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BFN203-Basic Financial Literacy

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Course Code & Title: BFN203-Basic Financial Literacy

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COURSE

GUIDE

ENT 207
BASIC FIANACIAL LITERACY

Course Team Dr. Sheu Abdullahi Araga (Course Writer) Department of Financial Studies Faculty of Management Sciences National Open University of Nigeria

Prof. Olowe Rufus Ayodeji (Course Editor)

Department of Finance,
University of Lagos

Dr. Lawal Kamaldeen A. A (H.O.D)
Department of Entrepreneurial Studies

Faculty of Management Sciences
National Open University of Nigeria

Dr. Timothy Ishola (Dean)

Faculty of Management Sciences

National Open University of Nigeria

NATIONAL OPEN UNIVERSITY OF NIGERIA

National Open University of Nigeria

Headquarters
University Village

Plot 91 Cadastral Zone

Nnamdi Azikiwe Expressway
Jabi, Abuja.

Lagos Office

14/16 Ahmadu Bello Way

Victoria Island, Lagos

e-mail: centralinfo@noun.edu.ng
URL: www.noun.edu.ng

Published by:

National Open University of Nigeria

ISBN:

Printed: 2017

CONTENTS

Introduction

Course Contents

Course Aims

Course Objectives

Working through This Course

Course Materials

Study Units

Textbooks and References

Assignment File

Assessment

Tutor-Marked Assignment

Final Examination and Grading

How to get the Best out of this Course

Facilitators/Tutors and Tutorials

Useful Advice

Summary

INTRODUCTION

ENT 207: Basic Financial Literacy is a semester course work of two credit units. It will be available to all students in the Department of Entrepreneurial Studies, Faculty of Management. The course consists of 4 modules involving the subject area of Basic Financial Literacy.

The course guide tells you what the course is all about and the relevant materials that you require to make your study very successful. Other vital information contained in this course guide deals with Assessment which consists of the Tutor- Market Assignments, and written examination.

The Course Contents

The course contents consist of basic financial literacy encompassing various areas that are very pertinent to the understanding of finance.

Course Aims

The aims of this course are to expose you to the knowledge of how to evaluate projects either as a project initiator or an evaluator. It aims to sharpen your skills in the evaluation of either new projects or existing projects with a view to deciding whether they meet certain predetermined investment criteria.

Course Objectives

At the end of this course you should be able to:

• discuss the intricacies of basic finance

• explain the basic elements of finance

• make use of knowledge of basic elements of finance.

• discuss the usefulness of basic financial literacy

The Course Materials

The main components of the course are:

1. The Course Guide

2. Study Units

3. References/Further Readings

4. Assignments

Study Units

There are 18 units in this course and they should be studied carefully

Module 1

Unit 1: Meaning, Nature And Types Of Investment

Unit 2: Venture Creation

Unit 3: Diversification As A Basis Of Investment Portfolio
Unit 4: Investing Wisely In Capital Market Using Hedging

Module 2

Unit 5: Investing Wisely In Capital Market Using Arbitrage
Unit 6: Investing Wisely In Capital Market Using Speculation
Unit 7: Investment In Derivatives
Unit 8: Investment Portfolio In Properties And Commodities

Module 3

Unit 9: Leveraging On Debts & Venture Capital In Creating Wealth
Unit 10: Intellectual Property And Royalties
Unit 11: Financial Market Instruments
Unit 12: Capital Gains And Continuous Cash Flows

Unit 13: Building Personal Cash Flows (Savings)

Module 4

Unit 14: Personal Financial Planning
Unit 15: Maintaining Savings Account For Cash Reserves
Unit 16: Planning For Contingency Fund
Unit 17: Insurance And Risk Hedging
Unit 18: Understanding Tax Issues

Module 1 provides you with the necessary background knowledge on investment. The remaining module 2 to 4 focus attention on the subject matter of basic elements of finance Each study unit will take at least two hours and it includes: introduction, objectives, main content, exercise, conclusion, summary, references and the Tutor-Marked Assignments (TMAs).

You are required to study the materials, reflect on them and do the exercises. You should also read the textbooks and other recommended materials in each study unit.

Assignments

In each unit, you will find some self assessment exercises which you are required to do. The self assessment exercises will enable you to have a better understanding of what you have studied.

Assessment:

As a student of the Open and Distance Learning (ODL) system, you are expected to access your learning ability by the extent of your understanding of the units and the entire course. This assessment prepares you for the final examination. The final examinations will come at the end of the course. You are expected to write this examination whose score together with what you made in the TMAs will form the course grade.

Tutor-Marked Assignment

In doing the Tutor-Marked Assignments, you are expected to apply what you have learnt in the contents of the study unit. The TMAs are expected to be computer base for grading. They constitute 30% of the total score.

Final Examination and Grading

At the end of the course, you will write the final examination. It will attract the remaining 70%.

This makes the final score to be 100%.

Summary

The course ENT 207 – Basic Financial Literacy will expose you to the knowledge and understanding of how to evaluate projects. When you complete the course, you would have been armed with the necessary knowledge required to evaluate investment opportunities.

MAIN

CONTENT

Module 1

Unit 1: Meaning, Nature And Types Of Investment

Unit 2: Venture Creation

Unit 3: Diversification As A Basis Of Investment Portfolio
Unit 4: Investing Wisely In Capital Market Using Hedging
Unit 5: Investing Wisely In Capital Market Using Arbitrage

Module 2
Unit 6: Investing Wisely In Capital Market Using Speculation

Unit 7: Investment In Derivatives
Unit 8: Investment Portfolio In Properties And Commodities

Unit 9: Leveraging On Debts & Venture Capital In Creating Wealth
Unit 10: Intellectual Property And Royalties

Module 3
Unit 11: Financial Market Instruments

Unit 12: Capital Gains And Continuous Cash Flows
Unit 13: Building Personal Cash Flows (Savings)
Unit 14: Personal Financial Planning
Unit 15: Maintaining Savings Account For Cash Reserves

Module 4
Unit 16: Planning For Contingency Fund
Unit 17: Insurance And Risk Hedging
Unit 18: Understanding Tax Issues

UNIT 1: MEANING, NATURE AND TYPES OF INVESTMENT

CONTENTS

1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Meaning and Nature of Investment
3.2 Characteristics of Investment
3.3 Types of Investment
3.3.1 Ownership Investment
3.3.2 Lending Investment
3.3.3 Marketable Security Investment
4.0 Conclusion
5.0 Summary
6.0 Tutor Marked Assignment
7.0 References/Further Readings

1.0 INTRODUCTION

This initial study unit of the course material is used to discuss the nature and type of investment. Investment is very important for the fact that it can be used to generate additional income. However, some elements of risk are inherent in any form of investment but risks vary from one investment to another. Therefore, the choice of investment is informed by the degree of risk involved but this can be ameliorated with a combination of investments. In this unit, discussion is on the meaning and nature of investment and the characteristics of investment. In addition, the various types of investment are also discussed.

2.0 OBJECTIVES

After studying this unit, you should be able to:

• Explain the term investment

• Identify and discuss the characteristics of investment
• Mention and explain types of investment

3.0 MAIN CONTENT

3.1 MEANING AND NATURE OF INVESTMENT

The term investment is fraught with many definitions but such expositions recognize the fact that investment requirements financial commitments, which implies that funds will have to be expended by the person who is investing. In general terms, therefore, investment involves spending of money with the hope of reaping some financial benefits. According to economists, investment is regarded as savings embarked upon as a result of “delayed consumption.”

Furthermore, investment is also recognized as the deployment of financial resources towards enhancing a person?s income or increasing the level of earnings from investible products in the future. For instance, investment takes place when certain amount of money is deposited in an account in the bank. According to economists, equipment acquired by a firm for production with which to earn income from its operations in the long run is an investment.

In finance, an investment involves utilization of funds in acquisition of financial assets such as stocks, bonds, bullion, real properties, and precious items. This holds that “practice of investment” implies acquisition of a product of financial value with expectation of generating desired returns in the future. An investment in good financial investment is fraught with reasonable level of market liquidity. In order to assess the value of a financial investment, a mechanism known as valuation becomes relevant.

Beattie (2017) posits that the term investment refers to something that is acquired with money with the expectation to generate income or profit from it. The author identifies three basic groups of investments such as ownership investment, lending investment, and cash investment.

SELF ASSESSMENT EXERCISE 1
Explain the term Investment.

3.2 CHARACTERISTICS OF INVESTMENT

The nature of financial many investments can exhibit the following characteristics or features.

