INVESTMENT

Question 1
Discuss briefly, the difference between the field of corporate finance and the field of
investents!
"nswer
The field of corporate finance deals with the decisions of finance ta#en by corporations
alon$ with the analysis and the tools re%uired for ta#in$ such decisions! The principal ai
of corporate finance is enhancin$ the corporate value and at the sae tie reducin$ the
financial ris#s of the copany! In addition to this, corporate finance also deals with
$ettin$ the a&iu returns on the invested capital of the copany! The a'or concepts
of corporate finance are applied to the probles of finance encountered by all type of
firs!
(orporate finance typically covers issues such as pro'ect analysis, capital structure,
capital bud$etin$, and wor#in$ capital ana$eent! )ro'ect analysis is concerned with
deterinin$ whether pro'ect should be underta#en, for e&aple, whether a new
warehouse should be built! (apital structure addresses the %uestion of what type of lon$*
ter financin$ is best and also the lon$ ter decisions relatin$ to the pro'ects and the
ethods re%uired to finance the! (apital bud$etin$, on the other hand, addresses the
%uestion of what lon$*ter investents to underta#e! +or#in$ capital ana$eent
addresses how to ana$e a fir,s day to day cash flow! Stated further, it is considered as
a short ter decision that deals with the short ter current liabilities and asset balance!
The ain focus here rests on the ana$eent of inventories, cash and, the lendin$ and
borrowin$ on a short ter basis! " proper finance structure is re%uired for achievin$ the
set $oals of corporate finance! The ana$eent has to therefore desi$n a proper structure
that has an optial i& of the different finance options that are available!
-enerally, the sources of finance will coprise of a i& of e%uity as well as debt! If a
pro'ect is financed throu$h debt, it results in causin$ a liability to the concerned
copany! .ence in such cases, the flow of cash has various iplications re$ardless of the
success of the pro'ect! The financin$ done by e%uity carries a lower ris# re$ardin$ the
coitents of the flow of cash, but the result of this is the dilution of the earnin$s and
the ownership! The cost involved in e%uity finance is also hi$her than in the case of debt
finance! .ence, it is understood that the finance done throu$h e%uity, offsets the
reduction in the ris# of cash flow! The ana$eent has to hence have a i& of both the
options.
(orporate finance is also concerned with how to allocate profits! )rofits are divided
aon$ shareholders throu$h dividend/, the $overnent 0throu$h ta&es/, and the fir
itself 0throu$h retained earnin$s/
1irs raise oney by issuin$ stoc# and bonds in the priary security ar#ets! These
securities are subse%uently traded in the secondary security ar#et, where they are
bou$ht and sold by investors! Thus, both investors and the fir have an interest in the
wor#in$s of the financial ar#ets! (orporate finance involves the interaction between
investors and financial ar#ets! These decisions are based on several criteria that are
2ichard 1loey
M3" 4 15
T.
3atch
Student Nuber +"6789:
1
INVESTMENT
inter*related! The ana$eent of corporate finance attepts to a&ii;e the fir<s value
by a#in$ investents in the pro'ects that have a positive yield! The finance options for
such pro'ects have to be done in a proper anner!
Investent is a ter with several closely*related eanin$s in business ana$eent,
finance and econoics, and also relates to savin$ or deferrin$ consuption! Investin$ is
the active redirection of resources= fro bein$ consued today, to creatin$ benefits in the
future> the use of assets to earn incoe or profit! "n investent is the choice by the
individual, after thorou$h analysis, to place or lend oney in a vehicle 0e!$! property,
stoc# securities, bonds/ that has sufficiently low ris# and provides the possibility of
$eneratin$ returns over a period of tie! )lacin$ or lendin$ oney in a vehicle that ris#s
the loss of the principal su or that has not been thorou$hly analy;ed is, by definition
speculation, not investent!
In the case of investent, rather than store the $oods produced or its oney e%uivalent,
the investor chooses to use that $oods either to create a durable consuer or producer
$ood, or to lend the ori$inal saved $oods to another in e&chan$e for either interest or a
share of the profits!
In the first case, the individual creates durable consuer $oods, hopin$ the services fro
the $oods will a#e his life better! In the second, the individual becoes an entrepreneur
usin$ the resource to produce $oods and services for others in the hope of a profitable
sale! The third case describes a lender, and the fourth describes an investor in a share of
the business!
In each case, the consuer obtains a durable asset or investent, and accounts for that
asset by recordin$ an e%uivalent liability! "s tie passes, and both prices and interest
rates chan$e, the value of the asset and liability also chan$e!
The investent decision 0also #nown as capital bud$etin$/ is one of the fundaental
decisions of business ana$eent= Mana$ers deterine the investent value of the
assets that a business enterprise has within its control or possession! "ssets are used to
produce streas of revenue that often are associated with particular costs or outflows! "ll
to$ether, the ana$er has to deterine whether the net present value of the investent to
the enterprise is positive usin$ the ar$inal cost of capital that is associated with the
particular area of business!
