Professional Documents
Culture Documents
A CKNOWLEDGEMENT
1
It gives us immense joy and pleasure to acknowledge the help of
all the people who have helped me complete this project.
I owe more than it can say to the experience and the guidelines of
my College and the excellent faculty and staff of.
D ECLARATION
C ERTIFICATE
2
I ________________________________hereby certify that the following
student of of has completed the project titled “INVESTMENT
MANAGEMENT” for the academic year 2010-11.
Contents
Sr. Topics
no Pg.no
01. Introduction 06-07
3
12. Total Returns 34-36
13. Conclusion 37
14. Bibliography 38
Introduction
• Definition:-
Investment Management:-
4
private investors may often refer to their services as wealth
management or portfolio management often within the context of
so-called "private banking".
5
Investment
Management: Who
does it?
The professional management of assets, such as real estate, and
securities, such as equities, bond and other debt instruments, is called
investment management. Investment management services are sought
by investors, which could be companies, banks, insurance firms or
individuals, with the purpose of meeting stated financial goals.
6
management. Asset management and wealth management are also called
portfolio management.
Investment
Management:
Process
The process of investment management involves the following:-
7
capacity and risk profile, as well as environmental constraints, such as
government regulations, market conditions and the state of the economy.
Selecting the assets:This involves selecting the individual options within the
wide asset classes.
8
Returns From
Investment
Return means the profit earned on the capital invested in the business. It
is expressed as a percentage. The return on an investment is the profit
required to establish and maintain the investment. Investors invest their
funds to make a profit which is known as a return. The goal of the
investment is to maximize the investor’s utility and maximizing expected
return.
9
Keep in mind that the calculation for return on investment and, therefore
the definition, can be modified to suit the situation -it all depends on what
you include as returns and costs. The definition of the term in the broadest
sense just attempts to measure the profitability of an investment and, as
such, there is no one "right" calculation.
Rate Of Return:-
In finance, rate of return (ROR), also known as return on investment
(ROI), rate of profit or sometimes just return, is the ratio of money
gained or lost (whether realized or unrealized) on an investment relative to
the amount of money invested. The amount of money gained or lost may be
referred to as interest, profit/loss, gain/loss, or net income/loss. The money
invested may be referred to as the asset, capital, principal, or the cost basis
of the investment. ROI is usually expressed as a percentage rather than a
fraction.
10
Calculation Of
Returns
The initial value of an investment, Vi, does not always have a clearly
defined monetary value, but for purposes of measuring ROI, the initial value
must be clearly stated along with the rationale for this initial value. The final
value of an investment, Vf, also does not always have a clearly defined
monetary value, but for purposes of measuring ROI, the final value must be
clearly stated along with the rationale for this final value.
(a) Single-period:-
rarith is sometimes referred to as the yield. See also: effective interest rate,
effective annual rate (EAR) or annual percentage yield (APY).
11
It is the reciprocal of the e-folding time.
(ii)
The geometric average rate of return calculated over n years is also known
as the annualized return.
12
The internal rate of return, also known as the dollar-weighted rate of
return, is defined as the value(s) of that satisfies the following equation:
where:
Ct = cashflow at time t
13
Comparisons
Between Various
Rates Of Returns
(c)
Arithmetic and logarithmic returns are not equal, but are approximately
equal for small returns. The difference between them is large only when
percent changes are high. For example, an arithmetic return of +50% is
equivalent to a logarithmic return of 40.55%, while an arithmetic return of
-50% is equivalent to a logarithmic return of -69.31%.
Logarithmic returns are often used by academics in their research. The main
advantage is that the continuously compounded return is symmetric, while
the arithmetic return is not: positive and negative percent arithmetic returns
are not equal. This means that an investment of $100 that yields an
arithmetic return of 50% followed by an arithmetic return of -50% will result
in $75, while an investment of $100 that yields a logarithmic return of 50%
followed by an logarithmic return of -50% it will remain $100.
