Meaning of Diversification:
The process of adding securities to a portfolio in order to reduce the portfolio’s unique risk and thereby the portfolios total risk.
Forms (Techniques) of Diversification:
a) Simple Diversification:
“Not putting all eggs in one basket”
In simple diversification, securities are selected added on random basis for making portfolio. Simple diversification reduces a portfolio’s total diversifiable risk to zero and only the undiversifiable risk remains. It is found that 10 – 15 securities are sufficient for a portfolio to minimize the portfolio’s total risk to the undiversifiable level.
b) Diversification across industries
In this diversification portfolio is constructed by selecting assets from different industries rather than from one industry. For eg if someone selects the securities from hotel banking, insurance co’s and other industries to make portfolio then it is called diversification across industries. But, empirical research has shown that diversifying across industries is not much better than simple selecting securities randomly.
c) Superfluous diversification
From research study, it is found that 10 – 15 assets in the portfolio are sufficient for risk diversification. But if more than 10 – 15 assets are added in the portfolio then such diversification is called superfluous diversification. It should be avoided; superfluous diversification will usually result in the following portfolio management problems:
1. Impossibility of good portfolio management
2. High search cost
3. High transaction cost
d) Simple diversification across quality rating
Some rating agencies rate different companies and their assets on the basis of the possibility of default risk (the risk of bank rupt) Under this categories we select assets randomly from the homogeneous quality ratings. The highest quality portfolio (of randomly diversified stocks) will be able to achieve lower levels of risk than the simple diversified portfolio of lower quality stocks.
e) Markowitz Diversification
Markowitz Diversification may be defined as combining assets which are less than perfectly positively correlated ( i.e. ≤ + 1 ) in order to reduce portfolio risk without sacrificing portfolio returns. Markowitz diversification is more analytical than simple diversification and considers assets correlations. The lower the correlation between assets, the more than Markowitz diversification will be able to reduce the portfolio’s risk. Therefore the Markowitz diversification focuses on the correlation between assets.
Thursday, September 9, 2010
Overview of Investment Alternative
Overview of Investment Alternative
1) Equity Security:
1. A. Common Stock: It represents ownership interest in issuing corporation.
a. Class A: Non voting common stock entitled to receive dividend.
b. Class B: Voting common stock not entitled to receive dividend.
1. B. Preferred Stock: Usually non voting but has priority over common stock in dividend and liquidation right.
2) Short Term Debt Securities: Obligations that matures in one year or less than one year.
2. A Negotiable CDs: Issue by federally insured commercial banks with minimum face value of Rs. 100,000.
2. B. Commercial Paper: Promissory negotiable notes issued by larger well known corporations.
2. C. Banker's Acceptance: Used by importers. The accepting bank guarantees payment by borrowers.
2. D. T-Bills
3) Intermediate and Long term Debt: Obligate that matures more then one year.
3. A. U. S. government Securities:
3. A.I. Treasury Notes: Maturity 1-10 years. Sold at face value with specified interest payment
3. A.II. Treasury Bonds: Maturity over 10 years.
3. A.III. Saving Bonds: Non negotiable saving instrument issued by government.
3. B. Municipal Securities:
3B.I Revenue Bonds: Issued to obtain financing for specific project such as hydropower, hospital. Revenue from these projects are earmarked to meet interest and principal payments.
3.B II. General Obligation Bonds: The general revenues (tax) of the issuer provides fund to meet interest and principal payments.
3. C Corporate Bonds
4. Hybrid Securities: Securities that have characteristic of both equity and debts.
4. A. Convertible preferred Stock: Convert preferred stock to common stock.
4. B Convertible Bonds: Convert bonds to common stock.
5 Derivative Securities: Securities whose value derives from the value of underlying securities.
5. A. Option: Provide the right to buy or sell shares of common stock of a specific corporation within a limited period of time at a designated price (Exercise price)
5. B Commodity Futures: Provides the contract holders the right to sell a specified amount of an agriculture or natural resources commodity a designated price with in a specified period to time.
5.C. Financial Futures: Provides the contract holders the right to sell a specified amount of common stock index; bonds or FCY at a designated price within a specified period of time.
