CHAPTER ONE

INTRODUCTION TO INVESTMENT

DEFINITION OF INVESTMENT
An investment is the current commitment of money for a period of time in order to derive future
payments that will compensate the investor for:
• (1) The time the funds are committed,
• (2) The expected rate of inflation, and
• (3) The uncertainty of the future payments.
More specifically, investment is the commitment of money or capital to the purchase of financial
instruments or other assets so as to gain profitable returns in the form of interest, income (dividends),
or appreciation (capital gains) of the value of the instrument.

INVESTMENT Vs SPECULATION Vs GAMBLING

Investment Vs Speculation
 A speculator can be defined as someone that seeks to buy and sell in order to take advantage of
market price fluctuations.
 An investor is someone who holds on to securities that provide a good income or capital gain by
virtue of them being based on something of real and increasing value.
 The most realistic distinction between the investor and the speculator is found in their attitude
toward stock-market movements. The speculator's primary interest lies in anticipating and
profiting from market fluctuations. The investor's primary interest lies in acquiring and holding
suitable securities at suitable prices.

Difference between Speculation and Investment

Basis Speculation Investment
Meaning • A message expressing an • The investing of money
opinion based on
incomplete evidence
Length commitment Is a short term only Is a longterm
Types of contract Speculator is a owner of Investor is a creditor of
 the speculation the Investment
Source of Income Is fluctuated & changes in market price Is earning from theenterprise
Quantity of Risk Is the high Is the low
Stability of Income Income is uncertain and unpredictable Income is very stable
Psychological attitude Speculator psychological Investor psychological attitude is a
of Participants attitude is a brave and careless cautious and conservative
Reasons for Purchase It is unscientific analysis It is scientific analysis
of intrinsic worth of intrinsic worth
Planning Horizon A very short planning horizon. His An investor has a relatively longer
holding may be a few to adays to a few planning horizon. His holding
months. period is usually at least one year
Risk Disposition A speculator risk is high An investor risk is less
Return Expectation A speculator looks for a high rate of An investor usually seeks
return moderate rate of return
Basis for Decisions A speculator relies more on hear say, A careful evaluation of the growth
technical charts and market psychology of the enterprise
Leverage A speculator normally takes to An investor uses his own
borrowings, which can be very funds avoid borrowed funds
substantial, to supplement his personal
resources.

• Gambling is defined as, an act putting money at risk by betting on an uncertain outcome with
the hope that you might win money. In other word, gambling is an act of taking the risk of losing
money in the expectation of a desired result.
• Investing means committing money in order to earn a financial return. The definitions seem to
indicate a higher element of chance or randomness in gambling, while investing appears to
be more rational.

OBJECTIVES OF INVESTMENT
In broad terms, four main investment objectives cover how you accomplish most financial goals.
These investment objectives are important because certain products and strategies work for one
objective, but may produce poor results for another objective. It is quite likely you will use several
of these investment objectives simultaneously to accomplish different objectives without any
conflict. Let’s examine these objectives and see how they differ.
 Capital Appreciation
Capital appreciation is concerned with long-term growth. A typical strategy employs making
regular purchases. You are not very concerned with day-to-day fluctuations, but keep a close eye
on the fundamentals of the company for changes that could affect long-term growth.
 Current Income
If your objective is current income, you are most likely interested in stocks that pay a consistent
and high dividend. You may also include some top-quality real estate investment trusts (REITs)
and highly-rated bonds. All of these products produce current income on a regular basis. Many
people who pursue a strategy of current income are retired and use the income for living expenses.
 Capital Preservation
Capital preservation is a strategy you often associate with elderly people who want to make sure
they don’t outlive their money. Retired on nearly retired people often use this strategy to hold on
the detention has. For this investor, safety is extremely important – even to the extent of giving up
return for security. The logic for this safety is clear. If they lose their money through foolish
investment and are retired, it is unlike they will get a chance to replace it. Investors who use capital
preservation tend to invest in bank CDs, U.S. Treasury issues and savings accounts.
 Speculation
They have no love for the companies they trade and, in fact may not know much about them at all
other than the stock is volatile and ripe for a quick profit. Speculators keep their eyes open for a
quick profit situation and hope to trade in and out without much thought about the underlying
companies.
 Tax Minimization:
An investor may pursue certain investments in order to adopt tax minimization as part of his or her
investment strategy. A highly-paid executive, for example, may want to seek investments with
favourable tax treatment in order to lessen his or her overall income tax burden.
 Marketability/Liquidity:
Many of the investments we have discussed are reasonably illiquid, which means they cannot be
immediately sold and easily converted into cash. Achieving a degree of liquidity, however,
requires the sacrifice of a certain level of income or potential for capital gains.
Common stock is often considered the most liquid of investments, since it can usually be sold
within a day or two of the decision to sell. Bonds can also be fairly marketable, but some bonds are
highly illiquid, or non-tradable, possessing a fixed term. Similarly, money market instruments may
only be redeemable at the precise date at which the fixed term ends. If an investor seeks liquidity,
money market assets and non-tradable bonds aren't likely to be held in his or her portfolio.

CHARACTERISTICS OF INVESTMENT
• Return: Investors buy or sell financial instruments in order to earn return onthem. The return on
investment is the reward to the investors. The return includes both current income and capital
gain or losses, which arises by the increase or decrease of the security price. Therefore, when we
talk about a return on an investment, we are concerned with the change in wealth resulting from
this investment.
• Risk: Risk is the chance of loss due to variability of returns on an investment.In case of every
investment, there is a chance of loss. It may be loss of interest, dividend or principal amount of
investment.
• Time: time is an important factor in investment. It offers several different courses of action.
Time period depends on the attitude of the investor who follows a ‘buy and hold’ policy. As time
moves on, analysis believes that conditions may change and investors may revaluate expected
returns and risk for each investment.
• Liquidity: Liquidity refers to the ability of an investment to be converted into cash as and when
required. The investor wants his money back any time. Therefore, the investment should provide
liquidity to the investor.
• Safety: Safety refers to the protection of investor principal amount and expected rate of return.
Investor prefers safety about his capital. Capital is the certainty of return without loss of money
or it will take time to retain it.
• Capital Growth: Capital Growth refers to appreciation of investment. Capital growth has
today become an important character of investment. It is recognizing in connection between
corporation and industry growth and very large capital growth
• Stability of Income:It refers to constant return from an investment. Stability of income must
look for different path just as security of principal. Every investor always considers stability of
monetary income and stability of purchasing power of income.

