CHAPTER1

THEINVESTMENTSETTING

WhatIsAnInvestment?
What you do with savings to make them increase over time is
investment
InvestmentDefined
Thecurrentcommitmentoffundsforaperiodoftimetoderivea
futureflowoffundsthatwillcompensateyouforthetimethe
fundsarecommitted,fortheexpectedrateofinflation,andfor
theuncertaintyofthefutureflowoffunds.
TheTimeValueofMoney
Adollartodayisworthmorethanadollartomorrow.
Moneyhastimevaluebecauseof:Realriskfreerate,Inflation
protection,andrisk
Reasonsforinvesting
Income.CapitalPreservation.CapitalAppreciation.
KeyIssuesinInvesting
Thereisatradeoffbetweenriskandexpectedreturn.
DevelopedFinancialMarketsarenearlyefficient.
Focusshouldbeonaftertaxreturns,netofexpenses.
Investorsshoulddiversifyacrossassetclasses,industries,and
countries.
TheFinancialEnvironment
Typesofinvestments:Directinvestment.IndirectInvestment.
Derivatives
MarketParticipants:Households.Businesses.Government.
InvestmentStrategies
AssetAllocation.ActiveMarkettiming.PassiveMaintain
predeterminedassetallocation.
SecuritySelection.ActiveStockPicking.PassiveIndexing.

EthicsandJobOpportunitiesinInvestments
RegisteredRepresentativewithaBrokerageFirm
InvestmentAnalystwithaBrokerageFirmorInvestmentBankers
InvestmentAnalystwithaBank
InvestmentAnalystwithaMoneyManagerorMutualFund
InvestmentAnalystwithInsuranceCompany
PortfolioManager
FinancialPlanner
ProfessionalDesignations:CharteredFinancialAnalyst(CFA).
CertifiedFinancialPlanner(CFP).

CHAPTER1
AnswerstoQuestions

1. When an individual's current money income exceeds his

current consumption desires, he saves the excess. Rather
than keep these savings in his possession, the individual
mayconsideritworthwhiletoforegoimmediatepossessionof
themoneyforalargerfutureamountofconsumption. This
tradeoff of present consumption for a higher level of
futureconsumptionistheessenceofinvestment.
An investmentisthe current commitmentoffundsfora
period of time in order to derive a future flow of funds
that will compensate the investor for the time value of
money,theexpectedrateofinflationoverthelifeofthe
investment, and provide a premium for the uncertainty
associatedwiththisfutureflowoffunds.
2. Students in general tend to be borrowers because they are
typically not employed so have no income, but obviously
consume and have expenses. The usual intent is to invest
themoneyborrowedinordertoincreasetheirfutureincome
stream from employmenti.e., students expect to receive a
better job and higher income due to their investment in
education.
3. Inthe2030yearsegmentanindividualwouldtendtobea
netborrowersinceheisinarelativelylowincomebracket
and has several expendituresautomobile, durable goods,
etc.Inthe3040segmentagaintheindividualwouldlikely
dissave since his expenditures would increase with the
advent of family life, and conceivably, the purchase of a
house. Inthe4050segment,theindividualwouldprobably
be a saver since income would have increased substantially
withnoincreaseinexpenditures.Betweentheageof50and
60 the individual would typically be a strong saver since
income would continue to increase and by now the couple
would be "emptynesters." After this, depending upon when
the individual retires, the individual would probably be a
dissaverasincomedecreases(transitionfromregularincome
toincomefromapension).
4. Thesavingborrowingpatternwouldvarybyprofessiontothe
extent that compensation patterns vary by profession. For
most whitecollar professions (e.g., lawyers) income would
tend to increase with age. Thus lawyers would tend to be
3