5. D. Option on Futures: Provides the right to buy or sell a specified commodity or financial futures within a limited period of time at a designated price.
5. E Rights: Rights share.
5.F Warrants: Issued by corporations provide holder the right or option to purchase additional bonds or shares of common stock from the issuing corporation at a specified price within designated period of time.
6) Real Assets:
6. A. Precious Metals: includes gold, silver, platinum and other metals.
6. B. Real Estate: Single and multi family residence undeveloped Land, commercial property and farm land.
6.C: Collections: Diamonds, prints, fine arts, stamps.
7) International Investments: Investment by individuals in debt or equity securities issued by organization outside the country of residence of the investor.
7. A. Multinational Corporation
7. B. Foreign Stock Traded on a Local Exchange.
8) Other Investment Alternatives:
8. A. Pension Funds:
8. B. Mutual Funds
1) Equity Security:
1. A. Common Stock: It represents ownership interest in issuing corporation.
a. Class A: Non voting common stock entitled to receive dividend.
b. Class B: Voting common stock not entitled to receive dividend.
1. B. Preferred Stock: Usually non voting but has priority over common stock in dividend and liquidation right.
2) Short Term Debt Securities: Obligations that matures in one year or less than one year.
2. A Negotiable CDs: Issue by federally insured commercial banks with minimum face value of Rs. 100,000.
2. B. Commercial Paper: Promissory negotiable notes issued by larger well known corporations.
2. C. Banker's Acceptance: Used by importers. The accepting bank guarantees payment by borrowers.
2. D. T-Bills
3) Intermediate and Long term Debt: Obligate that matures more then one year.
3. A. U. S. government Securities:
3. A.I. Treasury Notes: Maturity 1-10 years. Sold at face value with specified interest payment
3. A.II. Treasury Bonds: Maturity over 10 years.
3. A.III. Saving Bonds: Non negotiable saving instrument issued by government.
3. B. Municipal Securities:
3B.I Revenue Bonds: Issued to obtain financing for specific project such as hydropower, hospital. Revenue from these projects are earmarked to meet interest and principal payments.
3.B II. General Obligation Bonds: The general revenues (tax) of the issuer provides fund to meet interest and principal payments.
3. C Corporate Bonds
4. Hybrid Securities: Securities that have characteristic of both equity and debts.
4. A. Convertible preferred Stock: Convert preferred stock to common stock.
4. B Convertible Bonds: Convert bonds to common stock.
5 Derivative Securities: Securities whose value derives from the value of underlying securities.
5. A. Option: Provide the right to buy or sell shares of common stock of a specific corporation within a limited period of time at a designated price (Exercise price)
5. B Commodity Futures: Provides the contract holders the right to sell a specified amount of an agriculture or natural resources commodity a designated price with in a specified period to time.
5.C. Financial Futures: Provides the contract holders the right to sell a specified amount of common stock index; bonds or FCY at a designated price within a specified period of time.
5. D. Option on Futures: Provides the right to buy or sell a specified commodity or financial futures within a limited period of time at a designated price.
5. E Rights: Rights share.
5.F Warrants: Issued by corporations provide holder the right or option to purchase additional bonds or shares of common stock from the issuing corporation at a specified price within designated period of time.
6) Real Assets:
6. A. Precious Metals: includes gold, silver, platinum and other metals.
6. B. Real Estate: Single and multi family residence undeveloped Land, commercial property and farm land.
6.C: Collections: Diamonds, prints, fine arts, stamps.
7) International Investments: Investment by individuals in debt or equity securities issued by organization outside the country of residence of the investor.
7. A. Multinational Corporation
7. B. Foreign Stock Traded on a Local Exchange.
8) Other Investment Alternatives:
8. A. Pension Funds:
8. B. Mutual Funds
The Investment Process:
The Investment Process:
Investment process describes how an investor should go about making decision with regard to what marketable securities to invest in, how extensive the investment should be and when the investment should be made. A five step procedure for making these decisions forms the basis of the investment process.