In ters of financial assets, investents are often ar#etable securities such as a
copany stoc# 0an e%uity investent/ or bonds 0a debt investent/! "t ties the $oal of
the investent is for producin$ future cash flows, while at others it ay be for purposes
of $ainin$ access to ore assets by establishin$ control or influence over the operation of
a second copany 0the investee/!
2ichard 1loey
M3" 4 15
T.
3atch
Student Nuber +"6789:
?
INVESTMENT
"part fro this different orientation, investent also differs fro corporate finance in the
use of relevant research ethods! Specifically, investent probles in any cases allow
for a %uantitative odelin$ approach, while %ualitative research ethods, such as surveys
and case studies, are used ore fre%uently in corporate finance! 1urther, due to the lar$e
data sets available, for e&aple, on hi$h*fre%uency stoc# returns, the field of investent
often uses sophisticated statistical tied*series estiation techni%ues!
It is iportant to note that investents and corporate finance cannot possibly be treated
as entirely separate fields! 3oth investents and corporate finance build upon a coon
set of financial principles, such as the present value and the opportunity cost of capital!
The siilarities are ost stri#in$ between capital bud$etin$ and security analysis!
Specifically, in capital bud$etin$, an asset*pricin$ theory is needed to stiulate how
investor preferences affect the relevant discount rate for ris#y pro'ects! Siilarly, in
security analysis, an assessent of investent pro'ects and financial policy of the fir
are needed!
Thou$h, there are differences between the field of corporate finance and the field of
investents, there are siilarities between the as they both build on a coon set of
financial principles such as the present value and the cost of capital.
Question ?
@ist the five basic coponents of the investent process
"nswer
The five coponents of the investent process include=
1/ Investor characteristics
?/ Investent vehicles
8/ Strate$y developent
:/ Strate$y ipleentation and
5/ Strate$y onitorin$
2ichard 1loey
M3" 4 15
T.
3atch
Student Nuber +"6789:
8
INVESTMENT
Question 8
Describe the difference between financial assets and physical assets for each of the
followin$ characteristics=
a/ Divisibility
b/ Mar#etability
c/ .oldin$ )eriod
d/ Inforation "vailability
"nswer
1inancial assets consist of cash and other onetary assets and receivables in the for of
stoc#s, bonds, ri$hts, certificates, ban# balances, direct loans, $uaranteed loans ac%uired
after default, cash balances, and accounts receivable!
An the other hand, physical assets involve ites of econoic, coercial or e&chan$e
value that has a tan$ible or aterial e&istence! )hysical assets are the opposite of
intan$ible assets, which have value but are nonphysical such as leases, coputer
pro$ras or a$reeents! )hysical assets can be inventoried or stored, althou$h they ay
$o throu$h depletion, depreciation, deterioration or shrin#a$e in the stora$e process!
)hysical assets li#ely to be found in a restaurant, for e&aple, are chairs, tables,
refri$erators, coputer systes, and office supplies!
"n iportant distinction between financial and physical assets is that the latter are
incoe $eneratin$ assets used to produce $oods and services! 1inancial assets, in
contrast, represent clais a$ainst the incoe $enerated by real assets!
Investent in financial assets differs fro investent in physical assets in several ways
such as divisibility, ar#etability, holdin$ period, and inforation availability!
a/ Divisibility is the e&tent to which fractional aounts of an asset can be sold or
bou$ht! Ane uni%ue characteristic of investents in financial assets 0as to investents in
real assets/ is that financial assets are easily divisible! 1or e&aple, we can buy a sall
fraction of -eneral Electric 0-E/ throu$h coon stoc#! Ane cannot buy or sell a
portion of anufacturin$ plant or physical assets! "n asset is said to be divisible if one
can buy and sell sall portion of it! 1inancial assets are divisible, whereas ost physical
assets are not!
b/ Mar#etability is a function of the tradin$ volue and efficiency of the secondary
0resale/ ar#et for an instruent! 1inancial "ssets 0or security/ can be classified by how
easily assets can be bou$ht and sold! Mar#etable securities, such as 166 shares of "TBT
2ichard 1loey
M3" 4 15
T.
3atch
Student Nuber +"6789:
:
INVESTMENT
stoc#, can easily be bou$ht and sold by a phone call to a bro#er or via the internet and
therefore very li%uid! Non Mar#etable securities, such as staps or a house or a plant,
cannot be sold readily! Mar#etability reflects not necessarily the ar#et value but siply
the ease and speed with which an asset can be traded without havin$ to incur a substantial
price concession! (learly, if one wanted to sell a house in one day, then one would have
to offer a substantial discount to attract soeone to buy it iediately!
