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INVESTMENT SETTING

2/6/2012 Group 1

Term Paper
On

Investment Setting

Prepared For:
Tarik Hossain Lecturer Department of Accounting & Information Systems Comilla University

Prepared By:
Group 1 Consisting of: Farhana Afroje (07) Gulam Mostafa (35) Md. Iqramul Hasan Atik (36) Arzuman Fatema (49) Mosharref Husain (51)

Submission Date: February 06, 2012

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Comilla University Comilla

Tarik Hossain Lecturer Department of Accounting & Information Systems Comilla University Sir, Here is the term paper you asked us to prepare on January 24, 2012. This term paper includes the sections required according to the topic you asked us to select. We are confident that you will like our works. We appreciate your selection of our topic of this term paper. We thank you in advance. Sincerely yours

Farhana Afroje (on behalf of the Group 1)

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ACKNOWLEDGEMENTS
I take immense pleasure in thanking the Almighty Allah for making us capable of preparing and submitting this term paper. I would like to express our deep sense of gratitude to our course coordinator Tarik Hossain for his able guidance and useful suggestions, which helped us in completing the term paper, in time. Needless to mention that Gulam Mostafa (35), Md. Iqramul Hasan Atik (36), Arzuman Fatema (49),Mosharref Hossain (51); that is all of my group members have made unlimited effort to make this task successful. I want to thank all of them for all their valuable assistance in the term paper. Words are inadequate in offering my thanks to my classmates for their cordial help with adequate information in preparing the term paper.

Sincerely, (Farhana Afroje) On behalf of Group 1

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Executive Summary
This term paper highlights on the following topics: Forms of Investment The Setting of Investment Objectives Measurement of Risk & Return Systematic and Unsystematic Risk Differences between Risk & Return Under the forms of investment we discussed financial asset and real asset and also different categories of them. The discussion of the next section includes setting right objectives of an investment. In the measurement of risk and return we pointed out different formulas of determining risk and returns of investment. The major two types of risk are discussed in the next portion, which are systematic and unsystematic risk. Finally differences between systematic and unsystematic risk are highlighted.

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TABLE OF CONTENTS
1 FORMS OF INVESTMENT 2 THE SETTING OF INVESTMENT OBJECTIVES 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 3.1 3.2 4.1 4.1.1 4.1.2 4.1.3 4.2 4.2.1 4.2.2 RISK AND SAFETY PRINCIPLE CURRENT INCOME VS. CAPITAL APPRECIATION LIQUIDITY CONSIDERATIONS SHORT-TERM VS. LONG-TERM ORIENTATION TAX FACTOR EASE OF MANAGEMENT RETIREMENT RISK MEASURES MEASURES
OF OF

1 2 2 2 3 3 3 3 4 4 4 5 5 6 6 6 6 6 7 2 3

3 MEASUREMENT OF RISK AND RETURN RISK RETURN

4 SYSTEMATIC AND UNSYSTEMATIC RISK SYSTEMATIC RISK Interest Rate Risk Market Risk Purchasing Power Risk UNSYSTEMATIC RISK Business Risk Financial Risk

5 DIFFERENCES BETWEEN SYSTEMATIC AND UNSYSTEMATIC RISK 7 6 CONCLUSION BIBLIOGRAPHY Bibliography 8 9

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Investment has different meanings. Investment is putting money


into something with the expectation of gain that upon thorough analysis has a high degree of security for the principal amount, as well as security of return, within an expected period of time. Investment is also defined as the commitment of current funds in anticipation of receiving a larger future flow of funds.

1 Forms of Investment
Investment at first is broken down into financial assets and real assets. A financial claim on an asset that is usually documented by some form of legal representation can be defined as financial asset. Financial assets include stock, bond etc. Real asset on the other hand is am actual tangible asset that may be seen, felt, held, or collected. Example of real assts comprises real estate, gold etc. Financial asset and real asset are again divided into several different categories which we will highlight on a table:
Table 1: Financial Assets and Real Assets

Financial Assets
1.Equity claims direct Common stock Warrant Options 2. Equity claims indirect Investment company shares (mutual funds) Pension funds Whole life insurance Retirement accounts 3. Creditors claims Savings account Money market funds Commercial paper Treasury bills, notes, bonds Municipal notes, bonds Corporate bonds 4. Preference stock

Real Assets
1.Real estate Office building Apartments Shopping centres Personal residences 2. Precious metals Gold Silver

3. Precious gems Diamonds Rubies Sapphires

4. Collectibles Art Antiques Coins Rare Books


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5. Commodity features

5. Other Cattle Oil Common metals

2 The Setting of Investment Objectives


Setting clear investment objectives is a key to developing a successful investment strategy and for providing a framework for making decisions with respect to the prudent operation of a fund. We consult on the factors to be taken into consideration when defining the funds objectives and overall investment policy in respect of current legislative requirements and best practice. 2.1 Risk and Safety Principle Tolerance for risk is a very personal decision, and a question that is difficult for many investors to answer. In general, markets tend to provide higher returns in exchange for baring higher risk. It is important to be honest in assessing whether an investor is comfortable with market volatility, and the level he can tolerate. There is not only the risk of losing invested capital directly but also the danger of a loss in purchasing power. Investors can invest on low risk government instruments or longer-term debt instruments and common stock based on their degree of tolerance of risk. It is not only the inherent risk in an asset that must be considered but also the extent to which that risk is being diversified away in a portfolio. For example if we invest in gold, it will thrive on bad news, while common stocks generally do well in a positive economic environment. Lastly, the age and economic condition of risk are also important variables in determining the level of risk that an investor can actually handle with. 2.2 Current Income vs. Capital Appreciation Investors seeking for current income and seeking for capital appreciation obviously differ in setting their investment objectives. Although, this decision is closely tied to an evaluation of risk, it is separate. In purchasing stocks, the investor with a need for current income may opt for high-yielding, mature firms in such industries as public utilities, chemicals, or apparel. Those searching for price gains may look toward smaller, emerging firms in high technology, energy, or electronics. The latter firms may pay no cash dividend. But the investor hopes for an increase in value to provide the desire return.
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The investor needs to understand there is generally a trade-off between growth and income. Finding both in one type of investment is really unlikely. 2.3 Liquidity Considerations Liquidity is the ease with which an investor can convert investments to cash at fair market value. It is essential to recognize the need to convert investments into cash at the appropriate times. Most financial assets deal with a high degree of liquidity. Stocks and bonds can generally be sold within a matter of seconds at a price reasonably close to the last traded value. But it is not true in case of real assets such as real estate. It is a common phenomenon that a house or a piece of commercial real estate sits on the market for weeks, months, or years. Transaction costs or commissions involved in the transfer of ownership do affect liquidity of an investment indirectly. Financial assets are generally traded on a relatively low commission basis, whereas many real assets have transaction costs that run from 5 percent to 25 percent or more. 2.4 Short-term vs. Long-term Orientation In setting investment objectives, it must be decided whether to assume a short-term or long-term orientation in managing the funds and evaluating performance. Market strategies may also be long term or short term in scope. Those who attempt to engage in short-term market tactics are temped traders. They may buy a stock at 15 and hope to liquidate if it goes to 20. To help reach decisions, short-term traders often use technical analysis, which is based on evaluating market indicators series and charting. Those who take a longer-term perspective try to identify fundamentally sound companies for a buyand-sold approach. A long-term investor does not necessarily anticipate being able to buy right at the bottom or sell at the exact pack. 2.5 Tax Factor 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. Making contributions to a tax-sheltered retirement plan can be an effective tax minimization strategy.

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2.6 Ease of Management After making purchases into portfolio one will be required to manage the portfolio. Sound portfolio management makes life easy and ensures having more time to actually run portfolio and less time performing administrative aspects of the management process. As one invests more and more one becomes more knowledgeable about investing and portfolio management, portfolio management software should be no different. It should be advanced enough to grow as the portfolio grows and have all the right tools for the most important job in investing. 2.7 Retirement Even the relatively young must begin to consider the effect of their investment decisions on their retirement and the estates they will someday pass along to their potential families. Those who wish to remain single will still be called on to advise others as to the appropriateness of a given investment strategy for their family needs. 2.8 Risk The risk for an investment is related to the uncertainty associated with the outcomes from an investment. The desired or required rate of return for a given investment is generally related to the risk associated with that investment. Risk is thus variability of returns of an investment. There is another measure of risk also used in the investment community and that is beta. The beta measures the risk of a security relative to the market which is called systematic risk that cannot be diversified away in a portfolio of stocks and so it has special importance to the investors. As we have seen from each of the objectives discussed above, the advantages of one often come at the expense of the benefits of another. If an investor desires growth, for instance, he or she must often sacrifice some income and safety. Therefore, most portfolios will be guided by one pre-eminent objective, with all other potential objectives occupying less significant weight in the overall scheme. Choosing a single strategic objective and assigning weightings to all other possible objectives is a process that depends on such factors as the investor's temperament, his or her stage of life, marital status, family situation, and so forth. Out of the multitude of possibilities out there, each investor is sure to find an appropriate mix of investment opportunities.

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3 Measurement of Risk and Return


It is important to understand where to investment return is generated and where to take risk. The only way to know this is to measure it in investment portfolio. If risk is not measured it cannot be managed. We can measure risk and return and show where to take risk and estimate return. 3.1 Measures of Risk As risk is deviation in returns it is denoted by and is calculated by the following formula: = i=1n[(Xi-X) (Xi)] Market risk is called systematic or non-diversifiable risk which is measured by the following formula:

i =

rimim
m

Again can be calculated as: nXY (X) =(Y) nX - (X) There is another formula for calculating this systematic risk. That is:

=
3.2 Measures of Return

i=1nii

Like risk returns can also be measured by different formulas, which we will now point out:

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Forecasted dividend + Forecasted end of the period stock price Return, R = Initial investment Expected return, X= i=1nXi p (Xi) P1- P0 Probable return, R = DP0 + P0 Where, P1 = Estimated market price after one year P0 = Current Market Price D = Anticipated dividend Earnings after tax Return on Assets = Total assets EBIT Return on capital employed = Total capital employed EAT Return on Equity = Shareholders equity Sales EAT Return on investment = Total Sales assets Under Capital Asset Pricing Model, return is measured as, Ri= Rf + i (Rm - Rf) Where, Rf = Risk free rate of return Rm = Return on risky portfolio

4 Systematic and Unsystematic Risk


The total variability in returns of a security represents the total risk of that security. Systematic risk and unsystematic risk are the two components of total risk. Thus, Total Risk = Systematic Risk + Unsystematic Risk
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4.1 Systematic Risk Systematic risk is due to risk factors that affect the entire market such as investment policy changes, foreign investment policy, change in taxation clauses, shift in socio-economic parameters, global security threats and measures etc. It is beyond the control of investors and cannot be mitigated to a large extent. In contrast to this, the unsystematic risk can be mitigated through portfolio diversification. It is a risk that can be avoided and the market does not compensate for taking such risks. However the systematic risks are unavoidable and the market does compensate for taking exposure to such risks. Systematic risk is broken into three categories. They are: 4.1.1 Interest Rate Risk Interest rate risk is the chance that an unexpected change in interest rates will negatively affect the value of an investment. A bond having a face value of Tk. 100 issued with a coupon rate of ten percent when the market rate is also the same. If subsequent to the issue, the market interest rate moves up to 12.5 percent, no investor will buy the bond with 10 percent coupon interest rate unless the holder of the bond reduces the price to Tk. 80. When the price is reduced to Tk. 80, purchaser of the bond gets interest of Tk. 10 on an investment of Tk. 80 which is equivalent to 12.5 percent which is the same as the market interest rate. 4.1.2 Market Risk Market risk is a type of systematic share that affects shares. It is the day-to-day potential for an investor to experience losses from fluctuations in securities prices. This risk cannot be diversified away. 4.1.3 Purchasing Power Risk Risk that sudden changes in prices of consumables adversely affect the investors actual return from investment is referred to as purchasing power risk. It is the chance that the cash flows from an investment won't be worth as much in the future because of changes in purchasing power due to inflation. 4.2 Unsystematic Risk Unsystematic risk is due to factors specific to an industry or a company like labour unions, product category, research and
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development, pricing, marketing strategy etc. Unsystematic risk that can be eliminated by diversification. For example the unique risk of an ice-cream owner would be the weather. In bad weather the company would obviously generate worse sales then in sunny weather. Another example would be a mining company. The return they generate from the sale of the commoditys their mine is determined by commodity prices. Therefore the price of commodities would be an unsystematic risk. This risk is again categorised into two categories: 4.2.1 Business Risk Business risk he possibility that a company will have lower than anticipated profits, or that it will experience a loss rather than a profit. Business risk is influenced by numerous factors, including sales volume, per-unit price, input costs, competition, and overall economic climate and government regulations. A company with a higher business risk should choose a capital structure that has a lower debt ratio to ensure that it can meet its financial obligations at all times. 4.2.2 Financial Risk Financial risk is the risk that a company will not have adequate cash flow to meet financial obligations. Financial risk is the additional risk a shareholder bears when a company uses debt in addition to equity financing. Companies that issue more debt instruments would have higher financial risk than companies financed mostly or entirely by equity.

5 Differences between Systematic and Unsystematic Risk


Table 2: Differences of systematic and unsystematic risk

Subject
Definition

Systematic Risk
Systematic risk is due to risk factors that affect the entire market.

Unsystematic Risk
Unsystematic risk is due to factors specific to an industry or a company.

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Categorie s Diversific ation Effect Measure

Systematic risk has three categories: interest rate risk, market risk and purchasing power risk. It cannot be diversified away. It affects all the companies or industries of the market. Measure of systematic risk is beta ().

Unsystematic risk has two categories: business risk and financial risk. This risk can be reduced through diversification. It affects only specific industry or company.

Example

Unsystematic risk is measured through the mitigation of the systematic risk factor. Global turmoil will affect It may be possible that the whole stock market management of a company and not any single stock, may be poor, or there may similarly any change in the be strike of workers which interest rates affect the leads to losses. Since these whole market though factors affect only one some sectors are more company, this type of risk affected then others, this can be diversified away by type of risk is called non investing in more than one diversifiable risk because company because each no amount of company is different and diversification can reduce therefore this risk is also this risk. called diversifiable risk.

6 Conclusion
Setting investment in right way includes many important decision and situations. An investor who can examine the market, economy, industry level, interest rates etc in a right way can actually have his expected return on hand. He needs to know exact answers of the questions related to his investments, either his success will remain under doubt. Every investor should follow different technical analysis to become sure about his investment and to have a sound return for which he actually invests.

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Bibliography
1. Investment Management Geoffrey A. Hirt Stanely B. Block 2. Portfolio Management S. Kevin 3. Class lecture delivered by honourable course coordinator. 4. www.google.com 5. www.letslearnfinance.com 6. wiki.answers.com 7. brainmass.com 8. www.ehow.com 9. en.wikipedia.org/wiki/

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