Investment Management

(BRM2102)
INTRODUCTION
Issues covered in the
Investment Analysis and Portfolio
Management Course

1.0 An overview of investment Management

1.1 Financial institutions and markets

• Introduction

• Financial institutions and their functions

• Types of Financial Institutions

• Banking and Non-Banking

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 Course Objective

• How do we make the best or most informed investment decisions?

• How do we manage the portfolio of investments we have created?

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 Overview of investment evaluation
Definition of terms

Investment

• According to Reilly and Brown (2000), investment is the current

commitment of funds for a period of time in order to derive future
payments that will compensate the investor for

 the time the funds are committed,

 the expected rate of inflation and

 the uncertainty of the future payments.

• Investment is the commitment of funds to one or more assets that

will be held over some future time period (Jones, 1998).

• Investment is the study of the investment process.

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• Investment is concerned with the management of an investor’s
wealth, which is the sum of current income and the present value of
all future income. [This is why present value and compound interest
concepts have an important role in the investment process].
• The investor is trading a known pula amount today for some
expected future stream of payments that will be greater than the
current outlay.
• This answers the question: why do people invest and what do they
want from their investments?

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Investment Evaluation

• Investment evaluation is a crucial process that investors undertake to make informed decisions about

allocating their financial resources to various assets or projects. The goal is to assess the potential risks and

rewards associated with each investment opportunity. By carefully evaluating investments, investors can

optimize their portfolio and work towards achieving their financial objectives.

Key Concepts:

1. Risk and Return Trade-off: In finance, there is a fundamental relationship between risk and return.

Generally, investments with higher potential returns also carry higher levels of risk. Investors need to strike a

balance between seeking higher returns and managing risk to align with their risk tolerance and financial goals.

2. Diversification: Diversification is a strategy that involves spreading investments across different assets

or asset classes. By diversifying, investors aim to reduce the impact of individual asset performance on their

overall portfolio. This can help mitigate risk and create a more stable investment portfolio.

3. Investment Horizon: The investment horizon refers to the time period over which an investor plans to

hold an investment. Different investments may be suitable for short-term, medium-term, or long-term goals,

and the investment evaluation should align with the investment horizon.
Factors Influencing Investment Evaluation:

1. Financial Metrics: Investors analyze various financial metrics, such as earnings, revenue,

cash flow, and profitability, to evaluate the financial health and performance of a

company or investment opportunity.

2. Market Conditions: The overall market conditions, including economic trends, interest

rates, inflation, and geopolitical factors, can significantly impact investment decisions.

3. Industry Analysis: Understanding the dynamics and trends in a specific industry is crucial

for evaluating investments in companies within that sector.

4. Regulatory and Legal Considerations: Investors must consider the regulatory

environment and legal constraints when evaluating investments, especially in certain

industries or regions.

5. Competitive Landscape: Evaluating the competitive landscape helps investors assess the

potential growth and sustainability of a company or investment.

Methods of Investment Evaluation:

1. Fundamental Analysis: This approach involves analyzing a

company's financial statements, management team, industry position,
and competitive advantage to determine its intrinsic value.

2. Technical Analysis: Technical analysis involves studying past

market data, primarily price and volume, to forecast future price
movements and identify potential entry and exit points.

3. Valuation Models: Valuation models, such as discounted cash flow

(DCF), price-to-earnings (P/E) ratio, and price-to-book (P/B) ratio,
help investors assess the fair value of a company or asset.
Investment Decision-Making Process:
1. Setting Investment Objectives: Define specific investment objectives, such as
capital appreciation, income generation, or wealth preservation.
2. Risk Assessment: Evaluate the level of risk you are willing to accept and align it
with your investment goals.
3. Asset Allocation: Determine the allocation of funds among different asset classes
(stocks, bonds, real estate, etc.) to create a diversified portfolio.
4. Research and Analysis: Conduct thorough research and analysis of potential
investments using various methods and tools.
5. Implementation: Execute the investment strategy by purchasing selected assets
based on the evaluation.
6. Monitoring and Review: Regularly review the performance of investments and
make adjustments to the portfolio as needed.
•Investment evaluation is an ongoing process, and it requires continuous monitoring
and adaptation to changing market conditions and personal financial goals. Through a
systematic and well-informed approach, investors can make more rational decisions and
enhance their chances of achieving long-term success in their investment endeavors.
 Introduction:
Definition of terms

Why do people invest?

• People invest to improve welfare (monetary wealth, both current
and future).
• They invest to earn a return from savings due to their deferred
consumption.
• They want a rate of return that compensates them for the time, the
expected rate of inflation, and the uncertainty of return.
• This return is the investor’s required rate of return. [The central
them is selection of investments that give investor their required
rate of return].
• Funds to be invested come from assets already owned, borrowed
money, and savings or forgone consumption.

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 Difference between Investing and Saving

• Investing results in capital growth while saving is concerned about

capital preservation.
 Introduction:
Definition of terms

Investment Analysis

• Investment analysis is the study of financial securities for the

purpose of successful investing, that is, how to trade and in what
assets as well as the calculation of risks and returns, and the
relationship between the two.

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 Introduction:
Definition of terms

Real vs. Financial Investment

• Real investment is the purchase of physical capital such as land and

machinery to employ in the production process and earn increased
profit whereas financial investment is the purchase of “paper”
securities such as stocks and bonds.

• In this course, we are concerned about financial investment.

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 Introduction:
Definition of terms

Real assets vs. financial assets

i. Real assets

• are those assets that directly contribute to the productive capacity of the economy such as
machines, land and buildings, and knowledge.

• They are physical and human assets.

ii. Financial assets

• contribute indirectly to the economy. They are the means by which individuals hold their
claims on real assets - claims to the income generated by real assets or on income from the
government.

• A financial asset is actually a legal contract representing the right to receive future benefits
under a stated set of conditions. These assets are created and destroyed in the course of
business whereas real assets are destroyed through wear and tear or nature related
accidents.

• Financial assets allow for the separation of ownership and management of firms and
facilitate the transfer of funds.

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 Introduction:
Definition of terms

Types of investors:

• Individual investors are individuals who are investing on their own.

Sometimes individual investors are called retail investors.

• Institutional investors are entities such as investment companies,

commercial banks, insurance companies, pension funds, mutual
funds and other financial institution and are professional money
managers. They tend to have vast resources at their disposal.

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 The Nature of Investment

• Every investor (individual or institutional) has certain specific objectives to

achieve through his long term/short term investment.

• Such objectives may be monetary/financial or personal in character.

• The objectives include:

 Safety and security of the funds invested (principal amount).

 Profitability (through interest, dividend and capital appreciation).

 Liquidity (convertibility into cash as and when required).

• These objectives are universal in character as every investor will like to

have a fair balance of these three financial objectives. An investor will not
like to take undue risk about his principal amount even when the interest
rate offered is extremely attractive. These objectives or factors are known
as investment attributes.
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 The Nature of Investment

• There are personal objectives which are given due consideration by

every investor while selecting suitable avenues for investment.
Personal objectives may be like

 Provision for old age and sickness.

 Provision for house construction.

 Provision for marriage and education of children.

 Provision for dependents including wife, parents or physically

handicapped member(s) of the family.

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 The Nature of Investment

• The investment avenue(s) selected should be suitable for achieving the objectives
(financial and personal) decided. The merits and demerits of various investment
avenues need to be considered in the context of such investment objectives.

• To enable the evaluation and reasonable comparison of various investment

avenues, the investor should study the following attributes:

 Rates of return

 Risk

 Marketability

 Taxes

 Convenience

 Safety

 Liquidity

 Duration

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 Investment Environment

The investment environment has several elements:

• Financial markets: (money markets, capital markets, foreign
exchange markets, derivatives markets)
• Financial instruments or assets: (money market instruments:
treasury bills, certificates of deposits, etc; capital market
instruments: shares, bonds, exchange traded funds; foreign
exchange market: foreign currencies; derivative markets: forwards,
futures, options and swaps)
• Commodities markets: (minerals, metals and agricultural products)
• Real estate markets: (real estate investment trusts)
• Financial Institutions:
• Bank Financial Institutions: (commercial banks, investment banks,
savings banks, development banks, buildings societies, merchant
banks)
 Investment Environment

• Non-Bank Financial Institutions: (insurance and assurance

companies, management and fund firms, investment companies
with variable capital, asset management firms, microfinance
institutions)
• Deficit units: borrowers of loans or issuers or sellers of financial
instruments
• Surplus units: lenders or buyers of financial instruments
• Deficit and surplus units can either be individuals or corporates
(private sector and public sector businesses [local and central
government authorities])
• Deficit and surplus units can also be local residents and corporate or
foreign residents and corporates.
 Investment Environment

• Regulatory institutions and laws (Ministry of Finance and

Development Planning - central bank – Bank of Botswana; Non-Bank
Financial Institutions Regulatory Authority [NBFRA]; Botswana Stock
Exchange [BSE])
Financial Markets

An Overview of the Financial System

1. Function of Financial Markets and Financial Intermediaries

2. Structure of Financial Markets

• Debt and Equity Markets

• Primary and Secondary Markets

• Exchanges and Over-the-Counter Markets

• Money and Capital Markets

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3. Financial Instruments

• Money Market Instruments

• Capital Market Instruments

4. Role of Financial Intermediaries

• Transaction Costs and Economies of Scale

• Risk Sharing and Diversification

• Adverse Selection and Moral Hazard

5. Types of Financial Intermediaries

• Depository Institutions (Banks)

• Contractual Savings Institutions

• Investment Intermediaries
1. Function of Financial Markets and Financial Intermediaries

• Financial markets and financial intermediaries perform the function of

channeling funds from agents who have saved funds and want to lend

to agents who need funds and want to borrow.

2 Structure of Financial Markets

2.1 Debt and Equity Markets

• Debt instrument = a contractual agreement by the issuer of the

instrument (the borrower)to pay the holder of the instrument (the

lender) fixed dollar amounts (interest and

• principal payments) at regular intervals until a specified date

(maturity date) when a final payment is made.

Examples: Government and corporate bonds.

• Maturity = number of years or months until the expiration date.

• Short-term = maturity of less than one year.

• Long-term = maturity of more than ten years.

• Intermediate-term = maturity between one and ten years.

Equity = a contractual agreement representing claims to a share in the income and

assets of a business.

Example: Corporate stock.

• May pay regular dividends.

• Have no maturity date; hence are considered long-term securities.

Since equity holders own the firm, they are entitled to elect members of the firm’s

board of directors and vote on major issues concerning how the firm is managed.

A key feature distinguishing equity from debt is that the equity holders are the

residual claimants: the firm must make payments to its debt holders before making

payments to its equity holders.

Advantage to holders of debt instruments:

• Receive fixed payments, regardless of whether the borrower’s income and

assets become more or less valuable over time.

Disadvantage to holders of debt instruments:

• Do not benefit from an increase in the value of the borrower’s income or assets.

Advantage to holders of equities:

• Receive larger payments when the business becomes more profitable or the

value of its assets rises.

Disadvantage to holders of equities:

• Receive smaller payments when the business becomes less profitable or the

value of its assets falls.

2.2 Primary and Secondary Markets

• Primary market = market in which newly-issued securities are sold to initial buyers
by the corporation or government borrowing the funds.

• Example: Botswana Treasury issues a new Government bond, and sells it to Absa.

• Investment banks play an important role in many primary market transactions by

underwriting securities: they guarantee a price for a corporation’s securities and then
sell those securities to the public.

• Secondary market = market in which previously-issued securities are traded.

• Example: Absa sells the existing government bond to Imara Holding.

• Brokers and dealers play an important role in secondary markets:

• Brokers = facilitate secondary-market transactions by matching buyers with sellers.

• Dealers = facilitate secondary-market transactions by standing ready to buy and sell

securities.
Essential functions of secondary markets

• They allow the original buyers of securities to sell them before the
maturity date, if necessary. That is, they make the securities more
liquid.

• They allow participants in the primary markets to make judgements

about the value of newly-issued securities by looking at the prices of
similar, existing securities that are traded in the secondary markets
• Primary Markets:

1. Issuance of New Securities: The primary market is where new securities

are issued by corporations, governments, or other entities to raise capital
for various purposes. This is the initial offering of securities to the public.

2. Capital Formation: The primary market is crucial for capital formation as

it enables companies and governments to raise funds for business
expansion, research and development, infrastructure projects, and other
initiatives.

3. Investor Interaction: In the primary market, issuers directly interact with

investors by offering new securities at a specific price (initial offering
price) through methods like Initial Public Offerings (IPOs) or rights issues.
• Role of Intermediaries: Investment banks and underwriters often
play a significant role in the primary market by facilitating the
issuance process, determining the appropriate offering price, and
ensuring compliance with regulatory requirements.

• Ownership Transfer: Primary market transactions involve the transfer

of ownership from the issuer to the investors purchasing the newly
issued securities.

• Pricing: The price of securities in the primary market is determined

through negotiations between the issuer and the underwriters based
on market conditions and the perceived value of the securities.
• Secondary Markets:

1. Trading of Existing Securities: The secondary market is where previously

issued securities are traded among investors. It provides a platform for
buying and selling securities after the initial issuance in the primary
market.

2. Liquidity: The secondary market enhances the liquidity of securities by

allowing investors to buy or sell their holdings without requiring the
involvement of the original issuer. It provides a continuous marketplace for
trading.

3. Price Determination: Secondary markets play a key role in price discovery,

where the prices of securities are determined by the forces of supply and
demand among investors.
• Investor Interaction: Investors trade securities with each other in the
secondary market, and the issuer is typically not directly involved in
these transactions.
• Role of Intermediaries: Stock exchanges and brokerage firms
facilitate trading in the secondary market by providing platforms for
investors to execute transactions.
• Ownership Transfer: In the secondary market, ownership of
securities is transferred from one investor to another. The issuer is
not directly affected by these transactions.
• Pricing: Prices in the secondary market are determined by market
participants based on factors such as current market conditions,
investor sentiment, and fundamental company performance.
2.3 Exchanges and Over-the-Counter Markets

• Exchange = buyers and sellers meet in a central location.

• Example: New York Stock Exchange.

• Over-the-Counter (OTC) Market = dealers at different locations trade via

computer and

• telephone networks.

Examples: NASDAQ (National Association of Securities Dealers’ Automated

Quotation System); Government bond market.

2.4 Money and Capital Markets

• Money market = only short-term debt instruments are traded.

• Capital market = intermediate-term debt, long-term debt, and equities

traded.
3 Financial Instruments
3.1 Money Market Instruments
• The principal money market instruments are:
• Treasury Bills
• Negotiable Bank Certificates of Deposit
• Commercial Paper
• Banker’s Acceptances
• Repurchase Agreements
• Federal Funds
• Eurodollars
• All of these money market instruments are, by definition, short-term
debt instruments,
• with maturities less than one year
Treasury Bills:
• Issued by the US Government.
• Currently issued with maturities of 1, 3, and 6 months.
• Pay a fixedamountatmaturity.
• Make no regular interest payments, but sell at a discount.
• Example: A Treasury bill that pays off $1000 at maturity 6 months
from now sells
• for $950 today. The $50 difference between the purchase price and
the amount
• paid at maturity is the interest on the loan.
• Trade on a very active secondary market.
• Are the safest of all money market instruments, since it is very
unlikely that the US
• Government will go bankrupt
Negotiable Certificates of Deposit (CDs):
• Issued by banks.
• Make regular interest payments until maturity.
• At maturity, return the original purchase price.
• Large CDs, with value over $100,000, trade on a secondary market.
• “Negotiable” means that the CD trades on a secondary market.
Commercial Paper:
• Short-term debt issued by corporations..
• Make no interest payments, but sell at a discount.
• Trade on a secondary market.
Banker’s Acceptances:
• Bank draft (like a check) issued by a firm and payable at some future
date.
• Stamped “accepted” by the firm’s bank, which then guarantees that
it will be paid.
• Often arise in the process of international trade.
• Make no interest payments, but sell at a discount.
• Trade on a secondary market.
Repurchase Agreements:
• Very short-term loans, often overnight, with Treasury bills as
collateral, between a non-bank corporation as the lender and a bank
as the borrower.
• Non-bank corporation buys the Treasury bill from the bank.
• Simultaneously, the bank agrees to repurchase the Treasury bill later
at a slightly higher price.
• The difference between the original price and the repurchase price
is the interest.
Eurodollars:
• US dollar deposits at foreign banks.
3.2 Capital Market Instruments
• The principal capital market instruments are:
• Corporate Stocks
• Residential, Commercial, and Farm Mortgages
• Corporate Bonds
• Government Securities (Intermediate and Long-Term)
• State and Local Government (Municipal) Bonds
• Bank Commercial and Consumer Loans
• All of these capital market instruments are, by definition,
intermediate-term debt
• instruments, long-term debt instruments, or equities.
• Money Markets:
1.Short-Term Instruments: Money markets deal with short-term financial
instruments that have a maturity of one year or less. These instruments are
designed to facilitate the borrowing and lending of funds for short periods.
2.Liquidity Focus: The primary focus of money markets is on providing
liquidity and managing short-term cash needs. Participants in the money
market include institutions and individuals looking for safe and liquid
places to park their excess funds temporarily.
3.Examples: Money market instruments include Treasury bills, commercial
paper, certificates of deposit, repurchase agreements (repos), and short-
term government bonds.
4.Risk Profile: Money market instruments are generally considered to have
lower risk compared to longer-term investments. They are often backed
by government or high-quality corporate issuers.
5.Investment Horizon: Investors in money market instruments typically
have a short investment horizon and are interested in preserving capital
while earning a modest return.
• Capital Markets:
1. Long-Term Instruments: Capital markets deal with long-term financial
instruments that have maturities beyond one year. These markets are
focused on raising capital for businesses and governments for
investment in long-term projects.
2. Capital Formation: The primary function of capital markets is to
facilitate the issuance and trading of long-term securities, allowing
companies to raise funds for expansion, acquisitions, research, and
development.
3. Examples: Capital market instruments include stocks (equity), bonds
(debt securities with maturities over one year), preferred stock, and
other equity-linked instruments.
4. Risk Profile: Capital market instruments can vary widely in terms of risk.
Stocks are considered riskier due to their exposure to market
fluctuations, while bonds can range from very safe government bonds
to riskier corporate bonds.
5. Investment Horizon: Investors in capital market instruments typically
have a longer investment horizon, seeking returns over several years or
more. They are often willing to take on more risk in exchange for
potential higher returns.
4 Role of Financial Intermediaries

4.1 Transaction Costs and Economies of Scale

• Transaction costs = the time and money spent in carrying out

financial transactions.

• Financial intermediaries help reduce transaction costs by taking

advantage of economies of scale.

• Example: a bank can use the same loan contract again and again,
thereby reducing the costs of making each individual loan.
4.2 Risk Sharing and Diversification

• Risk = uncertainty about the returns investors will receive on any

particular asset.

• By purchasing a large number of different assets issued by a wide range

of borrowers, financial intermediaries use diversification to help with
risk sharing.

