INV2601 INTRODUCTION TO
INVESTMENT NOTES.
1
THE INVESTMENT BACKGROUND
STUDY UNIT 01: THE INVESTMENT SETTING
- The goal of investment management is to achieve the investor’s required return
- Required return is the return that compensates the investor for the time during
which funds are com...
THE INVESTMENT BACKGROUND
STUDY UNIT 01: THE INVESTMENT SETTING
- The goal of investment management is to achieve the investor’s required return
- Required return is the return that compensates the investor for the time during
which funds are committed
- It should exceed the opportunity costs and the expected rate of inflation
- Investing in investments that satisfy the required return helps the investor to create
wealth *Assets – Liabilities*
- The key to the accumulation of wealth is efficient asset allocation
INVESTMENT
- Current commitment of money based on fundamental research, to real and financial
assets for a given period in order to accumulate wealth over time
SPECULATION
Commitment of money in the hope of making extra ordinary profit based
presumptions *No research or analysis of the securities
GAMBLING
Involves betting on a certain outcome and taking the risk for the sake of enjoyment
of the risk and accepting any return
COMPONENTS OF REQUIRED RETURN
Required return: The minimum expected return the investor should accept from an
investment to compensate him for deferring consumption
a) TIME VALUE OF MONEY
- Refers to the real risk free rate, which is the rate that can be expected from
investments that provide the investor with certainty regarding expected returns
*government securities
- The value of the rand received today is not equal to the value of the rand to be
received in future, therefore investors have consider this in their determination of
the required return
b) EXPECTED RATE OF IINFLATION
- It influences the country’s nominal rates of interest, inflation causes a decrease in
purchasing power.
- The nominal rate of return is made up of the risk free rate (real rate of return +
inflation premium)
Example:
*RRFR – 3%, EI – 5%
NRFR = [(1+0.03) (1+0.05) -1] = 0.0815 = 8.15%
*The higher the expected rate of inflation the higher the nominal rate of return
c) MARKET CONDITIONS
- Demand and supply greatly influences the interest rates, it is driven by changes in
monetary and fiscal policy, this then affects the required return
d) RISK PREMIUMS
- An increase in the required return above the NRFR is called the risk premium
- The risk premium stems from a variety sources of risk i.e. business risk, financial risk,
liquidity risk, currency risk, political risk, callability risk, convertibility risk and e.t.c
Business risk:
- Uncertainty regarding the firm’s cash flows, monopolies have a greater certainty
with regards to cash flows, hence should require lower returns than do cyclical
companies
Financial risk:
- The risk that the firm won’t be able to service its debt *interest and principal
payments
- Default may result in a downgrade, and a downgrade will call for an additional
premium
- The greater the financial leverage an firm has the greater is this risk
Liquidity risk:
- The speed in which assets a be converted into cash at a favourable price
- The asset that is illiquid calls for an increase in the liquidity premium
Currency risk:
- The possibility of receiving a reduced amount when foreign securities are sold and
the currency converted to domestic currency
- A weaker rand increases the value of the foreign investment.
Political risk:
- Also called country risk, political unstable countries have risk of this nature, it may
rise from legislation and tax changes
Callability risk
- The risk that a bond may be retired before maturity if the issue exercises the call
option
- It increases required return, investor need to be compensated as there if a
possibilities of payments ceasing.
Convertibility risk:
- The risk that bonds may be converted to a certain number of the issuer’s shares
, 3
- An additional premium is required as compensation
- The discussion of risk premiums raises a question of how can firms alleviate risk *this
reduces the cost of borrowing
- This can be achieved through diversification that’s forming a portfolio compromising
of negatively correlated assets
- Portfolio risk is reduced as more negatively correlated assets are added, however
only diversifiable risk is eliminated.
Total risk = Non-systematic risk + systematic risk
Non-systematic risk = company specific risk = diversifiable risk
Systematic risk = market risk = Non diversifiable risk
FUNDAMENTAL PRINCIPLES OF INVESTMEMENTS
TIME VALUE OF MONEY
- Value of money changes overtime, it can increase because of interest earned over
time
RISK VS RETURN
RISK: Uncertainty regarding cash inflows of an investment due to various factors
RETURN: The rewards received from investing, which can be expressed in absolute
terms (monetary value) or as a percent derived from initial investment and ending
value of the investment.
MEASURING RETURN
Holding period return (HPR) = Ending value/ Beginning value
Holding period yield = HPR – 1
Annual holding period yield = HPR1/n- 1
*simple use a financial calculator to obtain the require values
*the other three variables will be given
F.V (ending value) = xxx
P.V (beginning value) = xxx
N (Number of years) = xxx
I/YR(HPY) = xxx
EXPECTED RETURN
ER = ∑return x probability
Scenario Probability Return
Pessimistic 0.20 5
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