1. Set Investment Policy
2. Perform Security Analysis
3. Construct a portfolio
4. Revise the portfolio
5. Evaluate the performance of the portfolio.
The process always starts with the investor and understanding his or her needs and preferences. For a portfolio manager, the first and often most significant part of the investment process is understanding the client’s needs, the client’s tax status and most importantly, his or her risk preferences. For an individual investor constructing his or her own portfolio, this may seem simpler, but understanding one’s own needs and preferences is just as important a first step as it is for the portfolio manager.
The next part of the process is the actual construction of the portfolio, which we divide into three sub-parts. The first of these is the decision on how to allocate the portfolio across different asset classes defined broadly as equities, fixed income securities and real assets (such as real estate, commodities and other assets). This asset allocation decision can also be framed in terms of investments in domestic assets versus foreign assets, and the factors driving this decision. The second component is the asset selection decision, where individual assets are picked within each asset class to make up the portfolio. In practical terms, this is the step where the stocks that make up the equity component, the bonds that make up the fixed income component and the real assets that make up the real asset component are picked. The final component is execution, where the portfolio is actually put together, where investors have to trade off transactions cost against transactions speed. While the importance of execution will vary across investment strategies, there are many investors who have failed at this stage in the process.
The final part of the process, and often the most painful one for professional money managers, is the performance evaluation. Investing is after all focused on one objective and one objective alone, which is to make the most money you can, given the risk constraints you operate under. Investors are not forgiving of failure and unwilling to accept even the best of excuses, and loyalty to money managers is not a commonly found trait. By the same token, performance evaluation is just as important to the individual investor who constructs his or her own portfolio, since the feedback from it should largely determine how that investor approaches investing in the future.
Investment process describes how an investor should go about making decision with regard to what marketable securities to invest in, how extensive the investment should be and when the investment should be made. A five step procedure for making these decisions forms the basis of the investment process.
1. Set Investment Policy
2. Perform Security Analysis
3. Construct a portfolio
4. Revise the portfolio
5. Evaluate the performance of the portfolio.
The process always starts with the investor and understanding his or her needs and preferences. For a portfolio manager, the first and often most significant part of the investment process is understanding the client’s needs, the client’s tax status and most importantly, his or her risk preferences. For an individual investor constructing his or her own portfolio, this may seem simpler, but understanding one’s own needs and preferences is just as important a first step as it is for the portfolio manager.
The next part of the process is the actual construction of the portfolio, which we divide into three sub-parts. The first of these is the decision on how to allocate the portfolio across different asset classes defined broadly as equities, fixed income securities and real assets (such as real estate, commodities and other assets). This asset allocation decision can also be framed in terms of investments in domestic assets versus foreign assets, and the factors driving this decision. The second component is the asset selection decision, where individual assets are picked within each asset class to make up the portfolio. In practical terms, this is the step where the stocks that make up the equity component, the bonds that make up the fixed income component and the real assets that make up the real asset component are picked. The final component is execution, where the portfolio is actually put together, where investors have to trade off transactions cost against transactions speed. While the importance of execution will vary across investment strategies, there are many investors who have failed at this stage in the process.
The final part of the process, and often the most painful one for professional money managers, is the performance evaluation. Investing is after all focused on one objective and one objective alone, which is to make the most money you can, given the risk constraints you operate under. Investors are not forgiving of failure and unwilling to accept even the best of excuses, and loyalty to money managers is not a commonly found trait. By the same token, performance evaluation is just as important to the individual investor who constructs his or her own portfolio, since the feedback from it should largely determine how that investor approaches investing in the future.
The Investment Environment:
1.2 The Investment Environment:
1.2.1 Securities:
A security is a fungible, negotiable instrument representing financial value. Securities are broadly categorized into debt securities, such as banknotes, bonds and debentures, and equity securities, e.g. common stocks. The company or other entity issuing the security is called the issuer.
Securities may be represented by a certificate or, more typically, by an electronic book entry. Certificates may be bearer, meaning they entitle the holder to rights under the security merely by holding the security, or registered, meaning they entitle the holder to rights only if he or she appears on a security register maintained by the issuer or an intermediary. They include shares of corporate stock or mutual funds, bonds issued by corporations or governmental agencies, stock options or other options, limited partnership units, and various other formal investment instruments that are negotiable and fungible.