SECURITY MARKET
Securities are typically divided into debt securities and equities. A debt security is a type of
security that represents money that is borrowed that must be repaid, with terms that define the
amount borrowed, interest rate and maturity/renewal date. Debt securities include government and
corporate bonds, certificates of deposit (CDs), preferred stock and collateralized securities (such as
CDOs and CMOs).

Equities represent ownership interest held by shareholders in a corporation, such as a stock. Unlike
holders of debt securities who generally receive only interest and the repayment of the principal,
holders of equity securities are able to profit from capital gains.

A market is a place used for buying and selling goods. A financial market is a market where
financial instruments are exchanged. Securities market is a component of the wider financial market
where securities can be bought and sold between subjects of the economy, on the basis of demand
and supply. Securities markets encompasses equity markets, bond markets and derivatives markets
where prices can be determined and participants both professional and non-professionals can meet.
Financial markets provide the following three major economic functions: price discovery, liquidity&
reduced transaction costs. The lender of funds (or investor) is the buyer of the asset and the borrower
of funds is the seller of the asset (or issuer of the security). The mechanism or system through which
financial assets are created and transferred is known as the financial market. Securities markets
determine price and participants can be both professional and non-professional. These markets
streamline the purchase and sales activities of investors by allowing transactions to be made quickly
and at a fair price.

Securities are investment certificates that represent either equity (ownership in the issuing
organization) or debt (a loan to the issuer). Corporations and governments raise capital to finance
operations and expansion by selling securities to investors, who in turn take on a certain amount of
risk with the hope of receiving a profit from their investment. Individual investors invest their own
money to achieve their personal financial goals. Institutional investors are investment professionals
who are paid to manage other people’s money. Most of these professional money managers work for
financial institutions, such as banks, mutual funds, insurance companies, and pension funds.
Institutional investors control very large sums of money. They aim to meet the investment goals of
their clients. Institutional investors are a major force in the securities markets.

Types / Segments of Financial Market

Different types of securities are traded in the securities market. These may
include ownership securities, debt securities, short-term securities, long-term securities,
government securities, non-government or corporate securities. Hence, on the basis of the maturity
period of securities traded in the market, the securities market is segmented into money market and
capital market.
A. Money market is the money market is the sector of the financial market that includes financial
instruments that have a maturity or redemption date that is one year or less at the time of
issuance. Treasury bills, commercial bills, commercial paper, certificate of deposit, etc. are the
short-term securities traded in the money market. Money market is the main source of working
capital funds for business and industry. It provides a mechanism for evening out short-term
surpluses and deficits.
The money market securities have three basic common characteristics:
- They have low default risk
- They mature in one year or less from their original issue date. Most money market
instruments mature in less than 120 days.
- They are usually sold in large denominations. Money Market Mutual funds can mitigate
(alleviate) this problem.
Money market transactions do not take place in one particular location or building rather traders
usually arrange purchase and sales between participants over a phone and complete them
electronically. Because of this money market securities usually have an active secondary market.

B. Capital market is the market segment where long-term securities (a financial instrument with an
original maturity greater than one year) and perpetual securities (those with no maturity) are
 bought and sold. Equity shares, preference shares, debentures and bonds are the long-term
securities traded in the capital market. The capital market is the source of long-term funds for
business and industry.

The comparison of money market and capital market

Features Money market Capital market
Term of circulation of Short-term, Long-term,
securities traded less than 1 year more than 1 year
Level of risk Low, because of trading Long-term securities,
short-term securities which traded in this market, is
have lower level of risk more risky
and high liquidity
Fund suppliers Central bank, Commercial Banks, insurance
banks, nonfinancial companies, pension funds,
business lending the large amounts
institutions with the excess of funds for a long-term
funds period; investment funds
with big pools of funds for
investing
Financial instruments Certificates of deposit; Common stocks;
Treasury bills; Preferred stocks;
Commercial paper; Treasury bonds;
Bankers’ acceptances; Municipal bonds;
Repurchase agreements, Corporate bonds;
other short-term other long-term investment
investment vehicles vehicles
Aims for raising money For financing of working For financing of further
capital and current needs business development and
investment projects
Levels of securities market
A. Primary market
The primary market is that part of the capital markets that deals with the issue of new securities.
Companies, governments or public sector institutions can obtain funding through the sale of a new
stock or bond issue. This is typically done through a syndicate of securities dealers. The process of
selling new issues to investors is called underwriting. In the case of a new stock issue, this sale is a
public offering. Dealers earn a commission that is built into the price of the security offering, though
it can be found in the prospectus. Primary markets create long term instruments through which
corporate entities borrow from capital market.
Features of primary markets are:
o This is the market for new long term equity capital. The primary market is the market where the
securities are sold for the first time. Therefore it is also called the new issue market (NIM).
o In a primary issue, the securities are issued by the company directly to investors.
o The company receives the money and issues new security certificates to the investors.
o Primary issues are used by companies for the purpose of setting up new business or for
expanding or modernizing the existing business.
o The primary market performs the crucial function of facilitating capital formation in the
economy.
o The new issue market does not include certain other sources of new long term external finance,
such as loans from financial institutions. Borrowers in the new issue market may be raising
capital for converting private capital into public capital; this is known as "going public."
B. Secondary market
The secondary market, also known as the aftermarket, is the financial market where previously
issued securities and financial instruments such as stock, bonds, options, and futures are bought and
sold. The term "secondary market" is also used to refer to the market for any used goods or assets, or
an alternative use for an existing product or asset where the customer base is the second market (for
example, corn has been traditionally used primarily for food production and feedstock, but a
"second" or "third" market has developed for use in ethanol production).

With primary issuances of securities or financial instruments, or the primary market, investors
purchase these securities directly from issuers such as corporations issuing shares in an IPO or
private placement, or directly from the federal government in the case of treasuries. After the initial
issuance, investors can purchase from other investors in the secondary market.

The secondary market for a variety of assets can vary from loans to stocks, from fragmented to
centralized, and from illiquid to very liquid. The major stock exchanges are the most visible example
of liquid secondary markets - in this case, for stocks of publicly traded companies. Exchanges such
as the New York Stock Exchange, Nasdaq and the American Stock Exchange provide a centralized,
liquid secondary market for the investors who own stocks that trade on those exchanges. Most bonds
and structured products trade “over the counter,” or by phoning the bond desk of one’s broker-
dealer. Loans sometimes trade online using a Loan Exchange.

