Fundamentals of Investment Notes | Important Questions | 10 Year | Shiv Das | Semester- 6

Fundamental Of Investment Important Questions 2022 (Sem-6) B.com (Hons.)

Q) What do you mean by swap?

Ans) A swap is an agreement or a derivative contract between two parties for a financial exchange so that they can exchange cash flows or liabilities. Through a swap, one party promises to make a series of payments in exchange for receiving another set of payments from the second party. Swaps usually include cash flows based on notional principal amounts like bonds or loans but the instruments can vary.

Types of swaps

Interest Rate Swaps
Currency Swaps
Debt-Equity Swaps
Total Return Swaps
Credit Default Swap (CDS)
Q) What do you mean by Dividend Payout Ratio?

Ans) A dividend payout ratio is a proportion of a company’s earnings that is paid to the shareholders. The ratio can range anywhere from zero to a hundred. In case a company does not pay any dividend due to losses, the dividend payout ratio is zero. In case a company pays the entire net income as a dividend, the ratio is hundred.

In general, companies payout a portion of their earnings to shareholders and retain the balance in their reserves. A growing reserve enhances the equity base of a company boosting its capability to raise debt. The retention ratio indicates the earnings retained by a company or transferred to reserves.

Generally, a company that is matured pays a steady dividend each year. In contrast, a company which is yet to break-even or make profits will not pay any dividend to the shareholder. Also, a higher retention ratio may indicate the growth-oriented nature of a company which wishes to invest in expansion.

Analysts, market experts, and investors calculate the payout ratio and retention ratio to determine the nature of the company and its policies. The ratios could be usefully analysed over a long period to determine the growth of a company and the return to shareholders. The analysis may also indicate the strength of the balance sheet of a company and its liquidity position.

Q) What is Market Risk?

Ans) There are various sources for market risk which include macro factors such as changes in interest rates, foreign trade policy, industrial output indicators, political turmoil, natural disasters and terrorist attacks. Systematic, or market risk tends to influence broad market behaviour.

Systematic risk can be differentiated from unsystematic risk, which is unique to a specific sector or industry or company. In the context of investment folio, it is called as non-systematic risk, specific risk, diversifiable risk or residual risk. An investor can reduce The unsystematic risk in an investment portfolio can be reduced through diversification.

The investment risk comprises of two major components namely market (systematic) risk and specific risk (unsystematic). The general types of market risks include interest rate risk, equity risk, debt risk, foreign exchange risk, currency risk and commodity risk.

The market regulators such as the Securities and Exchange Commission (SEC) or Securities and Exchange Board of India (SEBI) mandate disclosures by public corporations. Publicly-traded companies in the United States must disclose the effects of their productivity and results on the performance of the financial markets to the SEC. The requirement seeks to obtain the details of a company's exposure to financial risk.

For example, an investment company engaged in providing derivative products or foreign exchange futures are exposed to financial risk in comparison with companies that provide other types of investments. Such information helps investors and traders make better decisions based on their own risk assessment and risk management rules.

Q) What are the Financial Investments?

Financial investment refers to putting aside a fixed amount of money and expecting some kind of gain out of it within a stipulated time frame.

Important in Financial Investment

Planning plays a pivotal role in Financial Investment. Don’t just invest just for the sake of investing. Understand why you really need to invest money? Investing just because your friend has said you to do so is foolish. Careful analysis and focused approach are mandatory before investing.

Explore all the investment plans available in the market. Go through the pros and cons of each plan in detail. Analyze the risk factors carefully before finalizing the plan. Invest in something which will give you the maximum return.

Appoint a good financial planning manager who takes care of all your investment needs. He must understand your requirement, family income, stability etc to decide the best plan for you.

One needs to be a little careful and sensible while investing. An individual must read the documents carefully before investing.

Types of Financial Investment

An individual can invest in any of the following:

Mutual Funds
Fixed Deposits
Bonds
Stock
Equities
Real Estate (Residential/Commercial Property)
Gold /Silver
Precious stones

Need for Financial Investment

Financial Investment ensures all your dreams turn real and you enjoy life to the fullest without actually worrying about the future.

