Introduction to Financial Markets and Investment.pdf

An Introduction to Financial Markets and Financial Investments

By Dr. Chhiv Sok Thet Professor of Capital Markets and Stock Exchange and Human Resource Management, Pannasastra University of Cambodia

Phnom Penh, April 22, 2014 Research Paper by Chhiv S. Thet, PhD Professor, PUC & EAU, Cambodia, April 22, 2014

An Introduction to Financial Markets and Financial Investments: Dr. Chhiv S. Thet (2014)

TABLE OF CONTENTS Contents.................................................................................................................................2 Abstract.................................................................................................................................3 Introduction..........................................................................................................................4 Part I: Conception of Global Financial and Economic System 1.1 Function of the Global Economic System………………………………….…5 1.2 Function of the Global Financial System……………………………………..6 1.3 Function of Financial markets………………………………………………...9 1.4 Raising Funds for Investment………………………………………………...11 1.5 Model of Financial Markets…………………………………….……….……14 1.6 Types of Financial Markets…………………………………….……….…….15 1.7 Relationship between Lenders and Borrowers in the Financial Markets..........18 1.8 Key Players in the Financial Markets…............................................................18 1.9 Transactions in the Financial Markets…...........................................................21 Part II: Generalization of Financial Investment 2.1 Process of Financial Investment……………………………………..............24 2.2 Financial Assets in the Financial Markets………………………..………….26 Part III: Mathematic in Securities Investment 3.1 Calculation of Money Market Instruments………………………………….30 3.2 Calculation of Bond Price and Yield……..…………………………………32 3.3 Calculation of Stock Price and Dividend……………………………………36 3.4 Calculation of Derivative Securities…...…………………………………….….43 Part IV: Risks and Returns 4.1 Risks in Financial Investment...........................................................................48 4.2 Returns in Financial Investment.......................................................................52 4.3 Calculation of Expected Risks and Returns.....................................................54 Part V: Capital Markets ‘Analytical Tools for Economic Growth 5.1 Measure of Economic Growth..........................................................................61 5.2 Market Capitalization (%) to GDP...................................................................62 2


ABSTRACT The financial markets performed a vital function within the global economic system. It is the heart of global financial system which channels savings to the institutions needing funds for business development. Moreover, it develops a mechanism for financial investment which firms and government institutions can issue the stock, bond and other securities in order to raise extra funds to support their investments and business development projects. Simultaneously, the publics and investors take their money to invest the financial instruments for their income. Hence, this mechanism provides benefits to support economic growth and its affects to the economic and financial sector development in the country as well.

Accordingly, in order to share the significant knowledge of financial markets and financial investment, especially, the capital market establishment in the developing countries. I have extracted them from a part of literature review in my dissertation aiming to give this knowledge to the students, researchers, entrepreneurs, investors, corporations and other individual and institutions to have understanding of the concepts of financial markets, capital markets development and financial investment in the developing countries.

The study collected the secondary data and several sources of information in order to analyze and indicates the conception of financial markets and capital markets as well as its transaction of financial securities. The study also demonstrates how to calculate the money market instruments, bond price and bond yields, stock price and stock dividend and derivative securities as well as risks and returns in financial investment and analytical tools for economic growth.

3


Introduction The financial market has performed a vital function within the global financial and economic system. This market is the heart of the global financial system which mobilizes and allocates the savings and setting the interest rates and prices of financial assets. The financial markets were used as facilitator between lenders and borrowers or sellers and buyers of financial instruments such as stock, bond and other securities. Besides, it channels the savings to those businesses, individuals and institutions needing more funds for the business and investment project expansion and meets their business spending. Thus, the financial markets offer the support to the financial system like the financing, financial information, and equities as well as the corporate governance and financial investment.

Accordingly, the financial market development in the country, particularly; each nation which primarily focused on the capital markets development in the country. Then, it created a mechanism for financial investment in that nation. This mechanism allows the government institutions and private corporations to take opportunities to raise funds from the capital markets through the issuance of the financial instruments such as stock, bond and other securities to support the business and investment expansion projects.

In this regard, the investors, savers, businesspersons and securities dealers as well as and speculators have taken their opportunities to invest or trade the financial securities of the companies or other institutions in order to obtain their incomes from the interest rate, dividend growth and appreciation of securities prices.

4


PART I Conception of Global Financial and Economic System

1.1 Function of Global Economic System The key function of global economic system is an allocation of precious resource with the natural and laboring sources and skills as well as the capitals to produce goods and services. In economic system, it needs to place the inputs into productions in order to receive the goods and services for daily use, therefore, this movement created the production flow to response to the payment flow in economy (figure 1). Figure 1: the Global Economic System Flow of production

Land and natural resources Labor and management skills Capital equipment

Flow of payment

Goods and services sold to the public

Source: Peter S. Rose (2003); Money and Capital Markets: financial institutions and instruments in the global marketplace; Eight Edition; Published by McGraw-Hill/Irwin, New York, USA; page 4

The economic system requires gathering all inputs such as land, natural and laboring resources as well as management skills to place within the production in order to have goods and services for daily consumption. We can also say that the flow in the economic system is a movement between producing entities (companies and governments) and consuming units (households) (see figure 2). In economy, the householders provide labors, management skills and other resources to the corporation and government institutions in order to get back the

5


salary and compensation and those incomes have to pay for buying goods and services and paying tax for daily lives, besides, just remain for savings. 1 As result, it creates the flow of incomes for enterprises to encourage them to reproduce goods and services. In conclusion, income and production flow has mutual interdependence without ending. Figure 2: Flow of Income, Payment, and Production in Global Economic System Flow of expenditure for consumption and taxes Flow of production of goods and services

Producing units (business firms and governments)

©

Consuming units (households)

Flow of productive services Flow of incomes

Source: Peter S. Rose (2003); Money and Capital Markets: financial institutions and instruments in the global marketplace; Eight Edition; Published by McGraw-Hill/Irwin, New York, USA; page 5

1.2 Function of Global Financial System The financial system is very necessary for allocating all resources provided savings from households to the business firms and government institutions to produce goods and services for daily lives. Also, the financial system allows the people to transform the money or the savings from the lenders to the borrowers through the financial markets. In this system, it consists of some components such as the financial institutions, financial markets, financial instruments, the financial services and financial transactions.

1

Peter S. Rose (2003), Money and Capital Markets, published by McGraw-Hill/Irwin New York, USA, page 5

6


The financial system has great important role in daily lives; there are seven basic functions such as savings function, wealth and liquidity functions as well as credit and payments functions, risk protection and policy functions: 2 1. Saving functions: this function provides the publics with the opportunity to create savings by investing in bonds or stocks and other financial instruments in the financial markets to make profit. This flow provided additional cash into investments, especially for entrepreneurs that can produce more goods and services for livelihood. For any countries that have the savings flow decreases, in general, it will make their investments and the standard of living of that country began to decline. 2. Wealth function: this function provides an opportunity for individuals and companies to pick for property savings through securities investment in the capital markets and money market. Investments of stocks, bonds and other securities did not lose their value and generally, it has to make a profit. The risk of loss is less than the retained property in the form of investment in objects like car, motorbike….etc. that caused to lose their great values and risks in such an investment. 3. Liquidity function: the financial markets provide investors possibilities to transfer their financial instruments into cash very easily and at little risk. This operation made through the sale of securities in order to get their cash back when they need cash to expend. 4. Credit function: Besides, this system facilitated the allocation of savings from householders and other surplus units to supply financing to corporations and government institutions in order to expand their business, and investment.

2

Peter S. Rose (2003), Money and Capital Markets, published by McGraw-Hill/Irwin New York, USA, p. 9-10

7


5. Payment function: the financial system provides a mechanism to pay for goods and services. Financial assets for settlement include currency, current accounts and credit cards including other accounts that were used for replacing of currency. 6. Risk protection functions: the financial markets around the world has given business firms, government institutions and householders to protect against risk who happened to life, health, property and their income. This function requires policies, which made by the insurance company. In addition, the companies and individuals can protect themselves against risk through investment of their properties in the capital markets and the money market in order to prevent losses that will occur in the future. 7. Policy function: the financial markets provided an important guideline to the government which is implementing its policies and efforts to make the economy stable avoid inflation and controlling of interest rates, with credit operation for expenditure and borrowing from publics, which has an impact on the growth of production growth and job creation.

Furthermore, the financial system has created a flow for savings and investments as following: 3 Nature of Savings: Households use their money for spending and paying tax, then the remaining for savings. The business firms use their income left behind from tax payment, dividend and other expenses for savings. The government institutions can do savings unless those units have surplus income more than their current expenses. Nature of Investment: the capital flow from financial markets can support investment. The corporations and public institutions need capitals for constructing the building, schools and equipment, and purchasing raw materials and goods for inventory and

3


8


producing goods and services. Government institutions also need capitals for construction of schools, hospitals, roads, and support the public services for developing productivity; labor forces and standard of living (figure 3). Figure 3: Global Financial System

Demanders of funds

Flow of savings Suppliers of funds

(Business firms and governments)

(Households) Flows of financial services, incomes, and financial claims

Source: Peter S. Rose (2003); Money and Capital Markets:; 8th Edition; Published by McGrawHill/Irwin, New York, USA; page 7

1.3 Function of Financial Markets The financial markets have great significant functions in the global economic system 4 and it is an engine for global financial system. The financial market participates in economic growth for every country in the world by allocating and absorbing the savings from the investment of financial instruments and then transforms those savings to the business firms and other institutions needed more funds for their investment and business expansion as well as met their expenditures 5. In economy, the financial markets encourage entrepreneurs and government for long-term investment projects for technological diffusion, capital allocation, equities, risk management, corporate governance and human resource management, financial services and the securities trading and financial industry. In addition, the financial markets as

4


5

S. Kerry Cooper and Donal R. Fraser (1993), the Financial Marketplace, Fourth Edition, published by Addison-Wesley Publishing Company, USA, page 363-4

9


a mechanism allowing publics to trade the financial instruments such as stocks, bonds and other securities and other valuable products as energy, precious metal, gold and industrial and agricultural products as well as other valuable products ....etc. Financial markets can help the fund raising, the risk deduction and international trade and acting as a facilitator between the lenders and borrowers, it means that the mobilization of saving from families, companies and government institutions that have surplus budget given to other institutions that has budget deficit or needs more funds to expand the business and investment projects (figure 4).