C. Over-the-counter market
Over-the-counter (OTC) or off-exchange trading is to trade financial instruments such as stocks,
bonds, commodities or derivatives directly between two parties. It is contrasted with exchange
trading, which occurs via facilities constructed for the purpose of trading (i.e., exchanges), such as
futures exchanges or stock exchanges. OTC stocks are not usually listed nor traded on any stock
exchanges, though exchange listed stocks can be traded OTC on the third market. An over-the-
counter contract is a bilateral contract in which two parties agree on how a particular trade or
agreement is to be settled in the future. It is usually from an investment bank to its clients directly.
Forwards and swaps are prime examples of such contracts. It is mostly done via the computer or the
telephone. For derivatives, these agreements are usually governed by an International Swaps and
Derivatives Association agreement.
This segment of the OTC market is occasionally referred to as the "Fourth Market."
The NYMEX has created a clearing mechanism for a slate of commonly traded OTC energy
derivatives which allows counterparties of many bilateral OTC transactions to mutually agree to
transfer the trade to Clear Port, the exchange's clearing house, thus eliminating credit and
performance risk of the initial OTC transaction counterparts
 PARTICIPANTS OF FINANCIAL MARKET
On the financial markets, there is a flow of funds from one group of parties (funds-surplus units)
known as investors to another group (funds-deficit units) which require funds. However, often these
groups do not have direct link. The link is provided by market intermediaries such as brokers, mutual
funds, leasing and finance companies, etc. In all, there are a very large number of players and
participants in the financial market. These can be grouped as follows:
 The individuals: These are net savers and purchase the securities issued by corporates. Individuals

provide funds by subscribing to these securities or by making other investments.

 The Firms or corporates: The corporates are net borrowers. They require funds for different

projects from time to time. They offer different types of securities to suit the risk preferences of
investors’ Sometimes, the corporates invest excess funds, as individuals do. The funds raised by
issue of securities are invested in real assets like plant and machinery. The income generated by
these real assets is distributed as interest or dividends to the investors who own the securities.
 Government: Government may borrow funds to take care of the budget deficit or as a measure

of controlling the liquidity, etc. Government may require funds for long terms (which are raised by
issue of Government loans) or for short-terms (for maintaining liquidity) in the money market.
 Regulators: Financial system is regulated by different government agencies. The relationships

among other participants, the trading mechanism and the overall flow of funds are managed,
supervised and controlled by these statutory agencies in Ethiopiathe financial system is regulated
by National Bank of Ethiopia.
 Market Intermediaries: There are a number of market intermediaries known as financial

intermediaries or merchant bankers, operating in financial system. These are also known as
investment managers or investment bankers. The objective of these intermediaries is to smoothen
the process of investment and to establish a link between the investors and the users of funds.
Corporations and Governments do not market their securities directly to the investors. Instead, they
hire the services of the market intermediaries to represent them to the investors. Investors,
particularly small investors, find it difficult to make direct investment. A small investor desiring to
invest may not find a willing and desirable borrower. He may not be able to diversify across
borrowers to reduce risk. He may not be equipped to assess and monitor the credit risk of
borrowers. Market intermediaries help investors to select investments by providing investment
consultancy, market analysis and credit rating of investment instruments. In order to operate in
 secondary market, the investors have to transact through share brokers. Mutual funds and
investment companies pool the funds(savings) of investors and invest the amount in different
investment alternatives. Some of the market intermediaries are: :Lead Managers, Bankers to the
Issue, Registrar and Share Transfer Agents, Depositories, Clearing Corporations, Share brokers,
Credit Rating Agencies, Underwriters, Custodians, Portfolio Managers, Mutual Funds, Investment
Companies
These market intermediaries provide different types of financial services to the investors. They
provide expertise to the securities issuers. They are constantly operating in the financial market.
Small investors in particular and other investors too, rely on them. In principle, these intermediaries
bring efficiency to corporate fund raising by developing expertise in pricing new issues and
marketing them to the investors.
primarily brokers who act as agents for the primary lenders or the ultimate borrowers in the
purchase or sale of securities. There are also broker dealers who act on their own account by
buying and selling securities for a profit. This group also includes institutions which act as
registrars, managers, lead managers, share transfer agents, etc. at the time of issue of shares
by companies.

OVERVIEW OF INVESTMENT FUNDS AND INVESTMENT COMPANIES

When investors decide to invest in a particular asset class, such as equities, there are two ways they
can do it: direct investment or indirect investment.

Direct investing- investors buy and sell financial assets and manage individual investment portfolio
themselves. Investors take all the risk and their successful investing depends on their understanding
of financial markets, its fluctuations and on their abilities to analyze and to evaluate the investments
and to manage their investment portfolio. Direct investing is realized using financial markets.
Achieving an adequate spread of investments through holding direct investments can require a
significant amount of money and, as a result, many investors find indirect investment very attractive.

Indirect investing - investors are buying or selling financial instruments of financial intermediaries
(financial institutions) which invest large pools of funds in the financial markets and hold portfolios.
Indirect investing relieves investors from making decisions about their portfolio. As shareholders
with the ownership interest in the portfolios managed by financial institutions (investment
companies, pension funds, insurance companies, commercial banks) the investors are entitled to
their share of dividends, interest and capital gains generated and pay their share of the institution’s
expenses and portfolio management fee.
The risk for investor using indirect investing is related more with the credibility of chosen institution
and the professionalism of portfolio managers. Achieving an adequate spread of investments through
holding direct investments can require a significant amount of money and, as a result, many
investors find indirect investment very attractive. There is a range of funds available that pool the
resources of a large number of investors to provide access to a range of investments. These pooled
funds are known as collective investment schemes (CISs), funds, or collective investment vehicles.

The term ‘collective investment scheme’ is an internationally recognized one, but investment funds
are also very well-known by other names, such as mutual funds, unit trusts or open-ended
investment companies (OEICs).Other terminology that you need to be familiar with for this course is
open-ended funds and closed-ended funds.

