1. P R E S E N T E D B Y
G R O U P 8 ( M B F 3 R D B A T C H )
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The Investment Setting
Chapter-1
2. Contents
1. What is an Investments?
2. Meaning of Investment from different Perspectives
3. Defining Types of Investments
4. Types of Investors ~ Investments
5. How will you invest your excess income?
6. Why do individual invest?
7. Why give up savings/investing?
8. Pure Rate of Interest & Pure Time Value of Money
9. Investment Risk ~Risk Premium
10. Conclusion
3. Investment is the commitment of money or capital to purchase
financial instruments or other assets in order to gain profitable returns
in the form of interest, income, or appreciation of the value of the
instrument.
In order to drive future payment:
- The time the funds are committed
- The expected rate of inflation during this time period.
- The uncertainty of the future payments.
What is an Investment?
4. What is an Investment?
Investment
Income – Consumption Excess/Deficit Saving/Borrowing
Income>Consumption Excess Income Saving
Income<Consumption Higher Consumption Borrowing
Income = Consume ?
Excess Income ?
Expand Business ?
Increase Skills ?
Profitability ?
Cost Minimization ?
Profit Maximization ?
5. Meaning of Investment from different Perspectives
Investment Definition in terms of Economics :
Investment is defined as the per unit production of goods .
(Which have not been consumed , but will be used for the purpose of future production)
Investment Definition in terms of Business Management:
Investment refers to tangible assets and intangible assets.
(The decision for investment is also known as capital budgeting decision)
Investment Definition in terms of Finance:
Investment refers to the purchasing of securities or other financial assets from the capital
market. It also means buying money market or real properties with high market liquidity.
Example : Gold, silver, real properties, and precious items.
6. Investment Definition in terms of Personal Finance:
An investment is the implementation of money for buying shares , mutual funds or assets
with capital risk.
Investment Definition in terms of Real Estate:
Investment is referred to as money utilized for buying property for the purpose of
ownership or leasing. This also involves capital risk.
Example : Commercial Real Estate : Renting
Residential Real Estate: Buying properties
Meaning of Investment from different Perspectives
7. Defining Types of Investments
Ownership Investments
High risk-High return investments : Stocks , Real Estate, Precious objects
Lending Investments
Low risk-Low return investments : Savings , Bonds
Cash Equivalents
Easy to convert back into cash : Money market funds
Close, but Not Quite
Education
Not Investments
Consumer purchases
9. How will you invest your excess income?
Ownership Investments
Lending Investments
Cash Equivalents
INVESTOR’S PREFERENCE
Highest Return
Lowest Risk
Liquid Assets
Investors are trading a known dollar amount today for some expected future stream of
payments that will be greater than the current dollar amount today.
10. Why do individual invest?
One Possibility
Income< Consumption Higher Consumption Borrowing
Income>Consumption Excess Income Saving
Another possibility
Future Return = Future Consumption Give up Saving.
Trade-off
Present consumption > future consumption the reason for saving
11. Why do individual invest?
Individual Motives
Payment for Future Children’s Education
Major Willingness of Purchases
Saving for Retirement
Investment Motives
Profitability
Liquidity
Safety
12. Why give up savings/ investing?
Expect to receive in future > They gave up
Willing to pay back in future > They borrowed
Current Consumption > Current Income Give up
Future Return = Future Consumption Give up Saving
Future Current
Consumption – Consumption= Pure rate of interest
Rate Rate
13. Pure Rate of Interest & Pure Time Value of Money
Pure Rate of Interest
Economics concept of the theoretical interest rate that emerges in market of
loadable funds where conditions of perfect competition and certainty (Zero
Risk) prevail.
Pure time value of money
Pure time value of money is the interest rate demanded by an investor for
postponing his consumption and making available capital to a borrower.
14. Investment Risk ~Risk Premium
Future payment on investment is not certain, Investor’s preference :
Demand on IR > Nominal Risk free IR Investment Risk
Additional Return + Nominal Risk Free Interest Rate
Expected Return– (Risk Free Interest Rate ) Risk Premium
Risk Premium = Required Return - Risk-Free Rate
Risk Free interest Rate=Real Rate of return + Expected Inflation Premium
+ Risk Premium
Real Rate of Return = Nominal Rate of Return – Inflation Rate
Expected Return = Real Rate of Return + Expected Inflation Premium +
Risk Premium
Total Return = Current Income + Capital Gains - Capital Losses
Rate of Return =(Current Income + Capital Gains - Capital Losses)
Amount Invested
15. Conclusion
Q-Why do individuals invest ?
