Chapter 6 Principles of Investing
-
Upload
jane-sullivan -
Category
Documents
-
view
96 -
download
3
description
Transcript of Chapter 6 Principles of Investing
(C) 2001 Contemporary Engineering Economics
1
Chapter 6Principles of Investing
• Investing in Financial Assets
• Investment Strategies
• Investing in Stocks
• Investing in Bond
(C) 2001 Contemporary Engineering Economics
2
Investment Basics
• Liquidity – How accessible is your money?
• Risk – What is the safety involved?
• Return – How much profit will you be able to expect from your investment?
(C) 2001 Contemporary Engineering Economics
3
Real Return 2%
Inflation 4%
Risk premium 0%
Total expected return 6%
Real Return 2%
Inflation 4%
Risk premium 20%
Total expected return 26%
How to Determine Your Expected Return
Risk-free real return
InflationRisk
premium
U.S. Treasury Bills
Amazon.com
Very safe
Very risky
(C) 2001 Contemporary Engineering Economics
4
Figuring Average Versus Compound Return
F
i
i
( . )( . )( . )
.
( ) .
.
1 0 05 1 0 10 1 0 12
1 2936
1 1 2936
8 96%
3
i
5% 10% 12%
39%
Period ReturnYear 1 5%Year 2 10%Year 3 12% 0 1 2 3
5% 10% 12%
Average rate of return Compound Rate of Return
(C) 2001 Contemporary Engineering Economics
5
Compound Versus Average Rate of Return
Investment Case 1 Case 2 Case 3 Case 4 Case 5 Case 6
Average return 9.00% 9.00% 9.00% 9.00% 9.00% 9.00%
Balance at the end of year 3
$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%
Annual Investment Yield (Base investment of $1,000)
Investment Case 1 Case 2 Case 3 Case 4 Case 5 Case 6
Year 1 9% 5% 0% 0% -1% -5%
Year 2 9% 10% 7% 0% -1% -8%
Year 3 9% 12% 20% 27% 29% 40%
(C) 2001 Contemporary Engineering Economics
6
How to Determine Expected Financial Risk
• Risk: 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.
(C) 2001 Contemporary Engineering Economics
7
Returns from Various Investment Classes
Average Annual Return 1970-1997
Best Year Worst year
U.S. Stocks 13.0% 37.6% (1995) -26.5% (1974)
International Stocks
12.7% 39.4% (1993) -26.2% (1974)
Cash Equivalent 6.8% 14.1% (1981) 3.0% (1991)
Real Estate 8.8% 20.5% (1979) -5.6% (1991)
U.S. Bonds 9.3% 33.5% (1982) -5.6% (1994)
(C) 2001 Contemporary Engineering Economics
8
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• Broader diversification reduces risk• Broader diversification increase expected
return
(C) 2001 Contemporary Engineering Economics
9
Dollar-Cost Averaging Concept
Timing
Amount Invested
Fund
Unit Price
No. of Units Purchased
Ending Fund Balance
Month 1 $1,000 $5.00 200 $1,000
Month 2 $1,000 $4.00 250 $1,800
Month 3 $1,000 $2.50 400 $2,125
Month 4 $1,000 $3.75 267 $4,189
Month 5 $1,000 $5.00 200 $6,585
Totals $5,000 1,317
(C) 2001 Contemporary Engineering Economics
10
Broader Diversification Increases Return
Amount Investment Expected Return
$2,000 Buying lottery tickets
-100% (?)
$2,000 Under the mattress 0%
$2,000 Term deposit (CD) 5%
$2,000 Corporate bond 10%
$2,000 Mutual fund (stocks)
15%
(C) 2001 Contemporary Engineering Economics
11
Option Amount Investment Expected Return
Value in 25 years
1 $10,000 Bond 7% $54,274
$2,000 Lottery tickets -100% $0
$2,000 Mattress 0% $2,000
2 $2,000 Term deposit (CD)
5% $6,773
$2,000 Corporate bond 10% $21.669
$2,000 Mutual fund (stocks)
15% $65,838
$96,280
1
(C) 2001 Contemporary Engineering Economics
12
Investing in Stocks
• Stocks: Ownership shares in a corporation
• Ownership: If a company issues 1M shares, and you buy 10,000 shares, you own a 10% of the company.
• Valuation: (1) cash dividend and (2) share appreciation at the time of sale
(C) 2001 Contemporary Engineering Economics
13
Conceptual Stock Valuation
IBM Computer:Given:Stock price as of July 20, 2001: $105.50/shareEarnings growth for next 5 years: 13%Expected cash dividend in 2002: $2.00/shareExpected stock price in 3 years: $230/shareRequired return on your investment: 10%Find: Current value of stock
P
$2
( . )
$2( . )
( . )
$2( . ) $230
( . )
$175. $105. ,
1 010
1 013
1 010
1 013
1 010
61 50
2
2
3
underpriced
(C) 2001 Contemporary Engineering Economics
14
What Are Your Odds?