Figure 4: Diagram of Funds Flow in the Global Financial System

Indirect Financing

Surplus Units (Lenders) -Business Firms

Financing

Financing

Financing

Financial Intermediaries

Financing

Deficit Units Financing

Financial Markets

(Borrowers) -Corporations

-Government Units

-Government Units

-Individuals

-Households

-Foreigners

Direct Financing

-Foreigners

Source: Rose and Marquise (2006); Money and Capital Markets, McGraw Hill International, Singapore and Securities Commission Malaysia (2009), Introduction to Islamic Capital Market, Printed in Malaysia, by Dolphin Press Sdn Bhd

10


1.4 Raising Funds for Investment Development The financial market facilitates between the companies and other institutions that need more funds for investment expansion besides the banking system. Although commercial banks as a source of credit, but banks is financial intermediaries receiving deposits from the savers, and then provided those savings to the borrowers that need loans in short or medium or long terms for buying home or car or for operating small or medium businesses. Generally, commercial banks take less attention on long-term loan, so, the entrepreneurs or businessmen have used both options to find financing to support the business based on their possibilities. But, loans processes in the financial market is more complicated than loans in the banking system, generally, it requires corporations and institutions needing funds for investment must issues stock, bond and other securities and sell them to the publics. Whereas securities issued by those institutions were traded from one hand to another in the secondary market (Figure 4). Currently, the United States relied profoundly on fund raising in the financial markets, especially, issuance of securities such as stock and bond through the capital markets.

The financial markets help the business firms and government units to raise funds for the investment and business expansion, besides the banking system. If there are no financial markets, the business individuals or entrepreneurs and institutions are really met difficulties in finding the lenders themselves.

John Gurley and Edward Shaw (1960), economists pointed out that each business firm, household, and government were active in the financial system and must conform to the following identity 6: 6

John Gurley and Eward Shaw (1960) and Peter S. Rose (2003), Money and Capital Markets: financial institutions and instruments in the global marketplace, 8th Edition, Published by McGraw-

11


R – E = ∆FA - ∆D

Current income receipt – Expenditures out of current income

Change in holding of financial assets – Change =

in debt and equity outstanding

o (E) Current expense o (R) current income o (∆FA) building up holdings of financial assets o (∆D) paying off some outstanding debt and equities.

Accordingly, economic units must fall into one of three groups as following: •

Deficit budget unit (DBU): E>R; and so ∆D>∆FA => borrower of funds

•

Surplus budget unit (SBU): R>E; and so ∆FA>∆D => lenders of funds

•

Balance budget unit (BBU): R=E and so ∆D=∆FA=> neither lender and borrower

This context showed that the financial market has great important functions in transforming savings into the financial investment for strengthening the health and strength of national economic. If households and investors did not use their savings within investment, so, the national economic strength was shorten and revenue begin to fall down in the future and then leading to reduce expenditure of consumption and living standard also begins to decline. This may cause reduction of the workforce needs in the economy. As result, the rate of employment may start falling and also, unemployment rate will start increasing. 7

Hill/Irwin, New York, USA, page 33 7

Peter S. Rose (2003), Money and Capital Markets: financial institutions and instruments in the global marketplace, 8th Edition, Published by McGraw-Hill/Irwin, USA

12


The opinion of economists also realized that the role of financial system as a momentum of long-term economic growth and, it develops a significant improvement in the recent years. The financial system has been recognized as a system, which impact on the economic growth through mobilization and allocation of capital inflows. 8 For the countries that have a better financial system, the system can provide the benefits to those countries with the long-term growth potential. Merton (2003) also determined that the economic problems recently happened in Asia, because they did not entirely rely on the financial markets, they counted on this market a little. As a result, their economic growth dropped dramatically and rapidly. He also claimed that the development of an efficient financial market as well as its relevant institutions meaning that those countries can reduce the most reliance on financing of banking system for the economic growth, in particular, in the developing countries today. Currently, most of Asian countries have the advanced economic growths, but their capital markets are not created properly yet, they are still heavily depending on the banking system to finance their economic development. He also added that the U.S. economy in the 20th century reduced the reliance on the banking system by developing the financial markets and relevant institutions separately in order to fulfill the different functions. Doing like this in order to increases an efficiency of capital allocation process of the United States and reduce the suffering, fragility of the credit occurred in the history of the United States. In contrast, Japan's economy did not reduce the reliance on the banking system. He has still used both The banking systems and the capital markets and also takes an effort to solve the bank concerns. The reliance on banking system is not just to make an instable economy of the

8

Merton Milller (2005), Financial Markets and Economic Growth, Article first published by Journal of Applied Corporate Finance, volume 11, issue 3

13


country but also affect to the neighboring countries as well 9. A number of Asian countries have almost implemented as Japan by using the financing systems, both the banking system and the capital markets in order to support the stable financial system and sustainable economic growth.

1.5 Model of Financial Markets The model of financial markets used in the study is “Brownian models for financial markets” based on the work of Robert C. Merton and Paul A. Samuelson, as extensions to the one-period market models of Harold Markowitz and William Sharpe, and are concerned with defining the concepts of financial assets and markets, portfolios, gains and wealth in terms of continuous-time stochastic processes. Under this model, these assets have continuous prices evolving continuously in time and are driven by Brownian motion processes. This model requires an assumption of perfectly divisible assets and a frictionless market (i.e. that no transaction costs occur either for buying or selling). Another assumption is that asset prices have no jumps that is; there are no surprises in the market. This last assumption is removed in jump diffusion models. 10

Consideration of a financial market consisting of N + 1 financial asset, where one of these assets, called a bond or money-market, is risk free while the remaining N assets, called stocks, are risky. A financial market is defined as: 11 1. A probability space 2. A time interval

9

Economy Watch (November 2010), Types of Financial Market, http://www.economywatch.com

10

Tsekov, Roumen (2010). Brownian Markets, October 13, 2010

11

Karatzas, Ioannis, Shreve, Steven E. (1991), Brownian Motion and Stochastic Calculus, New York

14


3. D-dimensional Brownian process

adapted to the

augmented filtration 4. A measurable risk-free money market rate process 5. A measurable mean rate of return process

.

6. A measurable dividend rate of return process 7. A measurable volatility process

. such

8. A measurable, finite variation, singularly continuous stochastic 9. The initial conditions given by A financial market M is said to be standard if: (i) it is viable, (ii) the number of stocks is not greater than the dimension D of the underlying Brownian motion process W(t), (iii)

the market price of risk process

satisfies:

, almost surely and the

positive process is a martingale.

1.6 Types of Financial Markets The financial markets consist of the capital markets, money market and foreign currency exchange, commodity and derivative markets. Although, financial markets have many categories; but their main functions are different and also financial instruments are dissimilar, and the capital markets and money market classified as the most important markets in the global financial system. 12 The capital markets: there are two main markets, which provided long-term financing, or more than one year that consisting of stock exchange and bond market. Stock exchange allows the corporations to issue shares or equity securities in order to finance the investment projects and business expansion. Then, those securities 12

Peter S. Rose (2003), Money and Capital Markets, 8th Edition, Published by McGraw-Hill/Irwin, USA, page 12-13

15


brought to trade since then. Bond market issues bond or debt securities of corporations and government institutions in order to finance the investment projects and business enlargement. Then, those securities traded in the public since then.

The money market is a market that provides short-term financing or less than a year and securities issued by government, large corporations and financial institutions in order to support investment projects and expand their business. The short-term securities as treasury notes, certificate of deposit, commercial paper, banker’s acceptance, repos, and reverses.

The foreign exchange market (FOREX) is a market that allows trading of foreign currencies in order to facilitate imports and exports, as well as international investors who are investing and purchasing of foreign goods or they want to take profit from speculation of the exchange rate volatility or access to the market in order to exchange their currency for investment needs or buy other currencies to take profits or protect themselves from losses and reduce the risk which can be happened by exchange rate fluctuations.

The commodities market is a market trading products or raw materials as precious metals (gold, silver, platinum and other precious metals), agriculture (corn, beans, wheat, sugar, cotton, cocoa, and coffee), energy (crude, gas, ethanol, and gasoline), industry (iron, copper, lead, zinc, tin, aluminum, and nickel), animals and meat (animals as life animals, food, pork, beef). Those products traded in form of a standardized contract or also called a futures contract, which both selling and purchasing parties want to protect them from risk of loss, which will happen in the future was caused by rising or falling prices in the market.

The derivative market is a market where trading of derivative products such as the futures contract, forewords, options and swaps. Derivative is a kind of securities whose its 16


value based on or derived from the underlining assets. Those assets conclude stocks, bonds, currency, interest rates and market indexes.

Among the main compositions of financial markets, the capital markets and money market are most important; both markets are divided into the primary market and secondary market. 13 For the initial public offering (IPO) or new issue (public offering) was traded in the primary market that those activities held between issuers and underwriters. The securities issued in the primary market were traded in the secondary market that held between investors and investors. This means that investors hold securities in hand and intend to sell securities called sellers and investors who wish to buy or invest securities called buyer (Figure 5). Figure 5: Structure of the Global Financial Markets Financial Markets

FOREX

Capital Markets

Money Market

Commodities Market

Derivatives Market

Stock Exchange Primary

IPO (initial Public Offerings)

Secondary

Securities or issued securities

Bond Market

Sources: S. Kerry Cooper and Donal R. Fraser (1993); Financial Marketplace; Fourth Edition, USA; page 18-20 and Invest Korea; Korea Financial System; Korea’s Financial Market Structure, Seoul, www.investkorea.org/

13

Peter S. Rose (2003), Money and Capital Markets: financial institutions and instruments in the global marketplace, Eight Edition, published by McGraw-Hill/Irwin, New York, USA, page 12

17


1.7 Relationship between Borrowers and Lenders in the Financial Markets Lender

Financial institutions and intermedaries

Individuals,

Commercial bank

Household,

Insurance companies

Business firms

Retirement funds

Other institutions

Mutual funds or Investment firms Securities firms

Financial markets

Borrowers

Stock exchange

Corporations

Money market

Government

Bond market

Other institutions

Forex market Derivative market

Source: Peter S. Rose (2003); Money and Capital Markets; and Wikipedia; Financial Market