1. Earnings

The fundamental purpose of investment is to generate earnings. In other words, any form of investment is undertaken with the anticipation of making returns, which is the essence of any action in acquiring any financial product or sinking funds in investible commitment. In respect of financial products, the earnings can come in terms of some interest, capital gain over and above the principal amount invested and dividend from stock. The earning from investment can be expressed as follows:

Earnings = Prevailing Price of Stock less Original price

The capital gain as an instance of earnings is measured by the disparity between original price of the investible product and current market of the product. Basically, the earnings from financial products in investment is a function of many factors such as nature of the financial product, type

of stock, the firm?s line of business (petroleum, manufacturing or banking, etc.), state of the economy, and prevailing government policy, among others.

Hence, the essence of investment hinges on expected returns, which may be in form of capital gain or investment income that include dividends, interest, and rental income, among others.

Investors normally desire higher level of returns but such returns are associated with riskier investments.

2. Risk of Loss

In most cases, safety of investment can only be guaranteed if is done in financial products such as government security and firms with high networth. Financial products like government loan stock, bonds, treasury bills and treasury certificates, which are normally floated by government are known as gilt-edge securities because of their safety. Financial products of high networth companies are regarded as blue chip securities of their yields and high likelihood of safety.

The stocks of banks are generally fraught with some risk of loss of the volatile nature of their operations. Therefore, such stocks command affordable prices. In comparison, the stocks of oil companies are of less risk of loss because of their stable nature of operations. However, such stocks particularly of oil majors command higher prices and higher yields or earnings.

When investing in debt instruments (such as debenture, bond, etc.) of a company in blue chip companies or government authority, the risk of loss of the investment is less as a result of their secured operations, besides the inherent fixed interest payable on them. However, investment in ownership stocks (as financial products) such as equity or preference shares, the risk inherent in them is more. This is as a result of their unsecured nature and variability of their return and agency problem inherent in the companies. Factors such interest rate, tax on capital gains and dividends, inflation also affect returns from such investment.

3. Safety of Investment

Security of investment is very important. Security of investment herein refers to the protection or safety of the amount invested and the expected earnings. Security issue is very germane to choice of investment. While investing, you have to consider the safety of your funds and the probability that the expected gains will be earned invariably. Capital gains, for instance, cannot materialize if the capital itself is lost due to mismanagement of the firm?s affairs by the managers, fraud and fraudulent practices by staff, bad corporate governance, labour unrest, and pilferage of firm?s assets, etc. External factors such as economic downturn, volatile exchange rate, inflationary pressure, high interest rate, and unstable economic policies by the government, among others, can also affect realization of funds or capital invested.

4. Liquidity of Investment

Liquidity means the ease with which an investment can be converted into cash. The level of liquidity of an investment depends on many factors. The investor can always desire to convert the investment into physical cash in meeting urgent commitments. The ability of the investor to do so depends on the level of liquidity of the financial asset being held. The financial assets that are very liquid are the marketable securities such as treasury bills and treasury certificates as well as other government securities and to some extent, the stocks and debentures of blue chip companies.

SELF ASSESSMENT EXERCISE 2
Mention and explain the characteristics of Investment.

3.3 TYPES OF INVESTMENT

Beattie (2017) identifies some forms of investment which include ownership investment, lending investment,

3.3.1 Ownership Investment

This type of investment revolves around committing your funds in: capital market securities such as stocks (buying shares in companies through initial public offer (IPO) or stock brokers as dealers in stock exchange, subscribing to loan stocks of government and corporate bodies; establishing your own business entity or going into partnership with others to form business entity; committing your funds in acquisition of landed property (ownership of a real estate); and precious metals and objects.

i) Stocks

These are shares purchased as part ownership in companies. Certificates are normally issued as proof of ownership of such capital market securities. These shares can be equity stocks for ordinary shareholders or preference shares for preferred treatment for dividends and claims from the business.

ii) Derivatives

A derivative refers to a financial product which has its value dependent on the outcome of the original financial product as investment by the managers of the funds. Derivative products can be used for: insuring against price movements such as in the case of hedging; guiding against exposure to price movements for speculation; and as a means of having leeway to some other hybrid assets or markets (Crawford, and Sen, 1996; Koehler, 2005).

These investible instruments which you can commit your funds into include: common derivatives such as options, swaps, futures, and forwards; and collateralized debt obligations; credit default swaps. All these derivatives are normally traded on a stock exchange or over the counter (Koehler, 2005).

iv) Business Ventures

The money that is used in starting and running a business is an investment. Entrepreneurship is one of the hardest investments to make because it requires more than just money. Consequently, it is also an ownership investment with extremely large potential returns. By creating a product or service and selling it to people who want it, entrepreneurs can make huge personal fortunes. Bill Gates, founder of Microsoft and one of the world's richest men, is a prime example.

v) Real Estate

This involves investment in buying or building houses, apartments and other landed property with the purpose of leasing them out. Such items of investment can be acquired, restructured and then resell them. The house that you own and make use of as your residence does not qualify as an investment because it is not built or purchased for business purpose; not for generating revenue and profit. However, they are susceptible to some elements of risk such as damage and destruction arising from natural disasters.

vi) Precious Metals and Objects

Some people cultivate the habit of engaging in collection and preserving precious metals (gold, diamond, etc) and objects (such as paintings by renown painters) with the intention of reselling them in the future. The intention is to earn profits from them as their value appreciates. Precious metals and collectibles are not necessarily a good investment for a number of reasons, but they can be classified as an investment nonetheless. However, these objects are also susceptible to some elements of risk such as damage and destruction arising from natural disasters. They is also risk of physical depreciation that requires restoration before their sale invariably. These risks affect their values, and therefore can affect their eventual profits intended in the investment.

3.3.2 Lending Investments

This involves subscribing and investing in debt instruments of corporate entities such as bonds and debentures. These debt investments attract periodic earnings from interest payment by the companies using the funds to run their operations. The principal amount invested in them is paid back to you after their maturity date. Investment in debt instruments (bonds and debentures) is known for relatively lower risk when compared to ownership investments stocks and their returns (interests) are fixed. Stockholders can incur loss by not getting their money back in the event of the firm being declared bankrupt. Nevertheless, bond and debenture holders usually get their invested money back in case of insolvency.

3.3.3 Marketable Security Investment

Marketable securities refer to money market financial instruments that are easily convertible to physical cash. There are varieties of these financial instruments in which you can subscribe or invest. Some are called funds being handled by investment companies while others are usually floated by the apex bank (central bank) on behalf of the government. The ones being floated by the apex bank include Treasury bills and Treasury certificates.

i) Treasury bill

According to Investopedia (2012), a Treasury bill (T-bill) refers to short term debt obligation that is taken by the government through the apex bank. T-bill normally has a maturity date of some months but less than one year. It is normally issued by the apex bank on behalf of the government to raise funds for meeting shortfalls in revenue with which to finance recurrent government expenditure. The T-bill is a money market financial instrument that is usually

denominated in thousands of the country?s currency meant to be purchased in multiples of such denomination. An example can be a denomination of N1,000 in Nigerian currency if issued by the Central Bank of Nigeria for the Nigerian government. Interest is paid on regular basis till the maturity date when the principal amount invested on it by the investors is repaid.

You can purchase new T-bills at auctions as conducted by the apex bank for the government or old ones previously issued and held by investors through the secondary market. The T-bills that are purchased at auctions are normally priced through a competitive bidding process, at a discount from the par value. When you redeem your own T-bills at maturity date, you will be paid the par value or face value; resulting in a difference between the purchase price and the par value, which is the gain.

ii) Treasury Securities

Treasury securities are obligations of the government. They are issued to cover government budget deficits (excess of expenditures over revenues) and to refinance maturing government debt. The most common are bills, notes, and bonds. Treasury bills have original maturities of I year or less, while notes are for 1 to 10 years, and bonds have maturities greater than 10 years.

iii) Government agency securities:

Securities issued by an agency of the federal government particularly in the U.S. with implicit backing of the federal government. Repurchase agreements are essentially collateralized loans. A financial institution with large holdings of Treasury securities sells some portion of them for a predetermined period of time to obtain liquidity and promises to repurchase the securities at the end of that period. On the other side of the transaction is an institution with excess liquidity. The amount of the transaction is relatively large, and the interest rate is below the federal funds rate. The lower rate is justified, because the transaction is collateralized by government securities.

SELF ASSESSMENT EXERCISE 3
Differentiate between ownership investment and lending investment.