An open-ended fund is one that can create new shares in response to investor demand or cancel them
when sold so that their capital can expand or contract – an example is a mutual fund. In Ethiopia by
vertu of the commercial code requirements, capital maintenance is at the top of third-party protection
and thus such variability in capital (specifically to contract capital) is yet to be regulated. A closed-
ended fund, by contrast, has a fixed capital base so if an investor wants to buy shares, they will do so
on the stock exchange and buy them from another investor who wants to sell. They have a fixed
capital base. An investor is likely to come across a range of different types of investment funds, as
many are now established in one country and then marketed internationally.

INVESTMENT COMPANIES
• An investment company is an organization, trust, or entity that collects capital from various
investors to reinvest it in financial securities such as equity, debt, and a wide range of money
market instruments.
• The organization with surplus fund who engage in investment activities.
• The company will earn returns on its portfolio in interest, dividends, etc. These returns are then
forwarded to the individual investors, based on their share of the total investment fund.

For example, suppose a company invests $2 million, and one has invested $40,000 with this
company. They will get 2 percent of whatever returns the company generates.

• The type of assets chosen to invest will depend on the overarching management objective of that
particular company.
For instance, suppose the aim is the quick growth of investments. Then a large portion of funds
will be invested in shares and equity, as these assets yield the highest returns.
Suppose the objective is to generate stable, long-term returns while minimizing risk. Then debt
securities and commercial real-estate investments will be preferred, as they are less volatile than
equity.

• Thecompany shares the profit and losses with the investor in proportion to the investor’s interest
in the company.
• They employ financial managers who make important financial decisions on behalf of the
investors. The investors can thus enjoy access to many investment products that otherwise need
extensive research and preparation.
• Investment companies help small investors access professional financial management services,
minimize risk, and diversify their portfolios. They employ experienced finance managers who can
take clever financial decisions for the client, especially during times of crisis.
• The three investment company types are mutual fund (open-end and closed-end) and Unit
Investment Trusts (UIT).

A. Mutual funds
Mutual investment companies are also called managed company and obtain funds from large
number of investors through sale of units. The funds collected from investors are placed under
professional managers for the benefit of the investors.Mutual funds are classified into two:
 i. Open-ended investment company
An OEIC is another form of investment fund. They are a form of Investment Company with
variable capital (ICVC) that is structured as a company with the investors holding shares.
The term ‘OEIC’ is used mostly but they are also known as a variable capital company
(VCC). Here too investors deal directly with the fund when they wish to buy and sell.
 Continuously can sell shares to investors after the initial sale of shares that starts the funds.
Offer units/shares on a continuous basis and accept funds from investors continuously.
 Its shares are redeemable:-repurchase is carried out in a continuous basis thus, helping the
investors to withdraw their money at anytime. In another words, there is an interrupted exit
and entry into the funds.
 New investors can buy additional shares and existing shareholders cash in by selling their
shares back to the company. Issuing new shares or units to the investor at a price based on
the value of the underlying portfolio. If investors decide to sell, they again approach the fund,
which will redeem the shares and pay the investor the value of their shares, again based on
the value of the underlying portfolio. An open-ended fund can, therefore, expand and
contract in size based on investor demand, which is why it is referred to as open-ended..
 Has no maturity period and they are not listed in stock exchange.
 The open-ended fund provides liquidity to investors since repurchase facility is available.
 Repurchase price is fixed on the net asset value of the unit.
 Its capitalization is continuously changing.
The key characteristics of OEICs are the parties that are involved and how they are priced.

When an OEIC is set up, an authorised corporate director (ACD) and a depository are appointed.
The ACD is responsible for the day-to-day management of the fund, including managing the
investments, valuing and pricing the fund and dealing with investors. It may undertake these
activities itself or delegate them to specialist third parties. The register of shareholders is maintained
by the ACD.

The fund’s investments are held by an independent depositary, responsible for looking after the
investments on behalf of the fund’s shareholders and overseeing the activities of the ACD. The
depository plays a similar role to that of the trustee of a unit trust. The depository is the legal owner
of the fund investments and the OEIC itself is the beneficial owner, not the shareholders
ii. Closed-ended investment company
 A closed-ended investment company is another form of investment fund. When they are first
established, a set number of shares is issued to the investing public, and these are then
subsequently traded on a stock market. Usually sells no additional shares of its own stock
after the initial public offering.
 They do not generally buy back their shares from investors. Investors wanting to
subsequently buy shares do so on the stock market from investors who are willing to sell.
 The capital of the fund is therefore fixed, and does not expand or contract in the way that an
open-ended fund’s capital does. For this reason, they are referred to as closed-ended funds in
order to differentiate them from mutual funds, unit trusts and OEICs. Real Estate Investment
Trusts (REITs) is an example of closed-ended investment companies.These investment
companies list a fixed number of shares traded in the stock market.
 The shares of a closed-end fund trade in the secondary markets (e.g., on the-exchanges)
exactly like any other stock. To buy and sell, investors use their brokers, paying (receiving)
the current price at which the shares are selling plus (less) broker age commissions.

B. Unit investment trusts:

 It is a company that invests the money raised from many investors by selling shares to
investors in one time public offering in a generally a fixed portfolio of stocks, bonds or other
securities for specified period of time.
 Fixed portfolio means once portfolio of stock/bond is chosen they do not changed until
predetermined termination date.
 The UIT dissolve on particular date when its portfolio get liquidated and the proceeds handed
to investors.
 UIT permits secondary market which allows investors to buy and sell UIT shares, bonds at
the market price.
 The key difference is once UIT sets its portfolio, it remains the same for the life of the fund
and the term is fixed.
 The shares of a UIT are redeemable.
For example, a trust that has purchased $5 million of assets may sell 5,000 shares to the public at a
price of $1,030 per share, which (assuming the trust has no liabilities) represents a 3% premium over
the net asset value of the securities held by the trust. The 3% premium is the trustee’s fee for
establishing the trust. Investors who wish to liquidate their holdings of a unit investment trust may
sell the shares back to the trustee for net asset value. The trustees can either sell enough securities
from the asset portfolio to obtain the cash necessary to pay the investor, or they may instead sell the
shares to a new investor (again at a slight premium to net asset value).

A unit trust is an investment fund that is established as a trust, in which the trustee is the legal owner
of the underlying assets and the unit holders are the beneficial owners. As with other types of open
ended funds, the trust can grow as more investors buy into the fund, or shrink as investors sell units
back to the fund and they are cancelled. Investors deal directly with the fund when they wish to buy
and sell.