Mar#etability is a characteristic of financial assets that is not shared by real or physical
assets! Mar#etability, or li%uidity, reflects the feasibility of convertin$ an asset into cash
%uic#ly and without affectin$ its price si$nificantly! Stoc#s with a lar$e nuber of
shares outstandin$ that are actively traded are very li%uid! These securities are preferred
by investors who trade lar$e %uantities of securities, because their tradin$ activities will
have no 0or inial/ ipact on the securityCs price! Many financial assets are very easy
to buy and sell! .owever, ost physical assets are not very li%uid and hence are
described as illi%uid! "n investor who owns te&tile achines and who wants to sell the,
for e&aple, will $enerally have difficulty doin$ so!
c/ The holdin$ period a#es the $reatest difference in deterinin$ whether an asset is
entitled to short*ter or lon$*ter capital $ain treatent! +hen investors ac%uire
physical asset, they norally plan to hold it for relatively lon$ period! 3uyin$ new steel
producin$ achine, for e&aple, re%uire lar$e installation costs! Therefore, no one would
plan to hold this achine for a onth or even 'ust a year! .owever, the transaction cost
of buyin$ securities are relatively low, and investin$ for a onth or a year ay be
reasonable !Thus , the planned holdin$ period of securities can be uch shorter than the
correspondin$ holdin$ period of ost physical assets!
d/ Inforation about financial assets is abundant! "lthou$h in principle investors can
obtain inforation on real assets, it is typically hard to ac%uire and ay be costly! 1or
e&aple, suppose one en%uires about buyin$ an oil*drillin$ achine! It would be difficult
if not ipossible to $et inforation on the value of the achine! It i$ht also be difficult
to obtain the transportation and installation cost of the achine! )robably only a few
people in the oil industry have inforation to deterine these costs! The situation is
different in stoc# and bond! "nyone can open the wall street 'ournal or the financial
ties, loo# on the internet or call bro#ers to find out how uch a share of "T B T stoc#
cost! Siilarly, a person who wants to buy shares of "TB T stoc# can obtain inforation
0at alost no cost/ on earnin$s, dividends and so forth! Since this inforation is available
publicly, the ipact of any published factors on the value of the financial asset can be
analy;ed! This type of analysis cannot be done easily with real assets, at least not by all
investors!
In suary, it is iportant to note that the four factors such as ,divisibility,
ar#etability, holdin$ period and inforation availability, a#e investents in financial
assets different fro investents in physical assets!
2ichard 1loey
M3" 4 15
T.
3atch
Student Nuber +"6789:
5
INVESTMENT
Question :
(lassify each of the followin$ types of assets as either oney ar#et securities or capital
ar#et securities= Treasury notes> Municipal 3onds> 1ederal 1unds> Eurodollars> 2epurchase
"$reeents> (oercial )aper> Mort$a$es> Treasury 3ills> (orporate 3onds> Ne$otiable
(DS
"nswer
Money Market Instruments
Ne$otiable (DS
(oercial )aper
2epurchase "$reeents
Eurodollars
Treasury 3ills
1ederal 1unds
Capital Market Instruments
Municipal 3onds
Mort$a$es
(orporate 3onds
Treasury notes
2ichard 1loey
M3" 4 15
T.
3atch
Student Nuber +"6789:
9
INVESTMENT
Question 5
3riefly e&plain the ori$in of the followin$ sources of ris#=
a/ Interest*rate ris#
b/ E%uity ris#
c/ (oodity ris#
d/ Default ris#
e/ (redit*i$ration ris#
"nswer
a/ Interest*rate ris#
Interest rate ris# e&tracted fro 3asel (oittee on 3an#in$ Supervision,s paper
D)rinciples for the Mana$eent and Supervision of Interest 2ate 2is#/!The followin$ are
the sources of interest rate ris#:
2e*pricin$ ris#= "s financial interediaries, or ban#s encounter interest rate ris# in
several ways! The priary and ost often discussed for of interest rate ris# arises fro
tiin$ differences in the aturity 0for fi&ed*rate/ and re*pricin$ 0for floatin$*rate/ of
ban# assets, liabilities, and A3S positions! +hile such re*pricin$ isatches are
fundaental to the business of ban#in$, they can e&pose a ban#,s incoe and underlyin$
econoic value to unanticipated fluctuations as interest rates vary! 1or instance, a ban#
that funded a lon$*ter fi&ed*rate loan with a short*ter deposit could face a decline in
both the future incoe arisin$ fro the position and its underlyin$ value if interest rates
increase! These declines arise because the cash flows on the loan are fi&ed over its
lifetie, while the interest paid on the fundin$ is variable, and increases after the short*
ter deposit atures!
2e*pricin$ isatches can also e&pose a ban# to chan$es in the slope and shape of the
yield curve! Eield curve ris# arises when unanticipated shifts of the yield curve have
adverse effects on a ban#,s incoe or underlyin$ econoic value! 1or instance, the
underlyin$ econoic value of a lon$ position in 16*year $overnent bonds hed$ed by a
short position in 5*year $overnent notes could decline sharply if the yield curve is
steepin$, even if the position is hed$ed a$ainst parallel oveents in the yield curve!