Normally securities are only a piece of paper that represents (a)the rights of the investors on certain property and (b) the conditions under which s/he may exercise those rights.
The security can be used to refer to a legal representation of the right to receive prospective future benefits under stated conditions. Securities can be easily and efficiently transferred from one owner to antoher.
The rate of return (simply return) for any security can be calculated by using following principle:
Return =
Most popular securities available in market:
>Treasury Bills
> Long Term Bonds
> Common Stock
1.1.2 Security Markets:
Market where buyers and sellers of security come together and make security transactions. It is common place created to facilitate the exchange of financial assets. Security market can be classified into primary markets and secondary markets. Again Primary market itself can be subdivided into seasoned and unseasoned new issues. A seasoned new issue refers to the offering of an additional amount of an already existing security where as unseasoned new issue- also called Initial Public Offering (IPO)- involves the initial offering of a security to the public. Besides this way of distinguishing security markets other classification can be:
Money Vs Capital Market
Open Vs Negotiated Market
Spot Vs Future Markets.
1.1.3. Financial Intermediaries:
A financial intermediary is typically an institution that facilitates the channeling of funds between lenders and borrowers indirectly. That is, savers (lenders) give funds to an intermediary institution (such as a bank), and that institution gives those funds to spenders (borrowers). This may be in the form of loans or mortgages.
An institution that acts as the middleman between investors and firms raising funds. Often referred to as financial institutions. This can include chartered banks, insurance companies, investment dealers, mutual funds, and pension funds.Commercial banks are the financial intermediary we meet most often in macroeconomics, but mutual funds, pension funds, credit unions, savings and loan associations, and to some extent insurance companies are also important financial intermediaries.
Financial intermediaries provide two important advantages to savers. First, lending through an intermediary is usually less risky than lending directly. The major reason for reduced risk is that a financial intermediary can diversify. It makes a great many loans, and even though some of those loans will be mistakes, the losses will be largely offset by loans that are sound. In contrast, an average saver could directly make only a few loans, and any bad loans would substantially affect his wealth. Because an intermediary can put its "eggs" in many "baskets," it insures its depositors from substantial losses.
A second advantage financial intermediaries give savers is liquidity. Liquidity is the ability to convert assets into a spendable form--money--quickly. A house is an illiquid asset; selling one can take a great deal of time. If an individual saver has lent money directly to another person, the loan can also be an illiquid asset. If the lender suddenly needs cash, he must either persuade the borrower to repay quickly, which may not be possible, or he must find someone else who will buy the loan from him, which may be very difficult. Although the intermediary may use its funds to make illiquid loans, its size allows it to hold some funds idle as cash to provide liquidity to individual depositors. Only when a great many depositors want to withdraw deposits at the same time, which happens when there is a "run" on the institution, will the financial intermediary be unable to provide liquidity. Unless it can obtain help from the government or other institutions, it will be forced to suspend payments to depositors.
Economists are concerned that financial intermediaries can be a source of shocks to the economy, bumps that can disrupt the normal flow of economic life. This concern arises for at least two reasons. First, bank debt serves as money, so disruptions to banks can affect the amount of money in circulation. Second, financial intermediaries are tied together through chains of debts and assets. Because of these linkages, the failure of one financial intermediary can weaken others, increasing their chances of failure. As a result, there is the possibility that if a key financial intermediary fails, that failure can create a domino effect that could cause other financial institutions to fail, ultimately causing the financial sector to "seize up" and stop functioning. Serious disruption of the financial markets will disrupt the rest of the economy.
1.2.1 Securities:
A security is a fungible, negotiable instrument representing financial value. Securities are broadly categorized into debt securities, such as banknotes, bonds and debentures, and equity securities, e.g. common stocks. The company or other entity issuing the security is called the issuer.
Securities may be represented by a certificate or, more typically, by an electronic book entry. Certificates may be bearer, meaning they entitle the holder to rights under the security merely by holding the security, or registered, meaning they entitle the holder to rights only if he or she appears on a security register maintained by the issuer or an intermediary. They include shares of corporate stock or mutual funds, bonds issued by corporations or governmental agencies, stock options or other options, limited partnership units, and various other formal investment instruments that are negotiable and fungible.