14
Comparison of arithmetic and logarithmic returns for initial investment of
$100
Initial investment, Vi $100 $100 $100 $100 $100
Final investment, Vf $0 $50 $100 $150 $200
Profit/loss, Vf − Vi -$100 -$50 $0 $50 $100
Arithmetic return, rarith -100% -50% 0% 50% 100%
Logarithmic return, rlog -69.31% 0% 40.55% 69.31%
(e)
A 10% gain followed by a 10% loss is a 1% loss. The order in which the loss
and gain occurs does not affect the result. A 50% gain and a 50% loss is a
25% loss. An 80% gain plus an 80% loss is a 64% loss. To recover from a
50% loss, a 100% gain is required. The mathematics of this are beyond the
scope of this article, but since investment returns are often published as
"average returns", it is important to note that average returns do not always
translate into dollar returns.
15
0 5 6 5
Dollar Profit/(Loss) $5.00 $10.25 $15.76 $21.55
Compound Yield 5% 5.4%
Example #2 Volatile Rates of Return, including losses
Year 1 Year 2 Year 3 Year 4
Rate of Return 50% -20% 30% -40%
Geometric Average at End of
50% 9.5% 16% -1.6%
Year
$150.0 $120.0 $156.0
Capital at End of Year $93.60
0 0 0
Dollar Profit/(Loss) ($6.40)
Compound Yield -1.6%
Example #3 Highly Volatile Rates of Return, including losses
Year 1 Year 2 Year 3 Year 4
Rate of Return -95% 0% 0% 115%
Geometric Average at End of Year -95% -77.6% -63.2% -42.7%
Capital at End of Year $5.00 $5.00 $5.00 $10.75
($89.25
Dollar Profit/(Loss)
)
Compound Yield -22.3%
(g)
16
compliance: you do not annualize portfolios or composites for periods of less
than one year. You start on the 13th month.In the cash flow example below,
the dollar returns for the four years add up to $265. The annualized rate of
return for the four years is: $265 ÷ ($1,000 x 4 years) = 6.625%.
Uses Of ROI
• ROI is a measure of cash generated by or lost due to the investment. It
measures the cash flow or income stream from the investment to the
investor, relative to the amount invested. Cash flow to the investor can
be in the form of profit, interest, dividends, or capital gain/loss. Capital
gain/loss occurs when the market value or resale value of the investment
increases or decreases. Cash flow here does not include the return of
invested capital.
17
• During capital budgeting, companies compare the rates of return of
different projects to select which projects to pursue in order to
generate maximum return or wealth for the company's stockholders.
Companies do so by considering the average rate of return, payback
period, net present value, profitability index, and internal rate of return
for various projects.
• A return may be adjusted for taxes to give the after-tax rate of return.
This is done in geographical areas or historical times in which taxes
consumed or consume a significant portion of profits or income. The
after-tax rate of return is calculated by multiplying the rate of return by
the tax rate, then subtracting that percentage from the rate of return.
• A return of 5% taxed at 15% gives an after-tax return of 4.25%
• A return may be adjusted for inflation to better indicate its true value
in purchasing power. Any investment with a nominal rate of return less
than the annual inflation rate represents a loss of value, even though
the nominal rate of return might well be greater than 0%. When ROI is
adjusted for inflation, the resulting return is considered an increase or
decrease in purchasing power. If an ROI value is adjusted for inflation,
it is stated explicitly, such as “The return, adjusted for inflation, was
2%.”
Many online poker tools include ROI in a player's tracked statistics, assisting
users in evaluating an opponent's profitability.
18
Cash Or Potential
Cash Returns
(i) Time value of money:-
Investments generate cash flow to the investor to compensate the investor
for the time value of money.