The major differences between unit trusts and the open-ended funds are the parties to the trust and
how the units are priced.

The main parties to a unit trust are the unit trust manager and the trustee:

 The role of the unit trust manager is to decide, within the rules of the trust and the various
regulations, which investments are included within the unit trust. This will include deciding
what to buy and when to buy it, as well as what to sell and when to sell it. The unit trust
manager may outsource this decision-making to a separate investment manager. The manager
also provides a market for the units by dealing with investors who want to buy or sell units. It
also carries out the daily pricing of units, based on the NAV of the underlying constituents.
• Every unit trust must also appoint a trustee. The trustee is the legal owner of the assets in the
trust, holding the assets for the benefit of the underlying unit holders. The trustee also protects
the interests of the investors by, among other things, monitoring the actions of the unit trust
manager. Whenever new units are created for the trust, they are created by the trustee. The
trustees are organisations that the unit holders can trust with their assets, normally large banks
or insurance companies.
 Just as with other investment funds, the price that an investor pays to buy a unit trust or receives
when they sell is based on the NAV of the underlying portfolio. However, generally the pricing
of units in a unit trust is done on a dual-priced basis:

o The underlying portfolio of a unit trust is valued daily at both the bid and offer prices for
the investments contained within the portfolio.
o This produces two NAVs, one representing the value at which the portfolio’s investments
can be sold for and another for how much it will cost to buy.
o These values are then used to calculate two separate prices, one at which investors can
sell their units and one which the investor pays to buy units.

For this reason, unit trusts are described as dual-priced. They have a bid price, which is the price the
investor receives if they are selling, and an offer price, which is the price the investor pays if buying.
The difference between the two is known as the bid-offer spread. Any initial charges made by the
unit trust for buying the fund are included within the offer price that is quoted.

BENEFITS OF AN INVESTMENT COMPANY / COLLECTIVE INVESTMENT

Investment funds pool the resources of a large number of investors, with the aim of pursuing a
common investment objective. This pooling of funds brings a number of benefits, including:
 Professional management
Most, but not all, investment companies have full-time staffs of security analysts and portfolio
managers who attempt to achieve superior investment results for their investors. An individual
investor will get several benefits from the pooling of funds. For instance, investment companies
employ experienced and qualified finance managers. As a result, they can provide professional
investment management services that allow investors to reach their investment goals quickly and
with minimal risk.
 Diversification and divisibility
By pooling this money, investment companies enable investors to hold fractional shares of many
different securities. They can act as large investors even if and individual shareholder cannot.
 Record peeping and administration
Investment companies issue periodic status reports, keeping track of capital gains distributions,
dividends investments and redemptions and they reinvest dividend and interest income for
shareholders
 Lower transaction costs
Investment companies trade large blocks of securities, investment companies can achieve substantial
savings on brokerage fees and commissions
 Protecting investments during a crisis
An investment company will help a person define clear, achievable, and measurable goals, determine
how much risk they can take on, and diversify their portfolio so that they don’t face financial ruin if
one asset class is in jeopardy. This will help an investor stay on course and come out of these
economically turbulent times relatively unscathed.
 Access to geographical markets, asset classes or investment strategies which might otherwise
be inaccessible to the individual investor.
 In some cases, the benefit of regulatory oversight and tax deferral.

However, when one chooses an investment company, they must ensure that the company does not
charge any hidden fees or other associated costs. If one chooses a company without doing some
research into their fee structure, they could end up paying nine times more money in the form of
seemingly small costs.

The value of shares and most other investments can fall as well as rise. Some might fall
spectacularly, such as when banks had to be bailed out during the financial crisis. However, when an
investor holds a diversified pool of investments in a portfolio, the risk of single constituent
investments falling spectacularly could be offset by outperformance on the part of other investments.
In other words, risk is lessened when the investor holds a diversified portfolio of investments (of
course, the opportunity of a startling outperformance is also diversified away – but many investors
are happy with this if it reduces their risk of total or significant loss).

An investor needs a substantial amount of money before he or she can create a diversified portfolio
of investments directly. If an investor has only Birr 30,000 to invest, and wants to buy the shares of
30 different companies, each investment would be Birr 1,000. This would result in a large amount of
this Birr 30,000 being spent on commission, since there will be minimum commission rates of, say,
Birr100 on each purchase.

Alternatively, an investment of Birr 30,000 might go into an investment fund with, say, 80 different
investments, but, because the investment is being pooled with that of lots of other investors, the
commission as a proportion of the fund is very small partly for the fund will have better negotiation
power or can invest or purchase by itself.

An investment fund might also be invested in shares from many different sectors; this achieves
diversification from an industry perspective (thereby reducing the risk of investing in a number of
shares whose performance is closely correlated). Alternatively, it may invest in a variety of bonds.
Some investment funds put limited amounts of investment into bank deposits and even into other
investment funds.

The other main rationale for investing collectively is to access the investing skills of the fund
manager. Fund managers follow their chosen markets closely and will carefully consider what to buy
and whether to keep or sell their chosen investments. Few investors have the skill, time or inclination
to do this as effectively themselves.

However, fund managers do not manage portfolios for nothing. They might charge investors’ fees to
become involved in their CIS (entry fees or initial charges) or to leave (exit charges), plus annual
management fees. These fees are needed to cover the fund managers’ salaries, technology, research,
their dealing, settlement and risk management systems, and to provide a profit. Equally, there is no
guarantee that professional management will deliver superior results and that investment funds will
suffer during market downturns. Indeed, recent research has highlighted that many actively managed
funds consistently fail to beat their benchmarks, which has given rise to a growing debate between
proponents of active versus passive investing (see below) and placed pressure on actively managed
funds to reduce their charges.
 A. Investment Strategies
There is a wide range of funds with many different investment objectives and investment styles.
Each of these funds has an investment portfolio managed by a fund manager according to a clearly
stated set of objectives.
An example of an objective might be to invest in the shares of a certain country companies with
above average potential for capital growth and to outperform the FTSE (Financial Times Stock
Exchange) All Share index. Other funds’ objectives could be to maximise income or to achieve
steady growth in capital and income.
In each case, it will also be clear what the fund manager will invest in; for example, shares and/or
bonds and/or property and/or cash or money instruments; and whether derivatives will be used to
hedge currency or other market risks. It is also important to understand the investment style the fund
manager adopts. Investment styles refer to the fund manager’s approach to choosing investments and
meeting the fund’s objectives. In this section we will look at the difference between active and
passive management.

