Chapter 1 The Investment Environment

Chapter 1(The Investment environment)
1. Investment: An investment is an asset or item acquired with the goal of generating income or
appreciation. Appreciation refers to an increase in the value of an asset over time. When an
individual purchases a good as an investment, the intent is not to consume the good but rather to
use it in the future to create wealth. An investment always concerns the outlay of some asset today
—time, money, or effort—in hopes of a greater payoff in the future than what was originally put
in.
2. Real Assets: Real assets are physical assets that have an intrinsic worth due to their substance
and properties. Real assets include precious metals, commodities, real estate, land, equipment, and
natural resources.
3. Fixed-Income (debt) Securities: A fixed-income security is an investment that provides a return
in the form of fixed periodic interest payments and the eventual return of principal at maturity.
Unlike variable-income securities, where payments change based on some underlying measure—
such as short-term interest rates—the payments of a fixed-income security are known in advance.
4. Equity: Equity, typically referred to as shareholders' equity (or owners’ equity' for privately held
companies), represents the amount of money that would be returned to a company’s shareholders
if all of the assets were liquidated and all of the company's debt was paid off.
In addition, shareholder equity can represent the book value of a company. Equity can sometimes be
offered as kind. It also represents the pro-rata ownership of a company's shares. Equity can be found on a
company's balance sheet and is one of the most common pieces of data employed by analysts to assess the
financial health of a company.
5. Derivative Securities: A derivative is a financial security with a value that is reliant upon or
derived from, an underlying asset or group of assets—a benchmark. The derivative itself is a
contract between two or more parties, and the derivative derives its price from fluctuations in the
underlying asset.
The most common underlying assets for derivatives are stocks, bonds, commodities, currencies, interest
rates, and market indexes. These assets are commonly purchased through brokerages.
6. Agency Problem: The agency problem is a conflict of interest inherent in any relationship where
one party is expected to act in another's best interests. In corporate finance, the agency problem
usually refers to a conflict of interest between a company's management and the company's
stockholders. The manager, acting as the agent for the shareholders, or principals, is supposed to
make decisions that will maximize shareholder wealth even though it is in the manager’s best
interest to maximize his own wealth.
7. Security Analysis: Security analysis refers to the method of analyzing the value of
securities like shares and other instruments to assess the total value of business which will be
useful for investors to make decisions. There are three methods to analyze the value of securities –
fundamental, technical, and quantitative analysis.
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8. Passive Management: Passive management is a style of management associated with mutual
and exchange-traded funds (ETF) where a fund's portfolio mirrors a market index. Passive
management is the opposite of active management in which a fund's manager(s) attempt to beat
the market with various investing strategies and buying/selling decisions of a portfolio's securities.
Passive management is also referred to as "passive strategy," "passive investing," or " index
investing."
9. Active Management: The term active management implies that a professional money
manager or a team of professionals is tracking the performance of a client's investment
portfolio and regularly making buy, hold, and sell decisions about the assets in it. The goal of the
active manager is to outperform the overall market.
10. Financial Intermediaries: A financial intermediary is a firm or an institution that acts an
intermediary between a provider of service and the consumer. It is the institution or individual
that is in between two or more parties in a financial context. In theoretical terms, a financial
intermediary channels savings into investments. Financial intermediaries exist for profit in the
financial system and sometimes there is a need to regulate the activities of the same. Also, recent
trends suggest that financial intermediaries role in savings and investment functions can be used
for an efficient market system or like the sub-prime crisis shows, they can be a cause for concern
as well.
11. Investment Banker: Investment bankers are intermediaries who help their clients – whether
individuals, businesses, or governments – wisely invest their money. Investment bankers are also
responsible for buying and selling stocks and securities on behalf of their clients.
12. Primary Market: A primary market issues new securities on an exchange for companies,
governments, and other groups to obtain financing through debt-based or equity-based securities.
Primary markets are facilitated by underwriting groups consisting of investment banks that set a
beginning price range for a given security and oversee its sale to investors.
Once the initial sale is complete, further trading is conducted on the secondary market, where the bulk of
exchange trading occurs each day.
