Chapter #2

Investment Alternative
There are two main options available to investors:
1- Real Investment: It includes investing in some tangible or physical assets, such as
land, building, property, plant equipment and etc…
2- Financial Investment: it includes investing in financial assets that are contracts in
papers or electronic forms such as bonds, stocks, T-bills, saving bonds and etc…

Financial Assets VS Physical Assets

a. Financial assets are divisible, while most of physical assets are not divisible. An
asset is divisible, if the investor can buy or sell a small portion of it.
. In case of financial assets divisibility means that the investor can buy or sell a
small fraction of whole company as an investment object through buying or selling
a number of common stocks.
b. Financial assets are highly liquid and can be easily convertible into cash without
affecting its price significantly but physical assets are less liquid and cannot be
easily convertible into cash.
c. The planned holding period of physical assets are longer as compared to financial
assets, investors purchasing physical assets, usually plan to hold it for a long period
but investing in financial assets. Such as securities will be for months or a year.
d. Information about financial assets are more abundant sufficient and less costly to
obtain than information about physical assets.
. Information availability shoes the real possibility of investors to receive the
necessity info which can effect their investment decision and investment results. So
a big portion of information about financial assets is publically available.

Financial assets are divided into two types:

1- Non marketable financial assets
2- Marketable financial assets

1- Non Marketable Financial Assets:

Are those securities which are directly owned by investors and they are not tradable in the
financial market.
• Simply it means its ownership is not transferable.
Example: savings account, bank accounts etc...

● Certificates of deposits (CDs) are issued by banks and S&Ls which require minimum
deposits of $500 and have fixed durations (usually three months, six months, one year two
year) the rate increases with the size and the duration of the deposit.
● Money market certificates are issued by banks and S&Ls which require minimum deposits
of $10000 and have minimum durations of six months.
The investors can redeem these certificates only at the bank of issue.

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The U.S government offers both non-marketable and marketable securities.
• Investment in marketable financial assets are risky.

2- Marketable Financial Assets:

Are those financial assets that can be easily traded in financial markets between two investors
with the help of brokers.
• It can be converted into cash easily whenever the investor wants.
It is divided into 3 main types:
1- Money market securities
2- Capital market securities
3- Derivative Market securities

1- Money Market Securities:

Are those securities which their life are one year or less than one year.
• Money market securities are issued by government and can be issued by corporations.
Example: T-Bills, Commercial paper.

2- Capital Market Securities:

Are those securities which their life is more than one year and they are less liquid as money
market securities.
• It can be also issued by government and corporations.
Example: Bonds & Common stock, treasury notes etc.

3- Derivative Market Securities:

Are those securities which their values are derived from other securities or another
underlying assets.
Example: forward, future, swaps and options market securities.
• Options and future are standardized contract.
• Swap and forward are non-standardized contract.

Types of Derivative Securities

1. Forward Contracts:
It is an agreement in which a seller promises to deliver a predetermined quantity of an asset at
a certain date and price to a buyer.
• Most forward contracts private agreements and are not traded on exchange.
• The risk is very high in forward contract.
Example: A former locked or hedged the price of wheat in order to avoid the risk of price
change in the future.

2. Future Contracts:
It is a standardized agreement between buyer and seller to make a future delivery of a specific
asset at a fixed price.
It is standardized that will be traded on exchanges and created by clearinghouse that acts as a
middleman between seller and buyer.
• The benefit of clearinghouse is that the risk of default is eliminated.

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• Investors are always spectaculars when they notice that they face lose trying to close the
agreement before maturity date, and they don't want to deliver goods.
Example: Purchasing shares of companies.

3. Swap Contracts:
It is a type of derivative security in which the investors exchange one set of clash flows with
another set of cash flows.
• In currency swap two parties are enter into contract to exchange.
Example: There are two companies one in USA may need to get Japanese yen and another in
Japan may need to get U.S dollars, both enter into contract to exchange currency in
predetermined interest rate.
• Another type of swap contract is interest rate swap, it is an agreement between two parties
to exchange interest payments.

Interest rate swap Example:

• For example, assume that Charlie owns a $1,000,000 investment that pays him LIBOR +
1% every month. As LIBOR goes up and down, the payment Charlie receives changes.
• Now assume that Sandy owns a $1,000,000 investment that pays her 1.5% every month.
The payment she receives never changes.
•Charlie decides that that he would rather lock in a constant payment and Sandy decides that
she'd rather take a chance on receiving higher payments. So Charlie and Sandy agree to enter
into an interest rate swap contract.
• Under the terms of their contract, Charlie agrees to pay Sandy LIBOR + 1% per month on a
$1,000,000 principal amount (called the "notional principal" or "notional amount"). Sandy
agrees to pay Charlie 1.5% per month on the $1,000,000 notional amount.

4. Option contracts:
It is a contract that gives its owners the rights not an obligation to buy or sell a particular
asset at fixed price before a maturity date.