"nother iportant source of interest rate ris#, coonly referred to as basis ris#, arises
fro iperfect correlation in the ad'ustent of the rates earned and paid on different
instruents with otherwise siilar re*pricin$ characteristics! +hen interest rates chan$e,
these differences can $ive rise to une&pected chan$es in the cash flows and earnin$s
spread between assets, liabilities and A3S instruents of siilar aturities or re*pricin$
fre%uencies! 1or e&aple, a strate$y of fundin$ a one*year loan that re*prices onthly
based on the one*onth FS Treasury bill rate, with a one*year deposit that re*prices
onthly based on one*onth @I3A2, e&poses the institution to the ris# that the spread
between the two inde& rates ay chan$e une&pectedly!
2ichard 1loey
M3" 4 15
T.
3atch
Student Nuber +"6789:
G
INVESTMENT
"n additional and increasin$ly iportant source of interest rate ris# arises fro the
options ebedded in any ban# assets, liabilities, and A3S portfolios! 1orally, an
option provides the holder the ri$ht, but not the obli$ation, to buy, sell, or in soe
anner alter the cash flow of an instruent or financial contract! Aptions ay be stand*
alone instruents such as e&chan$e*traded options and over*the*counter 0AT(/ contracts,
or they ay be ebedded within otherwise standard instruents! +hile ban#s use
e&chan$e*traded and AT( options in both tradin$ and non*tradin$ accounts, instruents
with ebedded options are $enerally ore iportant in non*tradin$ activities! E&aples
of instruents with ebedded options include various types of bonds and notes with call
or put provisions, loans which $ive borrowers the ri$ht to prepay balances, and various
types of non*aturity deposit instruents which $ive depositors the ri$ht to withdraw
funds at any tie, often without any penalties! If not ade%uately ana$ed, the
asyetrical payoff characteristics of instruents with optional features can pose
si$nificant ris# particularly to those who sell the, since the options held, both e&plicit
and ebedded, are $enerally e&ercised to the advanta$e of the holder and to the
disadvanta$e of the seller! Moreover, an increasin$ array of options can involve
si$nificant levera$e which can a$nify the influences 0both ne$ative and positive/ of
option positions on the financial condition of the fir!
b/ E%uity ris#
The ris# on e%uity arises at any levels and situations! This is the ris# e&posure to
adverse chan$es in the stoc# ar#et as a whole! (orporations ay not have chosen the
appropriate capital desi$n, wei$htin$ debt versus e%uity! (orporate ay be e&posed to
e%uity ris#, in the case of er$ers or ac%uisitions! )rivate e%uity and venture capital
$roups bear also an iportant e%uity ris#, but with very freshly or even not yet issued
e%uity stoc#s! 1urtherore, relative value tradin$ des# also referred to as ris# arbitra$e
des#s ay have iportant e%uity e&posure!
c/ (oodity ris#
(oodity ris# is the e&posure the copanies face as a result of chan$e in coodity
prices! This ay be either e&plicit or as a side product of a copanyCs business! 1or
e&aple, a $old producer will be e&posed to a fall in the price of the coodity, which is
a direct function of his production! " haula$e copany,s e&posure to diesel price is
ar$uably a secondary e&posure to their ain line of business! (opanies that are fully
inte$rated alon$ a particular supply chain will ar$uably face offsettin$ price ris#s!
"dditionally, coodity occurs when there is potential for chan$es in the price of a
coodity that ust be purchased or sold! (oodity e&posure can also arise fro
non*coodity business if inputs or products and services have a coodity
coponent! (oodity price ris# affects consuers and end*users such as
anufacturers, $overnents, processors, and wholesalers! If coodity prices rise, the
cost of coodity purchases increases, reducin$ profit fro transactions!
2ichard 1loey
M3" 4 15
T.
3atch
Student Nuber +"6789:
7
INVESTMENT
)rice ris# also affects coodity producers! If coodity prices decline, the revenues
fro production also fall, reducin$ business incoe! )rice ris# is $enerally the $reatest
ris# affectin$ the livelihood of coodity producers and should be ana$ed
accordin$ly! (oodity prices ay be set by local buyers and sellers in the doestic
currency in order to facilitate local custoer business! .owever, when transactions are
conducted in the doestic currency for a coodity that is norally traded in another
currency, such as F!S! dollars, the e&chan$e rate will be a coponent of the total price
for the coodity, and the currency e&posure continues to be a consideration!
There are broadly four cate$ories of a$ents who face the coodities ris#
1! )roducers 0farers, plantation copanies, and inin$ copanies/ face price ris#,
cost ris# 0on the prices of their inputs/ and %uantity ris#
?! 3uyers 0cooperatives, coercial traders and trait ants/ face price ris# between
the tie of up*country purchase and sale, typically at the port, to an e&porter!
8! E&porters face the sae ris# between purchase at the port and sale in the
destination ar#et> and ay also face political ris#s with re$ard to e&port licenses
or forei$n e&chan$e conversion!
:! -overnents face price and %uantity ris# with re$ard to ta& revenues, particularly
where ta& rates rise as coodity prices rise 0$enerally the case with etals and
ener$y e&ports/ or if support or other payents depend on the level of coodity
prices!
d/ Default ris#
Default ris#s arise fro two sources! The first is the ris# of the positions that the trader
holds! Those positions can a#e or lose oney, and if the losses e&perienced by a
eber are bi$$er than the collateral held by the clearin$house, the eber ay default!