4.0 CONCLUSION

This unit of the course material has provided you with the basic knowledge about investment. Investment essentially involves deployment of financial resources towards enhancing a person?s income or increasing the level of earnings from investible products in the future. It also connotes acquiring asset(s) with money in the expectation of generating income or profit from them. Inherent in investment are the elements of risk. Therefore, when investing, you have to assess the risk involved in a financial instrument compared to the expected returns before committing your funds. Generally, therefore, considerations in investment include: risk of loss of investment; expected earnings or return from investment; safety of the funds invested; and liquidity in terms of degree of availability of the funds whenever you need the money.

5.0 SUMMARY

In this initial study unit of the course material, you have been taught the following topics:

• Meaning and Nature of Investment
• Characteristics of Investment
• Ownership Investment
• Lending Investment

• Marketable Security Investment

In the next study unit, you will be taken through venture creation.

6.0 TUTOR MARKED ASSIGNMENT
1. What is investment?
2. List and explain the characteristics of investment.
3. Compare and contrast ownership investment and lending investment

Answers to Self –Assessment Exercises

1. Explain the term Investment

Investment refers to the deployment of financial resources towards enhancing a person?s income or increasing the level of earnings from investible products in the future. In other words, investment refers to something that is acquired with money with the expectation to generate income or profit from it.

2. Mention and explain the characteristics of Investment

1. Earnings

The fundamental purpose of investment is to generate earnings or any form of investment is normally undertaken with the anticipation of making returns. This return is the essence of any action in acquiring any financial product or sinking funds in investible commitment. The earning from investment can be expressed as follow:

Earnings = Prevailing Price of Stock less Original price

2. Risk of Loss

When investing in debt instruments (such as debenture, bond, etc) of a company in blue chip companies or government authority, the risk of loss of the investment is less as a result of their secured operations, besides the inherent fixed interest payable on them. However, investment in ownership stocks (as financial products) such as equity or preference shares, the risk inherent in them is more.

3. Safety of Investment

Security of investment herein refers to the protection or safety of the amount of investment and the expected earnings. Security issue is very germane to choice of investment. While investing, you have to consider the safety of your funds and the probability that the expected gains will be earned invariably.

4. Liquidity of Investment

3. Differentiate between ownership investment and lending investment.

Ownership investment involves around committing your funds in: capital market securities such as stocks (buying shares in companies through initial public offer (IPO) or stock brokers as dealers in stock exchange, subscribing to loan stocks of government and corporate bodies; establishing your own business entity or going into partnership with others to form business entity; committing your funds in acquisition of landed property (ownership of a real estate); and precious metals and objects.

On the other hand, lending investment involves subscribing and investing in debt instruments of corporate entities such as bonds and debentures. These debt investments attract periodic earnings from interest payment by the companies using the funds to run their operations. The principal amount invested in them is paid back to you after their maturity date. These investment instruments are known for relatively lower risk when compared to ownership investments stocks and their returns (interests) are fixed. Stockholders can incur loss by not getting their money back in the event of the firm being declared bankrupt. Nevertheless, bond and debenture holders usually get their invested money back in case of insolvency.

7.0 REFERENCES AND FURTHER READINGS

Crawford, G. and Sen, B. (1996). Derivatives for Decision Makers: Strategic Management
Issues, New Jersey: John Wiley & Sons

Investopedia (2012). What is a 'Treasury Bill? Accessed on 10 January, 2017 from http://www.investopedia.com/terms/t/treasurybill.asp#ixzz4dCGLXsAV

Koehler, C. (2005). The Relationship between the Complexity of Financial Derivatives and Systemic Risk, Working Paper: 10–11.

UNIT 2: VENTURE CREATION

CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Meaning of venture creation
3.2 Process of Venture Creation
3.3 Role of Entrepreneur in Venture Creation
4.0 Conclusion

5.0 Summary
6.0 Tutor Marked Assignment

7.0 References/Further Readings

1.0 INTRODUCTION

The existence of almost all business entities is often as a result of the strategic role of the entrepreneurs. Therefore, the creation of such business undertakings owes it to the actions of the entrepreneurs. Hence entrepreneurs initiate required actions to create business ventures from their uncanny foresights in recognizing the potential requirement or desire for specific products (goods or services) in certain underserved markets. Venture creations result in the subsistence of almost all business entities, emerging from the uncommon attitudes towards assuming risks by some industrialists in every economy around the world. In this study unit of the course material, you are being taken through the discussion on creation of ventures in particular and the strategic role of entrepreneurs in such task generally.

2.0 OBJECTIVES

After studying this unit, you should be able to:

• Explain and explain the term venture creation
• Identify and discuss the stages involved in process of venture creation

• List and explain responsibilities of entrepreneurs in venture creation

3.0 MAIN CONTENT

3.1 MEANING OF VENTURE CREATION

The connotation of venture creation, as provided by the Cambridge Dictionary (2017), refers to the process of converting a new idea or technology into a business undertaking which can succeed and is invariably capable of attracting investors. This implies that potential entrepreneurs that are interested in identifying possible business ideas normally pay attention to everything in various media (print and electronic) which can be exploited to create business ventures.

Swier (2007) posits that venture creation refers to an action initiated for starting business venture

with the intent of filling the gap between an initiative and a “capitalized business. Relatedly,

most venture capitalists will only be interested in investing in a venture that portrays great fundamentals such as: competent management, profitable market, novel product, and reasonable quantum of sales revenue or turnover. To lay credence to this view, Gordon (2012) posits that venture creation process is an outcome of two interrelated stages of “discovery and exploitation.”

Furthermore, Swier (2007) observes that venture creation involves a process just like a manufacturing process because venture creation process ideas coupled with necessary productive inputs such as human efforts and technology into desired products for the consumers. Such venture becomes fundable venture once it can meet the current desires, needs, wants and aspirations of the target and potential markets.

Basically, as espoused by Swier (2007), the worth of a venture creation does not just involve creating ventures. More significantly, the establishing ventures should go through a process which decides whether or not the venture possesses a feasible and marketable product in available or emerging market. In addition, the venture should have a plan that is practically attainable based on available resources including the critical one, the capital.

The fundamental approach to venture creation (Bhave, 1994) involves generating business ideas through some stages which include: internally and externally stimulated opportunity recognition; commitment to physical creation; set-up of production technology; organization creation; product creation; connecting with potential markets, and generating customer feedback.

SELF ASSESSMENT EXERCISE 1
Explain the term venture creation.

3.2 Process of Venture Creation

There are various versions of the process of venture creation as formulated by many writers.
Some of these versions are identified and discussed below.

3.2.1 Deakins Model of Venture Creation Process

The steps involved in venture creation based on the classification by Deakins and Freel (2009), the updated version of Deakins in 1999.

i) Idea Formulation

This involves developing business ideas which can be influenced by family and friends. This calls for creativity in terms of the entrepreneur?s ability to link ideas to business that were not discovered previously (Deakins & Freel, 2009). Formulating business idea is very time-consuming which goes through refinement. The entrepreneur can find it necessary to discuss his

business ideas with people like family, friends and experts. It is also necessary to research on them before arriving on a selected one.

ii) Opportunity Recognition

This is regarded as the key stage in the new venture process. It involves stumbling on business opportunity and capitalizing on it to form business entity. Opportunity recognition is influenced by factors such as role models, cultural attitudes to risk and failure, changing socio-economic and technical environments. For instance, a business opportunity can be discovered form a change in the environment like a political decision by the government. It is argued that the cultural environment of the entrepreneur should be appropriate towards encouraging him/her to take risks that are associated with new venture. In essence, such an environment is supposed to be facilitative to encourage entrepreneurship. Based on the evaluation of a business opportunity, the entrepreneur takes a decision on whether or not to go ahead in establishing the venture.

iii) Pre-start Planning and Development

This stage involves embarking on market research, scouting for finance, finding partners and social capital for the new venture. The market research and information gathering become critical for establishing the new venture. The other preparatory procedures include raising funds, dealing with legal matters, exploring for a management team, linking skills to responsibilities, planning the entry strategy, and detailing out the business plan.

iv) Establishment and Launch

This stage is embedded in “intellectual property rights process, timing and role of serendipity.” The choice of the entry point on time, according to Deakins and Freel (2009), is critical for the venture?s success when intellectual property rights issues are concerned. During this stage, there are important activities to be carried out. Such actions include: learning in dealing with “customers, suppliers, bank officials, marketing efforts, patenting procedures and gaining experience” generally.

v) Post-Entry Development

This stage requires that the entrepreneur engage in necessary networks and taking appropriate steps for ensuring that the new venture gains credibility. This is the most critical issue that the entrepreneur faces in establishing the new venture in terms of the rating of the venture by customers, suppliers, etc. The first timer as an entrepreneur can make mistakes in respect of administrative and operational decisions. Comparatively, the experienced entrepreneur being brought into the new venture at this stage can help the inexperienced entrepreneur to obliterate such teething problems. The experienced partner can help raise awareness and publicity as well as the much needed network. Marketing efforts in this stage should not be overlooked as it is critical to gain new customers and to keep the existing ones.