borrowers in the early segments (when income is low) and

savers later in life. Alternatively, bluecollar
professions(e.g.,plumbers),whereskillisoftenphysical,
compensation tends to remain constant or decline with age.
Thusplumberswouldtendtobesaversintheearlysegments
anddissaverslater(whentheirincomedeclines).
5. In order to maintain purchasing power the nominal required
rate of return would have to increase by 7 percentage
points. Assuming a real interest rate of 3% and zero risk
premium,oneyearfromnowaninvestorwouldrequire$110to
purchasewhat$100wouldhavepurchasedoneyearago.Bynot
adjusting the required rate of return for inflation the
investorsuffersadeclineinpurchasingpower.
6. The time value of money refers to the idea that a dollar
todayisworthmorethanadollarinthefuture.
7. Aninvestor'srequiredrateofreturnisafunctionofthe
economy's risk free rate (RFR), an inflation premium that
compensatestheinvestorforlossofpurchasingpower,anda
risk premium that compensates the investor for taking the
risk. TheRFRisthepuretimevalueofmoneyandisthe
compensation an individual demands for deferring
consumption. Moreobjectively,theRFRcanbemeasuredin
termsofthelongrunrealgrowthrateintheeconomysince
the investment opportunities available in the economy
influence the RFR. The inflation premium, which can be
convenientlymeasuredintermsoftheConsumerPriceIndex,
is the additional protection an individual requires to
compensate for the erosion in purchasing power resulting
fromincreasingprices.Sincethereturnonallinvestments
isnotcertainasitiswithTbills,theinvestorrequires
apremiumfortakingonadditionalrisk. Theriskpremium
canbeexaminedintermsofbusinessrisk,financialrisk,
liquidityrisk,exchangerateriskandcountryrisk.
8. Required rate of return = Real Risk Free rate + Inflation
Premium + Risk Premium. Therefore the required rate of
returnhereis9%.
9. Investorswillpurchasethesafeassetratherthantherisky
asset.Demandforthesafeassetwillpushthepriceofthe
assethigherandtheyieldloweruntiltheyieldontherisk
assetexceededtheyieldonthesafeasset.
10.Becausetherequiredrateofreturnhasariskpremium.The
riskiertheassetthehighertheriskpremiumandtherefore
the higher the required rate of return on the asset. Thus
riskdrivesexpectedreturn.

11.Markets are operationally or internally efficiency if

transactions costs of trading are low. External or
information efficiency refers to the idea that new
informationisquicklyreflectedinassetprices.
12.Ataxreducesaninvestorsrateofreturn.Forexampleif
pretaxandpreexpenseannualreturnsare10%andthetax
rate is 25%. The after tax return to the investor is
0.10(1.25)=0.075or7.5%.Investmentexpensesalsoreduce
an investors rate of return. Using the previous example,
theinvestorsreturnaftertaxesandinvestmentexpensesof
5%wouldbe0.075(10.05)=0.07125or7.125%.
13.A sure thing investment would be a risk free asset that
would provide relatively low returns. In order to enhance
returnsanddiversifyriskaninvestorwouldhavetoinvest
acrossassetclasses.Ifthesurethinginvestmentwasa
risky asset then the investors could in the extreme loose
the whole investment. Diversifying across asset classes
helpsreduceriskandenhancereturns.
14.Themajorsourceofsavingsisthehouseholdsector.
15.Financial intermediaries function in primary markets and
helptogatherfundsfromsaversandchannelthemtoparties
such as the government and corporations. For example an
investment bank that underwrites an IPO is a financial
intermediary.
16.Brokers and dealers both function in secondary markets. A
broker helps to bring buyers and sellers together. On the
other hand a dealer, while assisting in the process of
bringingbuyresandsellerstogether,maytradefromhisown
account.
17.In the asset allocation decision an active investor will
attempttotimethemarket,thatistryanddeterminewhich
asset class is likely to outperform in the future and
increase the allocation to that asset class. A passive
investorontheotherhandwillstickwithapredetermined
assetallocationwithperiodicrebalancing.
Inthesecurityselectiondecisionandactiveinvestorwill
focus on stock picking. A passive investor would track a
marketindex.
18.Ifamanagerfelthehadexpertiseinmarkettimingbutnot
insecurityselectionthenhewouldfollowanactiveasset
allocationpolicyandapassivesecurityselectionstrategy.
Ifthemanagerfelthehadsuperiorstockpickingskillsbut
lacked expertise in market timing then the appropriate
5

strategy would be to follow a passive asset allocation

strategyandbeactiveinsecurityselection.
19.Practitioners in the financial services sector advise
clients and deal with large sums of money. Consequently,
ethicalconsiderationsareveryimportant.