Financial investment ensures you save for rainy days. Careful investment makes your future secure.

Financial investment controls an individual’s spending pattern. It decides how and what amount one should spend so that he has sufficient money for future.

Q) What do you mean by Credit Rating?

Ans.) A credit score is a 3-digit number that represents the creditworthiness of the borrower. Credit rating is the analysis of the possible credit risks associated with granting a financial instrument to an individual or a company. Based on the credit score, a lender determines whether the borrower can repay the loan amount or not.

The rating is provided based on the creditworthiness and the credentials of an individual or a company. The creditworthiness of an individual or a company is decided based on the lending and borrowing transactions done in the past. Credit rating is determined after weighing the statements of liabilities and assets, and their ability to meet the debt obligations.

It is recommended that you maintain a good credit rating if you would like to apply for a huge loan in the future.

You can maintain a good score given that you pay all your existing debts on time, check your credit report once in a while to stay informed of your score and keep your credit utilisation ratio below 30%.

The credit score is determined based on the following factors.

Payment History: 35%
Credit Utilisation: 30%
Credit History Duration: 15%
Credit Mix: 10%
New Credit: 10%

Q.) What do you mean by speculation?

Ans.) Speculation (also known as speculative trading) is a financial term that refers to the act of purchasing an asset (a commodity, good or real estate) that has a substantial risk of losing value but also holds the hope of gaining value in the near future. An investor who's into speculative trading purchases an asset in an attempt to gain profit from small fluctuations in the market. These are high-risk, high gain investments that are made for a short amount of time and once the investor gets the desired profit, the investment is sold. For example- An investor who invests in foreign currency buys some currency in the hopes of selling it at an appreciated rate when market fluctuations happen. This type of speculation is known as currency speculation.

Without the prospect of huge gains, there would be next to no motivation to be a part of speculation trading. There’s a thin line that separates speculation and simple investment which makes it pretty difficult for the market players to differentiate between them. Real estate is the perfect example of this. Buying real estate for the purpose of renting it out is considered investing but buying several apartments with the intention of earning a quick profit by reselling them after a short duration. Speculation traders provide market liquidity and can narrow the difference between the bid price and the asking price for an asset in the market. Speculative trading not only keeps the rampant bullishness in check but also prevents the risk of the formation of asset price bubbles through betting on successful outcomes.

Q.) Define Investment? Also give objectives of Investment?

Ans.) An investment is essentially an asset that is created with the intention of allowing money to grow. The wealth created can be used for a variety of objectives such as meeting shortages in income, saving up for retirement, or fulfilling certain specific obligations such as repayment of loans, payment of tuition fees, or purchase of other assets.

Understanding the investment definition is crucial as sometimes, it can be difficult to choose the right instruments to fulfill your financial goals. Knowing the investment meaning in your particular financial situation will allow you to make the right choices.

Investment may generate income for you in two ways. One, if you invest in a saleable asset, you may earn income by way of profit. Second, if Investment is made in a return generating plan, then you will earn an income via accumulation of gains. In this sense, ‘what is investment’ can be understood by saying that investments are all about putting your savings into assets or objects that become worth more than their initial worth or those that will help produce an income with time.

Financially speaking, an investment definition is an asset that is obtained with the intention of allowing it to appreciate in value over time. Generally, investments fall in any one of three basic categories, as explained below.

Objectives Of Investment

1. To Keep Money Safe

Capital preservation is one of the primary objectives of investment for people. Some investments help keep hard-earned money safe from being eroded with time. By parking your funds in these instruments or schemes, you can ensure that you do not outlive your savings. Fixed deposits, government bonds, and even an ordinary savings account can help keep your money safe. Although the return on investment may be lower here, the objective of capital preservation is easily met.

2. To Help Money Grow

Another one of the common objectives of investing money is to ensure that it grows into a sizable corpus over time. Capital appreciation is generally a long-term goal that helps people secure their financial future. To make the money you earn grow into wealth, you need to consider investment objectives and options that offer a significant return on the initial amount invested. Some of the best investments to achieve growth include real estate, mutual funds, commodities, and equity. The risk associated with these options may be high, but the return is also generally significant.