3.2.2 Hult Model of Venture Creation Process

The Hult Model involves an iterative process in which there are five phases as identified and explained below. However, as observed by Brettl, Kleinert and Karamatova (2010), regardless of the sequential approach of the model, it is feasible to go back in the process.

i) Idea Phase

The idea phase represents the beginning of the new venture creation. This does not imply that the business idea is not well developed yet but this stage provides the base towards the penchant of the entrepreneur to establish a new venture.

ii) Test and Persuasion Phase

During this stage, the potential entrepreneur will be interest in testing or discussing his/her business idea with the family, good friends and colleagues. It has been argued that empirical findings provide a favourably feedback from the entrepreneur?s background helps to encourage the achievement of the business idea. Basically, this second stage can be appreciated as a learning phase whereby the entrepreneur acquires the elementary information in legal realm and accounting.

iii) Preparation Phase

This phase requires that the entrepreneur engages in juggling figures (calculations), preparing relevant budgets, analyzing the market situation and invariably assessing the production process. Professional consultants can be contacted by the entrepreneur towards solving some jigsaw puzzles that may arise in the working process.

iv) Start-up Phase

This phase in the creation of the new venture usually calls for a starting point, “a triggering event” that encourages the entrepreneur towards finally implementing his/her business idea. It represents a crucial event, which can turn out to be “positive or negative in nature.” For example, exploring the leasing of business premises, machinery and equipment may pose a daunting task. The response of the owners can be positive or negative and the search continues until success smiles on the face of the entrepreneur.

v) Ongoing Business Phase

During this phase, the entrepreneur is expected to have contacts for resources such as capital funds, personnel, and other productive inputs like technology, raw materials, business premises, machinery and equipment. All these inputs will enable the entrepreneur to continue the implementation of his/her business idea. In the course of the new venture getting stabilised, the entrepreneur is still expected to devote much of his his/her moments and endeavor in steering the affairs of its operations. This becomes obvious so that success of the business can be guaranteed. All the necessary future moves such as entering into new markets by the entrepreneur in the business are expected to be in accordance with professional advice of the consultants.

3.2.3 Bhave Model of Venture Creation Process

The process of venture creation, according to Bhave (1994), involves stages such as opportunity recognition; commitment to physical creation; set-up of production technology; organization creation; product creation; connecting with potential markets, and generating customer feedback. These stages are discussed below.

i) Opportunity Recognition Stage,

Business concept creation incorporates the opportunity stage of the venture creation process. This is in essence involves converting a new idea or technology into a business undertaking, which is the foundation of the creation of any business venture by an entrepreneur. The recognition for business is normally internally and externally stimulated by the entrepreneur. He or she may already be working under an employer in which case the issue of stumbling on the venture idea arises in the course of work, which is called intrapreneurship. The idea of venture creation can even arise during industrial attachment, particularly for the graduates from Polytechnics and universities, during which they learn how to convert theoretical knowledge into practical products that are beneficial to mankind. For instance, engineering students have the opportunity of experiencing the workability of inverter in relation to conserving electricity in practical terms. And this experience can stimulate them to float companies for the production of inverters.

ii) Technology Set-Up Stage

This is embedded in the acquisition and setting up of production technology for the venture. This implies that the stage involves the purchase and establishment of the required (production) technology for the operations of the business undertaking. And it calls for the commitment towards physical creation of the required technological facility for the purpose of production of products (goods or services). All business undertakings in the modern time revolve around technology, which in itself is very dynamic. Since technology keeps on changing, an entrepreneur who wants to establish a new venture must embrace effective and efficient way of carrying out business operations with the latest cutting edge technology. In essence, new ventures must embrace latest technology for efficient production of goods and services, and particularly for timely (online real time) delivery of services to the customers in the target and potential markets.

iii) Organization Stage

This stage involves establishing the management structure of the venture with which to steer the affairs and ensure success and profitable operations of the business. The entrepreneur, more often than not, assumes the leadership position while bringing in some supportive personnel for the operations. The initial organizational structure is the simple line organization while it assumes larger dimension, such as functional structure, over time in the growth process of the venture.

Swier (2007) succinctly observes that the most significant characteristic of a venture creation is the management. The personnel that stir the daily affairs of the venture must sound pedigrees in terms skills (highly qualified) and uncanny commitment as well as entrepreneurial attitude for the business undertaking to succeed. The basic thing is based on finding very valuable human resources and giving them appropriate orientation regarding their strategic roles in the operations of the venture.

iv) Product Creation Stage

The novel idea inherent in venture creation has this as its core variable because this serves as the base for the operationalisation of the whole essence of the creation. The product to be produced from the venture emanates from the need to serve the gap identified in the existing production and marketing scenario. The gap as identified in the opportunity stage leads to novel idea regarding the type of product to produce and offer to the potential consumers or customers. The creation can be an enhancement in the existing product or a totally new product to satisfy the need and want of the target market.

v) Exchange Stage

This stage involves connecting with potential markets for the products of the venture. At this stage, information already generated from market research becomes very valuable. Marketing, in fundamental terms, involves getting the right products (goods and services) to the right market at the right time at the right price. This implies that after the production of the products from the new venture, the entrepreneur has to determine and fix appropriate price and push them out to the target markets through appropriate channels of distribution. Furthermore, the entrepreneur then takes decisions to deliver the products at appropriate time to the target market. The entrepreneur does not restrict the distribution of the products to only the target market, but he/she takes decision to reach other (potential) markets for the products to ensure marketing stability, expansion, and competitive leverage over competitors in the industry.

vi) Customer Feedback Stage

This stage involves generating information from the customers or users of your product (goods or services) regarding the performance; whether they are meeting their expectation or desires which motivate them to patronize such products.

In most cases, entrepreneurs do introduce distinct elements of novelty at each stage of the process of venture creation particularly in the areas of technological setup, product creation, exchange or connecting with the customers, and dealing with the ideas on improvement from the dealers and customers. Basically, the variations in the product concepts, technological utilization, commercialization of products from the venture, and recognition being accorded to the dealers and customers serve to differentiate one entrepreneurial undertaking from another.

SELF ASSESSMENT EXERCISE 2
Identify and discuss the stages involved in venture creation process according to Bhave (1994).

3.3 Role of Entrepreneur in Venture Creation

The entrepreneur constitutes the driving force for the recognition of a venture idea. Hence he/she assumes an important responsibility in the venture creation process (Brettl, Kleinert and Karamatova, 2010). An entrepreneur, as an industrialist, is regarded as a change agent in terms of acting to assume the risk inherent in the formation of a business venture. In order to create venture by an entrepreneur, he/she must possess uncanny forethought towards recognizing the potential requirement or desire for specific products (goods or services). Basically, creating a venture takes an unremitting progression which requires dogged commitment by the entrepreneur in creating the venture and introducing its products to the target markets effectively and efficiently.

The strategic role of the entrepreneur in creating a new venture revolves around the following responsibilities.

i) Idea Generation

It is the responsibility of an entrepreneur to begin with the inventing business ideas. This implies that the entrepreneur has onerous task of identifying and evaluating the business opportunities. Since this task is a difficult one, an entrepreneur is expected to search for inputs from all individuals around him/her such as friends, relatives, co-workers, members of the public, business or marketing consultants (if fund is available for it), and the media. The twin element of idea generation is the assessment of such ideas by the entrepreneur to arrive at the most advantageous, feasible and profitable venture prospect.