1.8 Key Players in the Financial Markets 1. Lenders in the financial market: (a) almost individuals can provide loans through deposit the savings in their bank account and/or participate in the pension program and pay a premium to insurance companies as well as investment in stock of companies, and corporate and government bonds, (b) All companies and institutions remaining the surplus budget or exceed at any period could use their budget for short-term investments in the money market. For companies with surplus budget always invest in stock, bond or repurchasing of their outstanding stock from the market. 2. Borrowers in the financial market: each individual can borrow money through banks for short-term needs or long-term financing for mortgage. Corporations can also find credits in order to support their cash flow or financing for corporation modernization or to expand their business in the future. The government institutions can borrow money to support their expenses on the industrial and agriculture sector development and subsidize other public institutions as well as various public services. 18


3. Financial intermediary is a financial institution acts as a facilitator between lenders and borrowers in the financial system. That means that savers take their money to deposit at the bank, and then bank uses those savings to provide loan for individuals or business units needing funds for business and investment. Financial intermediary consist of 14: depository institutions: commercial banks and non-depository institutions like saving and credit union and saving bank, contractual institutions: insurance companies and pension funds, investment institutions: investment companies, money market funds and real estate investment trust. 4. The U.S.’s financial institutions are institutions that provide main financial services to customers or its members and act as financial intermediaries being responsible in providing or transferring funds from investors, companies and government units to corporations and institutions that need more funds for investment development 15. Financial institution receives deposits from customers who deposit in bank account and provide interest rates to savers directly and indirectly, and then, provide loans to customers or companies that need funds. Sometimes, financial institutions act as service providers to customers and charge commission from them. In addition, there are some institutions used savings to invest in the real estate or stock and bonds and other institutions do both. Major financial institutions in the U.S. economy comprising of commercial banks, savings and loan association banking credit union, saving banks, insurance companies, mutual funds and private pension funds. These institutions attract funds from individuals, companies and government units to mobilize funds to provide loans to companies and institutions.16 These institutions comprise

14

Cooper, S. Kerry and Fraser, Donal R. (1993): Financial Marketplace, 4th Edition, AddisonWesley Publishing, pp.216-242 and Rose, Peter S. (2003), Money and Capital Markets, 8th Edition, published by McGraw-Hill, page 41

15

Gitman, Lawrence J. (2003), Principle of Managerial Management, 10th edition, Pearson, pp. 21

16

ibid., pp. 22

19


of the financial companies, money market funds and real estate investment funds. 17 Financial companies provide loans to business firms and consumers to fill short-term capital flows and long-term investment needs. Investment companies or mutual funds mobilize funds from contributions of thousands savers and investors from sale of the company’s shares and then used those funds to invest in securities and sell them when the market open and as representative of financial intermediaries that has rapid progress in recent years. Money market funds are kind of specialized-investment companies receiving saving account from individuals and companies and brought those funds to invest short-term quality securities in the money market. Real estate investment funds are small members of financial institutions involving to investment companies on housing and commercial property. Besides, there is another mortgage institution to facilitate providing credit for construction of new home and new business. Financial intermediaries and financial institutions have significant differences in each national financial system as measured by total financial assets. In the U.S, commercial banks have occupied over entire U.S. financial system comprising of financial assets more than US$6 trillion 18 occupied by banks of America and represents 1/4 of total wealth of U.S. financial institutions. Some financial intermediaries as commercial banks, savings and loan associations, saving banks and credit unions, if those institutions were totally combined can create assets of 1/3 of total wealth of U.S. financial institutions, whereas, number of financial assets remaining was divided into each part. Financial institutions have been actively participated within financial markets and act as supplier of funds and as demander funds for investment as well. 17

Peter S. Rose (2003), Money and Capital Markets: financial institutions and instruments in the global marketplace, Eight Edition, Published by McGraw-Hill/Irwin, New York, USA, Page 44

18

Kerry Cooper and Donald R. Fraser (1993), Financial marketplace, Fourth Edition 9, Page 216-17

20


1.9 Transactions in the Financial Markets The enterprises, companies and government institutions can choose sources of financing to support their investment projects and business expansion through banks or financing from public sources. Therefore, source of financing from bank is an indirect finance. Whereas, financing sources from the publics as the direct finance (figures 6, 7 and 8). Today, in the financial system, there is a sequence evolution from direct-finance source to semi-direct finance as a newborn form, which just appeared in the recent time in the trades of financial instrument. Hence, the transfer of funds from savers to demanders of funds in the financial markets, at least, must meet the following three ways 19 : (A) direct finance, (B) semi-direct finance and (C) indirect finance: A. Direct Finance is an operation that occurred when lenders provide loan directly to borrowers through issuance of securities like bond, stock and other securities as contracts for evidence of debt which it has borrowed. B. Semi-Direct Finance is an operation that occurred when lenders provide loan directly to borrowers with help of financial service providers and market-makers that helped sell IPOs/PO to the investors and providing services for securities trading as well. A and B above show that direct finance and semi-direct finance encouraged developing a source of the indirect finance. The activity was participated and supported from the financial intermediaries and institutions. C. Indirect Finance is an operation that occurred when lenders provide loan to the borrowers through financial intermediaries like commercial banks, insurances and financial companies. In this case, the borrowers have to issue a debt contracts to the loan providers.

19

Peter S. Rose (2003), Money and Capital Markets, 8th Ed., published by McGraw-Hill, NY, pp. 40

21


PART II Generalization of Financial Investment First, the study focuses on the viewpoint of investment. Usually, investment has general meaning and related sectors such as the investment in the field of macroeconomic, investment in the field of business administration and investment in the financial sector and real estate. But this study has significantly focused on "financial investment" as a part of the investment in the financial sector. A number of dictionaries and economic articles have defined the word of "Financial Investment" as "Money Investing" or "Investment in Finance" 20. Accordingly, financial investment was defined that is the current commitment of money and other resources in the expectation of gathering future benefits. As individuals purchase shares of companies and anticipates that they will make earnings in the future from appreciation of stock prices. The transaction identifies about time, money and risk in investment which were tied up. 21 Timothy (1978) defined that financial investment involves expectation of some positive rate of returns that can be reasonably expected after sufficient analysis has been made. Traditionally, it engages a known degree of risk, which dictates that the principal and future income value be relative certain. 22

Several financial experts defined that “the financial investment is relevance to the profitable level which properly received by expectation after doing sufficient analysis on this investment. Investment usually comes with risk that might be known and related to the real

20

World Economic Watch, Financial Investment & Investing Money, www.economic.com/investment

21

Zvi Bodie , Alex Kane, and Alan J Marcus (2008), Essentials of Investments, 7th Edition, published by McGraw Hill International, Singapore, pp. 2

22

Timothy E. Johnson (1978), Investment Principles, published by Prentice-Hall, USA, pp. 3

22


profits and principals” 23. There are some articles were defined that “the financial investment is placing of money into investment with expectation, especially, use of funds to purchase financial instruments in order to take profit in the forms of dividend, interest rate and appreciation of stock prices” 24 . Whereas Cambodian economists also described about investment that " Enterprises borrow money from the families to finance their investment projects through the issuance of stock and bond or borrow from other financial institutions, whereas cost was paid to lenders is the interest rate" 25.

In addition, financial investment is that when investors or individuals give their money to the issuing companies (issuers) and then those companies have used those funds to generate the profit for the individuals or investor as their shareholders. Whereas investors the company. For Individuals who give money to the investment projects or investment companies in order to take the profit, it is able to consider as “financial investment” the projects used those funds to create profits for all individuals as their members. Also, those members do not need to monitor the business activities of investment projects. Whereas individuals who use their money to buy real estate or gold or buy the license, financial service providers can create profits for those individuals, but this action is not considered as financial investments because the profits are not created by the financial investment. 26

However, the Australia Corporate Law defined that the financial investment is when inventors and individuals offer their money to invest in corporations and then the companies use those funds for increasing incomes for individuals and investors. In this regards, investors 23

ibid., pp. 33

24

Arthur O, Steven M. (2003), Economics: Principles in Action, 1st edit. Prentice Hall, USA, pp. 2

25

HANG Chuon Naron (2009), Macroeconomics, published by Preah Vihear, 1st edition, pp. 76

26

Timothy E. Johnson, (1978), Investment Principle, published by Prentice-Hall, USA, pp. 1-5

23


and individuals clearly known that the funds was used for generating income for individuals participating in the corporation. For individual who invested their money into the investment funds or investment companies in order to receive benefits was also considered as “financial investment” and corporations used those money to create more income for individuals who are their members who those are not required to control any business of company. 27 Based on definitions of financial investment defined in the Australia Corporate Law and Peter S. Rose (2003) showed about its mechanism relating between lenders and borrowers in the financial markets. Accordingly, lenders always are the surplus-budget units and individuals want to invest their money through stock and bond. Whereas, borrowers are the deficit-budget units such as the business firms, government and other institutions, which are seeking to raise funds for their business and investment in the capital markets.

2.1 Process of Financial Investment Individuals must clearly understand process of financial investment and mechanism of whole market with relationship in the industry, economy and also between brokerage firms and investors, when they are seeking to invest the financial instruments for a profit taking. However, all individuals and investors must have appropriate knowledge and experiences in the financial investment, if they have less experience in financial investments or nothing, they will face more difficulties to use their funds to properly for investment. 28

Generally, individuals or investors who wish to invest in the securities market. First, they have to create a proper own capital for investment. Then, just think about planning and investment process, with various risks associated with their investment. Another new risk is 27

Australian Corporation Acts 2001, SECTION 763 B

28

Economy Watch (2010), Securities Investment and Speculation, http://www.economywatch.com

24


"Personality" of investors who first encounter within their initial investment. Usually, the investors used their emotion more than analysis and evaluating securities. Meanwhile, the investors have to strongly understand about the analytical methods and investment process, if they don’t have the investment knowledge, they cannot be successful in investment. Whereas, the economic conditions must be appropriate to the investment and analyze industries, is it proper to the current economic conditions? After analyzing of economies and industries, investors will consider to choose a worthy corporation with better industrial situation, strong financial position, quality market improvement and products as well as proper production facilities. Accordingly, investors can determine which corporation is strong enough for them to invest. Another main fact is that analysis on securities and potential profit forecast of the corporation and level of risk that can make the profits vary and uncertain expectations. No any factor is better than analysis on securities and the potential of the company's profits. 29

