FIN 6160 Investment Theory

1. FIN 6160Investment Theory Lecture 1-2

2. The Investment Environment • Investment: An investment is the current commitment of money or other resources in the expectation of reaping future benefits. • Example: An individual might purchase shares of stock anticipating that the future proceeds from the shares will justify both the time that her money is tied up as well as the risk of the investment. • Investment decisions are made in an environment where higher returns usually can be obtained only at the price of greater risk and in which it is rare to find assets that are so mispriced as to be obvious bargains. Thus risk-return trade off and the efficient pricing of financial assets are central to the investment process. Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

3. Real Assets vs Financial Assets • Real Assets: The material wealth of real assets of the economy is ultimately determined by its productive capacity –goods and services it can produce. E.g. real assets are land, buildings, machines, and knowledge that can be used to produce goods and services. • Financial Assets: Financial assets such as securities (stocks, bonds, option, futures etc.) are no more than sheets of paper or, more likely, computer entries and do not contribute directly to the productive capacity of the economy. Instead, these assets are the means by which individuals in the well developed economies hold their claims on real assets. Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

4. Real Assets vs Financial Assets • Financial assets are claims to the income generated by real assets. If we can not own our own auto plant (a real asset), we can still buy shares in General Motors or Toyota (financial assets) and thereby share in the income derived from the production of automobiles. • While real assets generate net income to the economy, financial assets simply define the allocation of income or wealth among investors. Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

5. Taxonomy of Financial Asset • Fixed Income Securities: Fixed income of debt securities promise either a fixed stream of income or a stream of income that is determined according to a specified formula. • Example: a corporate bond typically would promise that the bondholder will receive a fixed amount of interest each year. Other so called floating rate bonds promise payments that depend on current interest rates. For example, a bond may pay an interest rate that is fixed at 2 percentage points above the rate paid on US treasury bills. Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

6. Securities Traded in Financial Markets • Securities can be classified as: • Money Market Securities • Capital Market Securities • Derivative Securities • Money market securities are debt securities that have a maturity of one year or less. They generally have a relatively high degree of liquidity. Money market securities tend to have a low expected return but also a low degree of risk. Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

7. Table: Money Market Securities Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

8. CapitalMarket Securities: Securities with a maturity more than one year are called capital market securities. Three common type of capital market securities are bonds, mortgages, and stocks. • Bonds & Mortgages: • Bonds are long term debt obligations issued by corporations and govt to support their operations. • Mortgages are long term debt obligations created to finance the purchase of real estate. • Bonds provide a return to investors in the form of interest income (coupon payments) every six months • Bonds and mortgages specify the amount and timing of interest and principal payments to investors who purchase them. • At maturity investors holding the debt securities are paid principal. Debt securities can be sold in the secondary market if investors do not want to hold them until maturity. • Long term debt securities tend to have a higher expected return than money market securities but they have more risk as well. Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

9. Table: Capital Market Securities Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

10. Stocks: • Stocks (also referred to as equity securities) are certificates representing partial ownership in the corporations that issued them. • Stocks are classified as capital market securities because they have no maturity and therefore serve as a long term source of funds. • Some corporations provide income to their stockholders by distributing a portion of their quarterly or yearly income in the form of dividends while others retain and reinvest all of their earnings, which allows them more potential for growth. • Investors can earn a return from stocks in the form of periodic dividends and a capital gain when they sell the stock. • Equity securities have a higher expected return than most long term debt securities but also exhibit a higher degree of risk. Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

11. Derivative Securities: • Derivative securities are financial contracts whose values are derived from the values of underlying assets (such as debt securities or equity securities). Many derivative securities enable investors to engage in speculation and risk management. Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

12. The Investment Process (Saving, Investing, Safe Investing): • Saving means not spending all of your current income on consumption. Investing, on the other hand, is choosing what assets to hold. One may choose to invest in safe assets, risky assets, or a combination of both. Safe investment is when one invest in risk-free asset (saving in an insured bank account). • An investor’s portfolio is simply his collection of investment assets. Once the portfolio is established it is updated or rebalanced by selling existing securities and using the proceeds to buy new securities, by investing additional funds to increase the overall size of the portfolio or by selling securities to decrease the size of the portfolio. • Investors make two types of decisions in constructing their portfolios. The asset allocation decision is the choice among these broad asset classes, while the security selection decision is choice of which particular securities to hold within each asset class. Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

13. Risk-Return Trade-off: • Investors invest for anticipated future returns, but those returns rarely can be predicted precisely. There will almost always be risk associated with investments. Actual or realized returns will almost always deviate from the expected return anticipated at the start of the investment period. • Investors prefer investments with the highest expected return with lowest possible risk. However, due to high competition there is no free lunch. If investors want higher expected returns, they will have to pay a price in terms of accepting higher investment risk. This is called risk-return trade-off in the security market. Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow