FIN 501 Lecture Notes - Lecture 2: Wrap Account, Verizon Communications, Positio

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7 Dec 2017

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Individual must balance return objective with risk tolerance (must think about risk and return and how much risk they can handle: your risk tolerance is affected by, your ability to take risk and your willingness to take risk. Asset allocation: how should you distribute your investment funds across the different classes of assets, asset allocation is the more important determinant of portfolio returns, 90% of portfolio performance stems from asset allocation and 10% from security selection. Full-service brokers: discount broker, deep-discount brokers, e-brokers or cyberbrokers, online investing has changed the industry, slashing brokerage commission, providing investment information, customer place buy and sell orders over the internet. Advisor/customer relations: any advice you receive is not guaranteed, broker works as your agent and has a legal duty to act in your best interest, brokerage firms do make profits from brokerage commissions and/or annual fees. Cash account: brokerage account in which securities are paid in full.

Related Questions

Hi guys could someone help me and explain in detail the two fundamental principles of investments â the risk/return tradeoff and diversification. Also, describe how asset allocation and the correlation of various securities within asset classes impact the riskiness of an investorâs portfolio.

I found an answer but it seems to me very long and not sure about it so can you help me out guys

ANS:

Risk /Return Tradeoff

Risk, return and liquidity are three dimensions of investment decision. Risk/Return trade off considers two dimension ie risk and return. As risk of an investment increases , its expected return will decrease. Risk is measured by volatility of return which can be statistically obtained by standard deviation of return. Higher the standard deviation, higher will be volatility of return and higher the risk

Risk can be also measured as a relative risk compared to the market. This is measured by stock beta with reference to a market index. Higher the beta, higher the value of stock Beta, higher will be the risk .

Investors seeking higher return will need to take higher risks.

Treasury bonds are almost risk free assets. This has the lowest rate of return. Stocks have higher risk , hence have higher expected return. High beta stocks will have higher risk and higher returns.

An investor should understand his risk taking ability and will have to make a trade off between risk and return depending on his risk apetite.

Diversification:

There is a saying, do not put all your eggs in one basket. The reason is that it has higher risk if all eggs are in one basket. If the eggs are distributed in different basket, risk of loss decreases.

Same principle is applied in investment. Diversification reduces risk.

If one invests in different classes of assets like bonds, stock, commodities and properties âhis risk is likely to reduce. Reduction in return in one asset is likely to be compensated by return in other asset.

Within one class of asset also, there should be diversification to reduce risk.

For example one stock âA âmay have expected return of 10% and standard deviation of 5%.This risk can be reduced by diversification in number of assets and the ratio of Risk/return can be decreased.

If we diversify and instead of investing 100% in stock A, we invest 60% in âAâ and 40% in another stock âBâ having expected return15% and standard deviation of 8%.assume the correlation between the two assets are 0.5

Portfolio return=wa*Ra+wb*Rb

Wa=Weight of asset A=0.6

Wb=Weight of asset B=0.4

Ra=Return of A=10%

Rb=Return of B=15%

Sa=Standard deviation of A=5%

Sb=Standard deviation of B=8%

Corr(a,b)=Correlation of A & B=0.2

Portfolio return=0.6*10+0.4*15=12%

Portfolio Variance=(wa^2)*(Sa^2)+(wb^2)*(Sb^2)+2wa*wb*Cov(a,b)

Cov(a,b)=Corr(a,b)*Sa*Sb=0.1*5*8=4

Portfolio Variance=(0.6^2)*(5^2)+(0.4^2)*(8^2)+2*0.6*0.8*4=23.08

Portfolio standard deviation=Square root of Variance=(23.08^0.5)=4.8%

The diversification has increased return and reduced risk

Stock A was giving 10% return with 5% standard deviation. With diversification of portfolio we have 12% return and 4.8% standard deviation. Risk return ratio is decreased.

It may be noted that, higher the correlation between assets in the portfolio, higher will be risk in terms of standard deviation. Hence it is better to diversify with uncorrelated assets.