Therefore, in order to prepare the investment in a good process, first, investors must allocate their financial assets into investment portfolio and then sell the existing securities when its price is head up and purchase new securities cheaper than in order to take profit from that operation or additionally increase their funds to make a larger investment portfolio or sell all securities to reduce investment portfolio. 30 Financial assets are classified as stocks, bonds, currencies and other financial products to create the securities investment portfolio. To make the financial asset allocation, each person who has a deposit at the bank, has to transfer the money from banks into the investment portfolio, then they can select securities such as stock and bonds....etc. if an investor purchase common stock from large companies which provides annual average profit 12 percent, whereas, treasury bills provide only 4.8 percent, 29

Timothy E. Johnson, (1978), Investment Principle, published by Prentice-Hall, USA, pp. 10

30

ibid., pp. 12

25


which securities the investors decide to invest? First, investors must understand that stock is equity securities with high risk, issued in the stock exchange, whereas, Treasury bill is a debt securities with no risk, issued in the money market. In addition, they do analysis and evaluation of the two securities which securities are valued to be most attractive? Both securities were evaluated that they are very attractive to investors, but the common stock price are much fluctuated depend on the situations and conditions of issuers. 31

2.2 Financial Assets in the Financial Markets Financial assets are usually defined as financial obligations or debt contract issued by debtors to investors. Financial assets are issued by private and government institutions. Generally, the private and government institutions issued both securities, debt and equity securities. Debt securities like the bonds and money market instruments were issued by major corporations and government institutions in order to raise funds from the public, whereas fund demanders have an obligation to pay interest rates to investors. The money market instruments are non-interest rate securities sold by discounted price at the over-the-counter market (OTC) with maturity ranging from 28 days (4 weeks/1 month), 91 days (13 weeks/3 months) and 182 days (26 weeks/6 months) up to 364 days (52 weeks/1 year) 32.

Whereas, the bonds have normal maturity from 1 year to 10 years, but in the United States the bonds have maturity up to 30 years. The borrowers in the bond market must pay the interest rates to lenders or investors every 6 months or 2 times a year and repay the principal when to get maturity. The government and corporate bonds can issue for long and

31

Economy Watch (2010), the Securities Investment and Speculation, http://www.economywatch.com

32

Zvi Bodie , Alex Kane, and Alan J Marcus (2008), Essentials of Investments, 7th Edition, published by McGraw Hill International, Singapore, pp. 5

26


short terms. 33 The government bonds issue to the public in order to raise funds for supporting the excess spending on general education, health cares, roads, public transportations and other public services. Whereas, the corporate bonds issued by the large corporations in order to finance their businesses development and investment projects. On the other hand, the corporate bonds always provide higher-interest rates than the government bonds because it has a tendency towards higher risk than the government bonds.

The equity securities or stock was issued by the major enterprises and corporations, their securities are representing a part of ownership in the corporations and provide their right to shareholders to get dividends. Stock ownership is very important aspect to the financial investment for the free economy of country; first; it is a source of important capital that financing from external origin of institution, and second; is a financial flow for corporations to expand their businesses and investments. 34

The commodity market instrument is a future contract range of products such as energy, precious metals, agricultural products and industrial products. These products are traded in the form of standardized contracts and usually called the futures contracts and they are traded in the organized exchange. 35

33

Timothy E. Johnson (1978), Investment Principles, published by Prentice-Hall, USA, Page 1-5

34

Stephen A. Ross, Randolph W.Westerfield and Bradford D. Jordan (2000), Fundamentals of Corporate Finance, 5th Edition, 4th International Edition, McGraw-Hill Company, USA, pp. 217

35

E-how money, Commodities Market Instruments, retrieved from http://www.ehow.com/info_8024407_traded- instrument-commodity-market.html

27


The currency market instrument is a contract and foreign currency, which are traded in the Foreign Exchange Market (FOREX). The foreign currencies are traded in two forms; the first form is a future contract and second form is a trade between currencies and other currencies. Investors who want to purchase the future contracts and currencies; they always wish to protect themselves from losses due to the exchange rate changes or demanding of the foreign currency for purchasing the foreign goods and services and also speculate to gain a profit from the exchange rate fluctuation.

The derivatives market is a part of financial markets for derivatives, where their products are derived from other forms of underlying assets. The derivative instrument is a contract was traded in the organized derivative market and the over-the-counter market. The contracts are standardized and non-standardized contracts such as future contracts, forwards, options and swaps. The cost of contracts needs to rely on the underlining assets meaning that when volatility of original asset price, it can make the price of derivatives change as well. So investors who come into this market is intended to protect them from the risk will be coming from the rise or drop of the original asset prices.

28


Table 2: Financial Instruments Traded in the Financial Markets Financial

Financial

markets

instruments

Issuers

Treasury bills

Publics, individuals and business firms,

Certificates of deposit Commercial papers

Money market

Investors

Banks and financial institutions

government and other institutions

Bankers’ acceptance Repos and reverses Publics, individuals Common stocks

Corporations and

and business firms,

Preferred stocks

public institutions

government and other

Stock market

institutions

Treasury bond and notes Municipal bond

Bond market

Corporate bond

Foreign Exchange

Foreign currencies

Market (Forex)

Currency contracts

Corporations and government institutions

Brokers and traders

Publics, individuals and business firms, government and other institutions Publics, individuals and other institutions

Future contract Derivatives Market

Forward contract

Producers, consumers,

Publics, individuals and

brokers and traders

other institutions

Swap and Option

Source: Zvi Bodie , Alex Kane, Alan J Marcus(2008); Essentials of Investments; Seventh Edition; McGraw Hill International; Singapore, Page 24-33, and S. Kerry Cooper and Donal R. Fraser (1993); Financial Marketplace; Fourth Edition; USA; page 16-18

29


PART III Mathematics of Financial Securities Investment The securities investment is an activity relating to trading in financial instruments, such as shares, bonds and contracts, currencies and other securities are dealt and speculated in the financial markets and want to make the profits from the transaction. 36 Normally, the securities transactions held by brokerage firms and investment advisors who facilitate buying and selling securities and recommend buying shares of companies with longlasting value and expect to have profits in the future. Besides, investors can buy and sell securities on their own by internet without use of brokerage firm. The differentiation in the investment

securities

is

relevant

to

the

proper

time

adjustment

of the investors in order to buy cheap securities and sell them costly in the future. Commonly, both institutional and individual investors always find the ways to make more profits through the savings in the securities investment. However, securities investment also created the opportunities and risks as well. Moreover, the investors must have the basic capability to calculate the prices, risks and returns of financial securities and able to analyze all situations and opportunities of the investment. 37 Based on Brownian model for financial markets defined the financial assets where one of the assets called bonds or money-market instruments (N+1) are free risk, so, its price S 0 (t)>0 with S 0 (0)=1, while the remaining assets (N) called stocks are risky. 38

36

Kathy Kristof (2000), Investing 101, First Edition, Bloomberg Press Princeton, USA, page 12

37

Pat Dorsey (2004), Successful Stock Investing: Morningstar’s Guide to Building Wealth and Winning in the Market, Morningstar, USA, page 30

38

Tsekov, Roumen (2010). Brownian Markets, October 13, 2010

30


3.1 Calculation of Money Market Instruments The money market instruments are most marketable, liquid and free risk and safe. They are financial market assets involved in short-term borrowing and lending. Buying and selling them with original maturities within one year or less. Trading in the money markets is done in the over-the-counter market (OTC). The market interest rate creates differentiation between the purchase and selling prices of securities when they get at maturity. When the loan is repaid, borrower retrieves securities and returns the fund to the lenders. ① Formula to calculate the current price of money market asset: 39 Days to Maturity   Current Price = Face Value x 1 − x Discount Yield  360  

The Treasury bill was trading in the form of discounted price from the face value, based on 360 days per year. Therefore, in order to calculate the value of bills, the above formula has been applied. If T-bill with a face value of US$1,000 and maturity of 26 weeks and now, the bill was sold for discounted price at 3.80%. In order to calculate the current price of T-bill, we have to applied this way P = 1,000 (1 - 0.038 x 182) 360 = 980.80. So, the price of T-bill is US$980.80 and got US$19.20 discount off the face value which will pay US$1,000 on maturity in four weeks. Table 3: Calculation of Money Market Instruments Day to

Purchasing

Selling

Maturity

price

Price

01 February 2007

27

4.70%

29 March 2007

83

05 April 2007

90

Maturity Date

Change

Yields

4.69%

-0.06

4.77

4.88%

4.87%

-0.02

4.99

4.91%

4.90%

-0.01

5.03

Source: the Wall Street Journal Online, T-Bills Listing on January 4, 2007

39

Zvi Bodie, Alex Kane, Alan J Marcus (2008), Essentials of Investments, Bank Discount Method Calculation, Seventh Edition, International Edition, Singapore, Page 27

31


According to the above T-bills listing, the Investment Bank intends to sell the T-bills with a face value of US$10,000 at a rate of 4.90% and maturity date is in 90 days. So, the price of bill (P) = 10,000 x [1- 0.0490 x (90/360)] = 9,877.50 and this bill was purchased for US$ 9,877.50. On the other hand, the formula of bank discount yield was applied this way Bank discount yield = (D/F) x (360/t) x 100% = (122.50/10,000) x (360/90) x 100% = 4.90%. ② Formula to calculate the yield of money market assets: Holding-Period Yield (HPY) = (P 1 - P 0 + D 1 )/P 0

P 0 = Purchase price

P 1 = price at maturity

D 1 = cash distribution at

maturity If we invest the T-bill with a face value of US$50,000 and the current market price was sold at US$49,700 and maturity date in 100 days. What is the HPY of the bill? So, the HPY was calculated this way, HPY = (50,000 - 49,700+0)/49,700*100% = 0.60%.

