payments.
• Use municipal bonds for tax-free income. Investors in higher tax brackets often benefit from
investing in municipal bonds, because their interest payments are exempt from taxes and
sometimes from state taxes. Yields on "minis" tend to be lower than comparable Treasury’s, but,
on a tax-effective basis, minis yield the same or more than comparable Treasury’s.
Know the risks. You can still lose money with bonds, but some are riskier than others.

• Consider credit risk. Lower-rated bonds offer higher yields but they also have a greater risk of
default. Keep this in mind before reaching for high yield.
• Low credit risk doesn't mean risk free. Certain bonds, like Treasury’s, have almost zero default
risk. But they are very vulnerable to interest rate risk, meaning prices will take a nose dive if
interest rates shoot up, which is important if you want to sell the bond on the secondary market.
Higher inflation can also erode the spending power of a bond's fixed payments.
• Watch price movements. Some bonds sell at a premium to par value, the amount the investor
gets back in principal when the bond matures. This open happens when interest rates for similar
issues are now lower than the rate on the bond you are considering. Some bonds, however, can be
redeemed early (known as "called back") and investors who take that risk can find themselves
getting a lower rate of return than anticipated and are unable to recoup that premium they paid.
Choose between bond funds and bonds. Once you know what you want to get out of your bond
portfolio, you need to determine the most cost efficient way of making it happen.
• Use bond funds to spread your bets. If you have less than $200,000 to invest in bonds and want
to own several different bonds or types of bonds, it may be easier to diversify through bond mutual
funds, which have lower minimum investments compared to buying bonds outright. They can also
be far easier to sell, if you need the money for something else. That's not to say you can't pull off
an individual bond portfolio with fewer assets you may just have to sacrifice some diversification.
• Buy individual bonds for more control. If you have enough assets, you can create your own
bond portfolio by buying individual bonds across various classes. Holding individual bonds also
reduces interest-rate risk by giving investors the option to hold bonds to maturity so they can get
their principal payments in full. Some financial advisers recommend what's called laddering --
buying bonds with different maturities to hedge against interest rate changes.
What not to do when considering a bond or bonds to buy.

• Don't aim just for yield. When interest rates are low, some investors may be willing to
take on more risk in exchange for higher payouts. But putting too much money into a single
bond issuer or bond type say allocating too much money to high yield bonds or Treasury
bonds can lead to large losses.
• Don't neglect credit ratings. Bonds can get downgraded when economic conditions
change. Don't assume that AAA-rated bond you bought years ago still has that high rating
today. Check credit rating agencies such as Standard & Poor’s, Moody’s Investors Service
and Fitch Ratings for news of downgrades or upgrades to bond issuers.

Chapter Three
STOCKS AND MARKETS
Before you start investing, you need a basic understanding of what a stock to trade in, which market
to focus in, what it means to invest, and how to evaluate stocks and market. Trade stocks on paper
before actually trading stocks with real money. Record your stock trades on paper, keeping track
of dates of the trades, number of shares, stock prices, profit or loss, including commissions, taxes
on dividend, and short or long term capital gains taxes you would have to pay for each trade.
It is also helpful to record the reasons for each buy or sell decision. Calculate your net profit or
loss less commissions and taxes for a meaningful period (1 year or more) and compare your results
with the market index, such as the S&P 500. Do not start trading with real money until you are
comfortable with your trading abilities.
When researching an investment there are typically five documents you want to get your hands on
to research the relative merit of a potential stock:
1. The 10K - this is the annual filing with the Securities and Exchange Commission (SEC) and is
probably the single most important research document available to investors about a company.
2. The most recent 10Q, which is a smaller version of the 10K that is filed at the end of each quarter
instead of each year.
3. Proxy statement – includes information on the Board of Directors as well as management pay and
shareholder proposals.
4. Statistical reports from various companies going back five or ten years with indication on the cash
flow of the company within specified number of years.
Types of Stock for markets:
Generally, there are five types of assets the average investor is likely to invest in the stock market:

1. Common stock - ownership of businesses or trading on ordinary shares in the common market.
2. Preferred stock - special types of stock that often pay high dividends but have limited upside
3. Bonds - corporate bonds, municipal bonds, savings bonds, government treasuries, etc.
4. Money markets - highly liquid funds that are designed to protect your purchasing power;
considered to be a cash equivalent
5. Real Estate Investment Trusts (REIT) - a special type of company designation that allows no
taxation at the company level provided more than 90% of earnings are paid out to the shareholders.
The assets are often invested in a variety of real estate projects and properties.
6. Mutual funds including exchange-traded funds, index funds, and actively managed funds.
How to invest in stock
Everyone wants to be financially secure. If you have a house, your house may be your biggest
"asset" but you will need to live in it for the rest of your life. If you want a financially secured
retirement or a vacation house, you must invest your savings through strategic plan that is
comfortably. Before you can invest, you need money. Don't start investing until you have a secured
job and six to twelve months of living expenses in a savings account, as an emergency fund, learn
how to budget your money and to spend your earnings wisely. Most investors have to be careful
not to spend any of their profits, and to keep some aside for future use, and for retirement, as well
as emergencies.
• Be prepared to always live within or even below and not beyond your means. This will help to
ensure that you always have enough money.
• Warren Buffet says that after you think, then think again. Warren Buffet says that if he cannot fill
out on a piece of paper several reasons to buy a stock, then he will not buy it.
• Open a stock brokerage account with a discount broker. No specific recommendation can be
offered here, as the stock brokerage business is a rapidly changing field. Trial and error is probably
the only way to find a good broker, but you should do your own due diligence by checking out

their site and looking at reviews online. The most important factor to consider here is cost, namely;
how much commission is charged, and what other fees are involved. Discount brokers generally
charge commissions of less than $10 per trade, some as low as $1 per trade, and some offer a
limited number of free trades per year, provided you meet certain criteria. Other than costs, you
should also consider whether dividend reinvestment is offered (which is the best way to build up
your positions), what research tools are offered, customer service, etc.
• Build a small portfolio of 10-50 stocks. Blue chips stocks are stocks of market leading companies
known for quality, safety, and ability to generate profit in good and bad times, although they are
generally fully priced and difficult to buy at a bargain price except in a severe bear market. Choose
stocks of companies with proven records of profitability with at least some earning in each of the
past ten years, pay at least some dividend in each of the past 15-20 years, at least 30 percent
earnings per share (EPS) growth over the past 10 years (using 3-year averages to smooth out
variations.
• Stay up-to-date with different value investing websites such as Motley Fool or Fallen Angel Stocks
to see what kind of deals are out there.
• If you do not have the time or inclination to learn about individual stocks, buying and holding no-
load, low expense index funds forever using a dollar cost averaging strategy is best and
outperforms most mutual funds, especially over the long term. The index funds with the lowest
expensive ratio and annual turnover are best. For investors with less than $100,000 to invest, index
funds are usually best. If you have more than $100,000 to invest, however, individual stocks are
generally preferable to mutual funds, because all funds charge fees proportional to the size of the
asset.
• Hold for the long term, at least 5-10 years, preferably forever. Avoid the temptation to sell when
the market has a bad day or month or even year. On the other hand, avoid the temptation to take
profit even if your stocks have gone up 50 percent, 100 percent, 200 percent, or more. As long as