Normally securities are only a piece of paper that represents (a)the rights of the investors on certain property and (b) the conditions under which s/he may exercise those rights.
The security can be used to refer to a legal representation of the right to receive prospective future benefits under stated conditions. Securities can be easily and efficiently transferred from one owner to antoher.
The rate of return (simply return) for any security can be calculated by using following principle:
Return =
Most popular securities available in market:
>Treasury Bills
> Long Term Bonds
> Common Stock
1.1.2 Security Markets:
Market where buyers and sellers of security come together and make security transactions. It is common place created to facilitate the exchange of financial assets. Security market can be classified into primary markets and secondary markets. Again Primary market itself can be subdivided into seasoned and unseasoned new issues. A seasoned new issue refers to the offering of an additional amount of an already existing security where as unseasoned new issue- also called Initial Public Offering (IPO)- involves the initial offering of a security to the public. Besides this way of distinguishing security markets other classification can be:
Money Vs Capital Market
Open Vs Negotiated Market
Spot Vs Future Markets.
1.1.3. Financial Intermediaries:
A financial intermediary is typically an institution that facilitates the channeling of funds between lenders and borrowers indirectly. That is, savers (lenders) give funds to an intermediary institution (such as a bank), and that institution gives those funds to spenders (borrowers). This may be in the form of loans or mortgages.
An institution that acts as the middleman between investors and firms raising funds. Often referred to as financial institutions. This can include chartered banks, insurance companies, investment dealers, mutual funds, and pension funds.Commercial banks are the financial intermediary we meet most often in macroeconomics, but mutual funds, pension funds, credit unions, savings and loan associations, and to some extent insurance companies are also important financial intermediaries.
Financial intermediaries provide two important advantages to savers. First, lending through an intermediary is usually less risky than lending directly. The major reason for reduced risk is that a financial intermediary can diversify. It makes a great many loans, and even though some of those loans will be mistakes, the losses will be largely offset by loans that are sound. In contrast, an average saver could directly make only a few loans, and any bad loans would substantially affect his wealth. Because an intermediary can put its "eggs" in many "baskets," it insures its depositors from substantial losses.
A second advantage financial intermediaries give savers is liquidity. Liquidity is the ability to convert assets into a spendable form--money--quickly. A house is an illiquid asset; selling one can take a great deal of time. If an individual saver has lent money directly to another person, the loan can also be an illiquid asset. If the lender suddenly needs cash, he must either persuade the borrower to repay quickly, which may not be possible, or he must find someone else who will buy the loan from him, which may be very difficult. Although the intermediary may use its funds to make illiquid loans, its size allows it to hold some funds idle as cash to provide liquidity to individual depositors. Only when a great many depositors want to withdraw deposits at the same time, which happens when there is a "run" on the institution, will the financial intermediary be unable to provide liquidity. Unless it can obtain help from the government or other institutions, it will be forced to suspend payments to depositors.
Economists are concerned that financial intermediaries can be a source of shocks to the economy, bumps that can disrupt the normal flow of economic life. This concern arises for at least two reasons. First, bank debt serves as money, so disruptions to banks can affect the amount of money in circulation. Second, financial intermediaries are tied together through chains of debts and assets. Because of these linkages, the failure of one financial intermediary can weaken others, increasing their chances of failure. As a result, there is the possibility that if a key financial intermediary fails, that failure can create a domino effect that could cause other financial institutions to fail, ultimately causing the financial sector to "seize up" and stop functioning. Serious disruption of the financial markets will disrupt the rest of the economy.
What is investment?
In finance, investment refers to purchasing securities or any other financial assets from the capital market or money market or purchasing real properties with high market liquidity for example, gold, silver, real properties, and precious items. Financial investments are investment in stocks, bonds, and many other types of security investments. Indirect financial investments can also be done with the help of mediators or third parties, such as pension funds, mutual funds, commercial banks, and insurance companies.
In finance, investment=cost of capital, like buying securities or other monetary or paper (financial) assets in the money markets or capital markets, or in fairly liquid real assets, such as gold, real estate, or collectibles. Valuation is the method for assessing whether a potential investment is worth its price. Returns on investments will follow the risk-return spectrum.