Q- What is an investment?
Q-What do they want from their investment?
Q-How do investors select investments?
How to measure the expected rate of return on an
investment?
How to quantify the uncertainty risk of expected
returns?
Direct Finance/Investment ?
Financial Intermediaries : Banks and Non-Banks Financial Institutions
Savings
Demand/Current Deposits
Time/Fixed Deposits
Call Deposits
In Indirect Finance/Investment ?
Financial Markets : Primary Market and Secondary Market
Short Term Investment – Money Market Instruments
Long Term Investment- Capital Market Instruments
Closely look like investment , Not Quite
1.Your education is called an investment and many times, it does help you earn a higher income.
A case could be made for you "selling" your education like a small business service in return for income like an ownership investment.
The reason it's not technically an investment is a practical one.
2. We'd be "investing" every time we bought an item that could potentially make us more productive,
such as investing in a stress ball to squeeze or a cup of coffee to wake you up.
It is the attempt to stretch the meaning of investment to purchases, rather than education, which has obscured the meaning.
Not Investments
Consumer purchases - beds, cars, TVs and anything that naturally depreciates with use and time - are not investments.
You don't invest in a good night's sleep by buying a foam pillow, or invest in entertainment by buying an mp3 player.
Since you can't reasonably expect someone to pay more for your pillow than the initial purchase cost.
Don't take it personally, but there's very little demand in the second-hand pillow market.
Closely look like investment , Not Quite
1.Your education is called an investment and many times, it does help you earn a higher income.
A case could be made for you "selling" your education like a small business service in return for income like an ownership investment.
The reason it's not technically an investment is a practical one.
2. We'd be "investing" every time we bought an item that could potentially make us more productive,
such as investing in a stress ball to squeeze or a cup of coffee to wake you up.
It is the attempt to stretch the meaning of investment to purchases, rather than education, which has obscured the meaning.
What is PURE RATE OF INTEREST?
An economic concept of the rate of theorertical interest That rises in a market of loanable funds. In this situation a perfect rate of competition and certainty applies. That is, there is no risk involved.
Law Dictionary: What is PURE RATE OF INTEREST? definition of PURE RATE OF INTEREST (Black's Law Dictionary)
Time value of money?
The idea that a dollar now is worth more than a dollar in the future, even after adjusting for inflation,
because a dollar now can earn interest or other appreciation until the time the dollar in the future would be received. This theory has its base in the calculation for present value.Read more: http://www.investorwords.com/4988/time_value_of_money.html#ixzz3x1s85VLc
Rate of return on a security consists of three components.
1. Pure time value of money
2. Inflation premium
3. Risk premium
For an individual, a risk premium is the minimum amount of money by which the expected return on a risky asset must exceed the known return on a risk-free asset in order to induce an individual to hold the risky asset rather than the risk-free asset.
It is positive if the person is risk averse.
Thus it is the minimum willingness to accept compensation for the risk.
Example of observed risk premium
Suppose a game show participant may choose one of two doors, one that hides $1,000 and one that hides $0. Further suppose that the host also allows the contestant to take $500 instead of choosing a door. The two options (choosing between door 1 and door 2, or taking $500) have the same expected value of $500, so no risk premium is being offered for choosing the doors rather than the guaranteed $500.
A contestant unconcerned about risk is indifferent between these choices. A risk-averse contestant will choose no door and accept the guaranteed $500, while a risk-loving contestant will derive utility from the uncertainty and will therefore choose a door.
If too many contestants are risk averse, the game show may encourage selection of the riskier choice (gambling on one of the doors) by offering a positive risk premium. If the game show offers $1,600 behind the good door, increasing to $800 the expected value of choosing between doors 1 and 2, the risk premium becomes $300 (i.e., $800 expected value minus $500 guaranteed amount). Contestants requiring a minimum risk compensation of less than $300 will choose a door instead of accepting the guaranteed $500.