3.2 Calculation of Bond Price and Yields The bond is a debt securities in which issued by the government institutions and large corporations (issuers) through underwriter in the primary market and then, those securities are sold to the securities firms or the investment banking and then sold continuously to the investors in the secondary market. The bond investment is a fixed-income investment and less risk than stock. The bond investors can hold the securities until the maturity to get both the interest and principal, or sell the bonds before maturity when the market opens. When the government institutions and large corporations need to raise the capital from the investors by issuing the bond and have an obligation to pay interest and repay the principal at maturity date. Additionally, in order to attract the potential investors in the market, the issuers always issue the bond price or the face value with appropriate value, terms and a fixed interest rate. 32


① Formula to calculate the bond price

The price or value of bond is determined by discounting the bond's expected cash flows to the present using the appropriate discount rate. The relationship is expressed for a semiannual and annual coupon bonds by the following formulas. Now, looking at the cash flow of a semiannual bond with face value $1000, a 10% coupon rate, and 15 years remaining until maturity and annual bond is $100 which is calculated by multiplying the 10% coupon rate times the $1000 face value. Thus, the periodic coupon payments equal $50 every six months. Frequently, most of bonds pay interest semiannually. However, the corresponding equations for annual and semiannual coupon bonds are provided on the bond equations: 40

Bond Cash Flows

Where: B0 – Bond Price C – Coupon r – Interest rate F – Face Value t – Years/Period

40

Business Finance Online, retrieved from http://www.zenwealth.com/BusinessFinanceOnline/BV/ BondValuation.html

33


A bond has maturity in 20 years with the face value US$1,000 and coupon rate of 5% and has a yield of 6%. Using the annual formula above to calculate the market bond price:

==>

B0 = $885.32

In the case of calculation of a semiannual bond price with a face value $1,000 with 10% coupon rate, and 15 years remaining until maturity and the required return is 12%.

 B0 = $862.35

Additionally, the calculation of the bond value is able to apply in the excel formula: 1.Annual bond value: PV (rate,nper,pmt,fv,type) => B 0 = (6%,20,50,1000) = $885.30 2. Semiannual bond value: PV (rate,nper,pmt,fv) => B 0 =(0.06,30,50,1000) = $862.35 ② Formula to calculate the bond yields

The yield to maturity (YTM) on a bond is the rate of return that the investors would

earn if they bought the bond at its current market price and held it until maturity. This is illustrated by the following equation: Where: B0 = the bond price, C = the annual coupon payment, F = the face value of the bond, YTM = the yield to maturity on the bond, and t = the number of years remaining until maturity 34


A semiannual bond with a face value of $US1000 and has a 10% coupon rate, and 15 years remaining until maturity that given the bond price is $862.35. Find the yield to maturity (YTM) on this bond:



YTM = 12%

In addition, the calculation of the YTM is able to apply in the excel formula: =RATE (nper,pmt,pv,fv)*2 => YTM = (30,50,-862.35,1000)*2*100% = 12% Whereas, the yield to call (YTC) is the rate of return that the investors would earn if they bought a callable bond at its current market price and held it until the call date that given the bond was called on the call date. This is illustrated by the following equation: Where: B0 = the bond price, C = the annual coupon payment, CP = the call price, YTC = the yield to call on the bond, and CD = number of years remaining until the call date A semiannual bond with a face value of US$1,000 and has a 10% coupon rate, 15 years remaining until maturity that given the bond price is US$1,175 and it can be called 5 years from now at a call price of US$1,100. Find the yield to call (YTC) on this bond:



YTC = 7.43%

35


Moreover, the calculation of the YTM is able to apply in the excel formula: RATE (nper,pmt,pv,fv*(1+CP))*2 => YTC = (10,100,-1175,11)*2*100% = 7.43% Whereas, the Hold-Period Yield (HPY/HPR) is a slight modification of YTM formula, the situation is that the investors hold a financial asset for a time, and then sells it to another investor before maturity. The HPY on a bond, you would simply take the difference between what you purchased and its current value. This is illustrated by the following equation: Pt+1 = Current price or price you sell/buy t = Time or years to mature Pt = Price of face value A 30-year semi-annual bond with face value of US$1,000 and has a coupon rate 8% and now the bond is selling at US$1050. What is the HPY of this bond? HPY =

80 + 1050 − 1000 = 0.13 𝐼𝐼𝑟 13% 1000

In this case, the current yield is falling at the market that it makes the bond price increases to $1050.

3.3 Calculation of Stock Price and Dividend Stock is equity securities that represents or evidences a part of ownership claim in a corporation or enterprise and entitles investors or shareholders to be part of the proportional share of the total number of share issued by the corporation and earnings and assets of the corporation. Thus, the equity securities indicate an institutional aspect of a private enterprise and resource of holding wealth, and a source of new capital funds for corporations. Equity securities are of great significance to the saving-investment process in a market economy for two reasons. First is that new issues of stock are often an important source of external capital funds and second is the basic role of equity securities in the financing flows of corporations. 36


The equity securities are riskier than bond because there is no fixed commitment for payments to the stockholders, but offer the possibility of higher returns. There are two types of equity securities are common stock and preferred stock: 1. Common stock is a form of corporate equity ownership and distinguishes from preferred stock. It represents ownership in a corporation. Holders of common stock exercise control by election. Common stockholders are on the bottom of the priority ladder for ownership structure. It is usually voting shares and the holders are able to influence the corporation through votes on establishing the corporate’s objectives and policy and electing the company's board of directors. Some holders of common stock also receive preemptive rights, which enable them to retain their proportional ownership in a company. There is no fixed dividend paid out to the common stockholders and so their returns are uncertain. If the company goes bankrupt, the common stockholders will not receive their funds until the creditors, bondholders and preferred shareholders have received their respective share of the leftover assets. The amount of the dividend on common stock unlike the amount of dividend on preferred stock is known before the stock is purchased. This makes common stock riskier than debt securities or preferred shares. 2. Stock Splits: the stock split is an action to increase the number of shares of the common stock outstanding. For a 2 for 1 split, for example, the number of shares of common stock is doubled. Once the firm decides to make a distribution to the investors, it has two primary means of doing so. The first is through cash dividends and the second is through stock repurchases. Many firms also declare stock splits and stock dividends that they wish the investors to consider valuable. Effect of stock split or stock dividend on the corporation as following:

37


2.1. Before stock split or stock dividend o Common stock (one million shares outstanding)

$2,550,000

o Retained earning

$4,450,000

o Total shareholders’ equity

$7,000,000

2.2 After 2 for 1 stock split o Common stock (two million shares outstanding)

$2,550,000

o Retained earning

$4,450,000

Total shareholders’ equity

$7,000,000

In this case, we conclude that the shareholders will receive two benefits: (a) Number of shares and dividends increased and (b) Expectation from appreciation of stock price

3. Preferred stock also known as preferred shares. It generally has a dividend that must be paid out before dividends to the common stockholders and commonly does not have voting rights. Also unlike common stock, a preferred stock pays a fixed dividend that does not fluctuate, although the company does not have to pay the dividend if it lacks the financial ability to do so. The main benefit to owning preferred stock is that the investor has a greater claim on the company's assets than common stockholders. Preferred shareholders always receive their dividends first and, in the event of the company goes bankrupt, preferred shareholders are paid off before common stockholders. However, the best way to think of preferred stock is as a financial instrument that has characteristics of both debts (fixed

38


dividends) and equity (potential appreciation). Similar to bonds, preferred stocks are rated by the major credit rating companies and receive fixed dividend, however, they do not carry the same guarantees as interest payments from bonds. Like common stock, preferred stocks represent partial ownership in a company, although preferred stock shareholders do not enjoy any of the voting rights of common stockholders. 4. Stock Valuation Equations: o Equation for Constant Growth Stock Price:

P0 = the stock price at time 0, D0 = the current dividend D1 = the next dividend at time 1 r = the required return (expected return) on the stock g = the expected growth rate of dividend in future (g
According to this formula, besides the calculation of bond price (P 0 ), it could be calculated to find the current and next dividends and grow rate in dividend and the required return on the stocks. Thus, this formula can create the following equations: r = D 0 (1+ g)/P 0 + g

D 0 = P 0 (r - g)/ (1 + g)

D 1 = P 0 (r - g)

g = (r - D 1 )/P 0

The corporation expects to pay the current dividend of $2.50 per share in the initial period, the discount rate of stock associate with 12%, and dividends are expected to grow at a rate of 6% each year. So, we have D 0 =$2.50, r = 0.12, g = 0.06.

39


To find the stock price (P 0 ), this formula has been applied as following: o Equation for Non-constant Growth Stock Price:

Where: P 0 = the stock price at time 0 D t = the expected dividend at time t T = the number of years of non-constant growth g = the long-term constant growth rate in dividends r = the required return on the stock, and r> g

The current dividend on a stock is $2 per share and the investors require a rate of return of 12%. Dividends are expected to grow at a rate of 20% per year over the next three years and then at a rate of 5% per year from that point on. There are 3 years of non-constant growth, thus, we have T = 3, the expected grow rate = 20% and r 12%, D 0 = 2, g c = 5%. In order to find this stock price (P 0 ), we have to calculate the expected dividends for year one through year four (D 1 to D 4 ) using the expected growth rates and apply the following equations: D 1 = D 0 (1+g) = 2(1 + 20) = $2.40 D 2 = D 1 (1+g) = 2.40(1 + 20) = $2.88 D 3 = D 2 (1+g) = 2.88(1 + 20) = 3.456 D 4 = D 3 (1+g) = 3.456(1 + .05) = 3.6288 P0 =

2.40 2.88 3.456 3.6288 + + + 1 2 3 (1 + .12) (1 + .12) (1 + .12) (. 12 + .05)

(1 + .12)−3 = $43.80

40


o Equation for Required Return Calculation on Stock: A stock that given the next dividend is $5.71 per share, the growth rate in dividends is 3.08%, and the stock price is $96.45 per share. In order to find the required return on stock, this formula has been applied r = D 0 (1+ g)/P 0 + g. Thus, we have D 1 = $5.71, g = 3.08% and P 0 = $96.45, the required return is calculated as follows: D1

5.71

r=

+g= P0

+ 0.0308 = 0.09 = 9% 96.45

o Equation for Calculation of Dividend Growth Rate for Stock: A stock that given the next dividend is $1.64 per share, the required return is 13.1%, and the stock price is $37.02 per share. In order to find the dividend growth rate for stock, this formula has been applied this way, g = (r - D 1 )/P 0 . So, we have D 1 = $1.64, g = 13.1% and P 0 = $37.02, the Dividend Growth Rate is calculated as follows: D1 g=r-

1.64 = 0.131 -

P0

= 0.0867 = 8.67% 37.02

o Equations for Calculation of Holding-Period Return (HPR) for Stock: If your stock investment has the following returns in the four quarters of a given year which has quarterly prices as $98, $101, $102 and $99 and also quarterly dividends as $1, $1, $1.5 and $1.5. Looking at the table below to calculate the quarterly rates and an annual HPR, The following formulas have been applied.

