L1: INVESTMENT
SETTING
Objectives: 1
• What is an investment?
• Types of Investments (Traditional vs Alternative)
• Historical versus Future Return and Risk Measurement
• Arithmetic Mean versus Geometric Mean
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WHY DO INDIVIDUALS
INVEST ?
There are 2 choices with
your earnings:
Save & tradeoff present
consumption for a larger
future consumption
Riskier option of investments
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DEFINING AN INVESTMENT
Current commitment of money for a
period of time in order to derive future
payments that will compensate for:
the time the funds are committed
the expected rate of inflation
uncertainty of future flow of funds.
These three make up required rate of return
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INVESTMENT CHOICES:
BONDS
Issued by:
Corporate
Municipal Council (finance infrastructural
projects)
Government (Treasury bonds)
Depending on maturity:
Bills matures in less than 1 year
Notes mature in 1 - 10 years
Bonds mature in over 10 years
Mortgage-backed bonds:
Prime
Subprime
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INVESTMENT CHOICES
EQUITY:
• Fixed income obligations that trade in secondary market
• Prior to 1990s reform financial market was strictly
regulated. The liberalisation that followed opened up the
local market
• Enactment of Securities Act saw establishment of LuSE in
1994 now has 30 listed companies
• BaDex established in 2011 for bond and derivatives
exchange
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INVESTMENT CHOICES:
ALTERNATIVE INVESTMENTS
An alternative investment is any
investment that doesn’t fall in the
realm “traditional” securities such
as stocks, bonds or mutual funds
These investments are worth
consideration if you want to
diversify your portfolio and
achieve higher returns
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WHAT ARE THE OBJECTIVES OF ALTERNATIVE IN
VESTMENTS?
Increased
Diversification
Lower Correlations
Lower Portfolio
Volatility
Portfolio Performance
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WHAT ARE THE RISKS OF
ALTERNATIVE IN VESTMENTS?
Lack of Regulation
Lack of Transparency
Inappropriate Use of
Leverage
Fraud
Manager Selection Risk
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TRADITIONAL VS
ALTERNATIVE
Traditional Alternative
Performance dependent Performance dependent
primarily on market returns primarily on advisor skill
Historically high correlation with Historically low to moderate
market indices correlation with market indices
Typically offers daily liquidity Typically have reduced liquidity
ranging from monthly to 12+
year lock-ups
Fixed management fee on Generally higher fees which
assets may include performance fees
under management
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TYPES OF ALTERNATIVE
INVESTMENT
Crypto-Currencies
Digital or virtual currency created as a peer-to-peer
payment system. Code was created in 2009 by
developer Satoshi Nakamoto.
Bitcoins are created as a reward for payment
processing work in which users who offer their
computing power. Called mining, individuals
engage in this activity in exchange for transaction
fees and newly minted bitcoins.
Besides mining, bitcoins can be obtained in
exchange for other currencies, products, and
services. Users can buy, send, and receive bitcoins
electronically for a nominal fee using wallet
software on a personal computer, mobile device, 10
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or a web application.
TYPES OF ALTERNATIVE
INVESTMENT
Crowdfunding
funding through a large pool of backers—the "crowd"—usually
online through a web platform.
4 types
Donation-based in which the backers essentially donate
money to support a cause.
Reward-based in which the backer receives a reward with a
clear monetary value in exchange of the pledge. The reward
is often a product or a pre-series item that the backer
helped producing by pledging money.
Credit-based in which the backer lends the money and
receives an interest rate in exchange.
Equity-based in which the backer receives shares of a
company in exchange of the money pledged. In this case the
money is pledged in the form of risk capital.
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TYPES OF ALTERNATIVE INVESTMENT
Business Development Companies (BDCs)
Regulated, closed-end investment firms that make
loans to, and/or invest in small, developing, or
financially troubled companies. They’ve stepped
into a role than commercial banks vacated during
the financial crisis, lending to companies that may
not otherwise get financing.