Fundamental issues inherent in assessment of business ideas include questions such as is the opportunity: worthwhile for investment; satisfactorily advantageous; practically profitable; competitively feasible; fraught with daunting risks; and above all, does the creator possess required personal skills and acumen to initiate and bring the venture into fruition.

ii) Developing a Business Plan:

Another important responsibility of the entrepreneur in venture creation involves the packaging a detailed business plan for the venture. The business plan becomes very significant to the accomplishment of the objectives of any new venture. This is in view of the fact that the business plan serves as the point of reference with which to assess whether the business venture is progressing or not as far as the predetermined goals and objectives are concerned. Some level of commitment is required of the entrepreneur in coming up with the business plan which can measure up to known standards and invariably stand the test of time.

iii) Generating Required Financial and Material Resources

operational requirements. The initial or seed money, as opined by Swier (2007), is normally required for market research, product development, and building management infrastructure. The entrepreneur is also expected to search for the needed human (personnel), technological and other material resources for the operations of the new venture.

iv) Establishing Management for the Venture

Another crucial responsibility of the entrepreneur in venture creation involves the management of the new venture. The entrepreneur has to employ capable hands with required qualifications, skills, and mental attitudes for the operations of the new venture. Once the required personnel are in place, the entrepreneur takes decisions on the organizational structure that best fits the nature of operations of the new venture

v) Developing Strategic Plans for the Future

This crucial responsibility of the entrepreneur in venture creation involves engaging in strategic planning for the future position of the new venture. The entrepreneur has the onerous task of taking decisions on the future potentials of the business which enables him to project the future growth and development. Herein, the entrepreneur becomes proactive in terms of planning for the stability, expansion, and funding of the future growth and development; whether through the use of venture capital, initial public offer or private placement of its shares to prospective investors.

SELF ASSESSMENT EXERCISE 3
List and explain responsibilities of entrepreneurs in venture creation.

4.0 CONCLUSION

This unit of the course material has provided you with the basic knowledge about the creation of ventures which arises from the actions of entrepreneurs. This implies that entrepreneurs constitute the architects in the creation of business undertakings because they initiate required actions to create ventures from the preserved need to fill gaps resulting from underserved markets. To create any venture, there is a specific process to follow with stages such as: opportunity recognition; commitment to physical creation; set-up of production technology; organization creation; product creation; connecting with potential markets, and generating customer feedback. In order to ensure the success of the new venture, entrepreneurs assume certain responsibilities like: generating venture idea, developing a business plan; generating required financial and material resources; establishing management for the venture; and developing strategic plans for the future.

5.0 SUMMARY

In this initial study unit of the course material, you have been taught the following topics:

• Meaning of venture creation;
• Process of Venture Creation; and

• Role of Entrepreneur in Venture Creation.

In the next study unit, you will be taken through diversification as a basis of investment portfolio.

6.0 TUTOR MARKED ASSIGNMENT
1. Explain the term venture creation
2. Compare and contrast the stages of venture creation in Deakins Model and Bhave Model.
3. Mention reasons why entrepreneur?s role is still very relevant after the creation of a venture.

Answers to Self-Assessment Questions

1. Explain the term venture creation.

Venture creation refers to an action initiated for starting business venture with the intent of filling the gap between an initiative and a “capitalized business. Furthermore, venture creation involves a process just like a manufacturing process because venture creation process ideas coupled with necessary productive inputs such as human efforts and technology into desired products for the consumers. Such venture becomes fundable venture once it can meet the current desires, needs, wants and aspirations of the target and potential markets.

The worth of a venture creation does not just involve creating ventures but establishing ventures should go through a process that decides whether or not the venture possesses a feasible and marketable product in available or emerging market. In addition, the venture should have a plan that is practically attainable based on available resources including the critical one, the capital.

2. Identify and discuss the stages involved in venture creation process according to Bhave (1994).

The relevant stages in the process of venture creation as identified by Bhave (1994) are discussed as follows:

i) Opportunity Recognition Stage,

ii) Technology Set-Up Stage

This stage involves the purchase and establishment of the required (production) technology for the operations of the business undertaking. And it calls for the commitment towards physical creation of the required technological facility for the purpose of production of products (goods or services). All business undertakings in the modern time revolve around technology, which in itself is very dynamic. Since technology keeps on changing, an entrepreneur who wants to

establish a new venture must embrace effective and efficient way of carrying out business operations with the latest cutting edge technology.

iii) Organization Stage

iv) Product Creation Stage

v) Exchange Stage

This stage involves connecting with target and potential markets for the products of the venture. At this stage, information already generated from market research becomes very valuable. The entrepreneur takes decisions, after the production of the products from the new venture, to fix appropriate price, select appropriate channels for distribution, and ensuring timely availability of the products in the target and potential markets.

vi) Customer Feedback Stage

3. Role of Entrepreneur in Venture Creation

The strategic role of the entrepreneur in creating a new venture revolves around the following responsibilities.

i) Idea Generation

business or marketing consultants (if fund is available for it), and the media. The twin element of idea generation is the assessment of such ideas by the entrepreneur to arrive at the most advantageous, feasible and profitable venture prospect.

ii) Developing a Business Plan:

iii) Generating Required Financial and Material Resources

A crucial responsibility of the entrepreneur in venture creation involves generating the needed financial and material resources for the new venture. More often than not, the initial capital of the business which is regarded as seed money is expected to be provided by the entrepreneur. The venture has to be at the stage of startup before the move to raise capital to cope with its operational requirements. The initial (seed) money is normally required for market research, product development, and building management infrastructure. The entrepreneur is also expected to search for the needed human (personnel), technological and other material resources for the operations of the new venture.

iv) Establishing Management for the Venture

v) Developing Strategic Plans for the Future

7.0 REFERENCES/FURTHER READINGS

Bhave, M. P. (1994). A process model of entrepreneurial venture creation, Journal of Business Venturing, 9(3): 223-242.

Brettl, E., Kleinert, V. and Karamatova, L. (2010). The New Venture Creation Process in Cooperation with Science Park Jönköping, Bechelor Thesis in Business Administration, submitted to JÖn Köp Ing Int E Rn At Io Nal Bus Ine S S S Ch Oo L, Jönköping

University. Accessed on from 19 March, 2017 from http://www.diva-portal.org/smash/get/diva2:322911/FULLTEXT01

Cambridge Business English Dictionary (2017). Cambridge: Cambridge University Press. Accessed on 19 March, 2017 from http://dictionary.cambridge.org/ dictionary/english/ venture-creation.

Corno, F., Lal, R. and Colombo, S. (2014). Entrepreneurship & New Venture Creation Key Elements of the Entrepreneurial Ecosystem Facilitating the Growth of ICT Entrepreneurs in Italy, European Scientific Journal, Special edition, 2: 330-345.

Deakins, D., & Freel, M.S. (2009). Entrepreneurship and small firms (5th ed.). London:
McGraw-Hill.

Gordon, S. R. (2012). Dimensions of the Venture Creation Process: Amount, Dynamics and Sequences of Action in Nascent Entrepreneurship. PhD Thesis submitted to Australian Centre for Entrepreneurship Research, School of Management, QUT Business School, Queensland University of Technology, Australian. Accessed on 19 March, 2017 from http://eprints.qut.edu.au/58078/1/Scott_Gordon_Thesis.pdf

Hult, M., Jerreling, A., & Lindblom, G. (1991). Öka nyföretagandet: teorier, modeller,
vägledning. Växjö: Högskolan.

Swier, R. (2007). Startup Florida, What is Venture Creation? Accessed on 19 March, 2017 from http://startupflorida.blogspot.com.ng/2007/06/what-is-venture-creation.html.

UNIT 3: DIVERSIFICATION AS A BASIS OF INVESTMENT PORTFOLIO

CONTENTS

1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Meaning of Investment
3.2 Value Investment
3.3 Diversification of Investment as a Basis for Portfolio
3.3.1 Meaning of Diversification

3.3.2 Using Diversification in Investment
3.3.3 Advantages and Disadvantages of Diversification
3.3.3.1 Advantages of Diversification
3.3.3.2 Disadvantages of Diversification
3.4 Ways to Avoid Inappropriate Diversification
4.0 Conclusion
5.0 Summary
6.0 Tutor Marked Assignment
7.0 References/Further Readings

1.0 INTRODUCTION

This study unit of the course material is used to expose you to the important issue of investment in the capital market. Since your money should stay with generating additional income, you have to invest it on securities being offered in the capital market. Value investment is also discussed in this study because you cannot just hold stocks without monitoring the pulse of the capital market to take advantage of price fluctuations. Furthermore, the study unit is also used to discuss the use of diversification towards ensuring wise investment of your money in the capital market, and the ways to avoid inappropriate diversification.

2.0 OBJECTIVES

After studying this unit, you should be able to:

• Define investment
• Explain value investment
• Discuss diversification in capital market investment
• Mention and explain advantages and disadvantages of diversification
• List and explain ways to avoid inappropriate diversification

3.0 MAIN CONTENT

3.1 Meaning of Investment

In general terms, investment in finance implies having to commit your money or to allocate your fund money in investible securities, financial instruments or all forms of business ventures (e.g., acquiring rental assets, estate undertaking, etc.) with the expectation of reaping some benefits in the future.