Except for rare periods of significant deflation where the opposite may be
true, a dollar in cash is worth less today than it was yesterday, and worth
more today than it will be worth tomorrow. The main factors that are used
by investors to determine the rate of return at which they are willing to
invest money include:
The time value of money is reflected in the interest rates that banks offer
for deposits, and also in the interest rates that banks charge for loans such
as home mortgages. The “risk-free” rate is the rate on U.S. Treasury Bills,
because this is the highest rate available without risking capital.
19
the cash flow expected in future from the investment. The higher the risk,
the higher the discount rate (rate of return) the investor will demand from
the investment.
The concept of 'income stream' may express this more clearly. At the
beginning of the year, the investor took $1,000 out of his pocket (or
checking account) to invest in a CD at the bank. The money was still his, but
it was no longer available for buying groceries. The investment provided a
cash flow of $10.00, $10.10, $10.20 and $10.30. At the end of the year, the
investor got $1,040.60 back from the bank. $1,000 was return of capital.
20
Percentage Yield or Future value for compound interest is higher than for
simple interest because the interest is reinvested as capital and earns
interest. The yield on the above investment was 4.06%.
Investment Risks
On ground of assurance of the return, there are two kinds of Investments -
Riskless and Risky. Riskless investments are guaranteed, but since the
value of a guarantee is only as good as the guarantor, those backed by the
full faith and confidence of a large stable government are the only ones
considered "riskless." Even in that case the risk of devaluation of the
currency (inflation) is a form of risk appropriately called "inflation risk."
Therefore no venture can be said to be by definition "risk free" - merely very
close to it where the guarantor is a stable government.
Types of risk:-
Depending on the nature of the investment, the type of investment risk
will vary.
A common concern with any investment is that you may lose the money you
invest - your capital. This risk is therefore often referred to as "capital risk."
If the assets you invest in are held in another currency there is a risk that
currency movements alone may affect the value. This is referred to as
"currency risk."
Many forms of investment may not be readily saleable on the open market
(e.g. commercial property) or the market has a small capacity and may
21
therefore take time to sell. Assets that are easily sold are termed liquid;
therefore this type of risk is termed "liquidity risk."
The risk that there may be a disruption in the internal financial affairs of the
investment, thereby causing a loss of value, is called "financial risk." A
prime example of that form of risk was experienced by the investors in
Enron, or one of the "dot-com" stocks that really never did have a profitable
financial footing. Many of the employees of Enron experienced both liquidity
and financial risk as the price decline in the stock of that company occurred
just as there was a "freeze" on stock liquidation in their retirement plans.
Perhaps the most familiar but often least understood form of investment risk
is "market risk." In a highly liquid market like the collective stock exchanges
in the United States and across the developed world, the price of securities
is set by the forces of supply and demand. If there is a high demand for a
given issue of stock, or a given bond, the price will rise as each purchaser is
willing to pay more for the security than the last one. The reverse of that
occurs when the sellers want to rid themselves of an issue more than the
buyers want to buy it. Each seller is willing to receive less than the last one
and the market price, or valuation, declines.
The same form of risks apply to a house, an issue of stock, a mutual fund, or
a bond. Some forms of investment risk can be insured against. For example,
the risk that an investment rental property might burn down, or the
custodian of your stock and bond investments might go out of business.
Most of the forms of risk that we concern ourselves with, financial risk,
market risk, and even inflation risk, can at least partially be moderated by
forms of diversification.
For example, a person investing $10,000.00 for one year may desire a gain
of $1,000.00, or a 10% return, providing a total investment of $11,000 after
one year. In reality, investing, as opposed to saving, rarely provides such a
neat solution. For example, the average annual compound return of the
broad American stock market over the time period from 1926 to 2006 was
just over 10% per year. During that eighty year period though, there were
more than a few times when massive declines in market value were
experienced by investors in that same stock market. From early in the year
2000 through the fall of the year 2002 for example, the broad measures of
market valuation, such as the S&P 500 Stock Index fell over 50%. For an
22
investor in 2006 to have seen that average compounded 10% return in the
S&P 500 Index, he or she would have had to invest in 1994. The 15%
average annual rate or return was there, it just took twelve years of patient
waiting to see it.