• Example: by lending to a large number of different businesses, a bank

might see a few of its loans go bad; but most of the loans will be repaid,
making the overall return less risky.

• Here, again, the bank is taking advantage of economies of scale, since it

would be difficult for a smaller investor to make a large number of
loans.
4.3 Adverse Selection and Moral Hazard

• Financial intermediaries also use their expertise to screen out bad credit risks and
monitor borrowers.

• They thereby help solve two problems related to imperfect information in financial
markets.

• Adverse Selection = refers to the problem that arises before a loan is made because
borrowers who are bad credit risks tend to be those who most actively seek out loans.

• Financial intermediaries can help solve this problem by gathering information about
potential borrowers and screening out bad credit risks.

• Moral Hazard = refers to the problem that arises after a loan is made because
borrowers may use their funds irresponsibly.

• Financial intermediaries can help solve this problem by monitoring borrowers’

activities.
5 Types of Financial Intermediaries
5.1 Depository Institutions (Banks):
• Commercial Banks
• Savings and Loan Associations
• Mutual Savings Banks
• Credit Unions
5.2 Contractual Savings Institutions
• Life Insurance Companies
• Fire and Casualty Insurance Companies
• Pension Funds
5.3 Investment Intermediaries
• Finance Companies
• Mutual Funds
• Money Market Mutual Funds
1.2 Investment management fundamentals

• Investment management involves making informed decisions to allocate funds among

various investment opportunities in order to achieve specific financial goals. Here are some
fundamental concepts in investment management:

• Diversification: Diversification is the practice of spreading investments across different

securities and sectors to reduce risk. It helps mitigate the impact of poor performance in
one investment on the overall portfolio.

• Investment Strategies: Investment managers employ various strategies, such as value

investing, growth investing, and passive indexing, to select and manage investments in line
with the investor's objectives.

• Risk Management: Effective risk management involves identifying, assessing, and mitigating
potential risks that could impact investment performance. Techniques include
diversification, hedging, and managing exposure to market volatility.

• Investment Vehicles: Investment managers choose from a range of investment vehicles,

including stocks, bonds, mutual funds, exchange-traded funds (ETFs), real estate, and
alternative investments, to achieve diversification and target specific objectives.
• Market Analysis: Investment managers conduct thorough market analysis to identify trends,

opportunities, and potential risks in different asset classes. Fundamental analysis (evaluating

financial health) and technical analysis (studying price patterns) are common approaches.

• Performance Measurement: Investment managers track and evaluate the performance of

investments against benchmarks. Performance measurement helps assess whether

investment decisions are meeting their intended goals.

• Risk and Return Trade-Off: One of the core principles in investment management is the

relationship between risk and return. Generally, higher returns are expected from

investments with higher levels of risk. Investment managers aim to balance risk and return

based on an investor's risk tolerance and financial objectives.

• Asset Allocation: Asset allocation involves deciding how to distribute investments across

different asset classes, such as stocks, bonds, real estate, and cash. The allocation should

reflect the investor's goals, time horizon, and risk tolerance.

• measurement helps assess whether investment decisions are meeting their intended goals.

• Rebalancing: Over time, the initial asset allocation of a portfolio can shift due to market

movements. Investment managers periodically rebalance portfolios to bring them back in line

with the target allocation.

• Tax Efficiency: Investment managers consider tax implications when making investment

decisions. Tax-efficient strategies aim to minimize taxes on investment gains and income.

• Investor Suitability: Investment managers take into account the unique financial circumstances,

goals, risk tolerance, and time horizon of each investor to create customized investment plans.

• Regulatory Compliance: Investment managers must adhere to regulations and legal

requirements governing financial markets. Compliance ensures ethical and legal behavior in

managing investments.

• Continuous Monitoring: Effective investment management involves ongoing monitoring of

portfolio performance and adjusting strategies as needed to adapt to changing market conditions

or the investor's changing circumstances