In finance, the major benefit from investment is the return on the fund invested. The return may consist of capital gain and/or investment income that include other financial benefits such as dividends, interest, and rental income, among others. The projected economic return is the appropriately discounted value of the future returns. This is because the future financial benefits are subject to the time value of money causing fluctuation in such value. The historic return comprises the actual capital gain and/or income over a period of time.

Investment generally results in acquiring assets such as financial assets, productive assets, and estate assts. In the case of financial assets, if they are available at prices worth investing, it is normally expected either to generate income or to appreciate in value because they can be sold at higher prices before, their maturity dates.

Generally, you invest with the intention of generating higher returns. Such undertakings are normally associated with riskier investments. Financial assets therefore, range from low-risk, low-return investments, such as government securities (e.g., loan stick and bond) to those with higher risk and higher expected commensurate reward, such as emerging markets stock investments.

Basically, investors are normally or often advised to adopt an investment strategy and diversify their portfolio, combination of investment assets in both the capital market and money market because diversification has the statistical effect of reducing overall risk in investment.

SELF ASSESSMENT EXERCISE 1
Explain the term Investment.

3.2 Value Investment

A value investor buys undervalued securities while he sells overvalued ones out of his investment portfolio in the capital market. In order to identify undervalued securities, a value investor uses analysis of the financial reports of the issuer to evaluate the security. Basically, value investors employ accounting ratios such as earnings per share and sales growth, to identify securities trading at prices below their worth.

The price to earnings ratio, or earnings multiple, is a particularly significant and recognized fundamental ratio, with a function of dividing the share price of stock, by its earnings per share. This will provide the value representing the sum investors are prepared to expend for each dollar of company earnings. This ratio is an important aspect, due to its capacity as measurement for

the comparison of valuations of various companies. A stock with a lower price to earnings ratio will cost less per share, than one with a higher price to earnings ratio, taking into account the same level of financial performance; therefore, it essentially means a low price to earnings ratio is the preferred option.

An instance, in which the price to earnings ratio has a lesser significance, is when companies in different industries are compared. An example; although, it is reasonable for a telecommunications stock to show a price to earnings ratio in the low teens; in the case of hi-tech stock, a price to earnings ratio in the 40s range, is not unusual. When making comparisons the price to earnings ratio can give you a refined view of a particular stock valuation.

For investors paying for each dollar of a company's earnings, the P/E ratio is a significant indicator, but the price-to-book ratio (P/B) is also a reliable indication of how much investors are willing to spend on each dollar of company assets. In the process of the P/B ratio, the share price of a stock is divided by its net assets; any intangibles, such as goodwill, are not taken into account. It is a crucial factor of the price-to-book ratio, due to it indicating the actual payment for tangible assets and not the more difficult valuation, of intangibles. Accordingly, the P/B could be considered a comparatively, conservative metric.

A popular valuation metric is earnings before interest, tax, depreciation and amortization (EBITDA), with application for example to valuing unlisted companies and mergers and acquisition.

For an attractive investment, for example a company competing in a high growth industry, an investor might expect a significant acquisition premium above book value or current market value, which values the company at several times the most recent EBITDA. A private equity fund for example may buy a target company for a multiple of its historical or forecasted EBITDA, perhaps as much as 6 or 8 times.

In certain cases, an EBITDA may be sacrificed by a company, in order for the pursuance of future growth; a strategy frequently used by corporate giants. This is a business decision that can impact negatively on buyout offers, founded on EBITDA and can be the cause of many negotiations, failing. It may be recognized as a valuation breach, with many investors maintaining that sellers are too demanding, while buyers are regarded as failing to realize the long-term potential of, expenditure or acquisitions.

SELF ASSESSMENT EXERCISE 2
Explain the term Value Investment.

3.3 Diversification of Investment as a Basis for Portfolio

3.3.1 Meaning of Diversification

Investment diversification is regarded as one of the basic building blocks of a solid portfolio.
Diversification is associated with the cliché that you should “not put all your eggs in one basket.”
This is the basic principle that informs a key element of portfolio diversification.

In basic terms, diversification is a technique that reduces risk by allocating investments among various financial instruments, industries and other categories. It aims to maximize return by investing in different areas that would each react differently to the same event.

Most investment professionals posit that, although it does not guarantee against loss, diversification is the most important component of reaching long-range financial goals while minimizing risk.

There are mainly two types of risk that are associated with investment in the capital market. These are systemic risk and unsystematic risk. Systematic or the market risk is associated with the firm?s operations; causes of systematic risk include inflation rates, exchange rates, political instability, war and interest rates. This type of risk is not specific to a particular company or industry, and it cannot be eliminated or reduced through diversification. This type of risk is undiversifiable, which implies that investors must accept it. The unsystematic risk is specific to a company, industry, market, economy or country; it can be reduced through diversification. The most common sources of unsystematic risk are business risk and financial risk. These forms of risk are susceptible to diversification such as carrying a portfolio of stocks to obliterate unnecessary losses, and as such they diversifiable. Thus, the aim of diversification is to invest in various assets so that they will not all be affected the same way by market events.

SELF ASSESSMENT EXERCISE 3
Explain the term Diversification.

3.3.2 Using Diversification in Investment

A basic diversified portfolio might include several investment categories such as stocks, bond and cash. Your allocation to each of these broad categories should be based upon your investment goals, your tolerance for risk, and your time horizon for needing the use of the money. In short your asset allocation should be an outgrowth of your financial plan. Investment diversification involves a portfolio strategy that calls for combining a variety of assets to reduce the overall risk of an investment portfolio.

Reason for diversification of investment is not far-fetched. Assuming you have a portfolio (combination) of only Bank A stocks. If it is brought to the public knowledge that the bank?s workers are going on an indefinite strike, and that all operations and branches of the bank will not be allowed by the union to function. The implication is that share prices of the bank stocks will drop. Your portfolio will experience a noticeable drop in value.

However, if you counterbalanced the banking industry stocks with a couple of oil company stocks, only part of your portfolio (that of Bank A) would be affected. In fact, there is the likelihood that the oil company stock prices would climb, as government announces rise in price of petrol corresponding to rise in the price of crude oil in the world market.

Nevertheless, you could diversify even further because there are many risks that affect both bank and oil. An event that reduces any form of operations in the banking industry hurts Bank A and by extension its stock price. Therefore, to achieve superior diversification, you would want to

diversify across many industries; not only different types of companies but also different types of industries. The more uncorrelated your stocks are, the better.

Furthermore, it is also important that you diversify among different classes of securities. Different financial assets such as bonds and stocks will not react in the same way to adverse events. A combination of asset classes will reduce your portfolio's sensitivity to market volatility. Generally, the bond and equity markets move in opposite directions. Therefore, if your portfolio is diversified across both areas, unpleasant movements in one will be offset by positive results in another.

Furthermore, there exists additional types of diversification, and many synthetic investment products have been created to accommodate investors' risk tolerance levels. However, these products can be very complicated and are not meant to be created by beginner or small investors. For those who have less investment experience, and do not have the financial backing to enter into hedging activities, bonds are the most popular way to diversify against the stock market.

Nevertheless, even the best analysis of a company and its financial statements cannot guarantee that it could not adverse results from operations, and thereby investment in the firm lost. Hence diversification cannot obliterate a loss, but it can reduce the impact of fraud and bad information on your portfolio.

Basically, owning five stocks (diversification) is better than owning one, but there comes a point when adding more stocks to your portfolio ceases to make a difference. Debate arises over how many stocks are needed to reduce risk while maintaining a high return. The most conventional view argues that an investor can achieve optimal diversification with only 15 to 20 stocks spread across various industries.

In the final analysis, diversification can help you manage risk and reduce the volatility of a financial asset's price movements. However, you have to understand the fact that no matter how diversified your portfolio is, risk can never be eliminated completely in capital market investment.

Fundamentally, you can reduce risk associated with individual stocks, but general market risks affect nearly every stock; so it is also important to diversify among different asset classes. The important point is that you have to find a medium between risk and return. This ensures that you achieve your financial goals while still getting a good rest of mind.

3.3.3 Advantages and Disadvantages of Diversification

3.3.3.1 Advantages of Diversification

The advantages of investment diversification include the following.

i) Risk Management

One advantage of diversification is risk management. Risk management is one of the essentials to successful investing. If you lose in some stocks, such can be counterbalanced with gains from

other securities or for you to get back to breakeven. Diversification through asset allocation may be the most important investment strategy an investor can master. Basically, therefore, the benefit of diversification involves lowered overall portfolio risk without lowering portfolio returns.

ii) Portfolio Optimization

Portfolio optimization is achieved by placing a larger percentage of high return investments in a diversified portfolio. This is due to the fact that proper diversification lowers the overall risk of a portfolio. You can place more aggressive assets in the portfolio. This implies that an investor who is willing to take a given amount of risk can invest more aggressively with a properly diversified portfolio as opposed to a non-diversified portfolio.

