Risk & Return

Whenever I considered doing anything major in my life, my Baba (Dad) would tell me that I needed to do a “Cost benefit analysis” first. I understood the gist of what he meant, and often thought a great deal about anything I considered doing; mostly resulting in me over-thinking it. During my study of finance in grad school, I came across the relationship between Risk and Return, and believe it or not, this is what really drove it home for me.

Clench your teeth through the technical part, it’ll stop hurting in a second.

Risk is defined as: A situation involving exposure to danger, and in finance it’s the possibility of financial loss.

Here’s the scenario: You have some money (Principal), you want to invest it in a security, there’s a chance it will grow, and a chance it will shrink. The chance the security will loose money is essentially the risk associated with it. Returns refer to the amount of interest that you can gain on the money you invest, or how much the money will grow.

In an attempt to keep my promise about reducing the pain, I’ll cut this short.

Investors (intelligent ones) are thought to be risk averse, meaning they avoid risk like the plague, as much as they can help it. Well, lo and behold there is a trick to reducing the risk on your investment!

It’s called diversification, which pretty much means what you thought it did: not to put all your eggs in one basket, or to invest the money in lots of different stocks or securities.

How that works, is that if one of the stocks you invested your money in goes bust, then it wont hurt so bad, because not all your money was invested there in the first place.

I think you got the idea now.

Back to my Baba, so he said make sure you analyze cost and benefit, pros and cons, risk and return. See the pattern? As Muslims we should constantly be making this analysis. I was in a situation where my Halaqah (Study circle) leader was sitting with me and telling me a story, when she just stopped. I asked her what was wrong, she said, “I was trying to see if benefit would come from telling you that detail or not.” Subhan Allah, such a small statement, but it had a profound affect on the way I see my actions. Every little action counts and should be treated accordingly. We have to look at our life in an objective manner to see the bigger picture.

May Allah SWT bless her, and anyone who has ever taught me anything.

We have to check our intentions constantly, and make sure that our Principal (our actions) isn’t invested in anything other than pleasing Allah SWT or bettering our hereafter. Investing in anything else would be the worst decision you could ever make right?

Allah SWT discusses this poor calculation in Surat Al-Baqarah verse 16:

“These are they who have bartered Guidance for error: But their transaction is profitless, and they have lost true direction.”

Muslims, like good investors should also be risk averse. We should avoid doing anything that, anger Allah SWT, and will as a consequence land us in the Hell fire (May Allah SWT protect us from it.) By ensuring our deeds are invested in Allah SWT’s pleasure we can’t go wrong. Allah SWT tells us just this in Surat Faatir verse 29:

“Those who recite the Book of Allah, establish regular Prayer, and spend (in Charity) out of what We have provided for them, secretly and openly, hope for a commerce that will never fail.”

We should also diversify our investments through doing as many different good actions as often as humanly possible. The bitter truth is that achieving sincerity in our actions towards Allah SWT is neither easy, nor is it guaranteed. There is no confirmation that Allah SWT accepts our deeds. If we could only be as fortunate as the sons of Adam when Allah SWT revealed that He accepted from one and not from the other as stated in Surat Al-Maidah verse 27:

“Recite to them the truth of the story of the two sons of Adam. Behold! They each presented a sacrifice (to Allah.: It was accepted from one, but not from the other.”

So we have to try our best to do as many sincere acts for Allah SWT, and hope for His Mercy and Pleasure in order to increase our chances to making it to Jannah Inshallah.

Here comes one last analogy from Baba, that like the other, makes a great deal of sense.

Your life is like a flight. It has a starting point, and a destination. You have a flight plan that draws out how to get where you are going, and for any Muslim that final destination should be Jannah inshallah. So, you go about following the plan. You finish high school, start college, go to university, and graduate.

Along the way you go slightly off course, you get so involved with your job that you start to slack off on praying sunnah, fasting Mondays and Wednesdays and praying on time. When that happens, you have to catch it, and immediately make a course correction. This will set you gladly back on your way to where you were supposed to be headed in the first place.