CHAPTER1
AnswerstoProblems
1. Therequiredrateofreturn=(1.03)(1.04)(1.04)1=0.114.
Onethousanddollarsinvestedat11.4%over10yearswouldgrow
to
1000(1+0.114)10=$2943.42
Over20years$1000wouldgrowto
1000(1+0.114)20=$8663.71
2. a. Required rate of return = (1.05)(1.06)(1.02) = 0.1353 or
13.53%
b. Required rate of return = (1.03)(1.08)(1.03) = 0.1458 or
14.58%
c.Requiredrateofreturn=(1.04)(1.0414)(1.05)=1.1372or
13.72%
151
1 0.0414
145

wheretheinflationpremiumis

3. At the end of 20 years $10,000 invested in the taxdeferred

accountwouldhavegrownto
10,000(1+0.08)20=$46,609.57
Aftertaxyouareleftwith
46,609.57(10.25)=$34,957.18
At the end of 20 years $10,000 invested in taxable account
wouldhavegrownto
10,000(1+0.06)20=$32,071.35.
Theaftertaxyieldis0.08(10.25)=0.06
4. Iftheaftertaxrateis7%thenattheendof20years$10,000
wouldgrowto
10,000(1+0.07)20=$38,696.84
which is higher than $34,957.18, the amount available at the
endof20yearsifinvestedinataxdeferredaccountat8%.
7

CHAPTER1
AnswerstoSpreadsheetExercises
1. Thebasicspreadsheetshouldlooklikethis
Spreadsheetexercise
Initialinvestment
Numberofyears
Basereturn
FutureValue
Asset
1
2
3
4
5

$10,000.00
25
7.0%
$54,274.33
Return Allocation
FV
100% $2,000.00 $
0% $2,000.00 $2,000.00
5% $2,000.00 $6,772.71
10% $2,000.00 $21,669.41
12% $2,000.00 $34,000.13
$64,442.25

a. Approximately10.45%
Initial
investment
Numberofyears
Basereturn
FutureValue
Asset
1
2
3
4
5

$10,000.00
25
7.0%
$54,274.33
Return Allocation
FV
100.00% $2,000.00 $
0.00% $2,000.00 $2,000.00
5.00% $2,000.00 $6,772.71
10.00% $2,000.00 $21,669.41
10.45% $2,000.00 $23,997.89
$54,440.01

b. Theportfoliovaluefallsto$62,442.25
Asset
1
2
3
4
5

Return Allocation
FV
100.00% $2,000.00 $
100.00% $2,000.00 $
5.00% $2,000.00 $6,772.71
10.00% $2,000.00 $21,669.41
12.00% $2,000.00 $34,000.13
$62,442.25

c. At 8% the value of the single asset portfolio is

$68,484.75
=(1.08)25(10000)
At 6% the value of the single asset portfolio is
$42,918.71
=(1.06)25(10000)
Thevalueoftheportfoliois$64,442.25
d. If all asset returns are 1% point lower than Exhibit
1.4,theportfoliovalueis$51,304.40
Asset
1
2
3
4
5

Return Allocation
FV
101.00% $2,000.00 $(0.00)
1.00% $2,000.00 $1,555.64
4.00% $2,000.00 $5,331.67
9.00% $2,000.00 $17,246.16
11.00% $2,000.00 $27,170.93
$51,304.40

Ifallassetreturnsare1%pointhigherthanExhibit1.4,
theportfoliovalueis$80,780.62
Asset
1
2
3
4
5

Return
99.00%
1.00%
6.00%
11.00%
13.00%

Allocation
FV
$2,000.00 $0.00
$2,000.00 $2,564.86
$2,000.00 $8,583.74
$2,000.00 $27,170.93
$2,000.00 $42,461.08
$80,780.62

e. A1%increaseinreturnscausesthefutureorterminal
valueofthesingleassetportfoliotoriseby26.18%.
A 1% decrease in returns causes the future or terminal
valueofthesingleassetportfoliotofallby20.92%.
10

A1%increaseinreturnsforeachassetcausesthefuture
orterminalvalueofthediversifiedportfoliotoriseby
25.35%.
A1%decreaseinreturnsforeachassetcausesthefuture
orterminalvalueofthediversifiedportfoliotofallby
20.39%.
Thediversifiedportfolioislessvolatile.

11