Diversification reduces unsystematic risk,but it cannot reduce systematic risk of overall market or economy

Roger McDonald, 55 years old and single, is a dental surgeon and owns a dental practice. Roger has accumulated a SGD2,000,000 investment portfolio with a large concentration in small-cap Singapore equities. Over the last 5 years the portfolio has averaged 15 percent annual total return on investment. Roger does not expect to retire before he is 70 years old. His current income is more than sufficient to meet his expenses. Upon retirement, he plans to sell his medical practice and use the proceeds to purchase an annuity to cover his retirement cash flow needs. He has no additional long term goals or needs.
In consultation with Roger, his investment advisor, Justin Teo has drawn up an investment policy statement with the following elements (Justinâs notes justifying each item are included):
Risk tolerance: Roger has above average risk tolerance.
Justinâs notes:
- Rogerâs present investment portfolio and his desire for larger returns indicate a high willingness to take risk.
- His financial situation (largely current asset base, has ample income to cover expenses, lack of need for liquidity or cashflow, and long time horizon) indicates a high ability to assume risk.
Return Objective: The return objective is an average total return of 10 per cent or more with a focus on long-term capital appreciation.
Justinâs notes:
- Rogerâs circumstances warrant an above-average return objective that emphasizes capital appreciation for the following reasons:
- Roger has a sizable assert base and ample income to cover his current spending; therefore, the focus should be on growing the portfolio.
- Rogerâs low liquidity needs and long time horizon support an emphasis on a long term capital appreciation approach.
- Roger does not rely on the portfolio to meet living expenses.
-The numerical objective of 10 per cent represents an estimate of a target Roger can aim for rather than a minimum return required to meet a specific financial goal.

Liquidity: Rogerâs liquidity needs are low.
Justinâs notes:
- Roger has no regular cash flow needs from the portfolio, because the income from his medical practice meets all current spending needs.
- No large, one-time cash needs are stated. However, it could be considered appropriate to keep a small cash reserve for emergencies.
Time Horizon: Rogerâs time horizon is long term and consists of 2 stages:
(1) The first stage consists of the time until his retirement, which he expects to be 15 years.
(2) The second consists of his lifetime following retirement, which could range
from 10 to 20 years. Justin has also summarised Rogerâs current portfolio in Exhibit 1 below:
Value Total Return Deviation
Short-term Bonds $200,000 10% 4.6% 1.6%
Domestic Large-Cap Equities $600,000 30% 12.4% 19.5%
Domestic Small-Cap $1,200,000 60% 16.0% 29.9%
Total Portfolio $2,000,000 100% 13.8% 23.1%
Exhibit 1: Rogerâs Current Investment Portfolio

Roger expects to receive an inheritance of SGD2,000,000 soon. Roger and Justin sit down to discuss its investment in one of the four index funds. Given Rogerâs already above average risk tolerance and level of portfolio risk, Roger and Justin have concluded that the risk tolerance description in the current IPS remains valid; they do not want to contemplate further increase in portfolio risk. On the other hand, they do not wish to reduce expected return. Justin is evaluating the four index funds shown in Exhibit 2 below for their ability to produce a portfolio that will meet the following two criteria relative to the current portfolio:
- Maintain or enhance expected return, and
- Maintain or reduce volatility.

Each Fund in Exhibit 2 is invested in an asset class that is not substantially represented in the current portfolio shown in Exhibit 1. Exhibit 2 presents statistics on those index
funds.
Expected Expected Correlation of
Index Annual Annual Standard Returns with Current
Fund Return Deviation Portfolioâs Return
Fund A 15% 25% +0.80
Fund B 11% 22% +0.60
Fund C 16% 25% +0.90
Fund D 14% 22% +0.65
Exhibit 2: Expected Risk, Return and Correlation of 4 Index Funds under Consideration

Question 1
(a) Recommend the most appropriate index fund to add to Rogerâs portfolio. Justify your recommendations by describing how your chosen fund best meets both of the stated criteria. (No calculations are required.)

(b) Twenty years later, Roger is meeting with you, his new financial advisor. You are evaluating if Rogerâs investment policy remains appropriate for his changed circumstances.
- Roger is now 75 years old and retired. His spending requirements are expected to increase with the rate of general inflation, which is expected to average 3.0 per cent annually.
- Roger estimates his current living expenses at SGD150,000 annually. An annuity, purchased with the proceeds from the sale of his medical practice, provides SGD20,000 of this amount. The annuity is adjusted for inflation annually using a national price index.
- Because of poor investment performance and a high level of spending, Rogerâs asset base has declined to SGD1,200,000 exclusive of the value of the annuity.
- Roger sold all of his small-cap investment last year and invested the proceeds in domestic bonds.
- Because his international equity investments have performed poorly, Roger has become markedly uncomfortable holding international equities.
-Roger plans to donate SGD60,000 to a charity in three months.