In the instance that you weren’t analyzing your actions, or plans for your immediate future in that light, would all of the little plans to finish college, get a job, get a promotion, etc. put you at the correct final destination?

The point is to highlight the importance of making conscious decisions about what you do with your life, if those decisions are all made based on what’s best for your hereafter, then with the help of Allah S.W.T you can’t go wrong.

When I got married, a dear friend and mentor told me to “make Allah SWT the center of your life, and everything else will fall into place.”

That advice stands true in any situation, for any person.

I will leave you with a verse from the Holy Quran (65:3):

“…And if any one puts his trust in Allah, sufficient is ((Allah)) for him.”

Thinking of Investing? Make sure you’re familiar with the Finance Lingo First!

Bond: A promissory note issued by a business or governmental unit.

Treasury Bond: Bond issued by the federal government that are not exposed to default risk. Sometime referred to as government bonds.

Corporate Bond: A debt issued by corporations and exposed to Default Risk.

Municipal Bond: Issued by the state and local government. The interest earned on municipal bonds is exempt from federal taxes, and also from state taxes if the holder is a resident of the issuing state.

Foreign Bond: A bond sold by a foreign borrower denominated in the currency of the country in which the issue was sold.

Par Value: The nominal or face value of a stock or bond. The par value of a bond generally represents the amount of money that the firm borrows and promised to repay at some future date. It is often $1,000 to $5,000.

Maturity Date: The date when the bonds par value is paid back to the bondholder. Maturity dates generally range from 10 to 40 years from the time of issue.

Coupon Payment: The Dollar amount of interest paid to each bondholder on the interest payment dates.

Coupon Interest Rate: Stated rate of interest on a bond defined as the coupon payment divided by the par value.

b) Floating-rate Bond: A bond whose coupon payment may vary over time, the coupon rate is linked to the rate on another security such as a Treasury security or some other rate such as LIBOR.

Zero compound Bond: Pays no coupons at all but is provided at a substantial discount below its par value and hence provides capital appreciation rather than interest income.

Original Issue Discount (OID) Bond: Any bond initially offered at a price significantly below its par value.

c) Call Provision: Gives the issuing firm the right to call the bonds for redemption at a price greater than the par value. This increase in price is called the Call Premium.

Redeemable Bond: Gives investors the right to sell the bonds back to the corporation at a price that is usually close to the par value. If interest rates rise, investors can redeem the bonds and reinvest at the higher rates.

Sinking Fund: Facilitates the orderly retirement of a bond issue. This can be achieved in one of two ways. 1. The company can call for redemption at par value a certain percentage of bonds each year. 2. The company may buy the required amount of bonds on the open market.

d) Convertible Bond: A security that is convertible into shares of common stock at a fixed price at the discretion of the bondholder.

Warrant: A call option issued by a company allowing the holder to buy a stated number of shares of stock from a company at a specified price. Warrants are generally distributed with debt or preferred stock to induce an investor to buy those securities at a lower cost.

Income Bond: Pays interest only if interest is earned. These securities cannot bankrupt a company. But from an investor’s standpoint they are riskier than other bonds.

Indexed (Purchasing Power) Bond: The interest rate of such a bond is based on an inflation index such as the consumer price index (CPI), so the interest paid rises automatically when the inflation rates rise, thus protecting the bondholders against inflation.

Premium Bond: When the going rate of interest is below the coupon rate a fixed rate bond is sold at a price higher than its par value or at a premium.

Discount Bond: When the going rate of interest is above the coupon rate, a fixed rate bond will sell below its par value or at a discount.

Current Yield: The annual coupon payment divided by the current market price.

Yield to Maturity (YTM): The rate of interest earned on a bond if it is held to maturity.

Yield to Call (YTC): The rate of interest earned on a bond if it is called. If current interest rates are well below an outstanding callable bonds interest rates then the YTC may be a more relevant estimate of expected return than the YTM, since the bond is likely to be called.

