Investments, Binder Ready Version: Analysis and Management, 13th Edition Solution Manual

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1Chapter 1: Understanding InvestmentsCHAPTER OVERVIEWChapter 1 is designed to be a standard introductory chapter. As such, its purpose is tointroduce students to the subject ofinvestments, explain whatinvestments is concerned withfrom a summary viewpoint, and outline what the remainder of the text will cover. It definesimportant terms such asinvestments, security analysis, portfolio management, expected andrealized rate of return, risk-free rate of return, risk, and risk tolerance.IT IS IMPORTANT TO NOTEthatChapter 1 discusses some important issues, such asthe expected return-risk tradeoff that governs the investment process, the uncertainty thatdominates investment decisions, the globalization of investments,andthe impact of institutionalinvestors. As such, the chapter sets the tone for the entire text and explains to the reader whatinvestments is all about. It establishes a basic framework for the course without going into toomuch detail at the outset.Chapter 1 also contains some material that will be of direct interest to students, includingthe importance of studying investments (using illustrations of the wealth that can be accumulatedby compounding over long periods of time) and investments as a profession. The CFAdesignation isalso brieflydiscussed.Equally important, Chapter 1 doesnotcover calculations and statistical concepts, data onasset returns, and so forth. The authorsfeel strongly that Chapter 1 is not the place to do thiswhen most students have little knowledge of what the subject is all about. They are not ready forthis type of important material, and since it will not be used immediately,they will lose sight ofwhy it was introduced. The authorsbelieve that it is much more effective to introduce thestudentsthoroughlyto what the subject involves.It is highly desirable for instructors to add their own viewpoints at the outset of thecourse,perhaps using recent stories from the popular press to emphasize what investments isconcerned with, why students should be interested in the subject, and so forth.One interestingand important topic that can be discussed in class is investment fraud. Scams continue day afterday, and many people lose their life savings. Most people will haveat leastheard of the Ponzischeme revealed in late 2008 involvingBernie Madoff. By learning a few basic investingprinciples, students will be able to avoid these “scams,” thereby possibly saving themselves ortheir family and friends from misfortune.Chapter 1 also discusses ethics in investing, setting the stage for examples of ethicalissues in other chapters.

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2CHAPTER OBJECTIVESTo introduce students to the subject matter ofinvestments from an overall viewpoint,including terminology.To explain the basic nature of the investing decision as a tradeoff between expectedreturnandrisk.To explain that the decision process consists ofsecurity analysisandportfoliomanagementand that external factors affect this decision process. These factorsincludeuncertainty, the necessity to think of investments in aglobal context, theenvironment involvinginstitutional investors, and the impact of the internet oninvesting.To organize the remainder of the text.

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3MAJOR CHAPTER HEADINGS [Contents]An Overall Perspectiveon InvestingJust Say NO!EstablishingaFrameworkfor InvestingSome Definitions[investment; investments; financial and real assets;marketable securities; portfolio]A Perspective on Investing[investing is only one part of overall financial decisions; take a portfolio perspective]Why Do We Invest?[to increase monetary wealth]Take a Portfolio PerspectiveThe Importance of Studying InvestmentsThe Personal Aspects[most people make investment decisions; examples of wealthaccumulation as a resultof compounding; people will be largely responsible for making investing decisionsaffecting their retirement;an understanding of thesubject will help students whenreading the popular press]Investments as a Profession[various jobssuch as security analysts, portfolio managers, stockbrokers, andfinancial advisors; financial planners;CFAdesignation]Understanding the Investment Decision ProcessThe Basis of Investment Decisions—Return and Risk[expected return; realized return; risk; risk-averse investor;risk tolerance;theExpectedReturn-Risk Tradeoff; diagram of tradeoff; ex post vs. ex ante; risk-freerate of return, RF]Structuring the Decision Process[a two-step process: security analysis and portfolio management]Important Considerations in the Investment Decision Process for Today’s InvestorsThe Great Unknown