13. Secondary Market: A secondary market is a market where investors purchase securities or
assets from other investors, rather than from issuing companies themselves.
14. Venture Capital: Venture capital is a form of private equity and a type of financing that
investors provide to startup companies and small businesses that are believed to have long-term
growth potential.
15. Private Equity: Private equity is an alternative investment class and consists of capital that is not
listed on a public exchange. Private equity is composed of funds and investors that directly invest
in private companies, or that engage in buyouts of public companies, resulting in the delisting of
public equity. Institutional and retail investors provide the capital for private equity, and the
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capital can be utilized to fund new technology, make acquisitions, expand working capital, and to
bolster and solidify a balance sheet.
A private equity fund has Limited Partners (LP), who typically own 99 percent of shares in a fund and
have limited liability, and General Partners (GP), who own 1 percent of shares and have full liability. The
latter are also responsible for executing and operating the investment.
16. Securitization: Securitization is the procedure where an issuer designs a marketable financial
instrument by merging or pooling various financial assets into one group. The issuer then sells this
group of repackaged assets to investors. Securitization offers opportunities for investors and frees
up capital for originators, both of which promote liquidity in the marketplace.
In theory, any financial asset can be securitized—that is, turned into a tradeable, fungible item of
monetary value. In essence, this is what all securities are. However, securitization most often occurs with
loans and other assets that generate receivables such as different types of consumer or commercial debt. It
can involve the pooling of contractual debts such as auto loans and credit card debt obligations.
17. Systematic Risk: Systematic risk refers to the risk inherent to the entire market or market
segment. Systematic risk, also known as “undiversifiable risk,” “volatility” or “market risk,”
affects the overall market, not just a particular stock or industry. This type of risk is both
unpredictable and impossible to completely avoid. It cannot be mitigated through diversification,
only through hedging or by using the correct asset allocation strategy.
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Chapter 2(Asset Classes and Financial Instruments)
1. The Instruments of Money Market
i Treasury Bill
ii Commercial Paper
iii Banker’s Acceptance
iv Certificate of Deposit (CD)
v Repurchase Agreement (Repo)
vi Short-term treasury notes and bonds
vii International emergency deposit
2. Treasury bill is government promissory letters. The government receives short-term loan (short-
term liabilities) through it. Treasury bill is the written document by which the government is
pledged to pay the due loan back with interest after three months. The interest is the difference
between the purchase price and the price paid either at maturity (face value) or the price of the bill
if sold prior to maturity. Theoretically, the government of Bangladesh issued three types of T-bills
through auctions, namely 91 days, 182days and 364 days.
Treasury Bills:
Most marketable of all money market securities.
Simplest form of borrowing.
Government raises money by selling bills to the public
Investors buy the bills at a discount from the stated maturity value
Maturities may be 4, 13, 26, or 52 weeks
Exempt from all state and local taxes
3. Certificate of Deposit (CD) is a savings certificate entitling the bearer to receive interest. A
banking certificate bears a maturity date, a specified fixed interest rate and can be issued in any
denomination. CDs are generally issued by the commercial banks. The term of a CD ranges from
one month to 05 years.
Certificates of Deposit (CD):
Time deposit with a bank
Interest bearing deposits at commercial banks or savings and loan associations
The bank pays interest & principle to the depositor only at the end of the fixed term of CD
4. Commercial Paper is a common form of unsecured, short-term debt issued by a corporation.
Commercial paper is typically issued for the financing of payroll, accounts payable, inventories,
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and meeting other short-term liabilities. Maturities on most commercial paper ranges from a few
weeks to months. Commercial paper is usually issued at a discount from face value and reflects
prevailing market interest rates.
Commercial Paper:
Issued by well-known companies
Short-term unsecured debt
Maturities 270 days
5. Banker's Acceptance is a form of payment that is guaranteed by a bank rather than an individual
account holder. Banker's Acceptances are most frequently used in international trade to finalize
transactions with relatively little risk to either party. Banker's acceptances are traded at a discount
in the secondary money markets.
Banker’s Acceptances
Order to a bank by a bank’s customer to pay a sum of money at a future date.
Maturities 6 months or less than one year.