If the eber has other financial resources, however, he can draw upon those resources
to a#e $ood the additional aount owed! Thus, a default occurs only if the losses on a
eber,s positions are lar$er than his capital! 3ut this capital is ris#y too! The financial
interediaries who are clearin$house ebers invest in other ris#y assets, and they ay
default if the losses on the other assets on their balance sheets are sufficiently $reat to
a#e it ipossible for the to cover their obli$ations to the clearin$house! This is the
second source of default ris#! The ris#s that deterine overall default ris# can be #nown
as Dposition ris#H and Dbalance sheet ris#!H "dditionally, the e&posure reflects the fact
that there is the possibility that one,s counterparty would not be able to pay his or her
financial obli$ation in a tiely anner!
Default ris# has a si$nificant effect on the value of a bond! If, for e&aple, a borrower<s
ability to repay debt is ipaired, default ris# is hi$her and the value of the bond will
decline! -enerally spea#in$, copanies and persons with hi$h default ris# stand a $reater
chance of a loan bein$ denied and pay a hi$her interest rate on the loans they do receive!
2ichard 1loey
M3" 4 15
T.
3atch
Student Nuber +"6789:
I
INVESTMENT
e/ (redit* i$ration ris#
The credit i$ration ris# is ost siply defined as the potential that a ban# borrower or
counterparty will fail to eet its obli$ations in accordance with a$reed ters! The $oal of
credit ris# ana$eent is to a&ii;e a ban#<s ris#*ad'usted rate of return by
aintainin$ credit ris# e&posure within acceptable paraeters! 3an#s need to ana$e the
credit ris# inherent in the entire portfolio as well as the ris# in individual credits or
transactions! 3an#s also consider the relationships between credit ris# and other ris#s!
The effective ana$eent of credit ris# is a critical coponent of a coprehensive
approach to ris# ana$eent and essential to the lon$*ter success of any ban#in$
or$ani;ation! In order words , it is the e&posure arisin$ fro the possible adverse effect to
the value of an investor Cs investent if the credit worthiness of his or her counterparty
decreases une&pectedly!
Most lenders eploy their own odels 0credit scorecards/ to ran# potential and e&istin$
custoers accordin$ to ris#, and then apply appropriate strate$ies! +ith products such as
unsecured personal loans or ort$a$es, lenders char$e a hi$her price for hi$her ris#
custoers and vice versa! +ith revolvin$ products such as credit cards and overdrafts,
ris# is controlled throu$h the settin$ of credit liits! Soe products also re%uire security,
ost coonly in the for of property!
2ichard 1loey
M3" 4 15
T.
3atch
Student Nuber +"6789:
16
INVESTMENT
Question 9
An 1 May, .eloise opened a ar$in account, buyin$ :66 shares of "3( copany,s stoc#
for J88 per share! .er initial ar$in re%uireents was 55K and the aintenance ar$in is
?5K=
a/ "t what stoc# price will .eloise receive a ar$in call 0assuin$ that .eloise
borrowed as uch as possible to open the account/L
b/ An 1 Mune, "3(,s stoc# price fell to J15, and .eloise received a ar$in call! She
decided to fulfill the ar$in re%uireents by depositin$ cash in her account! .ow
uch cash ust .eloise deposit if she is re%uired to restore the ar$in of 55KL
"nswer
a/
Nuber of Shares bou$ht N :66
Stoc# price N J88
Value of stoc# bou$ht N J18,?66
Mar$in re%uireent N J55K
Maintenance ar$in N ?5K
To deterine the price, ), that is e%ual to ?5K, I use the followin$ e%uation=
Total ar#et value of stoc# 4 aount borrowed N ?5K
Total ar#et value of stoc#
+here total ar#et value of stoc# N :66 O) N :66)
) N Stoc# price at aintenance ar$in
Investor,s e%uity NJ18,?66 O 6!55 N JG,?96
"ount borrowed NJ18,?66 * JG,?96 N J5,I:6
Therefore=
:66)*5I:6 N 6!?5K
:66)
:66) *5I:6 N166)
5I:6N 866)
) N 5I:6P866
) N J1I!76
.eloise will therefore receive a ar$in call when the stoc# price falls below J1I!76
b/
Nuber of shares bou$ht N :66
New stoc# price N J15
Total Stoc# value N J15 O :66 N J9,666
2ichard 1loey
M3" 4 15
T.
3atch
Student Nuber +"6789:
11
INVESTMENT
.eloise,s e%uity N J 9666* J5I:6 N J96
If the stoc# price at aintenance ar$in N J1I!76
"nd the new stoc# price N J15
Then the ar$in call price per share N J1I!76 * J15 N J:!76 per share
The Mar$in (all N J:!76 O :66 N J1,I?6
The aount of oney re%uired by .eloise to restore the ar$in of 55K is as follows=
@et Q represent the aount of oney re%uired to restore the ar$in to 55K
The aintenance ar$in therefore N J96R Q N 55K
J9,666 R Q
@et,s solve for Q
Q N 96 RQ N 8,866 R 6!55Q
Q* 6!55Q N 8,866* 96
6!:5Q N ?,?:6
Q N ?,?:6P6!:5
Q N JG,?66
Therefore, .eloise needs to deposit an aount of JG,?66 in the account to restore the ar$in
to 55K
2ichard 1loey
M3" 4 15
T.