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4[uncertainty dominates decisions--the future is unknown!]AGlobalPerspective[the importance of foreign markets; theeuro; emerging markets]The Importance of the Internet[using the internet to invest]Individual Investors vs. Institutional Investors[individual investors compete with institutional investors, but individuals are thebeneficiaries ofinstitutional investor activity; Regulation FD; spin-offs]Ethics in InvestingOrganizing the Text[Background; Realized and Expected Returns and Risk; Bonds; Stocks; SecurityAnalysis, including both fundamental and technical analysis; Derivative Securities;Portfolio Theory and Capital Market Theory; the Portfolio Management Process andMeasuring Portfolio Performance]

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5POINTS TO NOTE ABOUT CHAPTER 1Exhibits, Figures and TablesExhibit 1-1 discusses some professional designations used by people in the moneymanagement business. It offers a good opportunity to discuss with students the opportunities inthe field, such asbeing afinancial planner.Figure 1-1 is an important figure because it is the basis of investing decisions-indeed, it isthe basis of all finance decisions. It shows the expected return-risk tradeoff available toinvestors. This diagram should be emphasized because it can be used to generate much usefuldiscussion, including:•The upward-sloping tradeoff that dominatesinvestments.•The role of RF, the risk-free rate of return.•The importance of risk in all discussions of investing.•The different types of financial assets available.•The distinction between realized and expected return.NOTE:This diagram is relevant on the first day of class and the last.It is a good way to start thecourse and end it.NOTE:Example 1-1 shows wealth accumulations possible from an IRA-type investment. Ittypically generates considerable student interest to see the ending wealth that can be produced bycompounding over time. This type of example can be related to 401(k) plans, which are quicklybecoming of primary importance to many people.

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6SOME RECOMMENDATIONS WHEN DISCUSSING CHAPTER 1:1.The expected return-risk tradeoff is fundamental to any understanding ofinvestments.While it seems to be astraightforward concept, I find that students haveproblems with it.These problems revolve aroundunderstanding the realized tradeoff (what did happen) vs.the anticipated tradeoff (what is expected to happen). I discuss the followingrelationships to show the various tradeoffs.(a)Theexpected tradeoff(illustrated in the text),which is always upward slopingbecause rational investors must expect to receive a larger return if they are to assumemore risk. This is the basis of decision-making when investing.(b)Thelong-term (for example, 50 or more years) realized tradeoff, asillustrated bythe Ibbotson data and thereturnsdatausedin Chapter 6. This tradeoff must slopeupward if whatis taught ininvestments is to make sense; that is, we have a realproblem if over long periods of time,risky assets do not return more than safe assets.And, of course,they have done so in the past.Stocks havereturned more than bonds,which have returned more than T-bills, over very long periods of time.(c)Theshorter-term realized tradeoff, where safe assets outperform risky assets.2000-2002and 2008offer the perfect examples. The market declined sharplyin eachcase, and,therefore,T-bills returned more than stocks.On arealizedbasis, investorswere penalized for assuming risk.Obviously, they did not expect this to occur.Thus, diagrams for (a) and (b) look similar. The difference is the label on the verticalaxis: expected return for (a), and realized return for (b).2.The decline in the economy and in the stock market in 2000-2002 is a good illustration ofrisk, and of using the recent past to predict the future. During the late 1990s and into partof 2000, we heard a lot about day traders, and how we were now in a new environmentwhere the old standards of valuation,such as profitability,were much less important. Ofcourse, many of the high-flyers crashed and/or wentout of business.Today there is arenewed appreciationfor the traditional methods of stock valuation.The stock market decline of 2008 is a dramatic example of the risk that can impactinvestors. The decline was dramatic, and most investors who held stocks lost money.Many well known investors and professionally managed funds failed to anticipate thismarket decline or the extent and severity of it. Many investors found their retirementaccounts significantly diminished.3.It may be good practice to start talking about the dollar, and theeuro, at the beginning ofthe course. Movements in the dollar are a popular topic and an important one.