Reinvestment Risk: The risk associated with changes is interest rates at which an investor will receive on future securities.

Interest Rate Risk: Arise from the fact that bond prices decline when interest rates rise. Under these circumstances, selling a bond prior to maturity will result in a capitol loss, the longer term to maturity the larger the loss.

Default Risk: The risk that borrowers will not pay back the interest or principal on a loan as it becomes due.

Indenture: A legal document that spells out the rights of the bondholder and issuer.

Mortgage Bond: A bond for which the corporation pledges certain assets as a security. All such bonds are written subject to an indenture.

Debenture: An unsecured bond, and as such, it provides no lien against specific property as security for the obligation. Debenture holders are, general creditors whose claims are protected by properties not otherwise claimed.

Subordinated Debenture: Debentures that have claims on assets, in the case of bankruptcy only after senior debts as named in the subordinate’s debt indenture has been paid off. Subordinate debentures maybe subordinate to designated notes payable or to all other debt.

Development Bond: A tax-exempt bond sold by state and local governments whose proceeds are made available to corporations for specific uses (deemed by congress) to benefit society.

Municipal Bond Insurance: An insurance company guarantees to pay the principal and interest on a bond, should its issuer (municipality) default. This reduces the risk to investors who are willing to accept lower coupon rate for an insured bond issue compared to an uninsured issue.

Junk Bond: High-risk, High-Yield bond issued to finance leveraged buyouts, mergers, or troubled companies.

Investment-grade Bond: A bond with the rating of Baa/ BBB or above.

Real risk-free rate of Interest r*: That interest rate that equalizes the aggregate supply of, and demand and riskless securities in an economy with zero inflation. The real risk-free rate can be called the pure rate of interest since it is the rate of interest that would exist on very short-term, default-free U.S. Treasury Securities if the expected rate of inflation were zero.

Nominal rate of risk-free interest rRF: The real risk-free rate plus a premium for expected inflation. The short-term nominal risk-free rate is usually approximated by the U.S. Treasury bill rate, while the long-term nominal risk-free rate is approximated by U.S. Treasury bonds.

Inflation Premium (IP): The premium added to the real risk-free rate to compensate for the expected loss of purchasing power. It is the average rate of inflation rate over the life of the security.

Default Risk Premium (DRP): When a bond has default risk, a default risk premium is added to its risk-free rate to compensate investors for bearing default risk.

Liquidity: Refers to a company’s cash and marketable securities and to its ability to meet maturing obligations. A liquid asset is any asset that can easily be sold and converted into cash at its “fair” value. Active markets provide liquidity.

Liquidity Premium (LP): A liquidity premium is added to the real risk-free rate of interest, in addition to other premiums, if a security is not liquid.

Interest rate risk: Arise from the fact that bond prices decline when interest rates rise. Under these circumstances, selling a bond prior to maturity will result in a capitol loss, the longer term to maturity the larger the loss.

Maturity Risk Premium (MRP): The premium that must be added to the real risk-free rate of interest to compensate for the interest rate risk, which depends on a bonds maturity.

Reinvestment Rate Risk: Occurs when a short-term debt security must be “rolled over” If interest rates have fallen, the reinvestment of principal will be at a lower rate, with corresponding lower interest payments and ending values.

Term Structure of Interest Rates: The relationship between yield to maturity and term to maturity for bonds of a single risk class.

Yield Curve: The curve that results when YTM is plotted on the Y-axis and the years to maturity is plotted on the x-axis.

“Normal” Yield Curve: When the yield curve slopes upward it is said to be normal because it is like this most of the time.

Inverted “Abnormal” Yield Curve: A downward sloping yield curve.

Finance Terms You Should Be Familiar With

a) Proprietorship: An unincorporated business owned by a single individual.

Partnership: An unincorporated business owned by two or more individuals.

Corporation: A legal entity created by state law with multiple owners, all with limited liability.

b) Limited Partnership: A partnership where there are general and limited partners. The former are subjected to unlimited liability and control where as the latter are only liable for the amount of their investment in the business, and have no control. 