At least the investor in a S&P 500 Index Fund has some degree of assurance
that if he or she waits long enough a positive return is very likely to occur.
The investor who elected to invest everything in Enron is left only with the
assurance that the investment was a complete loss. Enron, as a stock issue,
was a part of the S&P 500, and its loss did have a temporary effect on that
index, but the effect was not permanent or, in the long run, of any
significance. That is the value of diversification. Further diversification away
from the large capitalization stocks that make up the S&P 500 Index has
historically tended to further reduce market and financial risk.
1] Credit risk:-
Most lenders employ their own models to rank potential and existing
customers according to risk, and then apply appropriate strategies. With
products such as unsecured personal loans or mortgages, lenders charge a
higher price for higher risk customers and vice versa. With revolving
products such as credit cards and overdrafts, risk is controlled through the
setting of credit limits. Some products also require security, most commonly
in the form of property.
Lenders will trade off the cost/benefits of a loan according to its risks and
the interest charged. But interest rates are not the only method to
compensate for risk. Protective covenants are written into loan agreements
that allow the lender some controls. These covenants may:
23
• allow for monitoring the debt requiring audits, and monthly reports
• allow the lender to decide when he can recall the loan based on
specific events or when financial ratios like debt/equity, or interest
coverage deteriorate.
A recent innovation to protect lenders and bond holders from the danger of
default are credit derivatives, most commonly in the form of a credit default
swap. These financial contracts allow companies to buy protection against
defaults, from a third party, the protection seller. The protection seller
receives a periodic fee (the credit spread) as compensation for the risk it
takes, and in return it agrees to buy the debt should a credit event
("default") occur.
Credit scoring models also form part of the framework used by banks or
lending institutions grant credit to clients. For corporate and commercial
borrowers, these models generally have qualitative and quantitative
sections outlining various aspects of the risk including, but not limited to,
operating experience, management expertise, asset quality, and leverage
and liquidity ratios, respectively.
2] Financial risk:-
Financial risk is normally any risk associated with any form of financing.
Risk is probability of unfavorable condition; in financial sector it is the
probability of actual return being less than expected return. There will be
uncertainty in every business; the level of uncertainty present is called risk.
Depending on the nature of the investment, the type of 'investment' risk will
vary. High risk investments have greater potential rewards, but also have
greater potential consequences.
A common concern with any investment is that the initial amount invested
may be lost (also known as "the capital"). This risk is therefore often
referred to as capital risk.
If the invested assets are being held in another currency, there is a risk that
currency movements alone may affect the value. This is referred to as
currency risk.
24
Many forms of investment may not be readily salable on the open market
(e.g. commercial property) or the market has a small capacity and may
therefore take time to sell. Assets that are easily sold are termed liquid:
therefore this type of risk is termed liquidity risk.
The risk that a company or project will not have adequate cash flow to meet
financial obligations; thus causing the business to file for bankruptcy.
Bilateral barter can depend upon a mutual coincidence of wants. Before any
transaction can be undertaken, each party must be able to supply
something the other party demands. To overcome this mutual coincidence
problem, some communities had developed a system of intermediaries who
can warehouse and trade goods. However, intermediaries often suffered
from financial risk.
Whilst higher risk normally implies higher overall rewards, this is not always
the case. For example a high risk mortgage client may be required to pay a
higher interest rate on their mortgage repayments in order to be accepted
as a bank's customer. However, this higher mortgage rate will in itself
increase the risk to the bank that the customer cannot meet their interest
payments, further increasing the risk.