Your chance of making return on your investment per year
If you hold stocks for
Your chance of losing money
0-10% 10-20% 20+ %
1 year 26% 18% 20% 37%
3 years 14% 28% 39% 19%
5 years 10% 31% 49% 10%
10 years 4% 42% 53% 1%
20 years 0 37% 63% 0
Source: Newsweek, November 10, 1997
(C) 2001 Contemporary Engineering Economics
15
What is Financial Option?
Call Option Put Option
100 shares of stock
At a predetermined
price
On or beforea predetermined
date
Strike (Exercise) price
Expiration date
AOL July Call (2001)
AOL stock
$50
July 20, 2001
The right To buy
The rightTo sell
Underlying asset
(C) 2001 Contemporary Engineering Economics
16
Call Option
$1.45 $60$39.47
Current Price(04/09/01)
Option Premium
Stock PriceJuly 20, 2001
StrikePrice
$50
AOL Call Option July 2001
Profit: $8.55BreakevenPrice
$51.45 Do NotExercise:Loss limited to $1.45
Take partial loss
(C) 2001 Contemporary Engineering Economics
17
Hold to maturityand trade at thestrike price
AOLDate:Feb 13, 2001Price:$48.09Strike price:$75Premium:$5,900 for 1000 shares
Expiration:Jan 2003
Trade for profit before optionexpires
Let the option expire If stock price drops to $70
If stock price rises to $100
If stock price rises to $78
If stock price rises to $90
If stock price rises to $80
($100-$75)* 1000=$25,000 from trade-$ 5,900 premium$19,000 profit
$5,000 from trade-$5,900 premium$ 900 loss
$15,000 from trade-$ 5,900 premium$ 9,100 profit
$3,000 from trade-$5,900 premium$2,900 loss
Lose yourpremium only$5,900 loss
(C) 2001 Contemporary Engineering Economics
18
Investing in Bond
• Bonds: Loans that investors make to corporations and governments.
• Face (par) value: Principal amount
• Coupon rate: yearly interest payment
• Maturity: the length of the loan
(C) 2001 Contemporary Engineering Economics
19
Bond Price Notation Used in Financial Markets
Corporate Bonds Treasury Bonds1/8=$1.25 5/8=$6.25 1/32=$0.3125
2/32=$0.6250
3/32=$0.9375
4/32=$1.25
17/32=$5.3125
18/32=$5.6250
19/32=$5.9375
20/32=$6.25
1/4=$2.50 3/4=$7.50 6/32=$1.5625
7/32=$1.8750
7/32=$2.1875
8/32=$2.50
21/32=$6.5625
22/32=$6.8750
23/32=$7.1875
24/32=$7.50
3/8=$3.75 9/32=$2.8125
10/32=$3.1250
11/32=$3.4375
12/32=$3.75
25/32=$7.8125
26/32=$8.1250
27/32=$8.4375
28/32=$8.75
1/8=$5.00 1=$10 13/32=$4.0625
14/32=$4.375
15/32=$4.6875
16/32=$5.00
29/32=$9.0625
30/32=$9.3750
31/32=$9.6875
32/32=$10
(C) 2001 Contemporary Engineering Economics
20
AT& T 7s05
Closing price: 108 1 / 4
$1,082.50
Coupon rate
Maturity date2005
No meaning,Spacing
(C) 2001 Contemporary Engineering Economics
21
Types of Bonds and How They Are Issued in the Financial Market
(C) 2001 Contemporary Engineering Economics
22
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
(C) 2001 Contemporary Engineering Economics
23
Bond Quotes
AT&T 7s05 6.5% 5 million 108 1/4
Coupon rate of 7%
Maturity (2005)
Current yield
Trading volume
ClosingMarket price
$1,082.50$70/108.25= 6.47%
(C) 2001 Contemporary Engineering Economics
24
Yield to Maturity
(a) Yield to maturity:
per semiannual period
(b) Current yield:
per semiannual period
$996. $48. ( / , ,20) $1, ( / , ,20)
.
( . ) .
$48.
$996..
25 13 000
4 84%
1 0 0484 1 9 91%
13
254 83%
2
P A i P F i
i
ia
(C) 2001 Contemporary Engineering Economics
25
Summary
• The three basic investment objects are: growth, income, and liquidity.
• The two greatest risks investors face are inflation and market volatility.
• Portfolios with long-term horizons need equities to offset inflation while short time frames requires debt and/or cash investments to reduce volatility
(C) 2001 Contemporary Engineering Economics
26
• Dollar-cost averaging is a planned transfer, over a period, of equal amounts from one assets to another.
• Diversification by combining assets with different patterns of return, it is possible to achieve a higher rate of return without increasing significant risk.
• Investing in stocks and bonds is one of the most common investment activities among the American investors.