Similar to postdated cheque.
Widely used in foreign trade.
6. Eurodollars are time deposits denominated in US dollars at banks outside the US banking system
(especially in the European banking system) and thus Eurodollars are not subject to regulations by
the Federal Reserve. So, Eurodollars are dollar-denominated deposits at foreign banks or at the
overseas branches of US banks.
Eurodollars
Dollar-denominated time deposits in commercial banks outside United States
Eurodollars deposits cannot be traded and they are not negotiable
7. Repo (Repurchase Agreement) means the purchase of securities with the agreement to sell them
at a higher price at a specific future date. For the party selling the security (and agreeing to
repurchase it in the future) it is a repo; for the party on the other end of the transaction (buying the
security and agreeing to sell in the future) it is a reverse repurchase agreement.
Repos are classified as a money-market instrument. They are usually used to raise short-term capital.
Bangladesh Bank sells this instrument to the commercial banks with the agreement that it will be bought
back after a certain period of time. It is used to control the supply of money in the economy.
8. Reverse Repo (Reverse Repurchase Agreement) is an act of buying securities with the intention
of returning—reselling—those same assets back in the future at a profit. This process is the
opposite side of the coin to the repurchase agreement. The central bank uses this tool when it feels
there is too much money floating in the banking system.
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If the reverse repo rate is increased, it means Bangladesh Bank will borrow money from the bank and
offer them a lucrative rate of interest. As a result, banks would prefer to keep their money with
Bangladesh Bank (which is absolutely risk-free) instead of lending it out. Consequently, banks would
have lesser funds to lend to their customers. This helps stem the flow of excess money into the economy.
Reverse repo rate signifies the rate at which the central bank absorbs liquidity from the banks, while repo
signifies the rate at which liquidity is injected.
Repos and Reverses
Dealers in government securities use repurchase agreements
Seller of such instrument may agree to repurchase it for a agreed-on price at a later date.
Collateralized loan from buyer to seller.
Bond Market Instruments
9. Treasury Notes & Bonds are marketable securities the government sells in order to pay off
maturing debt and to raise the cash needed to run the federal government. When a person buys one
of these securities, s/he is lending his/her money to the government of the Bangladesh. Treasury
notes and bonds are securities that have a stated interest rate that is paid semi-annually until
maturity. What make notes and bonds different are the terms to maturity. Notes are issued in two-,
three-, five- and 10-year terms. Conversely, bonds are long-term investments with terms of more
than 10 years.
10. Treasury bond refers to a certificate issued by the government acknowledging that money has
been lent to it and will be paid back with interest. Bond is a debt investment in which an investor
loans money to an entity (typically governmental) which borrows the funds for a defined period of
time at a variable or fixed interest rate. Bonds are used by sovereign governments to raise money
and finance a variety of projects and activities.
Treasury notes and bonds:
Treasury notes are similar to the treasury certificate accept with regard to time of maturity. Notes
have a maturity of one to ten years when they are newly issued.
Bonds mature and repay their face value within a period from ten to thirty years from the date of
issue. Some bond issues are callable or redeemable prior to maturity.
11. Treasury Inflation-Protected Securities (TIPS) are a form of US Treasury bonds designed to
help investors protect against inflation. These bonds are indexed to inflation, have the US
government backing, and pay investors a fixed interest rate as the bond's par value adjusts with the
inflation rate.
12. Federal Agency Debt Securities represents the face value of securities held by the Federal
Reserve. Agency securities are obligations of the Federal government agencies or government
sponsored agencies.
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13. International Bonds: An international bond is a debt obligation that is issued in a country by a
non-domestic entity in its native currency. International bonds are usually corporate bonds.
International bonds can offer portfolio diversification, but are highly subject to currency risk.
14. Municipal Bonds: A municipal bond is a debt security issued by a state, municipality or county to
finance its capital expenditures, including the construction of highways, bridges or schools. They
can be thought of as loans that investors make to local governments. Municipal bonds are exempt
from federal taxes and most state and local taxes, making them especially attractive to people in
high income tax brackets.