3. To Earn a Steady Stream of Income

Investments can also help you earn a steady source of secondary (or primary) income. Examples of such investments include fixed deposits that pay out regular interest or stocks of companies that pay investors dividends consistently. Income-generating investments can help you pay for your everyday expenses after you have retired. Alternatively, they can also act as excellent sources of supplementary income during your working years by providing you with additional money to meet outlays like college expenses or EMIs.

4. To Minimize the Burden of Tax

Aside from capital growth or preservation, investors also have other compelling objectives for investment. This motivation comes in the form of tax benefits offered by the Income Tax Act, 1961. Investing in options such as Unit Linked Insurance Plans (ULIPs), Public Provident Fund (PPF), and Equity Linked Savings Schemes (ELSS) can be deducted from your total income. This has the effect of reducing your taxable income, thereby bringing down your tax liability.

5. To Save up for Retirement

Saving up for retirement is a necessity. It is essential to have a retirement fund you can fall back on in your golden years, because you may not be able to continue working forever. By investing the money you earn during your working years in the right investment options, you can allow your funds to grow enough to sustain you after you’ve retired.

6. To Meet your Financial Goals

Investing can also help you achieve your short-term and long-term financial goals without too much stress or trouble. Some investment options, for instance, come with short lock-in periods and high liquidity. These investments are ideal instruments to park your funds in if you wish to save up for short-term targets like funding home improvements or creating an emergency fund. Other investment options that come with a longer lock-in period are perfect for saving up for long-term goals.

Q.) What are the factors to be considered for Economic Analysis?

Ans.) Economic factors affect the economy, including interest rates, tax rates, laws, policies, wages, and governmental activities. These factors are not directly related to the business but influence the investment value in the future.

The following are the top 10 economic factors that affect the business:

#1- Interest Rate

Interest rate is a major factor that affects the liquidity of cash in the economy. With an increase in investment, cash flow in the country decreases and results in a reduction in the country’s liquidity. Conversely, a decrease in investment cash flow in the country increases and increases the country’s liquidity.

A higher return on investment will attract investors. But, if the interest rate on loans increases, cash flow in the country decreases, resulting in a decrease in the nation’s liquidity. In contrast, with the decline in interest rate over a loan, cash flow in the country increases and increases the country’s liquidity. So, the interest rate affects the economy.

#2 – Exchange Rate

The exchange rate comes into the picture in the case of export and import. Due to this, it affects international payment and the price of goods, affecting the economy.

#3 -Tax Rate

The tax rate is a crucial part of the economy. The tax rate affects the price of goods and their sales, affecting the economy.

#4 – Inflation

The increase in the demand price of goods or services increases inflation and money supply.

#5 – Labor

Labour and cost or wage are always the important economic factors affecting the economy. As a result, many countries have started outsourcing labor from other countries. The company begins its plant or production where labor is cheap.

#6 – Demand / Supply

Demand or supply of goods or services affects the economy as with the increase in demand price of goods or service increase, which results in inflation. With inflation, the money reserve in the economy increases with the rise in the supply of goods or services. The price of the same decreases. Demand and supply depend on each other.

#7 – Wages

Wages paid to labor or employee are a direct cost to the company

added to the cost of goods or services through which it affects the economy. Another way wages affect the economy is by increasing wages, consuming power, and improving consumer spending.

#8 – Law and Policies

With change or modification in the law, the economy of the country changes. For example, if the government makes a law that should ban liquor in the country, it will affect companies dealing with it, their employees, and shopkeepers, which affects the economy at a broad level. Similarly, any policy made by the government will affect the economy.

#9 – Government Activity

Government activity also affects the economy. So, for example, if the government promotes any industry like insurance or medical or technology, it will encourage that sector that boosts its economy, overall supporting it.

#10 – Recession

A recession affects consumers’ purchasing power, forcing companies to drop their goods or services.

Q.) Difference between Forward Contracts and Future Contracts?

