Prepared by SM Nahidul IslamDept. of Finance & Banking 1. What is investment environment? Answer: Investment environment can be defined as the existing investment vehicles in the market available for investor and the places for transactions with these investment vehicles. The main types of financial investment vehicles are – a. Short term investment vehicles (Certificates of deposit, Treasury bills, Commercial paper, Bankers’ acceptances, and Repurchase agreements), b. Fixed-income securities (Long-term debt securities, Preferred stocks), c. Common stock, Speculative investment vehicles (Options, Futures etc.); d. Other investment tools (Various types of investment funds, Investment life insurance, Pension funds, Hedge funds). 2. What are the five steps to the investment process? What is the importance of each step to the n tire process? Answer: The investment process is concerned with how an investor should proceed in making decisions about what marketable securities to invest in, how extensive the investments should be, and when the investments should be made. The following five steps procedure for making these decisions forms the basis of the investment process: 1. Set investment policy: Setting of investment policy is the first and very important step in investment process. It identifies the investor’s risk tolerance and investment objectives. Setting investment policy is important because it provides the general framework around which the investment process is conducted. 2. Perform security analysis: Security analysis is at the center of the investment process. It involves specifically identifying financial assets to be purchased for and sold from the investor’s portfolio. 3. Construct a portfolio: Portfolio construction involves identifying those specific assets in which to invest, as well as determining the proportions of the investor's wealth to put into each one. 4. Revise the portfolio: Portfolio revision concerns the periodic repetition of the previous three steps. It is necessary because investing is a dynamic process that responds to changes in investment opportunities and the investor’s financial circumstances. 5. Evaluate the performance of the portfolio: portfolio performance evaluation is a feedback and control procedure intended to help the investor examine whether his or her investment program is meeting targeted objectives. 3. Why do secondary security markets not generate capital for the issuers of securities traded in those markets? Answer: Issuers receive the net proceeds of securities sales when their securities are initially sold in the primary market. These securities represent claims on the issuing entities. For publiclytraded securities, these claims can be transferred through sales of the securities. This trading among investors takes place in the secondary markets, where the issuers have no direct involvement. When an investor sells his or her shares of a particular security in the secondary market, the issuer has no means or right to receive any additional funds as a result of the trade. 1 mutual funds. however. 5. bonds. If this relationship did not exist. he or she would not be compensated for the resulting lost purchasing power. the insurance companies write policies promising to make payments in the event of the death of the insured individual. Pension funds receive employer (and sometimes employee) contributions and issue promises to pay retirement benefits in exchange.Prepared by SM Nahidul Islam Dept. Prices of higher-risk securities would have to adjust to provide investors with higher returns and therefore increase investors' willingness to hold these securities. 6. They could avoid additional risk and receive the same return by holding the lower-risk securities. The contributions are primarily invested in stocks. The rate of return expresses this difference relative to the initial wealth associated with the investment. Mutual funds receive cash from investors and. Therefore its ability to make these promised payments is unquestioned. Answer: Life insurance companies receive cash from individuals in the form of premiums. an investor can be certain of the return that he or she will earn on a Treasury bill investment. and higher-risk securities offered the same returns as lower-risk securities. Why are Treasury bills considered to be a risk free investment? In what way do investors bear risk when they own Treasury bills? Answer: Because the U. Such a situation could not be equilibrium. Treasury guarantees the payment of interest and principal on Treasury bills. of Finance & Banking 4. bonds. and pension plans each Act as financial intermediaries. and real estate. 2 . Explain why the rate of return on an investment represents the investor's relative increase in wealth from that investment? Answer: The rate of return measures the wealth associated with a particular investment (or investments) at the end of a period compared to the wealth associated with that investment at the beginning of the period. in exchange. In exchange. does not account for the effects of inflation. then higher-risk securities should exhibit higher returns over long periods of time. issue shares in the respective funds. and money market instruments.S. The proceeds from the funds' sales are invested in a wide variety of financial assets. Describe how life insurance companies. Therefore the difference in the beginning and ending wealth figures represents the increase in the investor's wealth derived from the investment. money market instruments. 