This is HPR Equation

==>

𝐻𝐻𝐻𝐻𝐻𝐻𝑛𝑛 = 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 + (𝑃𝑃𝑛𝑛+1 − 𝑃𝑃𝑛𝑛 ) 𝑃𝑃𝑛𝑛 41


1st Quarter

2nd Quarter

3rd Quarter

4th Quarter

Dividends

$1

$1

$1.5

$1.5

Stock Prices

$98

$101

$102

$99

Quarterly Rates

-1%

3%

5.5%

4%

Description

Annual Rate

11.8%

The Holding-Period Return (HPR) is calculated as follows: HPR 1 = ($98 – $100 + $1)/$100 = -1%

HPR 3 = ($102 – $100 + $3.5)/$100 = 5.5%

HPR 2 = ($101 – $100 + $2)/$100 = 3%

HPR 4 = ($99 - $100 + $5) / $100 = 4%

This is Annual HPR Equation =>1+HPR= (1+HPR 1 ) (1+HPR 2 ) (1+HPR 3 ) (1+HPR 4 ) HPR = [(1 -0.01) x (1 + 0.03) x (1 + 0.055) x (1 + 0.04)] - 1 = 11.8%

o Equation for Calculation of Preferred Stock Price: The preferred stock can be valued as a constant growth stock with a fixed-preferred dividend growth rate equal to zero. Thus, the price of a preferred stock can be determined using the following equation: Dp Pp = r

Where: Pp = the preferred stock price, Dp = the preferred dividend, and r = the required return on the stock

The share of preferred stock that given the par value is $100 per share, the preferredstock dividend rate is 8%, and the required return is 10%. This formula has been applied to calculate the price of a share of preferred stock. P 0 =

.08 x 100 .01

= $80

42


3.4 Calculation of Derivative Securities Derivatives are securities whose prices are derived from the underlying assets and its value is determined by the fluctuations in the underlying assets. Underlying assets are most commonly stocks, bonds, currencies, interest rates, commodities and market indices. Most common derivatives are the future contracts, forward contracts, options and swaps and generally used to hedge risk and speculative purpose.

Currency future contracts are traded in order to hedge the risk of exchange rate fluctuation while holding the financial assets like stock and other securities. Let’s say if the European investor purchases shares of American Corporations from American Exchange by using the U.S. dollars. Thus, in order to lock in a specified exchange rate for future stock sale and currency conversion back into Euro, the investor can buy a currency future contract. If, the investor purchase a 90-day future contract, amount of Euro 125,000 and base on the current market quote, one Euro is US$1.23354 or EUR/USD 1.23354, so, investor has to pay $154,192.50 to buy the contract and calculated this way 125,000 x 1.23354 = US$154,192.50. Moreover in the Forex market, the foreign currencies are traded as well. The traders buying and selling the foreign currencies in the market and make thousands of trades daily. Trading in the Forex may be used for varied purposes such as the import and export needs, the direct foreign investment and speculation for profit from the short-term fluctuation in exchange rates including management of existing positions or need to buy foreign goods and services and financial assets. Let's say EUR/USD 1.3675 is purchased that means that you are buying one Euro and selling US D 1.3675 at the same time.

Whereas, forward contracts are very similar to the futures contracts, except they are not traded on the organized exchange. Although the settlement price and the delivery date are 43


the same, but there is a difference between the gains and losses under the two contracts. The the gains or losses of future contracts are realized day by day because of the daily settlement and the gains or losses of the forward contracts are realized on maturity. Let’s say traders agree to accept payment in British Pound for the next three months, they may purchase the British Pound-future contract in order to guarantee that when those Pound can be sold for a specific U.S. dollar amount. Thus, trader can buy a 90-day contract at GBP100,000 at the over-the-counter that one Pound is equal to US$ 1.55665 or GBP/USD 1.55665. Then, trader has to pay 100,000 x 1.55665 = US$155,665 for that contract. One month later, the 90-day contracts rise from US$ 1.55665 to US$ 1.6500 per GBP, then trader decides to sell that contract in order to realize a profit. However, usually, this earning isn’t realized day by day like the future contract, it will make the same gain but on maturity, that is on the 90th day.

Options are the contracts that give the buyer or owner the right, but not the obligation, to buy (call option) or sell (put option) an underline asset or instrument at a specified strike price on or before a specified date. The option contract also specifies a maturity date and has an expiration date. When an option expires, it no longer has value and no longer exists. The primary types of the financial options are exchange-traded derivatives which are settled through a clearing house with guaranteed by the exchange and OTC options are traded between two private parties, and not listed on an exchange. The strike price is price of the underlying security can be bought or sold as detailed in the option contract and also identify the month they expire. Date of all options expires on the third Friday of the month unless that Friday is a holiday, then the options expire on Thursday. Options are quoted in per share prices, but it sold in the 100 share lots. A coption might be quoted at $2, but you would pay $200 because the option contracts are always sold in the 100-share lots.

44


A call option is a financial contract between two parties, the buyer and the seller of this type of option. The buyer of the call option has the right, but not the obligation, to buy an agreed quantity of a particular commodity or financial instrument from the seller of option at a certain time for a strike price. The seller or writer is obligated to sell the commodities or financial instruments to the buyer. The buyer pays a fee (a premium) for this right. When you buy a call option, you are buying the right to buy a stock at the strike price and before the expiration date. Let’s say a stock trades at $50 right now and you buy a call option with a $50 strike price, you have the right to purchase that stock for $50, even if the stock rises to $100, you still have the right to buy that stock for $50 before the call option expired. On the other hand, if the stock falls to below $50, the buyer will never exercise the option, since he would have to pay $50 per share when he can buy the same stock for less. If this occurs, the option expires worthless and the option seller keeps the premium as profit. Base on above instance, the current price of stock is $50 per share, and investor expects it will go up significantly. Then he buys a call contract from the call writer/seller. The strike price for the contract is $50 per share, and investor pays a premium $5 per share, or $500 total. If the stock does not go up, investor/buyer does not exercise the contract, then he has lost $500. Subsequently, the stock goes up to $60 per share before the contract expires. Then, buyer/investor exercises the call option to sell the stock on the market at market price for a total of $6,000. Thus, he has a net profit of $500 = (1000–500). However, if the stock price drops to $40 per share by the time the contract expires, the investor will not exercise the option and loses his premium of $500. Accordingly, If you take a “XYZ October 26 Call” it would be a call option on XYZ stock with a strike price of $26 that expires in October. So, you have a right to buy 100 shares of XYZ at $26 per share. If you are right, the stock rises from $26 to $30 per share before option expires, you could exercise your option and sell them for an immediate profit of $4 per share. 45


If you are wrong, the stock fell from the original $26 per share to $24 per share, you would simply let the option expire and suffer.

A put option is a financial contract between two parties and gives the right to the buyer to sell the underlying assets at a certain price on or before a certain date and becomes more valuable as the price of the underlying assets depreciates relative to the strike price. Let’s say a buyer thinks the price of a stock will decrease. He pays a premium which he will never get back, unless it is sold before it expires. The buyer has the right to sell the stock at the strike price to the writer and writer receives a premium from the buyer. If the buyer exercises his option, the writer will buy the stock at the strike price. If the buyer does not exercise his option, the writer's profit is the premium. Let’s say "Buyer A" purchases a put contract to sell 100 shares to "Seller B" for $50 per share. The current price is $55 per share, and “Buyer A” pays a premium of $5 per share. If the price of stock falls to $40 a share before expiration, then “Buyer A” can exercise the put option by buying 100 shares for $4,000 from the stock market, then selling them to “Buyer B” for $5,000. Buyer A's total earnings can be calculated at $500. It is the same calculation, if you buy one Sept 13 Taser 10 put, you have the right to sell 100 shares of Taser at $10 until September 2013. If the shares fall to $5 and you exercise the option at $10, then you can purchase 100 shares for $5 in the market and sell the shares to the option's writers for $10 each, which means that you make a profit $500 on the put option and also calculated this way = (100 x ($10-$5)) = $500.

Swaps are contracts to exchange the cash flows on or before a specified future date based on underlying assets of currencies/exchange rates, bonds/interest rates, commodities, stocks or other assets. Unlike most standardized and nonstandardized contracts as options, forwards and futures contracts, swaps are not exchange-traded instruments. Instead, swaps 46


are customized contracts that are traded in the over-the-counter (OTC) market between private parties. Firms and financial institutions dominate the swaps market, with few (if any) individuals ever participating. Because swaps occur on the OTC market. Now, let’s say that company A and company B enter into a five-year swap and company A pays company B an amount equal to 6% per annum on a notional principal of US$20 million. Company B pays Company A an amount equal to one-year LIBOR + 1% per annum on a principal of US$20 million. In order to calculate the cash flows of payment between both parties, a following figure has been applied annually based on one-year LIBOR 41:

Fixed Rate: 6% Company A

Floating Rate: LIBOR + 1%

Company B

Let's assume that the two parties exchange the payments annually on December 31. Thus, company A pays company B this way, $20,000,000 x 6% = US$1,200,000. Therefore, company B will pay company A like this, $20,000,000*(5.33% + 1%) = $1,266,000. Lastly, the company B has to pays $66,000 and company A pays nothing.

41

London Interbank Offered Rate, British Bankers Association - BBA

47


PART IV Risks and Returns 4.1 Risks in Financial Investment Risk is the potential of loss resulting from an action, activity or inaction. This idea indicates that a choice having influence on the outcome sometimes exists. Possible losses may be called "risks". Any human endeavor carries some risk, but some are much riskier than others.

Figure 9: Risk and Return The investors do not fully appreciate the Figure: 10

risks in the securities investment and they are difficult to obtain the result while individuals consider investing their money, and then were immediately faced with the conflict between their desire for safety of principal and future return. The investors are not always willing to accept the risks associated with high returns. The risk in holding securities is that the actual returns might be less than the expected returns. The investors attempt to secure the largest rate of returns at the high risk that are willing, but risk is uncertainty about the size of future returns. So, there is a positive relationship between amount of risks assumed and amount of expected returns. That is, the greater the risk, larger the expected returns and the larger the chance of a substantial loss. One of more difficult problems for investors is to estimate the highest level of risk that is able to assume 42.