Ans.) Forward Contracts - The forward contract is a privately-negotiated agreement between a buyer and seller to trade an asset at a future date at a specified price. As such, they don't trade on an exchange. Because of the nature of the contract, forward contracts have more flexible terms and conditions, including the number of units of the underlying asset and what exactly will be delivered, among other factors. Forwards have one settlement date: the end of the contract.

Many hedgers use forward contracts to cut down on the volatility of an asset's price. Since the terms are set when it is executed, a forward contract is not subject to price fluctuations. That means if two parties agree to the sale of 1,000 ears of corn at $1 each (for a total of $1,000), the terms cannot change even if the price of corn goes down to 50 cents per ear. It also ensures that delivery of the asset or cash settlement (if specified) will take place.

Because of the nature of these contracts, forwards are not readily available to retail investors. The market for them is often hard to predict. That's because the agreements and their details are generally kept between the buyer and seller, and are not made public. Since they are private agreements, there is a high degree of counterparty risk, which means there may be a chance that one party will default.

Futures Contracts- Like forwards, futures contracts involve the agreement to buy and sell an asset at a specific price at a future date. The futures contract, however, has some differences from the forward contract. These contracts are marked-to-market (MTM) daily, which means that daily changes are settled day by day until the end of the contract. The futures market is highly liquid, giving investors the ability to enter and exit whenever they choose to do so.

These contracts are frequently used by speculators, who bet on the direction in which an asset's price will move, they are usually closed out prior to maturity and delivery usually never happens. In this case, a cash settlement usually takes place.

Because they are traded on an exchange, they have clearing houses that guarantee the transactions. This drastically lowers the probability of default to almost never. Contracts are available on stock exchange indexes, commodities, and currencies. The most popular assets for futures contracts include crops like wheat and corn, and oil and gas.

Q.) Explain the types of Bonds?

Ans.) Bonds are issued by organizations generally for a period of more than one year to raise money by borrowing.

Organizations in order to raise capital issue bond to investors which is nothing but a financial contract, where the organization promises to pay the principal amount and interest (in the form of coupons) to the holder of the bond after a certain date. (Also called maturity date).Some Bonds do not pay interest to the investors, however it is mandatory for the issuers to pay the principal amount to the investors.

Following are the types of bonds:

Fixed Rate Bonds

In Fixed Rate Bonds, the interest remains fixed through out the tenure of the bond. Owing to a constant interest rate, fixed rate bonds are resistant to changes and fluctuations in the market.

Floating Rate Bonds

Floating rate bonds have a fluctuating interest rate (coupons) as per the current market reference rate.

Zero Interest Rate Bonds

Zero Interest Rate Bonds do not pay any regular interest to the investors. In such types of bonds, issuers only pay the principal amount to the bond holders.

Inflation Linked Bonds

Bonds linked to inflation are called inflation linked bonds. The interest rate of Inflation linked bonds is generally lower than fixed rate bonds.

Perpetual Bonds

Bonds with no maturity dates are called perpetual bonds. Holders of perpetual bonds enjoy interest throughout.

Subordinated Bonds

Bonds which are given less priority as compared to other bonds of the company in cases of a close down are called subordinated bonds. In cases of liquidation, subordinated bonds are given less importance as compared to senior bonds which are paid first.

Bearer Bonds

Bearer Bonds do not carry the name of the bond holder and anyone who possesses the bond certificate can claim the amount. If the bond certificate gets stolen or misplaced by the bond holder, anyone else with the paper can claim the bond amount.

War Bonds

War Bonds are issued by any government to raise funds in cases of war.

Serial Bonds

Bonds maturing over a period of time in installments are called serial bonds.

Climate Bonds

Climate Bonds are issued by any government to raise funds when the country concerned faces any adverse changes in climatic conditions.

Q.) What is the Random Walk Theory?

Ans.) The theory of random walks implies that stock price shifts have the same distribution and are distinct from each other. It is believed that the past change or pattern of a stock price or economy cannot be used to forecast the future movement.

In other words, random walk theory states that stocks are taking a random and unpredictable path, which, in the long run, makes all methods of predicting stock prices futile.