Since investment diversification involves the strategy of combining financial assets in such a way as to reduce the overall risk of a portfolio, it implies that to achieve investment diversification assets are allocated in such a way as to spread them in a variety of stocks industries.

3.3.3.2 Disadvantages of Diversification

i) Diversification Double Dip

This is one fallacy of diversification. Diversification is the sort of thing that suffers from what is called “double dip” because too much of a good thing can turn sour. In fact, empirical evidence portrays that most of the benefit of increased diversification, as measured by the standard deviation of returns, goes away once a portfolio has between 20 and 30 securities in it.

ii) Diversification’s Downside Danger

This is the second fallacy of diversification. Many investment brokers like to sell the notion of diversification as buying and holding two or more assets whose values don?t rise or fall together. They want investors to imagine it is practicable or possible. The danger is that if there is recession in the economy, almost all the stocks of quoted companies would lose their values. This happens between 1929 and 1932 during the Great Depression in the United States of America due to excessive speculation in the capital market.

SELF ASSESSMENT EXERCISE 4
Mention and explain advantages and disadvantages of diversification.

3.4 Ways to Avoid Inappropriate Diversification

i) Too many investments

It is very advisable that you keep your stock holdings down to a manageable number of investments; a number as few as 20 and not more than 30, in reasonable amount of funds without investing too much in a few stocks. In addition, the holdings should be diverse in the wisdom that the value of these funds or securities should not be tightly coupled with one another. Buying

stock in 20 different commercial banks will not diversify your portfolio but acquiring 20 stocks in different sectors and industries will ensure appropriate diversification. Hence having fewer investments in terms of stock investment implies that you will have an easier time making sense of it all.

ii) Buying foreign funds and stocks.

Many foreign-stock investment vehicles have historically performed poorly. If you own stocks in large multinational corporations, you are already getting enormous exposure to overseas economies. Empirical evidence abound to show that investment in such corporations could go awry because of their expose to weakness in the economies of countries apart from their home countries; home country being advance economy while the other countries are mainly developing economies struggling to survive. Managements of such corporations are paying much closer attention and getting far better insights into their overseas business interest than the action you can take to monitor their performance, which may be difficult for to understand. More so, the attention of their management even goes beyond what any foreign-stock mutual fund manager ever could.

iii) Diversifying based on market capitalization

Small rise in market capitalization and large fall in market capitalization should be capitalized for investment diversification. It is advisable to find strong corporate entities such as blue chip companies and invest in them regardless of what the total market capitalization is showing.

iv) Buying illiquid and high-fee investments.

Hedge funds and mutual funds are two favourites of the investment traders who tout diversification. The former are sold as “go-go high-octane vehicles” and the latter as “super-safe dividend” plays with zero volatility. On average, both perform poorly over time.

4.5 Conclusion

Investment in finance implies having to commit your money or to allocate your fund money in investible securities, financial instruments or all forms of business ventures. In value investing, you offload securities with higher prices and buy stocks with lower prices. Diversification involves having a combination of many classes of investment particularly in capital market securities. A basic diversified portfolio might include several investment categories such as stocks, bond and loan stock, among others. In finance, diversification refers to the process of allocating investment funds in such a way that reduces the exposure to any one particular asset or risk. A common path towards diversification is to reduce risk or volatility by investing in a variety of assets. Diversification is one of two general techniques for reducing investment risk.

5.0 SUMMARY

In this study unit of the course material, you have been taught the following topics:

• Meaning of Investment;

• Value Investment;
• Meaning of Diversification;
• Using Diversification in Investment;

• Advantages of Diversification;
• Disadvantages of Diversification; and
• Ways to Avoid Inappropriate Diversification

In the next study unit, you will be taken through investing wisely in capital market using hedging.

6.0 TUTOR MARKED ASSIGNMENT
1. Explain the term Investment.
2. Discuss the process of value investment.
3. Explain the term Diversification.
4. Mention and explain advantages and disadvantages of diversification.

Answers to Self-Assessment Exercises

1. Explain the term Investment.

Investment involves allocating your fund or money in investible securities, financial instruments or all forms of business ventures (e.g., acquiring rental assets, estate undertaking, etc.) with the expectation of reaping some benefits in the future. In finance, the major benefit from investment is the return on fund invested. The return may consist of capital gain and/or investment income that include other financial benefits such as dividends, interest, and rental income, among others.

2. Explain the term Value Investment.

Value investment involves buying undervalued securities while selling overvalued ones out of the investment portfolio in the capital market. In order to identify undervalued securities, a value investor uses analysis of the financial reports of the issuer to evaluate the security. Basically, value investors employ accounting ratios such as earnings per share and sales growth, to identify securities trading at prices below their worth.

3. Explain the term Diversification.

Diversification is a technique that reduces risk by allocating investments among various financial instruments, industries and other categories. It aims to maximize return by investing in different areas that would each react differently to the same event.

Most investment professionals posit that, although it does not guarantee against loss, diversification is the most important component of reaching long-range financial goals while minimizing risk.

There is systemic risk or the market risk as associated with the firm?s operations caused by inflation rates, exchange rates, political instability, war and interest rates. This type of risk is not

specific to a particular company or industry, and it cannot be eliminated or reduced through diversification, that is, undiversifiable.

There is unsystematic risk that is specific to a company, industry, market, economy or country, and it can be reduced through diversification. Sources of this risk include business risk and financial risk, and they diversifiable. Thus, the aim of diversification is to invest in various assets so that they will not all be affected the same way by market events.

4. Mention and explain advantages and disadvantages of diversification. Advantages of investment diversification include the following.

i) Risk Management

One advantage of diversification is risk management. Risk management is one of the essentials to successful investing. If you lose in some stocks, such can be counterbalanced with gains from other securities or for you to get back to breakeven.

ii) Portfolio Optimization

Disadvantages of Diversification include the following

i) Diversification Double Dip

Diversification is the sort of thing that suffers from what is called “double dip” because too much of a good thing can turn sour. There is evidence portrays that most of the benefit of increased diversification goes away once a portfolio has between 20 and 30 securities in it.

ii) Diversification?s Downside Danger

Many investment brokers like to sell the notion of diversification as buying and holding two or more assets whose values don?t rise or fall together. The danger is that if there is recession in the economy, almost all the stocks of quoted companies would lose their values.

7.0 REFERENCES/FURTHER READINGS

Elton, E. J. and Gruber, M. J. (1977). Risk Reduction and Portfolio Size: An Analytic Solution,
Journal of Business, 50: 415-37

Douglas, M. (1990). The Disciplined Trader, New York: New York Institute of Finance.

Jorion, P. (2009). Financial Risk Manager Handbook (5 ed.), New Jersey: John Wiley and Sons.

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UNIT 4: INVESTING WISELY IN CAPITAL MARKET USING HEDGING

CONTENTS

1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Meaning of Hedging
3.2 Using Hedging in Investment
3.3 Advantages and Disadvantages of Hedging
3.3.1 Advantages of Hedging

3.3.2 Disadvantages of Hedging
4.0 Conclusion
5.0 Summary
6.0 Tutor Marked Assignment
7.0 References/Further Readings

1.0 INTRODUCTION

In respect of investing wisely in capital market, hedging is also useful toward making returns on your fund. It is advisable to engage services of brokerage firms (as traders in financial market) since they are professionals in such market. This study unit of the course material, therefore, is mainly used to expose you to the meaning and process of using hedging in investment as far as the capital market securities are involved. Furthermore, the unit also discusses the advantages and disadvantages of using hedging to ensure investing profitably in the capital market.

2.0 OBJECTIVES

After studying this unit, you should be able to:

• Define hedging in capital market;
• Discuss the process of using hedging for profitable investment in capital market;
• Mention and explain advantages of hedging; and

• List and discuss disadvantages of hedging.

3.0 MAIN CONTENT

3.1 Meaning of Hedging

A hedge is an investment which is undertaking in order to reduce the risk of adverse price movements in a financial asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract. In other words, a hedge is an investment position which is intended for use in offsetting potential losses or gains that may be incurred by a companion investment. In simple terms, a hedge is used to reduce any substantial losses that may occur in investment which has to do with financial assets in the capital market.

A hedge is an investment position which is intended for use in offsetting potential losses or gains that may be incurred by a companion investment. In simple terms, a hedge is used to reduce any substantial losses that may occur in investment, which has to do with financial assets in the capital market.