Types of financial investments include shares, other equity investment, and bonds (including bonds denominated in foreign currencies). These financial assets are then expected to provide income or positive future cash flows, and may increase or decrease in value giving the investor capital gains or losses.
Trades in contingent claims or derivative securities do not necessarily have future positive expected cash flows, and so are not considered assets, or strictly speaking, securities or investments. Nevertheless, since their cash flows are closely related to (or derived from) those of specific securities, they are often studied as or treated as investments.
Investments are often made indirectly through intermediaries, such as banks, mutual funds, pension funds, insurance companies, collective investment schemes, and investment clubs. Though their legal and procedural details differ, an intermediary generally makes an investment using money from many individuals, each of whom receives a claim on the intermediary.
In finance, investment=cost of capital, like buying securities or other monetary or paper (financial) assets in the money markets or capital markets, or in fairly liquid real assets, such as gold, real estate, or collectibles. Valuation is the method for assessing whether a potential investment is worth its price. Returns on investments will follow the risk-return spectrum.
Types of financial investments include shares, other equity investment, and bonds (including bonds denominated in foreign currencies). These financial assets are then expected to provide income or positive future cash flows, and may increase or decrease in value giving the investor capital gains or losses.
Trades in contingent claims or derivative securities do not necessarily have future positive expected cash flows, and so are not considered assets, or strictly speaking, securities or investments. Nevertheless, since their cash flows are closely related to (or derived from) those of specific securities, they are often studied as or treated as investments.
Investments are often made indirectly through intermediaries, such as banks, mutual funds, pension funds, insurance companies, collective investment schemes, and investment clubs. Though their legal and procedural details differ, an intermediary generally makes an investment using money from many individuals, each of whom receives a claim on the intermediary.
Market index
Market Index
Securities market index are construct to get the answer of following questions; “What is the market doing?”, “What did the market do yesterday?” Index number is devoid of dollar values or other units of measure. Stock market index are “pure number” use for marketing composition between different index numbers in the same series of other index number. Market index are also know as the indicator of the movement of the overall securities prices in the secondary market.
E.g.
Nepal Stock Exchange (NEPSE)
Dow Jones Industrial Average (DJIA)
Standard & Poor 500 Index
Market index furnish a handy summary of historical price levels in their specific markets, especially when they are presented in graphical form. By the use of index, investors who own several securities in a give market or industry can quickly get an indication of how mkt movements have affected the value of their portfolio. Similarly, indexes are useful for historical analysis. By analyzing mkt indexes and other economic indicators, an analyst may detect some consistent relationship between different indexes and the fortunes of sectors of the economy.
Methods of Calculating Index:
There are four most popular methods to compute market index. They are:
1) Price Weighting:
The Dow Jones Industrial Average is calculated by using this method. In this method index is calculated by summing the prices of the stocks that are included in the index and ends by dividing this sum by a constant (called Divisor). Mathematically, the formula is:
Securities market index are construct to get the answer of following questions; “What is the market doing?”, “What did the market do yesterday?” Index number is devoid of dollar values or other units of measure. Stock market index are “pure number” use for marketing composition between different index numbers in the same series of other index number. Market index are also know as the indicator of the movement of the overall securities prices in the secondary market.
E.g.
Nepal Stock Exchange (NEPSE)
Dow Jones Industrial Average (DJIA)
Standard & Poor 500 Index
Market index furnish a handy summary of historical price levels in their specific markets, especially when they are presented in graphical form. By the use of index, investors who own several securities in a give market or industry can quickly get an indication of how mkt movements have affected the value of their portfolio. Similarly, indexes are useful for historical analysis. By analyzing mkt indexes and other economic indicators, an analyst may detect some consistent relationship between different indexes and the fortunes of sectors of the economy.
Methods of Calculating Index:
There are four most popular methods to compute market index. They are:
1) Price Weighting:
The Dow Jones Industrial Average is calculated by using this method. In this method index is calculated by summing the prices of the stocks that are included in the index and ends by dividing this sum by a constant (called Divisor). Mathematically, the formula is:
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