Timothy Johnson (1978) and other economists determined that there were many types of risk such as purchasing-power risk, credit risk, market risk, interest rate risk, business and operational risks, equity and financial risks. Thus, the investors must be aware all types of 42

Timothy E. Johnson (1978), Investment Principles, Published by Prentice-Hall,, USA, Page 17

48


systematic risks and unsystematic risks. Therefore, the investors must know how to measure and manage the investment risk. In finance, there are different types of risk can be classified under two main groups: 1. Systematic risk 2. Unsystematic risk The Systematic risk is due to the influence of external factors, which are normally uncontrollable from an organization's point of view. Systematic risk is a macro in nature as it affects a large number of organizations operating under a similar stream or same domain. It cannot be planned by the organization. Types of risk under systematic risk are listed below: o Interest rate risk o Market risk o Purchasing power or Inflationary risk

The Interest-rate risk arises due to variability in the interest rates from time to time. It particularly affects debt securities as they carry the fixed rate of interest. The interest-rate risk is further classified into the price risk reinvestment rate risk. The Market risk is associated with consistent fluctuations seen in the trading price of any particular shares or securities. That is, it is a risk that arises due to rise or fall in the trading price of listed shares or securities in the stock market. The market risk is further classified into the absolute risk, relative risk, directional risk, non-directional risk, basis risk and volatility risk. Whereas, the purchasing power risk is also known as inflation risk. It is so, since it originates from the fact that it affects a purchasing power adversely. It is not desirable to invest in securities during an inflationary period. The purchasing power or inflationary risk is classified into demand inflation risk and cost inflation risk. 49


The Unsystematic risk is due to the influence of internal factors prevailing within the organizations. Such factors are normally controllable from an organization's point of view. The Unsystematic risk is a micro in nature as it affects only a particular organization. It can be planned, so that necessary actions can be taken by the organization to mitigate (reduce the effect of) the risk. The types of risk under unsystematic risk are below: o Business or liquidity risk. o Financial or credit risk. o Operational risk.

The Business risk is also known as the liquidity risk. It is so, since it originates from the sale and purchase of securities affected by the business cycles, technological changes, etc. The business or liquidity risk is classified into the asset liquidity risk and funding liquidity risk. Whereas, the financial risk is also known as credit risk and arises due to change in the capital structure of the organization. The capital structure mainly comprises of three ways by which funds are sourced for the projects. The financial/credit risk classified into the exchange rate risk, recovery rate risk, credit event risk, non-directional risk, sovereign risk and settlement risk. Whereas, the operational risks are the business process risks failing due to human errors. This risk will change from industry to industry. It occurs due to breakdowns in the internal procedures, people, policies and systems. The operational risk is classified into the model risk, people risk, legal risk and political risk.

The professionals have two common ways to measure risk: (1) Beta model (2) Variance and Standard deviation model

50


Beta model is a measure of the volatility, or systematic risk of securities or portfolios in comparison to the overall market movements. Beta is used in the capital asset pricing model (CAPM), is a model that calculates the expected return of an asset based on its beta and expected market returns. Beta is an indicator of how risky a particular stock is and it is used to evaluate its expected rate of return. Beta is one of the fundamentals that stock analysts consider when choosing stocks for their portfolios, along with price-to-earnings ratio, shareholder's equity, debt-to-equity ratio, and other factors. Therefore, in order to calculate the risk and return of your portfolio investment, this formula has been applied:

Beta =

(Cov(r a ,r b )) or (Covariance of Market Return with Stock Return) (Var)(r b ) or Variance of the Stock Market Return

Or Expected Rate of Return = R = Rf + B (rm - rf) ==> Beta = (R - Rf) / (Rm - Rf)

R = Expected Rate of Return, Rf = Risk-Free Interest Rate Rm = Expected Market Return, B = Stock Beta

Let’s say we have the market rate 30.32%, risk-free return rate 0.26% and beta 2.147. In order to calculate the expected of return, this formula has been applied, R = Rf + B (rm - rf) = E(r) = 0.26% + 2.147(30.32 – 0.26%) = 64.82%. This is the rate of return an investor could expect on an investment in which his/her money is not at risk, such as U.S. T-Bills for investments in U.S. dollars and EU Government Bills for investments that trade in euros. This figure is normally expressed as a percentage. o Risk-free rate = 2% o Stock’s rate of return = 7% o Market rate of return = 8%

51


Using a simple equation to calculate the Beta: o 7% - 2% = 5% o 8% - 2% = 6% o 𝛽=

5 6

= 0.833

𝛽 < 1 => beta of less than 1 means that the security will be less volatile than the market

𝛽 > 1 => beta of greater than 1 show that the price of securities will be more volatile than the market.

𝛽 = 1 => beta of 1 indicates that the price of securities will move with the market

𝛽 < 0 => beta of less than 0 means that the stock is losing money while the market is gaining.

If a stock's beta is 1.2, it's theoretically 20% more volatile than the market. Many utilities stocks have a beta of less than 1. Conversely, most high-tech, Nasdaq-based stocks have a beta of greater than 1, offering the possibility of a higher rate of return, but also posing more risk.

4.2 Returns in Financial Investment Standard Deviation is a unit of measurement expressed as a percentage and sheds light on historical volatility and is the real key to understanding the risk of your investment portfolio. Standard deviation describes the probability of the distribution of a series of data. If a volatile stock will have a high standard deviation while the deviation of a stable blue chip stock will be lower. A large distribution tells us how much the return on the fund is deviating from the expected normal returns. Thus, risk reflects the chance that the actual return on an investment may be very different than the expected return. One way to measure risk is to calculate the variance and standard deviation of the distribution of returns. Consider the probability distribution for the returns on stocks A and B provided below. 52


State

Probability

Return on Stock A

Return on Stock B

1

20%

5%

50%

2

30%

10%

30%

3

30%

15%

10%

4

20%

20%

-10%

The expected returns on stocks A and B were calculated below. The expected return on stock A was found to be 12.5% and the expected return on stock B was found to be 20%. In order to calculate the expected returns of asset, this formula can be applied: N

E [R] = � piRi

Where: N = the number of states,

i=1

p i = the probability of state i,

R i = the return on the stock in state i, and E[R] = the expected return on the stock Stock A: E [R A ] = 0.20(5%) + 0.30(10%) + 0.30(15%) +0.25(20%) = 12.5% Stock B: E [R B ] = 0.20(50%) + 0.30(30%) + 0.30(10%) +0.25(-10%) = 20% As the result, the calculation shows that the Stock B offers a higher expected return than Stock A or E [R B ] > E [R A ]. However, that is only part of the investment; they haven't yet considered risk. Thus, in order to compute the measure risk, the standard deviation and Variance has been determined as expected value of square deviation as below formula: 𝑁

𝑉𝑎𝑟[𝐻𝐻] = 𝜎 2 = � 𝑝𝑖 (𝐻𝐻1 − 𝐸[𝐻𝐻])2 𝑖=1

53


σ2A = 0.20(0.50 − 0.125)2 + 0.30(0.10 − 0.125)2 + 0.30(0.15 − 0.125)2

+ 0.20(0.20 − 0.125)2 = 0.00263 ==> σ2A = √0.00263 = 0.0512 = 5.12%

σ2B = 0.20(0.50 − 0.20)2 + 0.30(0.30 − 0.20)2 + 0.30(0.10 − 0.20)2

+ 0.20(−0.10 − 0.20)2 = 0.04200 ==> σ2B = √0.04200 = 0.2049 = 20.49%

As result, though Stock B offers a higher expected return than Stock A E[R B ]>E[R A ], but it also is riskier since its variance and standard deviation are greater than Stock A. Most investors choose to hold securities as part of a diversified portfolio.

4.3 Calculation of Expected Risks and Returns Let’s see the table below and calculate the expected rate of risks (σ) and expected rate of returns E(r) on portfolio investment alternatives: Economy

Probability

T-Bill

AA

BB

CC

DD

Recession

0.10

8%

-22%

28%

10%

-13%

Below average

0.20

8%

-2%

14.7%

-10%

1%

Average

0.40

8%

20%

0.0

7%

15%

Above average

0.20

8%

35%

-10%

45%

29%

Boom

0.10

8%

50%

-20%

30%

43%

1.00 (100%)

4.3.1 Calculation of Expected Returns on Each Alternative E(r) AA = 0.10(-22%) + 0.20(-2%) + 0.40(20%) + 0.20(35%) + 0.10(50%) = 17.4% E(r) BB = 0.10(28%) + 0.20(14.7%) + 0.40(0%) + 0.20(-10%) + 0.10(-20%) = 1.7% E(r) CC = 0.10(10%) + 0.20(-10%) + 0.40(7%) + 0.20(45%) + 0.10(30%) = 13.8% E(r) DD = 0.10(-13%) + 0.20(1%) + 0.40(15%) + 0.20(29%) + 0.10(43%) = 15.30% 54


4.3.2 Calculation of Expected Risks on Each Alternative σ

T-bills

= 0.0%

σ AA = [(-22 - 17.4)20.10 + (-2 - 17.4)20.20 + (20 - 17.4)20.40 + (35 - 17.4)20.20 + (50 - 17.4)20.10)]1/2 = 20.0% σ BB = [(28 – 1.7)20.10 + (14.7 – 1.7)20.20 + (0 – 1.7)20.40 + (-10 – 1.7)20.20 + (-20 – 1.7)20.10)]1/2 = 13.4% σ CC = [(10 – 13.8)20.10 + (-10 – 13.8)20.20 + (7 – 13.8)20.40 + (45 – 13.8)20.20 + (30 – 13.8)20.10)]1/2 = 18.8% σ DD = [(-13 – 15)20.10 + (1 – 15)20.20 + (15 – 15)20.40 + (29 – 15)20.20 + (43 – 15)20.10)] 1/2 = 15.3%

Securities

Expected Returns

Expected Risks

AA

17.4%

20.0%

BB

15.0%

15.3%

CC

13.8%

18.8%

DD

1.7%

13.4%

T-bills

8.0%

0.0%

Base on the result shows that the risk of stock AA (20%) is higher than its return (17.4%) and the risk of stock BB (15.3%) is higher than its return (15%). Whereas, the risk of stock CC (18.8%) is higher than its return (13.8%) and the risk of stock DD (13.4%) is higher than the return (1.7%) and the T-bills is free risk (8.0%). Thus, the calculation is estimated that this portfolio provides average return smaller than higher risk. 55