BDCs are very similar to venture capital funds, but
can be sold to retail investors. Many BDCs are set
up much like closed-end investment funds and are
actually public companies that are listed on the
NYSE, AMEX and Nasdaq.
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TYPES OF ALTERNATIVE
INVESTMENT
Regulation A+
A new exemption from the registration
requirements of the Securities Act of 1933
that would permit nonpublic companies to
conduct securities offerings of up to $50
million in any rolling 12-month period.
Passed as part of the JOBS Act and is
designed to provide greater access to small
businesses by creating a bridge from private
placements to public offerings.
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GIVEN THE CHOICE BETWEEN 2
INVESTMENTS WHICH ONE WOULD
YOU PICK?
Investment A Investment B
Yr1 Yr2 Yr3 Yr1 Yr2
K150 K250 K250 K350
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HPR & HPY
Holding Period Return:
HPR =
Holding Period Yield:
HPY = HPR -1
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MEASURES OF
HISTORICAL RATES OF
RETURN
Investment cost K250 and is worth
K350 after 2 years holding period.
HPR= = 1.40 Note this is for 2
years
Annual HPR= = 1.1832
Annual HPY = Annual HPR-1=
1.1832-1=0.1832
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EXPECTED RETURN AND
VARIANCE
Expected Standard
Return Deviation
N (years, Σ
months or
days)
Probabilities ΣPR
Probabilities ΣPR
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MEASURING PAST RISK
K100 K105 K117.6 K104.664
Step 1: Find HPR for each year
Step 2: Find past return
Step 3: Find risk
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MEASURES OF FUTURE
RETURN
(Probability of Return) (Possible Return)
i 1
=0.2(5) +0.6(15) +0.2(25)
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MEASURING FUTURE
RISK
=0.2 +0.6+0.2
=20+0+20
=40 = variance
Standard deviation = 6.3246
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AM VS GM
Arithmetic Mean:
AM HPY/ n
where :
HPY the sum of annual
holding period yields
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AM VS GM
Geometric Mean:
GM HPR 1
n 1
the product of
annual HPR
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AM VS GM
AM= =0.05
GM= -1= 0.03353
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EXPECTED RETURN AND
VARIANCE
Expected Standard
Return Deviation
N (years, Σ
months or
days)
Probabilities ΣPR
Probabilities ΣPR
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COEFFICIENT OF VARIATION
Measure of relative variability
that indicates risk per unit of
return
i
CV E(R)
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COEFFICIENT OF VARIATION
Investment Investment
A B
Expected 7% 12%
Return
Standard 5% 7%
Deviation
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COEFFICIENT OF VARIATION
Investment A Investment B
Expected Return 7% 12%
Standard 5% 7%
Deviation
Coefficient of 5/7 = 0.714 7/12 = 0.583
Variation
B has less risk per
unit and is
therefore better
investment
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END OF TOPIC QUESTIONS
A stock costing K100 pays K5 dividend with every
possible outcome. The possible outcomes that the
stock might sell for at year-end and the probability of
each are:
A. What is the expected return on the stock?
B. What is the standard deviation of the expected
return?
Year End Price (K) Probability
90 0.1
95 0.2
100 0.4
110 0.2
115 0.1
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End-of-Year Price (K) Annual Total
Year Dividends (K) Return (%)
END OF TOPIC QS 2000
2001
2002
K65.00
K72.00
K67.00
K1.20
K1.50
K1.50
—
13.07%
–4.86%
2003 K70.00 K1.60 6.87%
2004 K72.50 K1.60 5.86%
A. Calculate the arithmetic mean return over 2000 to 2004.
B. Calculate the geometric mean return over 2000 to 2004.
C. What is the dividend yield earned by an investor who purchases
the stock at the end of 2000 and holds it till the end of 2001?
D. Using you answer in part A, calculate the standard deviation of
over the holding period 2000 to 2004.
E. Calculate the coefficient of variation and interpret your results.
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M.Mukwena 30