7. if inflation rose sharply and unexpectedly during the time that an investor held Treasury bills. The proceeds from the policy sales are primarily invested in stocks. The government has the unlimited authority to tax and print money to repay its debts. This certain Treasury bill return. Although the short maturity of Treasury bills makes this issue relatively unimportant. Does it seem reasonable that higher return securities historically have exhibited higher risk than have securities that yielded lower returns? why Answer: If one assumes that investors dislike risk. with the specific assets depending on the funds' particular investment objectives. then investors could not be induced to hold these riskier securities. of Finance & Banking 8. and the investor's investment time horizon (partly a function of age and career status). Treasury with a maximum term-to maturity of one year. Selectivity: An aspect of security analysis that entails forecasting the price movements of individual securities. and other financial intermediaries. Technical Analysis: A form of security analysis that attempts to forecast the movement in the prices of securities primarily on the basis of historical price and volume trends in those securities. These intrinsic values are compared to existing market prices to estimate current levels of mispricing. 9. Some obvious factors would include the investor's financial objectives (for example. Secondary Market: The market in which securities are traded that have been issued at some previous point in time. Treasury bill: A pure-discount security issued by the U. Risk: The variability of expected rate of return associated with the given assets. Distinguish between technical and fundamental security analysis Answer: Technical analysis attempts to forecast the movement in the prices of securities based predominately on historical price trends in those same securities. Investment Adviser: An individual or organization that provides investment advice to investors. 3 . Money Markets: Financial markets in which financial assets with a term to maturity of typically one year or less are traded. Financial Intermediary: An organization that issues financial claims against itself and uses the proceeds of the issuance primarily to purchase financial assets issued by individuals. or buildings. such as land. Timing: An aspect of security analysis that entails forecasting the price movements of asset classes relative to one another. the investor's willingness to bear risk. the investor's current financial circumstances. Fundamental analysis seeks to determine the intrinsic values of securities based upon estimates of the securities' future cash flows. saving for retirement or building a child's college fund). the difference between current income and current Real Investment: An investment involving some kind of tangible asset. Security Market: See Financial Market. equipment. Fundamental Analysis: A form 01" security analysis that seeks to determine the intrinsic value of securities on the basis 01" underlying economic factors. What factors might an individual investor take into account in determining his or her investment policy? Answer: Many factors could influence an investor's investment policy. Also.Prepared by SM Nahidul Islam Dept. partnerships. Glossary Investment: The sacrifice of certain present value for (possibly uncertain) future value. These intrinsic values are compared with current market prices to estimate current levels of mispricing. Financial Investment: An investment in financial assets. corporations. government entities. Savings: Foregone consumption. Primary Market: The market in which securities are sold at the time of their initial issuance.S. Capital Markets: Financial markets in which financial assets with a term to maturity of typically more than one year are traded. 000 + $3.133 = -13.000) = . One year ago the stock Sold for $33.000) = . as shown in Equation (1. ($23.000)/($20.000 in savings out Of the bank and invest it in a portfolio of stocks and bonds.000in cash dividend was received on the stocks.000.(The stock and bond income was not reinvested in Ray's portfolio.182 = 18.2% 2.000) = .1) in the text. in the case of Ray's portfolio: a. What was the return on the portfolio during the year? Solution: Using the formula for the return on an investment shown above.040 = 4.000)/ ($150. Flit Cramer owns a portfolio of common stocks that was worth $150.000in coupon Payments was received on the bonds.3% c.$20. What was the return on Ray's bond portfolio during the year? c. Flit's portfolio was worth$162. What was the return on Ray's total portfolio during the year Answer: Using the formula for the return on an investment shown above. Ray's stock and bond holdings were worth$ 25.300 = 30. What was the Rate of return for an investor in Colfax stock over the last year? Solution: The return on an investment. and $3.000 at the Beginning of the year.000 + $1.000) = -.080 = 8. ($48.