Investment Theory, Environment and Financial Markets

Question 1

Types of Investment Risk

Answer 1

1) Business - Uncertainty in income flows caused by the nature of the firm’s business (sales volatility, financial/operating leverage)

2) Market (systematic risk) - Macroeconomic factors present for all investments. Measured by BETA

3) Reinvestment - Coupon/interest payments are not reinvested at the calculated yield to mature (when the interest rate falls, investor will not achieve anticipated return)

4) Interest - Risk that the bond will decline in value if the interest rates rise

5) Purchasing Power (inflation) - Cost of living increases or reduced purchasing power

6) Marketability - Risk of not being able to transfer the ownership of a security to any other investor

7) Liquidity - Risk of not being able to sell a security quickly at its FMV

8) Political - Uncertainty of returns caused by the possibility of a major change in the political or economic environment in a country

9) Exchange rate - Uncertainty of return is introduced by acquiring securities denominated in a currency different from that of the investor (changes in exchange rates affect the investors return)

Question 2

Measurement of Risk

Answer 2

1) Standard Deviation - Measures the dispersion of possible returns (variance) and the square root of the variance is the standard deviation. Also known as total risk (includes market and business risk)
- The larger the variance, the greater the dispersion, and the greater the uncertainty/risk of the investment

2) BETA (market risk) - measure the systematic risk of an asset, which relates the the co-movement of the investment to the movement of the market (Low risk investments = BETA <1, high risk investments = BETA >1)

Question 3

Influence on Time on Investment Risk

Answer 3

1) Effects of Time - The longer the investment horizon, the more risk can be incorporated into the financial plan
- Holding stocks and bonds in the short term hold more risk due to the volatile nature of stock prices, or uncertainty of future inflation and interest rate levels)

Question 4

Risk Measurement for Fixed Income Securities (Bonds)

Answer 4

1) Duration and convexity
- Bond prices move inversely with changes in interest rates, that is, as interest rates rise (fall), bond values fall (rise).
- Bonds with longer duration (longer maturities) tend to be more volatile given changes in interest rates, thus if you expect interest rates to fall, you want to buy bonds with long duration to achieve the highest price appreciation of your investment.
- Bonds with shorter duration (shorter maturities) tend to be less volatile given changes in interest rates, thus if you expect interest rates to rise, you want to buy bonds with short duration to suffer the lowest decrease in value of your investment.
- Bonds with higher convexity magnify this relationship

Question 5

Factors that Affect Duration

Answer 5

1) Factor - The higher (lower) the coupon/interest rate
Duration - The lower (higher) the duration

2) Factor - The longer (shorter) the maturity date
Duration - The higher (lower) the duration

NOTE:

1) If you anticipate interest rates are going to fall, you would want to select the bonds or bond portfolio with the longest duration, to achieve the largest increase in value.

2) If you anticipate interest rates are going to rise, you would want to select the bonds or bond portfolio with the shortest duration, to achieve the smallest decrease in value.

Question 6

Dividend Discount Model (DDM)

Answer 6

Used to value dividend paying stocks (value of any security is equal to the present value of the future cash flows, or expected dividends paid to shareholders).

Ps = D1 / (r-g)

D1 = expected dividend
r = required return by investors
g = dividend growth rate

Question 7

Price-Earnings

Answer 7

Indicates how much investors are willing to pay for each dollar of company earnings (ratio of market price to earnings per share)

Signifies an investors confidence in the earnings potential of a company

1) High P/E ratio indicates a high degree of confidence in the earning potential of the company (growth stocks)

2) Low P/E ratio indicates a low degree of confidence in the earning potential of the company (value stocks)

P/E = (Dividend Payout) / (r-g)

Dividend Payout = (Dividends) / (Earnings)

NOTE: SEE TABLE ON PAGE 32