Types of Option contracts:

1- Call option: It gives its owner the right not obligation to purchase something on a fixed
price in the future.
2- Put option: It gives its owner the right to sell something.
▪︎ Strike price (fixed price)
▪︎ Maturity dare (Certain date)
▪︎ Rights are sold in the market
• Option premium or price: paid by the buyer to the seller to get the right.

● Call option:
Buyer: Expects the price of the security to increase.
Seller: Expects the price of the security to decrease.

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● Put option:
Buyer: Expects the price of the security to decrease.
Seller: Expects the price of the security to increase.

• In case of option maturity, it may be expired or exercised or sold.

Benefits of derivative securities:
• to use future opportunities, minimize the cost and also lock the prices.
• Minimize the risk fluctuations in price of commodities, currency etc.

Example:
Payoff Diagram for a Call Option
Two Parties A & B
A is buyer of call
B is seller of call
10 nestle shares

Profit per
Option ($)
Buyer

4
2
Stock Price
0 at Expiration
25 27 29 31
-2
-4
Seller

Strike Price is= $25

Option premium = $4

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Example:
Payoff Diagram for Put Option
TWO PARTIES A AND B
A is buyer of put, asset 1G gold, 31 may
B is seller of Put,

Profit per
Option ($)

Buyer

4
2 Stock/Gold
price at
0
19 21 23 25 27 expiration
-2
-4

Seller

Strike Price = $25

Premium Option = $4

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Note: (Call Option)
• The profit of buyer of call option is unlimited.
• The loss of the seller of call option is unlimited.
• The loss of buyer of call option is limited and is equal to option premium.
• The profit of seller of call is limited and is equal to option premium.
• The profit of buyer of call option is the loss of the seller of call option.
• The loss of buyer of call option is the profit of seller of call option.

Note: (Put Option)

• The profit of buyer of put option is unlimited.
• The loss of the seller of put option is unlimited.
• The loss of buyer of put option is unlimited and is equal to option premium.
• The profit of seller of put is limited and is equal to option premium.
• The profit of buyer of put option is the loss of the seller of put option.
• The loss of buyer of put option is the profit of seller of put option.

Chapter #3
Direct Vs Indirect Investing
Investors can use direct and indirect type of investing, direct investing is directly involves
financial market and indirect investing involves financial intermediaries.

Direct investment:
In direct investing the investors buy or sell financial assets by the help of brokers and manage
the portfolio investment themselves.
• The success of investing depends on the understanding of investors about financial markets
and changes in financial markets.
• All the risk will be tolerated by themselves.

Indirect Investing:
Investors are buying or selling financial instruments of financial institutions (investment
companies, pension funds, insurance companies etc.), which they invest large amount of fund
in the financial markets and hold portfolios.
Investors are the shareholders in these portfolios which managed by financial institutions, the
dividends, interest and capital of Investors will be controlled by financial institutions and
charge portfolio management fee from the Investors.
• Third party is involved.

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Investment Companies
Investment companies is a company whose main business purpose is holding securities of
other companies for investment, the investment companies invest money on behalf of its
shareholders.
• Beside that investment companies offer professional management services, and the
shareholders pay some charges for that.
Example: Affiliated Managers Group Inc, Castle holding corporation etc...

Types of Investment Company

it has four types:

1- Unit investment trust (UITs):

Are registered investment companies that purchase fixed, unmanaged portfolio of
stocks or bonds they are preselected by investment professionals for a predetermined
time for a specific goal, the investment do not change unless a company is bought or
merged with another company.
• Its investment is also called passive investment, once purchased then not actively
traded.
• UITs are sold in units instead of shares.
• UITs doesn't need active management of portfolio, so therefore they don't charge
management fees but initial sales charges they will receive from 1% to 5%.

2- Exchange Traded Funds (ETF):

It is investment company which keep its portfolio of stocks over a sector, region or
market to diversify risk, management fees is lower and it is not actively traded that's
why capital gain is realized less.
• Its main advantages over other mutual funds are lower fees and greater tax
efficiency.
Example: Qubes in NASDAQ stock exchange etc.

3- Closed-end investment companies:

Are those investment companies that will issue shares at first issue (IPOs) and after
that they will not issue additional shares.
• It is not traded by net asset value.
• The supply of these shares are limited.
• Net assets value (NAV) = Market value of portfolio - Liabilities/Numbers of shares
outstanding.
• There is no sales charges, but investors must pay a commission to buy or sell them
like stock.

Example on NAV:
•An investment firm manages a mutual fund and would like to calculate the net asset
value for a single share. The investment firm is given the following information
regarding its mutual fund:
•Value of securities in portfolio: $75 million (based on end of day closing prices)
•Cash and cash equivalents of $15 million

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 •Accrued income for the day of $24 million
•Short-term liabilities of $1 million
•Long-term liabilities of $12 million
•Accrued expense for the day of $5 million
•20 million shares outstanding

4- Open-end investment companies:

Are those investment companies that are able to buy and sell an unlimited number of
shares. Shares of these companies can only be bought and sold directly from the
issuing fund company, and they cannot be traded in any type of secondary market.
• Shares only be sold back to company at net asset value.
• It is also called mutual funds.
Example: American funds, American century etc...

Chapter #3 continues…