3atch
Student Nuber +"6789:
1?
INVESTMENT
Question G
+hat are the difference between re$ulations and ethicsL
"nswer
2e$ulation refers to controllin$ of huan or societal behaviour by rules or restrictions!
2e$ulation can ta#e any fors= le$al restrictions proul$ated by a $overnent
authority, self*re$ulation, social re$ulation 0e!$! nors/, co*re$ulation and ar#et
re$ulation! Ane can consider re$ulation as actions of conduct iposin$ sanctions 0such as
a fine/! This action of adinistrative law, or ipleentin$ re$ulatory law, ay be
contrasted with statutory or case law!
2e$ulation andated by a state attepts to produce outcoes which i$ht not otherwise
occur, produce or prevent outcoes in different places to what i$ht otherwise occur, or
produce or prevent outcoes in different tiescales than would otherwise occur!
(oon e&aples of re$ulation include attepts to control ar#et entries, prices,
wa$es, pollution effects, eployent for certain people in certain industries, standards of
production for certain $oods, the ilitary forces and services! The econoics of iposin$
or reovin$ re$ulations relatin$ to ar#ets is analysed in re$ulatory econoics!
Ethics on the other hand, involves two thin$s! 1irst, ethics refers to well based standards
of ri$ht and wron$ that prescribe what huans ou$ht to do, usually in ters of ri$hts,
obli$ations, benefits to society, fairness, or specific virtues! Ethics, for e&aple, refers to
those standards that ipose the reasonable obli$ations to refrain fro rape, stealin$,
urder, assault, slander, and fraud! Ethical standards also include those that en'oin
virtues of honesty, copassion, and loyalty! "nd, ethical standards include standards
relatin$ to ri$hts, such as the ri$ht to life, the ri$ht to freedo fro in'ury, and the ri$ht
to privacy! Such standards are ade%uate standards of ethics because they are supported by
consistent and well founded reasons!
Secondly, ethics refers to the study and developent of one<s ethical standards! "s
entioned above, feelin$s, laws, and social nors can deviate fro what is ethical! So it
is necessary to constantly e&aine one<s standards to ensure that they are reasonable and
well*founded! Ethics also eans, then, the continuous effort of studyin$ our own oral
beliefs and our oral conduct, and strivin$ to ensure that people, and the institutions they
help to shape, live up to standards that are reasonable and solidly*based
Ethics therefore ebodies the ideals one should strive for and how one should behave!
2e$ulations, however, are rules established by $overnents for the purpose of
identifyin$ unacceptable behavior, but it is obvious that le$islators cannot possibly
ipose re$ulations on every possible unethical action! It can therefore be the case that
behavior that is unacceptable fro an ethical standpoint can be acceptable under e&istin$
re$ulations!
2ichard 1loey
M3" 4 15
T.
3atch
Student Nuber +"6789:
18
INVESTMENT
Question 7
Stoc# " $enerates a capital $ain of 7K every 9 onths! Dividends are paid sei annually
to$ether and the stoc#,s 9 onth dividend yield is :K! Fse the li#in$ ethod and the
inde& ethod to calculate the 1*year rate of return to an investor who pays J166 to buy
the stoc# and hold it for 1 year! "ssue that the first dividend will be paid e&actly 9
onths fro the purchase date!
"nswer
a/ Fsin$ @in#in$ ethod
(apital -ain N 7K
)eriod N Every 9 onths
Dividend N :K
Investent N J166
(apital $ain after 9 onths N 6!67 O J166 N J7
Investent after 9 onths N J166R J 7 N J167
Dividend after 9 onths N 6!6: O J166 N J:
2ate of return N 0EMV 4 3MV R D/P166
+here=
EMV N Endin$ Mar#et Value N J167
3MVN 3e$innin$ Mar#et Value N J166
D N Dividend N J:
Therefore=
2eturn after 9 onths N 0167 *166 R :/P 166
N1?P166
N1?K
"fter one year=
(apital -ain N 6!67 O J167 N J7!9:
Investent N J167 R J7!9: N J119!9:
Dividend N 6!6: O J167 N J:!8?
Fsin$ the rate of return e%uation %uoted above
+here=
EMV N 119!9:
3MV N167
D N J:!8?
Therefore=
2ate of 2eturn on Investent N 0119!9: *167 R :!8?/P167
N1?!I9P167 N 6!1? N 1?K
N 1?K
2ichard 1loey
M3" 4 15
T.
3atch
Student Nuber +"6789:
1:
INVESTMENT
The tie*wei$hted return on investent after 1 year is e&pressed by the followin$
e%uation=
@2 N 01R r
1
/O01R r
?
