Lecture no14 investing in financial assets

Investing in Financial Assets Lecture No 14 Chapter Contemporary Engineering Economics Copyright © 2016 th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved A Investment Basics The three basic investment objects are: growth, income, and liquidity • Liquidity: How accessible is your money? • Risk: How much risk is involved? • Return: How much profit will you be able to expect from your investment? The two greatest risks investors face are inflation and market volatility th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Basic Concept: How to Determine Your Expected Return Real Return 2% Inflation 4% Risk premium 0% Total expected return 6% Real Return 2% Inflation 4% Risk premium 20% Total expected return 26% U.S Treasury Bills Very safe Risk-free real return Risk Inflation premium Very risky A start-up company th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Figuring Average versus Compound Return 5% Average rate of return th Contemporary Engineering Economics, edition Park 12% 10% Compound Rate of Return Copyright © 2016 by Pearson Education, Inc All Rights Reserved Annual Investment Yield (Base investment of $1,000) Investment Case Case Case Case Case Case Year 9% 5% 0% 0% -1% -5% Year 9% 10% 7% 0% -1% -8% Year 9% 12% 20% 27% 29% 40% Compound Versus Average Rate of Return Investment Case Case Case Case Case Case Average return 9.00% 9.00% 9.00% 9.00% 9.00% 9.00% Balance at the end of year $1,295 $1,294 $1,284 $1,270 $1,264 $1,224 Compound return 9.00% 8.96% 8.69% 8.29% 8.13% 6.96% th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved How to Determine Expected Financial Risk • Risk refers to the chance that some unfavorable event will occur • Volatility measures the deviation from the expected value, or sudden swings in value, from high to low or the reverse • Standard deviation measures the degree of volatility when you have the probabilistic information about the uncertain event • Beta measures how closely a fund’s performance correlates with broader stock market movement • Alpha shows whether a fund is producing better or worse returns than expected, given the risk it takes th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved B Investment Strategies • Trade-off between risk and reward • • • Cash: the least risky with the lowest returns Debt: moderately risky with moderate returns Equities: the most risky but offering the greatest payoff • Dollar-cost averaging concept: planned transfer, over a period, of equal amounts from one asset to another • Broader diversification reduces risk: by combining assets with different patterns of return, it is possible to achieve a higher rate of return without increasing significant risk • Broader diversification increases expected return • Portfolios with long-term horizons need equities to offset inflation while short time frames requires debt and/or cash investments to reduce volatility th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Dollar-Cost Averaging Concept Amount Invested Fund No of Units Purchased Ending Fund Balance Unit Price Timing Month $1,000 $5.00 200 $1,000 Month $1,000 $4.00 250 $1,800 Month $1,000 $2.50 400 $2,125 Month $1,000 $3.75 267 $4,189 Month $1,000 $5.00 200 $6,585 Totals $5,000 th Contemporary Engineering Economics, edition Park 1,317 Copyright © 2016 by Pearson Education, Inc All Rights Reserved Broader Diversification Increases Return Amount Investment $2,000 Buying lottery tickets $2,000 Under the mattress 0% $2,000 Term deposit (CD) 5% $2,000 Corporate bond 10% $2,000 Mutual fund (stocks) 15% th Contemporary Engineering Economics, edition Park Expected Return -100% (?) Copyright © 2016 by Pearson Education, Inc All Rights Reserved Expected Value in 25 Years Option 1: Invest $10,000 in  one asset category (say, bond with 7% interest) Option 2: Invest $10,000 in  five different classes of assets th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved C Investing in Stocks Investing in stocks and bonds is one of the most common investment activities among American investors • Stocks: Ownership in a corporation • Ownership: If a company issues one million shares, and you buy 10,000 shares, you • own 10% of the company Valuation: (1) cash dividend and (2) share appreciation at the time of sale th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Conceptual Stock Valuation Given: • • • • • Stock price as of May 1, 2015: $72/share Earnings growth for next years: 8% Expected cash dividend in 2016: $2.00/share Expected stock price in years: $95/share Required return on your investment: 10% Find: Current value of stock th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Valuation • Cash Flow $95 th Contemporary Engineering Economics, edition Park $2 $2 $2 Copyright © 2016 by Pearson Education, Inc All Rights Reserved D Investing in Bonds • Bonds: Loans that investors make to corporations and governments • Face (par) value: Principal amount (typically $1,000 or $10,000) • Coupon rate: Nominal interest rate quoted on par value • Maturity: The length of the loan th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Types of Bonds and How They are Issued in the Financial Market th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Bond Price Notation Used in Financial Markets Corporate Bonds 1/8=$1.25 1/4=$2.50 Treasury Bonds 5/8=$6.25 3/4=$7.50 3/8=$3.75 1/8=$5.00 th Contemporary Engineering Economics, edition Park 1=$10 1/32=$0.3125 17/32=$5.3125 2/32=$0.6250 18/32=$5.6250 3/32=$0.9375 19/32=$5.9375 4/32=$1.25 20/32=$6.25 6/32=$1.5625 21/32=$6.5625 7/32=$1.8750 22/32=$6.8750 7/32=$2.1875 23/32=$7.1875 8/32=$2.50 24/32=$7.50 9/32=$2.8125 25/32=$7.8125 10/32=$3.1250 26/32=$8.1250 11/32=$3.4375 27/32=$8.4375 12/32=$3.75 28/32=$8.75 13/32=$4.0625 29/32=$9.0625 14/32=$4.375 30/32=$9.3750 15/32=$4.6875 31/32=$9.6875 16/32=$5.00 32/32=$10 Copyright © 2016 by Pearson Education, Inc All Rights Reserved How To Read a Bond Notation Maturity date No meaning, 2020 spacing AT&T 7s20 Closing price: 108 1/4 $1,082.50 th Contemporary Engineering Economics, edition Park Coupon rate Copyright © 2016 by Pearson Education, Inc All Rights Reserved How Do Prices and Yields Work? • Yield to Maturity: The actual interest earned from a bond over the holding period • Current Yield: The annual interest earned as a percentage of the current market price th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Bond Quotes Maturity (2020) AT&T 7s20 Trading volume 6.5% million 108 1/4 Closing Coupon rate of 7% Current yield $70/108.25 = 6.47% th Contemporary Engineering Economics, edition Park Market price $1,082.50 Copyright © 2016 by Pearson Education, Inc All Rights Reserved Example 4.20: Yield to Maturity and Current Yield  Given: • Par value = $1,000 • Initial purchase price = $996.25 • Coupon rate = 9.625% per year paid semiannually • Maturity = 10 years Find: • (a) Yield to maturity • (b) Current yield th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Solution (a) Yield to maturity i = 4.8422% per semiannual (b) Current yield th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Example 4.23: Bond Value Over Time Given: • Mr Gonzalez wishes to sell a bond that has a face value of $1,000 The bond bears an interest rate of 8% with bond interest payable semiannually • Four years ago, $920 was paid for the bond At least a 9% return (yield) in the investment is desired Find: • What must be the minimum selling price? th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Solution • Semiannual interest payment = $40 • Required semiannual return = 4.5% • Desired selling price of the bond (F) th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved ... interest) Option 2: Invest $10,000 in  five different classes of assets th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved C Investing. .. All Rights Reserved C Investing in Stocks Investing in stocks and bonds is one of the most common investment activities among American investors • Stocks: Ownership in a corporation • Ownership:... Education, Inc All Rights Reserved Valuation • Cash Flow $95 th Contemporary Engineering Economics, edition Park $2 $2 $2 Copyright © 2016 by Pearson Education, Inc All Rights Reserved D Investing in