A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of over-the-counter and derivative products, and futures contracts.

Hedging is the practice of taking a position in one market to offset and balance against the risk adopted by assuming a position in a contrary or opposing market or investment.

SELF ASSESSMENT EXERCISE 1
Explain the term Hedging.

3.2 Using Hedging in Investment

Equity in a portfolio can be hedged by taking an opposite position in futures. To protect your stock picking against systematic market risk, futures are shorted when equity is purchased or a long future when stock is shorted.

One way to hedge is the market neutral approach. In this approach, an equivalent naira amount in the stock trade is taken in futures – for example, by buying N10,000 worth of say First Bank shares and shorting N10,000 worth of All Share Index; the index in which the bank?s share trades in Nigerian Stock Exchange.

Another way to hedge is the beta neutral. Beta is the historical correlation between a stock and an index. If the beta of First Bank stock is 2, then for a N10,000 long position in bank, an investor would hedge with a N20,000 equivalent short position in the All Share Index.

In respect of hedging a stock price, a common hedging technique used in the financial market is the long/short equity technique. The scenario is this:

A stock trader who believes that the stock price of Company A will rise over the next month, due to the company's new and efficient method of producing products, buys Company A shares with the intention to earn profit from their expected price increase, as he believes that shares are currently underpriced. However, if Company A operates in a highly volatile industry, there is a risk of a future event that affects stock prices across the whole industry, including the stock of Company A along with all other companies.

Since the trader is interested in the specific company, rather than the entire industry, he has to hedge out the industry-related risk by short selling an equal value of shares from Company A's direct, yet weaker competitor, Company B.

The first day the trader's portfolio is as given below:

• Long 1,000 shares of Company A at N1 each
• Short 500 shares of Company B at N2 each

The trader has sold short the same value of shares (the value, number of shares × price, is N1, 000 in both cases).

If the trader was able to short sell an asset whose price had a mathematically defined relation with Company A's stock price, for example, a put option on Company A shares, the trade might be essentially riskless. In this case, the risk would be limited to the put option's premium.

On the second day, a favorable news story about the industry?s products is published and the value of all the products stock goes up. Company A?s stock increases by 10% because it is a stronger company, while that of Company B increases by just 5%:

• Long 1,000 shares of Company A at N1.10 each: N100 gain

• Short 500 shares of Company B at N2.10 each: N50 loss (in a short position, the investor loses money when the price goes up)

The trader might regret the hedge on day two, since it reduced the profits on the Company A?s position. But on the third day, an unfavorable news story is published about the health effects of the products, and all prices of stocks crash: 50% is wiped off the value of the industry?s products in the course of a few hours. Nevertheless, since Company A is the better company, it suffers less than Company B:

Value of long position (Company A):

• Day 1: N1,000
• Day 2: N1,100
• Day 3: N550 => (N1,000 - N550) = N450 loss

Value of short position (Company B):

• Day 1: -N1,000
• Day 2: -N1,050
• Day 3: -N525 => (N1,000 - N525) = N475 profit

Without the hedge, the trader would have lost N450 (or N900 if the trader took the N1,000 he has used in short selling Company B's shares to buy Company A's shares as well). But the hedge

– the short sale of Company B results in a profit of N25 during a dramatic market collapse.

Hedging can be used in other different ways such as foreign exchange trading. The stock example above represents a typical sort of hedge, known in the industry as a pairs trade due to the trading on a pair of related securities. As the practitioners in the capital market become more sophisticated, along with the mathematical tools used to calculate values or models, the types of hedges have increased greatly.

SELF ASSESSMENT EXERCISE 2
Discuss Hedging as it relates to using it for investing wisely in the capital market.

3.3 Advantages and Disadvantages of Hedging

3.3.1 Advantages of Hedging

i) Lower risk of investment

The main advantage of the hedge is that it lowers the risk of an investment significantly. If an investor makes an investment in which variables are out of his control -- as is the case in nearly any investment -- then he stands to lose money if things do not go as he planned. A hedge can help him offset these losses and thus reduce any unwanted risk.

ii) Flexibility in its investment option

Hedge funds are extremely flexible in their investment options because they use financial instruments generally beyond the reach of mutual funds.

iii) Easily best managed investment fund

The flexibility in hedge funds, which includes use of hedging strategies to protect downside risk, gives hedge funds the ability to best managed investment risks. This is linked to performance incentives available for hedge fund managers who manages and shares the rewards as well as risks with the investors.

iv) Exposure to markets that can easily forecast future trends

Hedges are particularly popular with companies that have exposure to certain markets, such as commodities or interest rates. For instance, airlines and railroads spend substantial amounts for fuel for their operations, and so hedging future fuel costs can protect them against a spike in the market price for energy products.

v) Less volatile than individual stocks

Hedge funds can be less volatile than individual stocks or mutual funds because: hedge funds are particularly popular with companies that have exposure to certain markets; it lowers the risk of an investment significantly; and its ability to best managed investment risks because of performance incentives available for hedge fund managers.

3.3.2 Disadvantages of Hedging

i) Higher minimum investment amount required

Hedge fund normally requires a very high minimum amount, which is way only high networth individuals, pension funds, endowment funds, insurance funds, corporate funds can utilize this investment route.

ii) Higher risk

Hedge funds mostly take higher risk to generate higher returns which increases the risk of losing money. One wrong huge investment decision can lead to huge losses for the entire hedge funds.

iii) Lower liquidity

Hedge funds have lower liquidity compared to other funds in the market. The investors cannot buy or sell instantly whenever they want.

iv) Mispricing

The price of the hedge fund units is decided by the management itself which can lead to mispricing of the hedge fund net asset value, and because of this, buyers can end up paying more than actual or the seller can end up receiving less than the actual amount.

v) Short selling and margin calls

Hedge funds have huge exposures in the short selling and margin calls which carries very high risk of losing money.

vi) Low regulation

All hedge funds are very much unregulated which increases the possibility of unfair trade practices (e.g., trade on insider information) and publishing of wrong information about the performance. Investors have become worst affected.

vii) Lower risk management

Hedge funds normally have very low risk management process in place which makes them more vulnerable during any financial crisis or liquidity crisis situation.

viii) High management fees

Hedge funds normally charge very high management and performance fees if the performance is good, which reduces the effective return to the investors significantly.

ix) Management section bias

The management normally selects the best performing hedge while publishing the performance report every time and ignore the worst performed hedge funds to make the performance report more attractive to investors. The worst affected hedge funds are withdrawn from the market without anyone noting it except the investors who lose the invested money. The selection of best performing funds is done to attract potential investors and to increase the asset under management which serves as the most important parameter of a hedge fund.

SELF ASSESSMENT EXERCISE 3
What are the Advantages and Disadvantages of Hedging?

4.5 Conclusion

Hedging is another strategy that can be used to take advantage of wise investment in the capital market. When you are making a large investment, it is advisable to use a hedge investment. Such investment provides a kind of insurance policy designed to protect you in the event that your large investment collapses. The financial hedge provides protection, guarding you against significant losses. Yet, hedges are not always useful and, if injudiciously purchased, can be a waste of money. The relative advantages and disadvantages of a hedge depend greatly on the situation in which the hedge is applied, as well as the hedge cost. In some situations, a hedge will be absolutely necessary to make sure that you as investor will remain financially solvent, regardless of what happens. In other cases, it merely signals an overcautious investor cutting into his own

5.0 SUMMARY

In this study unit of the course material, you have been taught the following topics:

• Meaning of Hedging;
• Using Hedging in Investment;
• Advantages of Hedging; and
• Disadvantages of Hedging

In the next study unit, you will be taken through investing wisely in capital market by using arbitrage.

6.0 TUTOR MARKED ASSIGNMENT
1. Explain the term Hedging.
2. Discuss the process of using Hedging in Investment.
3. Identify and explain advantages and disadvantages of Hedging.

Answers to Self Assessment Exercises

1. Explain the term Hedging.

2. Discuss Hedging as it relates to using it for investing wisely in the capital market.

In respect of hedging a stock price, a common hedging technique used in the financial market is the long/short equity technique.

3. What are the Advantages and Disadvantages of Hedging?

Advantages of Hedging include the following.

i) Lower risk of investment

ii) Flexibility in its investment option

Hedge funds are extremely flexible in their investment options because they use financial instruments generally beyond the reach of mutual funds.

iii) Easily best managed investment fund

iv) Exposure to markets that can easily forecast future trends

v) Less volatile than individual stocks

Disadvantages of Hedging include the following