 Passive Management
Passive management is seen in those types of investment funds that are often described as index
tracker funds. Index-tracking, or indexation, involves constructing a portfolio in such a way that it
will track, or mimic, the performance of a recognised index. Index funds have been one of the fastest
growing areas of investment. Indexation is undertaken on the assumption that securities markets are
efficiently priced and cannot therefore be consistently outperformed. Consequently, no attempt is
made to forecast future events or outperform the broader market.

The advantages of employing indexation are that:

• Relatively few active portfolio managers consistently outperform benchmark indices.
• Once set up, passive portfolios are generally less expensive to run than active portfolios, given a
lower ratio of staff to funds managed and lower portfolio turnover.

The disadvantages of adopting indexation, however, include the following:

 Performance is affected by the need to manage cash flows, rebalance the portfolio to replicate
changes in index constituent weightings and adjust the portfolio for stocks coming into, and
 falling out of, the index. This can lead to tracking error if the performance does not match that of
the underlying index.
 Indexed portfolios may not meet all of an investor’s objectives.

 Active Management
In contrast to passive management, active management seeks to outperform a predetermined
benchmark over a specified time period. It does so by employing fundamental and technical analysis
to assist in the forecasting of future events, which may be economic or specific to a company, so as
to determine the portfolio’s holdings and the timing of purchases and sales of securities. Actively
managed funds usually have higher charges than those that are passively managed.

Two commonly used terms in this context are ‘top-down’ and ‘bottom-up’.
 Top-down means that the manager focuses on economic and industry trends rather than the
prospects of particular companies.
 Bottom-up means that the analysis of a company’s net assets, future profitability and cash flow
and other company-specific indicators is a priority.

Included in the bottom-up approach is a range of investment styles, including:

 Growth investing – which is picking the shares of companies with present opportunities to
grow significantly in the long term.
 Value investing – which is picking the shares of companies that are undervalued relative to
their present and future profits or cash flows.
 Momentum investing – which is picking the shares whose share price is rising on the basis
that this rise will continue.
 Contrarian investing – the flip side of momentum investing, which involves picking shares
that are out of favour and may have hidden value.

 Combining Active and Passive Management

Having considered both active and passive management, it should be noted that active and passive
investment are not mutually exclusive. Index-trackers and actively managed funds can be combined
in what is known as core-satellite management. This is achieved by indexing, say, 70% to 80% of
the portfolio’s value (the core), so as to minimise the risk of underperformance, and then fine-tuning
this by investing the remainder in a number of specialist actively managed funds or individual
securities. This is the satellite element of the fund.

INVESTMENT VEHICLES
Investment in financial assets differs from investment in physical assets in those important aspects:
• Financial assets are divisible, whereas most physical assets are not. An asset is divisible if investor
can buy or sell small portion of it. In case of financial assets it means, that investor, for example, can
buy or sell a small fraction of the whole company as investment object buying or selling a number of
common stocks.
• Marketability (or Liquidity) is a characteristic of financial assets that is not shared by physical
assets, which usually have low liquidity. Marketability (or liquidity) reflects the feasibility of
converting of the asset into cash quickly and without affecting its price significantly. Most of
financial assets are easy to buy or to sell in the financial markets.

The main types of financial investment vehicles are:

 Short term investment vehicles (money market instruments);
 Fixed-income securities;
 Common stock;
 Speculative investment vehicles;
 Other investment tools.

 Short - term investment vehicles are all those which have a maturity of one year or less. Short
term investment vehicles often are defined as money-market instruments, because they are traded
in the money market which presents the financial market for short term (up to one year of
maturity) marketable financial assets. The risk as well as the return on investments of short-term
investment vehicles usually is lower than for other types of investments. The main short term
investment vehicles are:
 Certificates of deposit;
 Treasury bills;
 Commercial paper;
  Bankers’ acceptances;
 Repurchase agreements.

a. Certificate of deposit (CDs) is written promises by a bank to pay a depositor. It is a time

deposit, a financial product commonly offered to consumers by banks, thrift institutions (A thrift
institution is a financial institution formed primarily to accept consumer deposits and make home
mortgages. Nowadays, they have original maturities from six months to three years. Negotiable
certificates of deposit are CDs issued by large commercial banks that can be bought and sold
among investors. On the maturity date, the investor is repaid the principal plus interest.
Certificate of deposit bears a specified interest rate and can be issued in any denomination. They
are different from savings accounts in that the CD has a specific, fixed term (often three months,
six months, or one to five years), and, usually, a fixed interest rate. Usually grant higher interest
rates than they do on accounts from which money may be withdrawn on demand. Most
certificates of deposit cannot be traded and they incur penalties for early withdrawal. For large
money-market investors financial institutions allow their large-denomination certificates of
deposits to be traded as negotiable certificates of deposits.

b. Treasury bills (also called T-bills) are short-term securities issued by the government; they have
original maturities of either four weeks, three months, or six months. Treasury bills
havematurities of less than one year. They have the unique feature of being issued at a discount
from their nominal value and T-bills carryno stated interest rate. The other important feature of
T-bills is that they are treated as risk-free securitiesignoring inflation and default of a
government, which was rare in developed countries, the T-bill will pay the fixed stated yield
with certainty. But, of course, the yield on T-bills changes over time influenced by changes in
overall macroeconomic situation. T-bills are issued on an auction basis. The issuer accepts
competitive bids and allocates bills to those offering the highest prices. Bills are thus regarded as
high liquid assets. Non-competitive bid is an offer to purchase the bills at a price that equals the
average of the competitive bids. Bills can be traded before the maturity, while their market price
is subject to change with changes in the rate of interest. But because of the early maturity dates
of T-bills large interest changes are needed to move T-bills prices very far. Bills are thus
regarded as high liquid assets.
c. Commercial paper is unsecured promissory note—a written promise to pay— issued by a large,
creditworthy corporation or a municipality. Most commercial paper is backed by bank lines of
credit, which means that a bank is standing by ready to pay the obligation if the issuer is unable
to due. Commercial paper may be either interest bearing or sold on a discounted
basis.Commercial paper is a means of short-term borrowing by large corporations. Large, well-
established corporations have found that borrowing directly from investors through commercial
paper is cheaper than relying solely on bank loans. Commercial paper is issued either directly
from the firm to the investor or through an intermediary. The most common maturity range of
commercial paper is 30 to 60 days or less. Commercial paper is riskier than T-bills, because there
is a larger risk that a corporation will default. Also, commercial paper is not easily bought and
sold after it is issued, because the issues are relatively small compared with T-bills and hence
their market is not liquid.