25
Heath-Jarrow-Morton framework was developed in the early 1990s by David
Heath of Cornell University, Andrew Morton of Lehman Brothers, and Robert
A. Jarrow of Kamakura Corporation and Cornell University.
1. Marking to market, calculating the net market value of the assets and
liabilities, sometimes called the "market value of portfolio equity"
2. Stress testing this market value by shifting the yield curve in a specific
way. Duration is a stress test where the yield curve shift is parallel
3. Calculating the Value at Risk of the portfolio
4. Calculating the multiperiod cash flow or financial accrual income and
expense for N periods forward in a deterministic set of future yield
curves
5. Doing step 4 with random yield curve movements and measuring the
probability distribution of cash flows and financial accrual income over
time.
6. Measuring the mismatch of the interest sensitivity gap of assets and
liabilities, by classifying each asset and liability by the timing of
interest rate reset or maturity, whichever comes first.
4] Liquidity risk:-
In finance, liquidity risk is the risk that a given security or asset cannot be
traded quickly enough in the market to prevent a loss (or make the required
profit).
26
Manifestation of liquidity risk is very different from a drop of price to zero. In
case of a drop of an asset's price to zero, the market is saying that the asset
is worthless. However, if one party cannot find another party interested in
trading the asset, this can potentially be only a problem of the market
participants with finding each other. This is why liquidity risk is usually found
higher in emerging markets or low-volume markets.
5] Market risk:-
Market risk is the risk that the value of a portfolio, either an investment
portfolio or a trading portfolio, will decrease due to the change in value of
the market risk factors. The four standard market risk factors are stock
prices, interest rates, foreign exchange rates, and commodity prices. The
associated market risk are:
27
• Equity risk, the risk that stock prices and/or the implied volatility will
change.
• Interest rate risk, the risk that interest rates and/or the implied
volatility will change.
• Currency risk, the risk that foreign exchange rates and/or the implied
volatility will change.
• Commodity risk, the risk that commodity prices (e.g. corn, copper,
crude oil) and/or implied volatility will change.
As with other forms of risk, the potential loss amount due to market risk
may be measured in a number of ways or conventions. Traditionally, one
convention is to use Value at Risk. The conventions of using Value at risk is
well established and accepted in the short-term risk management practice.
28
Measurement Of
Risks
Risk concerns the expected value of one or more results of one or more
future events. Technically, the value of those results may be positive or
negative. However, general usage tends focus only on potential harm that
may arise from a future event, which may accrue either from incurring a
cost ("downside risk") or by failing to attain some benefit ("upside risk").
There are many definitions of risk that vary by specific application and
situational context. The widely inconsistent and ambiguous use of the word
is one of several current criticisms of the methods to manage risk.
One set of definitions presents risks simply as future issues which can be
avoided or mitigated, rather than present problems that must be
immediately addressed. E.g. "Risk is the unwanted subset of a set of
uncertain outcomes." (Cornelius Keating)
29
Or more generally,
One of the first major uses of this concept was at the planning of the Delta
Works in 1953, a flood protection program in the Netherlands, with the aid
of the mathematician David van Dantzig. The kind of risk analysis pioneered
here has become common today in fields like nuclear power, aerospace and
the chemical industry.
30
assessment of its expected harm must be combined into a believable
scenario (an outcome), which combines the set of risk, regret and reward
probabilities into an expected value for that outcome.
Thus, in statistical decision theory, the risk function of an estimator δ(x) for
a parameter θ, calculated from some observables x, is defined as the
expectation value of the loss function
L,
The two probabilities are sometimes combined and are also known as
likelihood. If any of these variables approaches zero, the overall risk
approaches zero.
31
Returns When
Capital Is At Risk
(a)
Stock returns are usually calculated for holding periods such as a month, a
quarter or a year.
32
Reinvestment when capital is at risk: rate of return and
yield:-
Yield is the compound rate of return that includes the effect of reinvesting
interest or dividends.
33
• The final investment value of $103.02 is a 3.02% Yield on the initial
investment of $100. This is the compound yield, and this return can be
considered to be the return on the investment of $100.