15. Corporate Bond is a debt security issued by a company in order for it to raise capital. An investor
who buys a corporate bond is effectively loaning money to the company in return for a series of
interest payments, but these bonds may also actively trade on the secondary market. Corporate
bonds are typically seen as somewhat riskier than U.S. government bonds, so they usually have
higher interest rates.
Corporate Bonds
Private firms borrow money directly from the public or when the corporations go to the capital
market to obtain money for all corporate purposes
Long-term debt securities
16. Mortgage is a debt instrument, secured by the collateral of specified real estate property that the
borrower is obliged to pay back with a predetermined set of payments. Mortgages are also known
as "liens against property" or "claims on property." With a fixed-rate mortgage, the borrower pays
the same interest rate for the life of the loan. Individuals and businesses use mortgages to make
large real estate purchases without paying the entire purchase price up front. Over many years, the
borrower repays the loan with interest until she or he owns the property free and clear.
17. Mortgage-Backed Security (MBS): A mortgage-backed security (MBS) is an investment similar
to a bond that is made up of a bundle of home loans bought from the banks that issued them.
Investors in MBS receive periodic payments similar to bond coupon payments. The MBS is a type
of asset-backed security. As became glaringly obvious in the subprime mortgage meltdown of
2007-2008, a mortgage-backed security is only as sound as the mortgages that back it up.
18. How a Mortgage-Backed Security Works?
First, a bank or mortgage company makes a home loan. The bank then sells that loan to an investment
bank. It uses the money received from the investment bank to make new loans. The investment bank adds
the loan to a bundle of mortgages with similar interest rates. It puts the bundle in a special company
designed for that purpose. It's called a Special Purpose Vehicle (SPV) or Special Investment Vehicle
(SIV). That keeps the mortgage-backed securities separate from the bank's other services. The SPV
markets the mortgage-backed securities.
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Mortgages and mortgage backed securities
➢ Ownership claim in a pool of mortgages or an obligation that is secured by such a pool
Equity Securities
19. Common Stock and Preferred Stock: Common stock and preferred stock are the two main types
of stocks that are sold by companies and traded among investors in the open market. Each type
gives stockholders a partial ownership in the company represented by the stock.
20. Common Stock is the most common type of stock that is issued by companies. It entitles
shareholders to share in the company’s profits through dividends and/or capital appreciation.
Common stockholders are usually given voting rights with the number of votes directly related to
the number of shares owned. Of course, the company’s board of directors can decide whether or
not to pay dividends as well as how much is paid. Owners of common stock have “pre-emptive
rights” to maintain the same proportion of ownership in the company over time. If the company
circulates another offering of stock, shareholders can purchase as much stock as it takes to keep
their ownership comparable. Common stock has the potential for profits through capital gains. The
return and principal value of stocks fluctuate with changes in market conditions. Shares (when
sold) may be worth more or less than their original cost. Shareholders are not assured of receiving
dividend payments. Investors should consider their tolerance for investment risk before investing
in common stock.
21. Preferred Stock is generally considered less volatile than common stock but typically has less
potential for profit. Preferred stockholders generally do not have voting rights as common
stockholders do, but they have a greater claim to the company’s assets. Preferred stock may also
be “callable” which means that the company can purchase shares back from the shareholders at
any time for any reason although usually at a favorable price. Preferred stock shareholders receive
their dividends before common stockholders receive their dividends and these payments tend to be
higher. Shareholders of preferred stock receive fixed, regular dividend payments for a specified
period of time, unlike the variable dividend payments sometimes offered to common stockholders.
Of course, it is important to remember that fixed dividends depend on the company’s ability to
pay as promised. In the event that a company declares bankruptcy, preferred stockholders are paid
before common stockholders. Unlike preferred stock, common stock has the potential to return
higher yields over time through capital growth.
22. Why is preferred stock referred to as a hybrid security?
Preferred stock is a hybrid security because it combines features of common stocks and bonds. At the
same time, it has several unique features that set it apart from both.
Preferred stock is sometimes referred to as a hybrid security because of its bond-like characteristics. Like
bonds, preferred stocks have a par value which is affected by interest rates. When interest rates rise, the
value of the preferred stock declines. However, the value of common stock shares is regulated by demand
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