/ 4 1
+here=
@2 N lin#ed return or tie*wei$hted rate of return
r
1
N period 1 tie*wei$hted rate of return
r
?
N period ? tie*wei$hted rate of return
Fsin$ the rate of return fro the e%uation above=
r
1
N 1?K N 6!1?
r
?
N 1?K N 6!1?
N 01R 6!1?/ 01R6!1?/ * 1
N 01!1?/ 01!1?/*1
N1!?5::* 1
N 6!?5::
N?5!::K
Therefore the tie wei$hted rate of return on the portfolio usin$ lin#in$ ethod is
?5!::K
b/ Fsin$ the inde& ethod=
"t each dividend payent date, the nuber of additional shares purchased is e&pressed
as follows=
"S N 0Nn O D/P)n
+here=
"S N "dditional shares
Nn N Nuber of shares at the be$innin$ of the period N 1
D N Dividend at the end of the period N J:
)n N Endin$ price N J167
Therefore=
Nuber of additional shares 0"S/ after 9 onths e%uals
"S
9onths
N 01/0J:/PJ167 N 6!68G68G share
Nuber of shares after 9 onths N J1R J6!68G68G N J1!68G68G
Nuber of additional shares 0"S/ after 1 year is as follows
"S
1year
N 01!68G68G/0J:!8?/PJ119!9: N 6!687:6I share
Nuber of shares after 1 year N J1!68G68G R J6!687:6I N J1!6G5::9
Fsin$ the Inde& rate forula=
Inde& rate N 0)
n
O Nn/P 0)o O No/ *1
+here=
)
n
N Endin$ price 0new price/ N J119!9:
N
n
N Nuber of shares at the end of the period N J1!6G5::9
)o N 3e$innin$ price 0old price/ N J166
No N Nuber of shares at the be$innin$ of the period N J1
2ichard 1loey
M3" 4 15
T.
3atch
Student Nuber +"6789:
15
INVESTMENT
2 N[ 0119!9:/01!6G5::9/P0166/01/ ]- 1
R = 25.44%
Therefore the tie wei$hted rate of return on the portfolio usin$ inde& ethod is also
?5!::K! The two results are therefore the sae!
Question I
If a dividend discount odel indicates that a stoc# is undervalued, investors should buy the
stoc#! Is this stateent always true, only soeties true, or never trueL E&plain your answer
carefullyL
"nswer
Dividend discount odel is a widely accepted financial tool used to evaluate stoc#s based
on the net present value of the future dividends! It wor#s by analy;in$ and a#in$
assuptions related to $rowth in dividends and interest rates! It,s a tool that is heavily
based on speculation but what sets it apart fro other financial tools is its ability to
copare specific nubers based on the $iven data with accuracy!
Dividend discount odel can only be applied to stoc#s that pay dividends! Dividends are
portion of earnin$s that a copany decides to $ive out as cash or stoc# to its
shareholders! (opanies that offer dividends, li#e Microsoft, are usually very stable and
secure and have financial stren$th to continue payin$ dividends!
Dividend discount odel can also help investors decide if the future $rowth in dividends
is worth the investent today! The concept of tie value of oney is crucial in
calculations related to dividend discount odel! 1uture $rowth in dividend payents is
discounted to present value of the stoc# to see if the stoc# is undervalued or overvalued!
"ny stoc# that trades at a lower price than the issuin$ copany<s reputation, earnin$s
outloo#, or financial situation would see to erit is considered undervalued!
Fndervaluation ay occur when investors lose interest in a copany, perhaps because it
hasn<t #ept pace with its copetitors, or if there are ana$eent probles!
Soe investors concentrate on identifyin$ and investin$ in undervalued stoc#s,
soeties called siply value stoc#s, drawn by their bar$ain prices and the e&pectation
of recovery!
The dividend discount odel is therefore a useful heuristic odel that relates the present
stoc# price to the present value of its future cash flows in the sae way that a bond is
priced in ters of its future cash flows! .owever, bond pricin$ is a ore e&act science,
2ichard 1loey
M3" 4 15
T.
3atch
Student Nuber +"6789:
19
INVESTMENT
especially if the bond is held to aturity, since its cash flows and the interest rate of those
cash flows are #nown with certainty, unless the bond issuer defaults! The dividend
discount odel, however, depends on pro'ections about copany $rowth rate and future
capitali;ation rates of the reainin$ cash flows! 1or instance, in a bear ar#et, the
capitali;ation rate will be hi$her than in a bull ar#et! .ere, investors will deand a
hi$her re%uired rate of return to copensate the for a perceived $reater aount of ris#!
-ettin$ either the capitali;ation rate or the $rowth rate wron$ will yield an incorrect
intrinsic value for the stoc#, especially since even sall chan$es in either of these factors
will $reatly affect the calculated intrinsic value! 1urtherore, the $reater the len$th of
tie considered, the ore li#ely both factors will be wron$! .ence, the true intrinsic
value of a stoc# is cannot be #nown, and, thus, it cannot be deterined whether a stoc# is
undervalued or overvalued based on a calculated intrinsic value, since different investors
will have a different opinion about the copany,s future!