d. Bankers acceptancesare the vehicles createdto facilitate commercial trade transactions. A

banker's acceptance starts as an order to a bank by a bank's customer to pay a sum of money at a future
date, typically within six months. These vehicles are called bankers acceptances because a bank
accepts the responsibility to repay a loan to the holder of the vehicle in case the debtor fails to
perform. Before acceptance, the draft is not an obligation of the bank; it is merely an order by the
drawer to the bank to pay a specified sum of money on a specified date to a named person or to the
bearer of the draft. Upon acceptance, which occurs when an authorized bank accepts and signs it, the
draft becomes a primary and unconditional liability of the bank. When the bank approves the order for
payment as "accepted", it assumes responsibility for ultimate payment to the holder of the acceptance.
Banker’s acceptances are short-term fixed-income securities that are created by non-financial
firm whose payment is guaranteed by a bank. This short-term loan contract typically has a higher
interest rate than similar short –term securities to compensate for the default risk. Since bankers’
acceptances are not standardized, there is no active trading of these securities.

A draft can require immediate payment by the second party to the third upon presentation of the
draft. This is called a sight draft. Checks are sight drafts. In trade, drafts often are for deferred
payment. An importer might write a draft promising payment to an exporter for delivery of goods
with payment to occur 60 days after the goods are delivered. Such drafts are called time drafts.
They are said to mature on the payment date. In this example, the importer is both the drawer and the
drawee.

In cases where the drawer and drawee of a time draft are distinct parties, the payee may submit the
draft to the drawee for confirmation that the draft is a legitimate order and that the drawee will make
payment on the specified date. Such confirmation is called acceptance—the drawee accepts the
order to pay as legitimate. The drawee stamp ACCEPTED on the draft and is thereafter obligated to
make the specified payment when it is due. If the drawee is a bank, the acceptance is called a
bankers acceptance (BA).

e. Repurchase agreement (a repo) is the sale of security with a commitment by the seller to buy
the security back from the purchaser at a specified price at a designated future date. Basically, a
repo is nothing more than a collateralized short term loan, where collateral is a security. The
collateral in a repo may be a Treasury security, other money-market security. The difference
between the repurchase price and the sale price is the interest cost of the loan, from which repo
rate(interest rate in a repo ) can be calculated. Because of concern about default risk, the length
of maturity of repo is usually very short. If the agreement is for a loan of funds for one day, it is
called overnight repo; if the term of the agreement is for more than one day, it is called a term
repo. A reverse repo is the opposite of a repo. In this transaction a corporation buys the securities
with an agreement to sell them at a specified price and time.

 Fixed-income securities are those which return is fixed, up to some redemption date or
indefinitely. This type of financial investments is presented by two different groups of securities:
a. Long-term debt securities can be described as long-term debt instruments representing the
issuer’s contractual obligation. These are securities that have maturity longer than 1 year. The
buyer (investor) of these securities is lending money to the issuer, who undertake obligation
periodically to pay interest on this loan and repay the principal at a stated maturity date. Long-
term debt securities are traded in the capital markets. The place where bonds and other debt
instruments are sold is called the debt market. From the investor’s point of view these securities
 can be treated as a “safe” asset. But in reality the safety of investment in fixed –income securities
is strongly related with the default risk of an issuer. The major representatives of long-term debt
securities are bonds, but today there are a big variety of different kinds of bonds, which differ not
only by the different issuers (governments, municipals, companies, agencies, etc.), but by
different schemes of interest payments which is a result of bringing financial innovations to the
long-term debt securities market. As demand for borrowing the funds from the capital markets is
growing the long-term debt securities today are prevailing in the global markets.

b. Preferred stocks are equity security, which has infinitive life and pay dividends and has residual
claim on the company’s assets. But preferred stock is attributed to the type of fixed-income
securities, because thedividend for preferred stock is fixed in amount and known in advance.
Though, this security provides for the investor the flow of income very similar to that of the
bond. The main difference between preferred stocks and bonds is that for preferred stock the
flows are forever, if the stock is not callable. The preferred stockholders are paid after the debt
securities holders but before the common stock holders in terms of priorities in payments of
income and in case of liquidation of the company. If the issuer fails to pay the dividend in any
year, the unpaid dividends will have to be paid if the issue is cumulative. If preferred stock is
issued as noncumulative, dividends for the years with losses do not have to be paid. Usually
same rights to vote in general meetings for preferred stockholders are suspended (do not have
voting right). Because of having the features attributed for both equity and fixed-income
securities preferred stocks is known as hybrid security. A most preferred stock is issued as
noncumulative and callable. In recent years the preferred stocks with option of convertibility to
common stock are proliferating.

 The common stock is the other type of investment vehicles which is one of most popular among
investors with long-term horizon of their investments. Common stock represents the ownership
interest of corporations or the equity of the stock holders. Holders of common stock are entitled
to attend and vote at a general meeting of shareholders, to receive declared dividends and
toreceive their share of the residual assets, if any, if the corporation is bankrupt. The issuing
common stocks and selling them in the market enables the company to raise additional equity
capital more easily when using other alternative sources. Thus many companies are issuing their
 common stocks which are traded in financial markets and investors have wide possibilities for
choosing this type of securities for the investment.

 Speculative investment vehicles the term “speculation” could be defined as investments with a
high risk and high investment return. Using these investment vehicles speculators try to buy low
and to sell high, their primary concern is with anticipating and profiting from the expected
market fluctuations. The only gain from such investments is the positive difference between
selling and purchasing prices.

 Other investment tools:

• Various types of investment funds
• Investment life insurance
• Pension funds
• Hedge funds

Derivative Assets:
The value of such an asset derives from the value of some other asset or the relationship between
several other assets. Future and options contracts are the most familiar derivative assets. Corporate
risk management often involves the buying and selling of derivative securities. A derivative security
is a financial asset that represents a claim to another financial asset or real asset. For example, a
stock option gives the owner the right to buy or sell stock, a financial asset, so stock options are
derivative securities. The instruments that can be used to provide such protection are called
derivative instruments, so named because they derive their value from whatever the contract is
based on. These instruments includefutures contracts, forward contracts, option contracts, swap
agreements, and cap and floor agreements. Dear student, do you know what these instruments meant
by? Have you ever heard it? If so, what is it?