Discuss how each of the following components of Rogerâs investment policy statement should now reflect the changes in his (note that the observations should focus on but not limited to the direction and magnitude of change in each component rather than on a specific numeric change):
(i) Risk tolerance
(ii) Return requirement
(iii) Liquidity needs
(iv) Time horizon

(c) Rogerâs investment portfolio at 75 years old is summarised in Exhibit 3 below:
Current Expected Expected
Allocation Return Standard Deviation
Cash equivalents 2% 5% 3%
Fixed Income 75% 7% 8%
Domestic Equities 10% 10% 16%
International Equities 3% 12% 22%
Domestic Real Estate 10% 10% 17%
_______________________________________________________________
Exhibit 3: Rogerâs Investment Portfolio at Age 75 Years Old

Given Rogerâs changed circumstances, state whether the current allocation to each asset class should be lower, the same, or higher. Justify your response with one reason for each asset class. No calculations are required and responses should be based only on Rogerâs changed circumstances and the information in
Exhibit 3.
(i) Cash Equivalents
(ii) Fixed Income
(iii) Domestic Equities
(iv) International Equities
(v) Domestic Real Estate

(d) Explain one (1) way in which Roger might seek to reduce the tension between his current return requirement and his current risk tolerance.

orangewildebeest816

Time Value of Money Project

Name: __________________

Please show all your work if you use the Calculator. If done in Excel, please send me the spreadsheet / workbook.

What is the market value of the following bond?

Coupon 8%

Maturity date 2038

Interest paid semiannually

Par Value $1000

Market interest rate 10%

What is the market value of the following bond?

Coupon 9%

Maturity date 2028

Interest paid semiannually

Par Value $1000

Market interest rate 8%

What is the yield to maturity of the following bond?

Coupon 9%

Maturity date 2027

Interest paid semiannually

Par Value $1000

Market price $955.00

What is the current yield of bond in Question 3?

The risk free rate is 7%, the return in the market is 10%, and the beta is 1.30.What return must you receive to be satisfied that you are being fairly compensated for the risk of the firm?

What should a zero coupon bond maturing for $1000 in 9 years with a 7% market rate sell for?

Page Two

Preferred stock has a dividend of $12 per year.The required return is 6%.What should be the price per share?

Hurricane Corporation expects to grow its dividend by 5% per year.The current dividend is $2 per share.The required return is 8%.

What is the estimated value of a share of common stock?

If price is $40 and dividends were $1.50 per share but expected to grow at 4% per year, what would be the required rate of return?

Compute the expected return for the following investment

State of nature Probability Return

Boom 25% 20%

Average 60% 8%

Recession 15% 0%

The following are the expected returns on a portfolio of investments.What is the expected rate of return on the portfolio?

Investment # of shares Price per share Expected return

A. 2000 $20 10%

B. 3000 $10 15%

C. 1000 $15 8%

You take out a $200,000 mortgage for 20 years at 6%.

What is your monthly payment?

What is the principle and interest on the first payment?

What is the principle and interest on the twelfth payment?

How much interest will you pay over the 20 years?

You bought a house 8 years ago with a $250,000 mortgage.It was a 15 year loan with monthly payments which will pay off the loan when you make the last payment. The interest rate was 6%.What are your monthly payment and your current loan balance?How much interest will you pay in the upcoming year?

Page Three

You want to retire has a millionaire. How much do you need to put away each month if:

You use common stocks and have an average return of 10%?

You use corporate bonds and have an average return of 6%?

You use government bonds and have an average return of 4%?

You put your money in a CD at 2.5% interest rate?

(Please use your own age. If you are over 45, please solve for saving a $100,000.)

You are offered a contract with a signing bonus. If they offered you either $215,000 in cash or $2,000 a month for 15 years, guaranteed, which do you take (based strictly on the math)? Your safe rate of return is 7.5%.

You are 30 years old today and planning to retire at age 62.You want to plan your finances for living 35 years past age 62 and die dead broke. You determine you will need $3000 per month from age 62 for the 35 years.

Your plan is to go live in the tropics, on the beach, and live on coconuts and fishing. Also, you need to conclude your retirement savings at age 55 because all your spare money then will be going to your childrenâs education.

The question is how much money you will need to save each month between now and 55 so that you can quit contributing. The expected return on your investments over the whole period is 10% per year. Please ignore inflation.

tealmacaw743

FIN 501 Lecture Notes - Lecture 2: Wrap Account, Verizon Communications, Positio

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