The techniques to manage risk: The individual investors can use several methods to help reduce the risk and volatility in their portfolios. These include diversification, asset allocation, Dollar cost averaging Portfolio rebalancing. 1. Diversification is a technique that reduces the unsystematic risk by allocating investments among various financial instruments, industries and other categories. It aims to maximize return by investing in different areas that would each react differently to the same event. Most investment professionals agree that, although it does not guarantee against loss, diversification is the most important component of reaching long-range financial goals while minimizing risk. Generally, investors confront two main types of risk when investing. Diversifiable risk is associated with every company and also known as "systematic risk" or "market risk". Causes are things like inflation rates, exchange rates, political instability, war and interest rates. This type of risk is not specific to a particular company or industry, and it cannot be eliminated, or reduced, through diversification; it is just a risk that investors must accept. Whereas, diversifiable risk also known as "unsystematic risk" and it is specific to a company, industry, market, economy or country; it can be reduced through diversification. The most common sources of unsystematic risk are business risk and financial risk. Thus, the aim is to invest in various assets so that they will not all be affected the same way by market events. Now, let's say you have a portfolio of only airline stocks. If it is publicly announced that airline pilots are going on an indefinite strike, and that all flights are canceled, share prices of airline stocks will drop. Your portfolio will experience a noticeable drop in value. If, however, you counterbalanced the airline industry stocks with a couple of railway stocks, only part of your portfolio would be affected. In fact, there is a good chance that the railway stock prices would climb, as passengers turn to trains as an alternative form of transportation. 56


But, you could diversify even further because there are many risks that affect both rail and air, because each is involved in transportation. An event that reduces any form of travel hurts both types of companies. Statisticians would say that rail and air stocks have a strong correlation. Therefore, to achieve superior diversification, you would want to diversify, not only different types of companies but also different types of industries. The more uncorrelated your stocks are better. Thus, diversification can help investors to manage risk and reduce the volatility of an asset's price movements or can reduce risk associated with individual stocks, but general market risks affect nearly every stock, so it is important to diversify also among different asset classes. The key is to find a medium between risk and return; this ensures that you achieve your financial investment goals. 2. Asset allocation is an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio according to the investor's risk tolerance, goals and investment time frame. 43There is no simple formula that can find the right asset allocation for every individual. However, the consensus among most financial professionals is that asset allocation is one of the most important decisions that investors make. In other words, your selection of individual securities is secondary to the way you allocate your investment in stocks, bonds, and cash, real estate, and equivalents, even insurance investments, commodities, collectibles, and other categories count, which will be the principal determinants of your investment results. This method establishes and adheres to a base policy mix as a proportional combination of assets based on expected rates of return for each asset class. For example, if stocks have historically returned 10% per year and bonds have returned 5% per year, a mix of 50% stocks and 50% bonds would be expected to return 7.5% per year. Let’s see the Harvard Asset Allocation as of June 30, 2008 used as an 43

Asset Allocation Definition (2011), retrieved from Investopedia

57


investment strategy to attempt to balance of risk versus return by adjusting the percentage of each asset in an investment portfolio. Thus, the Harvard has allocated their assets such as the absolute return, fixed income, and domestic, foreign and private equities as well as real assets and cash to put in the investment portfolio = 19% + 16% + 12% + 22% + 12% + 24% + (-5%) = 100%.

Picture 10: the Harvard Asset Allocation

3. Dollar cost averaging (DCA) is an investment strategy for reducing the impact of volatility on large purchases of financial assets such as equities. DCA reduces the risk of incurring a substantial loss resulting from investment in the market. DCA is not always the most profitable way to invest a

large sum, but it minimizes downside risk.

44

Let’s say that more shares are purchased when

prices are low, and fewer shares are bought when prices are high. Eventually, the average cost per share of the security will become smaller and smaller. Dollar-cost averaging lessens the risk of investing a large amount in a single investment at the wrong time. For example, you decide to purchase $1,000 worth of XYZ each month for three months. In January, XYZ is worth $3, so you buy 100 shares. In February, XYZ is worth $5, so you buy 100 additional shares and then in March XYZ share is worth $10, so you buy 100 shares. Finally, in April, XYZ share is worth $4, so you buy 100 shares. In total, you purchased 400 shares for an average price of approximately $5.5 each. The cost average has been calculated in the following table:

44

Dollar Cost Averaging: A Technique that Drastically Reduces Market Risk. Retrieved 2009-03-22

58


Date

Price per Share

Shares

Cost

January 15

$3

100

$300

February 15

$5

100

$500

March 15

$10

100

$1,000

April 15

$4

100

$400

Total

400

$2,200

Average Price per Share

$5.50

4. Portfolio rebalancing is a powerful risk-control strategy. As a portfolio’s different investments produce the altered returns, the portfolio drifts from its target asset allocation, acquiring risk and return characteristics that may be inconsistent with an investor’s goals and preferences. A rebalancing strategy addresses this risk by formalizing guidelines about how frequently the portfolio should be monitored, how far an asset allocation can deviate from its target before it’s rebalanced, and whether periodic rebalancing should restore a portfolio to its target or to some intermediate allocation. The objective of portfolio rebalancing is to maintain a consistent mix of asset classes, most commonly equities and fixed income in order to control risk at the level desired by the investors. This is accomplished by transferring funds from higher-performing classes to lower-performing classes. When asset classes deviate from their target by a certain dollar amount, the investors have to find the way to rebalance. For instance, if you have a $10,000 portfolio investment and hold $5,000 in equities (50%) and $4,000 in the fixed income (40%) and 1,000 in the real estate (10%) on January 31, 2011, after the market takes action a few months up to March 30, 2011 and your portfolio has changed 45% equities, 35% bonds and 20% real estate. Thus, you would rebalance your portfolio in order to balance your current holdings of $5,000 equities (50%), and $4,000 fixed-income (40%) and $1,000 real estate (10%).

59


PART V Capital Markets ‘Analytical Tools for Economic Growth According to the previous research findings showed that the development of capital markets in the country, it provided chances and benefits to the economic growth, particularly, its mechanism offers opportunities for companies and institutions seeking financing beside banking system in order to expand their investment and business projects in the future. Moreover, this mechanism also gave choices to investors and publics to participate in this investment activity.

Moreover,

beside

the

benefits

to

economic

growth,

this

mechanism

can help country's financial integration into the global financial system and strengthen the co untry's financial sector more robust including keeping the macroeconomic stability. In the findings of University of Science Economics of Romania showed that development of capital markets helped boost the economic growth of the country during 2000 to 2006, accompanied

by

the

development

of

the

financial

system

and

the variables used for measuring in the study are the variables of market capitalization size and listed stocks including of trading volume. 45 Whereas Nieuwerberg, Buelens and Cuyvers

also

said the development of the capital markets in Belgium to help promote national economic gr owth during 1873-1935 as measured by the variables of market capitalization size and numbers of listing stocks. Whereas, Harry Garresten, Robert Lensink and Elmer Sterken showed

45

relationship

between

Laura, Victor, Delia, Andreas (2008): correlation between capital market and economic growth, pp. 8

60


the economic growth and development of the capital markets when economic growth has impetus 1% it determines that the market capitalization ratio increase 0.4%.

5.1 Measure of Economic Growth To analyze on the economic growth and capital market development is used has

a a

classical

relationship

model between

is the

a quantities

total of

production outputs

and

function inputs.

that Depend

on the following equation shows the relationship between the inputs and outputs to determine the economic growth as measured by the production function Y = AF (K, N). 46To facilitate the calculation, we assume key inputs, which comprise (N) labor (K) as capital. Therefore, this equation showed that the outputs (Y), which depends on the level of inputs and technology. If technology (A) higher, they can produce more item by item. Thus, the equation above shows the contribution of inputs through the productivity formation to increase the outputs. Accordingly, the labor and capital contribute to the economic growth (outputs). The improvement of technology is the productivity development of the workforce.

According to the function of production “Cobb and Douglas” showed relationship between the vital inputs and outputs to the economic growth that economists always used the function of production, which found by Wicksell (1851-1926) and was taken to verify the data by Charles Cobb and Paul Douglas in 1928. This function can write a formula Y = ALαKβ or Y = A x Lα x Kβ which represented by (Y) = is the production, (L) = labor input and (K) = capital input and (A) = total factor productivity. α and β = is the constancy of labor and capital. The two values are determined by the appropriate technology. If α = 0.15, and

46

Hang Choun Naron (2009), Macroeconomics, first edition, Phnom Penh, pp. 162

61


labor force growth at 1%, will lead to increase of 0.15%. If α + β = 1, will lead to the production function has constantly increased. If L and K increased 20% Y also increased by 20%. If α + β <1, the profit from the investment will be dropped. If α + β>1, the profits from the investment will be increased. This growth model showed a close relationship between a living standard of people and key factors such as savings rates, population growth and the progress of technology. The evolutions of economic growth and its impetus including the motive force to the slow economic countries will step up to the advance economic countries.

Solow’s economic growth model described that there is an interaction or relationship to the five macroeconomic equations: (1) the function equation of macro production (2) the equation of GDP (3) the equation of savings (4) the equation of capital transformation and (5) the equation of transformation of labor. 47 Solow growth model was used for calculation and analysis of the amount of all the products and services that each nation produces and uses. Especially domestic product equation or called gross domestic product or was called GDP. Thus, GDP is the value of all finished products and services that produced in an economy at a time, whereas, the value of goods and services are identified depending on the market price. The GDP is calculated by three methods: (1) Method of productions (2) Method of expenses and (3) Method of incomes As said by the theory, the equation of GDP can be determined as follows: GDP = C + G + I + (X-M) ==> Y = GDP = C + G + I + (NX)

47

Solow–Swan growth model, the economic growth models, the framework of neoclassical growth models

62


When GDP increases, the gross products as outputs (Y) increase because of the investments and total incomes increase for improving the domestic products and services as well as the total expenditure and consumption for reduction of the import and improve the export.

63


5.2 Market Capitalization (%) to GDP Additionally, the model of the World Bank (2011) has been used for calculation to find out the market capitalization of listed companies (% of GDP). The market capitalization is the share price times the number of shares outstanding and divided by the nominal GDP and time 100%. The following formula has applied in the U.S. markets and the world markets as well. A ratio used to determine whether an overall market is undervalued or overvalued. Market Capitalization to GDP =

Stock Market Capitalization x 100 Nominal GDP

Source: ACEMAXX-ANALYTICS: US-Börsen: Marktkapitalisierung versus BIP 2010, https://www.chartstore.com

64

Introduction to Financial Markets and Investment.pdf

Recommend Documents