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7ANSWERS TO END-OF-CHAPTER QUESTIONS1-1.The termInvestmentscan be thought of as representingthe study of the investmentprocess. Aninvestmentis defined as thecommitment of funds to one or more assets tobe held over some future time period.1-2.Traditionally, the investment decision process has been divided into security analysis andportfolio management.▪Security analysisinvolves the analysis and valuation of individual securities; that is,estimating value, a difficult job at best.▪Portfolio managementutilizes the results of security analysis to construct portfolios.As explained in Part II, this is important because a portfolio taken as a whole is notequal to the sum of its parts.1-3.The study of investments is important to many individuals because almost everyone haswealth of some kind and will be faced with investment decisions sometime in their lives.One important area where many individuals can make important investing decisions isthat of retirement plans, particularly 401(k) plans. In addition, individuals often havesome say in their retirement programs, such as allocation decisions to cash equivalents,bonds, and stocks.The dramatic stock market gains of 1995-1999 and the sharp losses in 2000-2002and2008illustrate well the importance of studying investments. Investors who werepersuaded in the past to go heavily, or all, in stocks reaped tremendous gains in theirretirement assets as well as in their taxable accounts in 1995-1999 and then often sufferedsharp losses in2000-2002 and 2008.1-4.Afinancial assetis a piece of paper evidencing some type of financial claim on anissuer,whether private (corporations) or public (governments).Areal asset, on the other hand, is a tangible asset such as gold coins, diamonds, or land.1-5.Investments, in the final analysis, is simply a risk-return tradeoff. In order to have achance to earn a return above that of a risk-free asset, investors must take risk. Thelarger the return expected, the greater the risk that must be taken.The risk-return tradeoff faced by investors making investment decisions has thefollowing characteristics:The risk-return tradeoff is upward sloping because investment decisions involveexpected returns (vertical axis) versus risk (horizontal axis).Thevertical interceptis RF, therisk-free rate of return available to allinvestors.

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81-6.An investor would expect to earn the risk-free rate of return (RF) when he or she investsin a risk-free asset. This isthe zero risk point on the horizontal axis in Figure 1-1.1-7.Disagree. Risk-averse investors will assume risk if they expect to be adequatelycompensated for it.1-8.Thebasic nature of the investment decisionfor all investors is the upward-slopingtradeoff between expected return and risk that must be dealt with each time an investmentdecision is made.1-9.Expected returnis the anticipated return for some future time period, whereasrealizedreturnis the actual returnthat occurredover some past period.1-10.In general, the termriskas used in investments refers to adverse circumstances affectingthe investor’s position. Risk can be defined in several different ways.Riskis definedhere as the chance that the actual return on an investment will differ from its expectedreturn.Beginning students will probably think of default risk and purchasing power risk veryquickly. Some may be aware ofinterest rate riskandmarket riskwithout fullyunderstanding these concepts (whichareexplained in later chapters). Other risksincludepolitical riskandliquidity risk. Students may also rememberfinancial riskandbusiness risk from their managerial finance course.1-11.As explained in Chapter 21, return and risk form the basis for investors establishing theirobjectives. Some investors think of risk as a constraint on their activities. If so, risk isthe most important constraint. Investors face other constraints, including:timetaxestransaction costsincome requirementslegal and regulatory constraintsdiversification requirements1-12.Allrationalinvestors are risk averse because it is not rational when investing to assumerisk unless one expects to be compensated for doing so.All investors do not have the same degree of risk aversion. They are risk averse tovarying degrees, requiring different risk premiums in order to invest.1-13.Investors should determine how much risk they are willing to take before investing—this is theirrisk tolerance. Based on their risk tolerance, investors can then decide howtoinvest. Investors may seek to maximize their expected return consistent with theamountof risk they are willing to take.1-14.The external factors affecting the decision process are:

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9(1)uncertainty—the great unknown(2)the global investments arena(3)the importance of the internet(4)individual investors vs. institutional investorsThe most important factor is uncertainty, theever-present issuewith which allinvestors must deal. Uncertainty dominates investments, and always will.1-15.Institutional investorsinclude bank trust departments, pension funds, mutual funds(investment companies), insurance companies, and so forth. Basically, these financialinstitutions own and manage portfolios of securities on behalf of various clienteles.They affect the investingenvironment (and therefore individual investors) throughtheir actions in the marketplace, buying and selling securities in large dollar amounts.However, although they appear to have several advantages over individuals (researchdepartments, expertise, etc.),reasonably informed individuals should be able to performas well as institutions, on average, over time. This relates to the issue of marketefficiency.1-16.Required rates of return differ as the risk of an investment varies. Treasury bonds,generally accepted asbeing free from default risk, are less risky than corporates, andtherefore have a lower required rate of return.1-17.Investors should be concerned with international investing for several important reasons.First, international investing offers diversification opportunities, and diversification isextremely important to all investors as it provides risk reduction. Second, the returns maybe better in foreign markets than in the U.S. markets. Third, many U.S. companies areincreasingly affected by conditions abroad--for example, Coca Cola derives most of itsrevenue and profits from foreign operations. U.S. companies clearly are significantlyaffected by foreign competitors.The exchange rate (currency risk) is an important part of all decisions to investinternationally. As discussed in Chapter 6 and other chapters, currency risk affectsinvestment returns, both positively and negatively.1-18.The long run ex ante tradeoff between expected return and risk should be an upwardsloping line indicating that the greater the risk taken, the greater the expected return.The long run ex post tradeoff between return and risk should also be upward sloping ifinvesting is to make sense. Over long periods,riskier assets should return more than lessrisky assets.1-19.Disagree. If investors always attempted to minimize their risk, they would only invest inTreasurysecurities. Instead, investors seek a balance between expected return and risk.

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101-20.Disagree. If investors sought only to maximize their returns, they would purchase theriskiest assets, ignoring the risk they would be taking.Once again, investors must seek abalance between expected return and risk.

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11Chapter 2: Investment AlternativesCHAPTER OVERVIEWThe purpose of Chapter 2 is to provide an overview of the major types of financial assetsavailable to investors and discussed in later chapters.It alsooutlinesthe important alternativesof direct and indirect investing, thereby providing the foundation for Chapter 3.Obviously,these assets cannot be discussed in detail in this chapter; however,instructors can provide additional details as they see fit. What is important here is for students tobe exposed to the major types of financial assets early in the course in order for them tounderstand the basics of alternative investment opportunities. For example, if an instructor wereto refer to an example or concept involving a call option or a convertible security, the studentmay have no idea what is being discussed.A good example is derivatives, a topic of publicdiscussion in 2009 because of the financial crisis.Chapter 2 first discusses the non-marketable alternatives available to investors, such assavings accounts, because many students have encountered these already. Also, they offer agood contrast to the marketable securities, which are the focus of the text.Money market securities are discussed briefly,primarily becausethese assets typicallyare owned by individual investors in the form of money market mutual funds.Chapter 2 concentrates on the major capital market assets, bonds and stocks, whileproviding a very brief coverage of derivative securities.The chapter also includes a shortdiscussion of private equity, which allows high net worth investors and institutions to directlyinvest in nonpublic companies. Most students will have heard about private equity funds, but willhave little knowledge about them, thus, they will find the topic informative and interesting.The idea ofindirect investing--the ownership of investment company shares--isintroduced in Chapter 2 inExhibit2-1. This is because of the important alternative that suchownership provides all investors. They can turn their funds over to a mutual fund orETFandnot have to make investment decisions. It is desirable for students to think about this alternativeearly in their study. Many investors will opt for a combination of direct and indirect investing,and this alternative needs to be explainedearly in the course. Chapter 3 is devoted to indirectinvesting and provides a detailed discussion of investment companies.CHAPTER OBJECTIVESTo provide an overview of the major financial assets available to investors and discussedin subsequent chapters.Toprovide somedetailonthe financial assets ofmostimportance,bondsand stocks.To explain investors’ alternatives, which consist of direct investing, indirect investing, or,as is often done, a combination of the two.