$33)/($33) = . A year later. $20.000)/($30.000 .Prepared by SM Nahidul Islam Dept. of Finance & Banking Problems and Solution 1. At the beginning of the year.000 and $23. During the Year $1. Colfax Glassworks stock currently sells for $36 per share. At the end of the year. Ray Fisher decided to take $50. is given by: ROR Ending Wealth Beginning Wealth Beginning Wealth In the case of Colfax stock: ROR = ($36 + $3 .000 + $4.$50.000into corporate bonds. respectively.000 was placed into common stocks and$30.0% 4 . ($25.$150.0% b.000 .0% 3.) a.000 .The company recently paid a $3per share dividend. in the case of Flit's portfolio: ($162.$30. What was the return on Ray's stock portfolio during the year? b.000 .000.000)/($50. What are the average return and standard deviation of this portfolio? How do they compare with the 1976-1995.63% 1977: 25. on the other hand.Prepared by SM Nahidul Islam Dept.45%.23%.) Answer: Based on Table 1. the average annual return on Treasury bills during the period 19421951 was 0. Financial advisers often contend that elderly people should invest their portfolios more conservatively than younger people.08%.67 1989: -21. The following table shows the annual returns on a portfolio of small stocks during the20year period from 1976 to 1995.38 1982: 28. Common stocks have by far outperformed other asset classes historically. Given the increase in Treasury bill return volatility from the first period to the second.56 1994: 3.67 1988: 22.67%.1? 1976: 57. An elderly person must be concerned about maintaining the purchasing power of his or her investments. of Finance & Banking 4. In 1951the Treasury Department and the Federal Reserve System(the Fed) Came to an agreement known as the "Accord. common stocks seem to be well-suited to helping maintain that purchasing power.88% 1986: 6." whereby the Fed was no longer Obligated to peg interest rates on Treasury securities.56 1995: 34.37%. can always raise taxes or print money to cover its debt obligations. Therefore.87 1993: 20. The standard deviation of small stock returns during this period was 19. Average return and standard deviation of the common stock portfolio whose annual returns are shown in Table1. 5. compared to returns on bonds and money market investments.38% 1981: 13.65%. Just what proportion of the portfolio should be held in common stocks is another matter. government bonds? Answer: Corporate bonds.85% 1991: 44.30 1992: 23. common stocks are the only asset class to historically produce a large premium over inflation. government. Why are corporate bonds riskier than U.72%. The U. The standard deviation of Treasury bill returns during 1942-1951 was 0.46 1984: -6. does it appear hat the Fed did indeed stop pegging interest rates? (See endnote2 for the formula for Standard deviation.98 1979: 43.S. as discussed in the answer to the previous problem. Should a conservative investment policy for an elderly person call for owning no common stocks? Discuss the reasons for your answer.46 1983: 39. Moreover. the government has an unlimited ability to satisfy its debt obligations. The standard deviation of common stock returns during this period was 13.S.88 1985: 24. From 1952-1961 the average annual return was 2.01 1987: -9. it does appear that the Fed stopped pegging interest rates in 1951.94 The average annual return on common stocks during 1976-1995 was 15. 6.35 1978: 23.66 1990: -21. always bear the risk that the issuer might default on its debts. no matter how creditworthy the issuer. Answer: It is probably not advisable for an elderly person to hold a portfolio that includes no commons stocks.1. 5 . 8. What were the average returns and standard deviations on Treasury bills for the ten-year periods from 1942 to 1951and from 1952 to 1961? From these data.11 1980: 39. Given their historical performance.46 Answer: The average annual return on small stocks during 1976-1995 was 21. From 1952-1961 the standard deviation was 0. securities. In addition. establishing an investment objective of "making a lot of money. some investors contend that returns on foreign securities are generally higher than those on comparable U.Prepared by SM Nahidul Islam Dept. While this contention is controversial. maximizing returns. might entail inordinate levels of risk. 10. securities. 6 . of Finance & Banking 9.S.S. an investor who believes it could increase both the expected risk and return performance of his or her portfolio by including foreign securities. More appropriate would be an investment objective that jointly establishes desired levels of return and risk. Why might it be reasonable to believe that including securities issued in foreign Countries will improve the risk-reward performance of your portfolio? Answer: Foreign security returns do not necessarily move in the same direction as returns on U. This effect is known as diversification and can significantly improve the risk performance of a portfolio." or equivalently. Why does it not make sense to establish an investment objective of making a lot of money" Answer: Because returns on financial assets are directly related to risk. For that reason. including them in a portfolio will tend to dampen the ups and downs of the portfolio’s total returns.