The disadvantage of this ROI calculation is that it does not take into account
the fact that not all the money was invested during the entire year (the
dividend reinvestments occurred throughout the year). The advantages are:
(1) it uses the cost basis of the investment, (2) it clearly shows which gains
are due to dividends and which gains/losses are due to capital gains/losses,
and (3) the actual dollar return of $3.02 is compared to the actual dollar
investment of $104.06.
Since all returns were reinvested, the ROI might also be calculated as a
continuously compounded return or logarithmic return. The effective
continuously compounded rate of return is the natural log of the final
investment value divided by the initial investment value:
Total Returns
This section addresses only total returns without the impact of U.S. federal
individual income and capital gains taxes.
34
Mutual funds report total returns assuming reinvestment of dividend and
capital gain distributions. That is, the dollar amounts distributed are used to
purchase additional shares of the funds as of the reinvestment/ex-dividend
date. Reinvestment rates or factors are based on total distributions
(dividends plus capital gains) during each period.
35
P(1+T)n = ERV
Where:
n = number of years.
(i) Example
Example: Mutual Fund with low volatility and a regular annual dividend,
reinvested at year-end share price, initial share value $100
End of: Year 1 Year 2 Year 3 Year 4 Year 5
Dividend $5 $5 $5 $5 $5
Capital Gain
$2
Distribution
Total Distribution $5 $5 $7 $5 $5
Share Price $98 $101 $102 $99 $101
Shares Purchased 0.05102 0.04950 0.06863 0.05051 0.04950
Shares Owned 1.05102 1.10053 1.16915 1.21966 1.26916
Reinvestment Factor 1.05102 1.05203 1.07220 1.05415 1.05219
• Total Return = (($101 x 1.05219) - $100) / $100 = 6.27% (net of
expenses)
• Average Annual Return (geometric) = (((28.19)/100)+1) ^ (1/5)) – 1) x
100 = 5.09%
36
mutual fund share value/price. From the shareholder's perspective, a capital
gain distribution is not a net gain in assets, but it is a realized capital gain.
Conclusion
37
In a financial context, risk is a synonym for uncertainty – the possibility
that the actual outcome will differ from the mean expected outcome. It is
therefore a neutral rather than a negative concept. Investors are risk-averse
in the sense that they require more return for taking on more risk. Risk itself
is measured by the standard deviation of actual returns around the mean
expectation. In the real world, investment risk is created by a number of
different factors that affect the certainty of returns in different ways and to
different extents. The financial markets, and in particular the stock market,
play a crucial role in the control and diversification of risk. They provide a
means whereby investors can get their money back by selling on their
interests to other investors. This resolves a conflict of interest between firms
(which want to keep the use of resources for as long as possible) and
investors (who accept a lower return if they can see the opportunity for an
early exit).
Having established a fair return for a particular investment (in terms of time
preference rate, allowance for inflation and risk premium), we can use this
as a discount rate for establishing the present value of expected cash flows.
If this exceeds the price demanded by the market, the investment offers a
positive net present value and should be acquired. If the present value is
less than the price demanded, the investment is relatively expensive and
should be passed over. This rule of positive net present value is the
dominant rule in financial decision-making.
Bibliography
1] Articles from:-
⇒ www.wikipedia.com
38
⇒ www.narachinvestment.com
⇒ www.visioninvestment.com
⇒ www.articlesbase.com
⇒ www.investorwords.com
⇒ www.openlearn.ac.uk
⇒ www.scribd.com
⇒ www.rci.rutgers.edu
⇒ www.work911.com
⇒ www.economywatch.com
⇒ www.beginnermoneyinvesting.com
⇒ www.sharemarketbasics.com
⇒ www.ehow.com
⇒ www.investopedia.com
⇒ www.thefreelibrary.com
3] e-books [books.google.co.in]:-
4] Statistics:-
⇒ en.wikipedia.org
39