Limited Liability Partnership: Also known as an LLC is where all partners are only liable for their investment in the business.

Professional Corporation: An incorporated business that offers limited liability to its multiple owners (shareholders) that invest in the business with minimal risk.

c) Stockholder wealth maximization: To increase the company’s ability to generate cash flow, which in turn leads to payouts to stockholders.

d) Money Market: The markets for short-term (less than one year to maturity) highly liquid debt securities.

Capital Market: The markets for intermediate or long-term (1- 5 years to

maturity) and corporate stocks.

Primary Market: The markets in which corporations raise new capital.

Secondary Market: The markets in which existing outstanding securities are traded among investors.

e) Private market: Markets where transactions occur directly between two parties.

Public Market: Markets where standardized contracts are traded on organized exchanges, such as a common stock or corporate bonds.

Derivatives: Financial instruments or securities that derive their value from another security.

f) Investment Banker: A facilitator to help transfer capital from savers to businesses by buying stocks or bonds from corporations and selling them to savers in the form of securities.

Financial Service Corporation: Conglomerates that include several financial institutions under one corporation.

Financial Intermediary: A bank or a mutual fund that takes cash from savers in exchange for its own securities and reinvests the cash in businesses securities.

g) Mutual Fund: Corporations that accept money from savers and use the money to invest in different securities, and pooling funds helps reduce risk to investors.

Money market Fund: Interest bearing checking accounts.

h) Physical Location Exchanges: Types of secondary markets where traders physically meet and trade in a specific location. Examples include NYSE and AMEX.

Computer/ Telephone Network: Types of secondary markets where traders make exchanges over computer or telephone networks and do not meet in person. An example of a computer or telephone networks is Nasdaq.

i) Open Outcry Auctions: An auction where traders meet in person and communicate via shouts and signals to trade.

Dealer Market: A market where dealers keep inventory of traded stocks and list the prices that they are willing to buy and sell at on a computerized quotation system.

Electronic Communications Network: An electronic system that matches market orders to buy and sell at the lowest prices. It then executes the transaction and notifies the parties involved.

j) Production Opportunities: The ability to turn capital into benefits. An example is when a student borrows to pay for college; they expect to get a better job and higher income from their investment.

Time Preference for Consumption: The choice of a buyer or business to save or spend their money in the present or to invest it and enjoy greater spending in the future.

k) Foreign Trade Deficit: When the government imports more than it exports or buys more than it sells on the international market, this debt is paid by borrowing, resulting in a deficit.

Non-Profit Information Systems

There are several aspects of Information System design that ensure a successful system is put in place. An information system must be able to handle information in the following areas, customer information, volunteer information, accounting information, and marketing information.

 

Customer or client information is very important to the non-profit, as they are the main source of funding though donations. Client information should be kept up-to-date and needs constant management and maintenance. In addition, clients can be categorized by their levels of activity and involvement with the non-profit. This information can be useful in the short listing of individuals for special events, such as a Donor’s appreciation dinners and awards.

 

Volunteer information management is important to non-profits, since they form the organizations workforce.  Information systems can be used to store biographical information about volunteers and when and where they volunteer. Some volunteers serve from a corporate or association background, these volunteers can be sorted according to their corporate identity, displaying the relationships between volunteers and their respective corporation, foundation, civic group, or agency. 

 

Accounting or Financial information is one of the most important to any organization. An Information system would incorporate the donations, grants, gifts and any other inbound funds with their respective donors. This would allow the organization to track its donations and account for the sources of its funding. In addition the system would facilitate the production of financial reports for filing with the IRS or other decision-making bodies.

 

Last but not least, Marketing information would also be managed by the information system. Marketing information would use the client information for mailing campaigns, e-mails, invitations to events, etc. This would allow the NPO to determine the effectiveness of its marketing techniques and adjust them accordingly. Although Marketing is often considered a function of for-profit organizations it is essential that NPO’s embrace the importance of marketing to build recognition, recruit members and volunteers and spread awareness about the non-profit.