 Definition of Derivatives
The term “derivatives” is used to refer to financial instruments which derive their value from some
underlying assets. The underlying assets could be equities (shares), debt (bonds, T-bills, and notes),
and currencies. Derivatives derive their names from their respective underlying asset for example if
a derivative’s underlying asset is equity, it is called equity derivative and so on. Derivatives can be
traded either on a regulated exchange, such as the NYSE or off the exchanges, i.e., directly between
the different parties, which is called “over-the-counter” (OTC) trading. The basic purpose of
derivatives is to transfer the price risk (inherent in fluctuations of the asset prices) from one party to
another; they facilitate the allocation of risk to those who are willing to take it. In so doing,
derivatives help mitigate the risk arising from the future uncertainty of prices. For example, on
November 1, 2011 a coffee farmer may wish to sell his harvest at a future date (say January 1, 2012)
for a pre-determined fixed price to eliminate the risk of change in prices by that date. Such a
transaction is an example of a derivatives contract. The price of this derivative is driven by the spot
price of coffee which is the "underlying asset".

Options
Like forwards and futures, options are derivative instruments that provide the opportunity to buy or
sell an underlying asset on a future date. An option is a derivative contract between a buyer and a
seller, where one party (say First Party) gives to the other (say Second Party) the right, but not the
obligation, to buy from (or sell to) the First Party the underlying asset on or before a specific day at
an agreed-upon price. In return for granting the option, the party granting the option collects a
payment from the other party. This payment collected is called the “premium” or price of the option.
Call option: the buyer has a rights but not an obligation to buy underlying asset. Put option: the seller
has a rights but not an obligation to sellunderlying asset The right to buy or sell is held by the
“option buyer” (also called the option holder); the party granting the right is the “option seller” or
“option writer”. Unlike forwards and futures contracts, options require a cash payment (called the
premium) upfront from the option buyer to the option seller. Options can be traded either on the
stock exchange or in over the counter (OTC) markets. Options traded on the exchanges are backed
by the Clearing Corporation thereby minimizing the risk arising due to default by the counter parties
involved. Options traded in the OTC market however are not backed by the Clearing Corporation.

Types of options
There are two types of options—call options and put options.
Call option
A call option is an option granting the right to the buyer of the option to buy the underlying asset on
a specific day at an agreed upon price, but not the obligation to do so. It is the seller who grants this
right to the buyer of the option. It may be noted that the person who has the right to buy the
underlying asset is known as the “buyer of the call option”.Since the buyer of the call option has the
right (but no obligation) to buy the underlying asset, he will exercise his right to buy the underlying
asset if and only if the price of the underlying asset in the market is more than the strike price on or
before the expiry date of the contract.

Put option
A put option is an option granting to the owner the right, but not the obligation , to sell an asset at
specified price (strike price), by predetermined date to a given party .

Difference future and options

Future Options
Both the buyer and the seller are The buyer of the option has the right and not
under an obligation to fulfill the an obligation whereas the seller is under
contract. obligation to fulfill the contract if and when the
buyer exercises his right.
The buyer and the seller are The seller is subjected to unlimited risk of
subject to unlimited risk of loss. losing whereas the buyer has limited potential
to lose (i.e. the option premium).
The buyer and the seller have potential to make The buyer has potential to make unlimited gain
unlimited gain. while the seller has a potential to make limited
gain. On the other hand the buyer has a limited
loss potential and the seller has an unlimited
loss potential.

In today’s investing world, the word options refer to puts and calls. Options are created not by
corporations but by investors seeking to trade in claims on a particular common stock. A call (put)
optiongives the buyer the right but not the obligation to purchase (sell) a fixed quantity of shares at a
specified price (called the exercise price) within a specified time. The maturities on most new puts
and calls are available up to several months away, although a new form of puts and calls called
LEAPS has maturity dates up to a couple of years.

 Futures and Forwards

Futures contracts have been available on commodities such as corn and wheat for a long time.
Recently, they have also become available on several financial instruments, including stock market
indexes, currencies, Treasury bills, Treasury bonds, bank certificates of deposit, and government
national mortgage associations (GNMA).

A forward contract,
A forward contract or simply a forward is a contract between two parties to buy or sell an asset at a
certain future date for a certain price that is pre-decided on the date of the contract.The future date is
referred to as expiry dateand the pre-decided price is referred to as Forward Price. It may be noted
that Forwards are private contractsand their terms are determined by the parties involved.A forward
is thus an agreement between two parties in which one party, the buyer, enters into an agreement
with the other party, the seller that he would buy from the buyer an underlying asset on the expiry
date at the forward price.Therefore, it is a commitment by both the parties to engage in a transaction
at a later date with the price set in advance. This is different from a spot market contract, which
involves immediate payment and immediate transfer of asset. A forward contract differs in that it is
usually non-standardized (that is, the terms of each contract are negotiated individually between
buyer and seller), there is no clearinghouse, and secondary markets are often nonexistent or
extremely thin.

A futures contract
Like a forward contract, a futures contract is an agreement between two parties in which the buyer
agrees to buy an underlying asset from the seller, at a future date at a price that is agreed upon today.
However, unlike a forward contract, a futures contract is not a private transaction but gets traded on
a recognized stock exchange. In addition, a futures contract is standardized by the exchange. All the
terms, other than the price, are set by the stock exchange (rather than by individual parties as in the
case of a forward contract). In addition, both buyer and seller of the futures contracts are protected
against the counter party risk by an entity called the Clearing Corporation. In case one of the parties
defaults, the Clearing Corporation steps in to fulfill the obligation of this party, so that the other
party does not suffer due to non-fulfillment of the contract. To be able to guarantee the fulfillment of
the obligations under the contract, the Clearing Corporation holds an amount as a security from both
the parties. Thisamount is called the Margin money and can be in the form of cash or other financial
assets.

Difference between forward and future

Forward Future
Privately negotiated contracts(traded over the Traded on an exchange
counter)
Not standardized Standardized contracts
Settlement dates can be set by the parties Fixed settlement dates as declared by the
Exchange

High counter party risk Almost no counter party risk