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12MAJOR CHAPTER HEADINGS [Contents]Organizing Financial AssetsDirect Investing[invest directly and indirectly in money market, capital market and other securities]AGlobalPerspective[why this is important in today's investing environment]Nonmarketable Financial Assets[savings accounts; certificates of deposit (CDs); money market deposit accounts(MMDAs); U.S. government savings bonds--key features summarized in table form]Money Market SecuritiesThe Treasury Bill[discussion of important money market securities in table form; emphasis on Treasurybills as a riskless asset; calculating the discount yield]Money Market RatesCapital Market SecuritiesFixed-Income SecuritiesBonds[definition; characteristics--par value, maturity, zero coupon bond, call feature,bondprices, accrued interest, discounts and premiums]Types of BondsGovernment Agency SecuritiesAsset-backed Securities[definition, examples; securitization trends; why investors buy asset-backedsecurities]Rates on Fixed-Income Securities[general relationships]

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13Equity SecuritiesPreferred Stock[definition; characteristics; new forms]Common Stock[definition; characteristics-book value, market value,dividends, dividend yield,payout ratio, stock dividends and stock splits, the P/E ratio; investing internationallyin equities]InvestingGloballyin Equities[ADRs—definition and examples]Private Equity[definition; investor types; types of funds]Derivative Securities[Corporate-created securities: warrants;options;futurescontracts]Options[definition; very brief basics of puts and calls]Futures Contracts[definition; purposes]A Final Note

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14POINTS TO NOTE ABOUT CHAPTER 2Exhibits, Figures andTablesExhibit 2-1 is useful for organizing financial assets into one diagram. It illustrates bothdirect and indirect investing.Exhibit 2-2 outlines the major non-marketable financial assets in order that this topic canbe covered quickly and efficiently.Exhibit 2-3 discusses the major money market securities in table format, relieving thestudent and instructor from even more tedious details in the body of the chapter. This tablecontains the relevant facts about these assets. THE IMPORTANT POINT TO STRESS ISTHAT MOST INDIVIDUAL INVESTORS WILL OWN THESE ASSETS INDIRECTLYTHROUGH MONEY MARKET MUTUAL FUNDS.Exhibit 2-4 contains a basic summary of S&P debt rating definitions.

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15ANSWERS TO END-OF-CHAPTER QUESTIONS2-1.Indirect investinginvolves the purchase and sale of investment company shares. Sinceinvestment companies hold portfolios of securities, an investor owning investmentcompany shares indirectly owns a pro-rata share of a portfolio of securities.2-2.Treasury bills are auctioned weekly in a bid process. Bills are sold at less than face value(a discount) and redeemed at maturity for the face value, with this spread constituting aninvestor’s return. The greater the discount (the smaller the price paid for the bills), thelarger the return.2-3.Negotiable certificates of deposit (CDs)are marketable deposit liabilities of the issuingbank that pay a stated interest rate and are redeemable from the issuer at maturity by theholder. The minimum deposit is $100,000. Because they are negotiable, they can be soldin the open market before maturity.Non-marketable certificates of depositaresold by banks and other institutions.Penaltiesmay existfor early withdrawal of funds. Most importantly, these CDs are nonnegotiable.The owner (purchaser) must deal directly with the issuing institution.2-4.Bonds are issued by the federal government, federal government agencies,municipalities, and corporations. The last two are the most risky. If one has to be chosenas the most risky, it presumably would be corporates since general obligation municipals(as opposed to revenue bonds) are backed by the taxing power of the issuer.2-5.Fannie Maesare issued by the Federal National Mortgage Association, a government-sponsored agency whichbecamea privately owned corporation tradedon the NYSE.In September, 2008, the government seized control of Fannie Mae and Freddie Mac,placing them in a government conservatorship, somewhat similar to a bankruptcyreorganization. These securities are much more risky now than before the crisis of 2008.Ginnie Maesare issued by the Government National Mortgage Association, a wholly-owned government agency issuing fully-backed securities. Ginnie Mae is known for itspass-through certificates, where both principal and interest are passed through monthly tothe certificate holders.2-6.The two basic types of municipals aregeneral obligation bonds, which are backed by the“full faith and credit” of the issuer, andrevenue bonds, which are repaid from therevenues generated by the project they were sold to finance.2-7.As a result of mortgage refinancings, investors in Ginnie Maes face the risk that themortgages may be repaid earlier than expected by borrowers refinancingtheirobligations.

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