So while it is obvious that stoc#s are priced accordin$ to the ar#et,s e&pectations of
future cash flows fro ownin$ the stoc#, both as to dividends and future stoc# price,
there is no way to ascertain e&actly what that true intrinsic value is!
It,s a $ood idea to buy a stoc# that is undervalued because the aount of future cash
flows it is able to $enerate! Fsin$ dividend discount odel, it is very easy to identify
$rowth or incoe stoc#s that can prove to be profitable if the investent is ade in the
present!
An the other hand, one has to #eep in ind that dividend discount odel is hi$hly
speculative and is based on variety of assuptions! In theory it is one of the best financial
tools available to investors but in the real world it is better to use wide ran$e of tools to
evaluate stoc#s!
It is therefore not always true that when the dividend discount odel indicates that a
stoc# is undervalued, investors should buy the stoc#, since the odel itself is based on a
lot of assuptions and when these assuptions are not realised investors i$ht be
ne$atively affected! It would be better for the investors to use wide ran$e of tools to
evaluate the stoc#s to be able to ascertain the stoc#s, intrinsic value before buyin$ it!
2ichard 1loey
M3" 4 15
T.
3atch
Student Nuber +"6789:
1G
INVESTMENT
Question 16
(onsider a position consistin$ of J?66,666 investent in asset " and a J566,666 investent
in asset 3! "ssue that the daily volatilities of the assets are 1!9K and 1!?K, respectively,
and that the correlation coefficient between their returns is 6!8=
a/ +hat is the one*day I5K Va2 for the portfolio
b/ +hich is the five*day IIK Va2 for the portfolio
c/ +hich conclusions can be drawn fro the difference between the outcoes of parts a and
b!L
"nswer
a/ Ane*day I5K Va2 for the portfolio
"sset " N J?66,666
"sset 3 N J566,666
Total portfolio value N JG66,666
Volatility of " N 1!9K
Volatility of 3 N 1!?K
(orrelation coefficient N 6!8
+ei$htin$ of " N ?66,666PG66,666 N ?7!5GK
+ei$htin$ of 3 N 566,666PG66,666 N G1!:8K
"ssuin$ the ean for the portfolio is ;ero!
Then
Va2
1*a
N *0Sa Ow
1
?
T
1
?
R w
?
?
T
?
?
R ?w
1
w
?
T
1
T
?
U
1,?
/ O p
+here=
Sa N *1!9::I
+
1
N wei$htin$ of stoc# " N ?7!5GK
+
?
N wei$htin$ of stoc# 3 N G1!:8K
T
1
N volatility of stoc# " N 6!619
T
?
N volatility of stoc# 3 N 6!61?
U
1,?
N the correlation coefficient between stoc#s " and 3 N 6!8
) N total portfolio value N JG66,666
Therefore=
Va2
I5K
N *0*1!9::IO 6!?75G
?
O6!619
?
R6!G1:8
?
O6!61?
?
R?O6!?75GO6!G1:8O6!619O6!61?O6!8/
O JG66,666
Therefore=
Va2
I5K
N J1?,561!?5
This eans that there is a 5K chance that portfolio ay e&perience a loss of at least
J1?,561!?5 at the end of the ne&t tradin$ day under noral ar#et conditions!
2ichard 1loey
M3" 4 15
T.
3atch
Student Nuber +"6789:
17
INVESTMENT
b/ 1ive*day IIK Va2 for the portfolio
"ssuin$ the ean for the portfolio is ;ero
+here=
Sa N *?!8?98
+
1
N wei$htin$ of stoc# " N ?7!5GK
+
?
N wei$htin$ of stoc# 3 N G1!:8K
T
1
N volatility of stoc# " N 6!619
T
?
N volatility of stoc# 3 N 6!61?
U
1,?
N the correlation coefficient between stoc#s " and 3 N 6!8
) N total portfolio value N JG66,666
Fsin$ the Va2
IIK
Fsin$ the forula fro 0a/ above the IIK Va2 for the portfolio is as follows=
Va2
IIK
N *0*?!8?98O6!?75G
?
O6!619
?
R6!G1:8
?
O6!61?
?
R?O6!?75GO6!G1:8O6!619O6!61?O6!8/ O
JG66,666
N J1G,9GI!7I
Therefore the 5*day IIK Va2 e%uals
Va2
5* day, IIK
N J1G,9GI!7I O 5
N J8I,588!::
This eans that there is a 1K chance that the portfolio ay lose at least J8I,588!:: at the
end of the ne&t five tradin$ days under noral ar#et conditions!
c/ It can now be concluded fro the fore$oin$ results that when the confidence level $oes
hi$h, in this case fro I5K to IIK, the ris# level also $oes hi$h! It can also be concluded
that the ore the tradin$ days under noral ar#et conditions the hi$her the ris# level!
2ichard 1loey
M3" 4 15
T.
3atch
Student Nuber +"6789:
1I