Investment Process Quiz

Process of Building Investment

• Investment decisions involve two key steps: asset allocation and security selection.
• Asset allocation determines the proportion of funds to be invested in different asset classes (e.g., bank accounts, financial markets, real estate).
• Security selection involves choosing specific assets within each asset class.

Financial Markets

• Financial markets are categorized into money markets and capital markets.

Money Market

• The money market is a subsector of the fixed-income market dealing with short-term debt instruments.
• Money market instruments are characterized by high liquidity, low risk, and often have large denominations.
• Examples of money market instruments include Treasury bills, certificates of deposit, and commercial paper.

Treasury Bills

• The government issues Treasury bills to raise funds.
• Treasury bills are short-term government securities sold at a discount from their face value.
• They mature within 52 weeks.
• Treasury bills are known for their high liquidity, low transaction costs, and low risk.

Certificates of Deposit (CDs)

• CDs are time deposits offered by banks with a fixed maturity date.
• Funds deposited in CDs cannot be withdrawn on demand.
• The bank pays the depositor the principal amount plus interest only at the end of the maturity term.

Commercial Paper

• Large firms issue short-term debt directly to the public in the form of commercial paper, rather than borrowing from banks.

Money Market: Interbank Rates

• The Fed funds rate is the interest rate on short-term loans between financial institutions in the United States.
• The London Interbank Offered Rate (LIBOR) is the benchmark interest rate at which banks in London lend to each other.
• LIBOR rates are widely used for transactions involving several currencies, including GBP, yen, and euros.
• EURIBOR, EONIA, and ESTER are key interest rates for banks in the Eurozone.
• The Saudi Arabian Interbank Offered Rate (SAIBOR) is the benchmark rate for interbank lending in Saudi Arabia.

Capital Markets

• The capital market consists of bond/sukuk markets, equity markets, and derivative markets.

Bond/Sukuk Market

• The bond market deals with longer-term debt instruments compared to those traded in the money market.
• Bonds can be issued by corporations (corporate bonds) or governments (treasury bonds).
• Bonds offer fixed-income payments, known as coupon payments.
• Sukuk are Sharia-compliant financial instruments that provide fixed returns and priority of repayment in case of bankruptcy.

Stocks (Equities)

• Stocks represent ownership shares in a firm.
• Shareholders have voting rights and receive dividends (common stocks vs. preferred stocks).
• Shareholders have a residual claim on the firm's assets in case of bankruptcy, receiving any remaining value after other creditors are paid.
• Shareholders benefit from limited liability; they are only responsible for the amount invested and are not personally liable for the firm's obligations.

Derivative Markets

• Derivatives are financial instruments whose value is derived from the value of other underlying assets (e.g., stocks, bonds, exchange rates, commodities).
• Key types of derivatives include options, futures, and swaps.

Call Option

• A call option grants the buyer the right to purchase an asset for a specified price (exercise or strike price) on or before a certain expiration date.

Put Option

• A put option grants the buyer the right to sell an asset for a specified price (exercise price) on or before a certain expiration date.

Profits and Losses: Buyer Call Option

• A trader who wants to hedge against rising prices buys call options.
• Example: The spot price of an asset is 150 SAR, the strike price is 160 SAR, and the premium is 5 SAR.
• The buyer profits if the spot price exceeds the strike price at maturity. The profit is calculated as: (Spot price - Strike price - Premium) X The Number of Units.
• The buyer incurs a loss if the spot price is below the strike price at maturity. The loss is capped at the premium.

Profits and Losses: Seller Call Option

• A seller of a call option expects the price of the underlying asset to decline.
• The seller receives the premium.
• The seller incurs a loss if the spot price exceeds the strike price at maturity. The loss is potentially unlimited as the spot price can rise infinitely.
• The seller makes a profit if the spot price is below the strike price at maturity. The profit is capped at the premium.

Profits and Losses: Buyer Put Option

• A trader who wants to hedge against falling prices buys put options.
• Example: The spot price of an asset is 170 SAR, the strike price is 160 SAR, and the premium is 5 SAR.
• The buyer profits if the spot price falls below the strike price at maturity. The profit is calculated as: (Strike price - Spot price - Premium) X The Number of Units.
• The buyer incurs a loss if the spot price is above the strike price at maturity. The loss is capped at the premium.

Profits and Losses: Seller Put Option

• A seller of a put option expects the price of the underlying asset to rise.
• The seller receives the premium.
• The seller incurs a loss if the spot price falls below the strike price at maturity. The loss is potentially unlimited as the spot price can fall infinitely.
• The seller makes a profit if the spot price is above the strike price at maturity. The profit is capped at the premium.

Futures Contracts

• Futures contracts obligate traders to buy or sell an asset at an agreed-upon price on a specified date.
• Unlike options, futures contracts require a mandatory purchase or sale of the asset, not just the right to do so.
• Futures contracts have no premium; instead, a margin account is used to cover potential losses.
• Profits and Losses in Futures are calculated as (Closing Price - Initial Price) X The Number of Units.

Swaps

• Swaps are contracts where two parties exchange the cash flows or values of different assets.
• Examples include fixed-for-variable rate swaps, where one party pays a fixed interest rate and receives a variable rate, and vice versa.