the fundamentals are still sound, do not sell. Just be sure to invest with money you don't need for
five or more years. However, it does make sense to sell if the stock price appreciates too much
above its value, or if the fundamentals have drastically changed since purchase so that the company
is unlikely to be profitable anymore.
• Hold on to the winners and do not add to the losers without good reason. Peter Lynch said that if
you have a garden and every day you water the weeds and pick the flowers, that in one year you
will have all weeds. Peter Lynch said that he was the best trader on Wall Street for 13 years because
he picked the weeds and watered the flowers.
• Avoid stock tips. Do your own research and do not seek or pay attention to any stock tips, even
from insiders. Warren Buffett says that he throws away all letters that are mailed to him
recommending one stock or another. He says that these salesmen are being paid to say good things
about the stock so that the company can raise money by dumping stocks on unsuspecting investors.
• Likewise, don't watch media or pay attention to any television advert, radio or internet coverage
of the stock market. Focus on investing for the long term, 20 years, 30 years, 50 years, or more,
and not get distracted by short term gyrations of the market.
• Invest regularly and systematically. Dollar cost averaging forces you to buy low and sell high and
is a simple, sound strategy. Set aside a percentage of each paycheck to buy stocks every month.
And remember that bear markets are for buying. If the stock market drops by 20 percent or more,
move more cash into stocks, and move all available discretionary cash and bonds into stocks if the
stock market drops by more than 50 percent. The stock market has always bounced back, even
from the crash that occurred between 1929-1932.
• Consider selling portions of your holdings as a stock appreciates significantly, at least 50 percent
to 300 percent, based on quality of the stock. Use upper limit for better quality stocks. Letting your
winners run as long as the story is still good will increase your long-term chance for success.

Warren Buffet says that you should hold winners forever, but if the price-to-book gets too high
(above 100 is definitely too high), you should consider selling the stock.
• Consult a reputable broker, banker, or investment adviser if you need to. Never stop learning, and
continue to read as many books and articles as possible written by experts who have successfully
invested in the types of markets in which you have an interest. You will also want to read articles
helping you with the emotional and psychological aspects of investing, to help you deal with the
ups and downs of participating in the stock market. It is important for you to know how to make
the smartest choices possible when investing in stock and even if you makes the wisest decisions,
to know how to deal with loss in the event that it happens.
Warnings
• Do not engage in insider trading. If you trade stocks using insider information before the
information is made public, you may face prosecution. No matter how much money you could
potentially make, it is insignificant compared to the legal troubles you could get into.
• Only invest in stocks money you can afford to lose and will not need for at least 15-20 years.
Stocks can go down sharply over the short term, but over the long term they tend to outperform all
other types of investment options. If you want to invest money you will need in the short term
(within 5 years or less), consider bonds instead.
• Do not buy stocks on margin. Stocks may fluctuate widely without notice and using leverage can
wipe you out. You don't want to buy stocks on margin, watch stocks plunge 50 percent or so,
wiping you out, and then bounce right back and then gain some. Buying stocks on margin is not
investing, but speculating.
• Stick with stocks, and stay away from options and derivatives, which are speculations, not
investments. You are more likely to do well with stocks, but in options and derivatives you are far
more likely to lose money.

• Do not attempt to time the market, guessing when stocks hit bottoms or tops. Nobody, other than
liars, can time the market.
• Do not day-trade or trade stocks for short term profits. Remember, the more frequently you trade,
the more commissions you incur, which will reduce any gains you have. Also, short term gains are
taxed more heavily than long-term (more than 1 year) gains.
• Avoid "momentum investing", the practice of buying the hottest stocks that have had the biggest
run recently. This is pure speculation and not investing, and it does not work. E.g. the hottest tech
stocks during the late 1990s.
• Don't blindly feed the dogs, namely, buying the stocks that have had the lowest returns and appear
cheap. Most stocks are cheap for a reason. Just because a stock that was trading at above $100 and
is now trading at $1 does not mean that it can't possibly go lower. All stocks can go to zero, and
many have. Remember, it does not matter how low you buy a stock, if it goes to zero, you have
lost 100% of your money. Always do your research before investing in anything.
• Don't blindly trust the investment advice of anyone, especially who will make money from your
buying and/or selling (this includes brokers, advisers and analysts).
• When it comes to money, people lie to save their pride. When someone gives you a hot tip,
remember that it is just an opinion.
Tips
• The share price of a stock has no relation to whether the stock is cheap or expensive. Refer to
Motley Fool, Better Investing and other groups of "value investors" for advice on determining the
fair value of a stock.
• Buy companies that have little to no competition. Airlines, Retail Stores and Auto Manufacturers
are generally considered bad long-term investments because they are in fiercely competitive
industries, which are reflected by low profit margins in their income statements. In general, stay
away from seasonal or trendy industries like retail and regulated industries like utilities and

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