Tutorial 1 Solutions – Assets & Investments

[Readings: Ch1; Ch2; Ch4]

Q1 Discuss the overall purpose people have for investing. Define investment.

When an individual’s current money income exceeds his current consumption desires, he
saves the excess. Rather than keep these savings in his possession, the individual may
consider it worthwhile to forego immediate possession of the money for a larger future
amount of consumption. This trade-off of present consumption for a higher level of future
consumption is the essence of investment.

An investment is the current commitment of funds for a period of time in order to derive
a future flow of funds that will compensate the investor for the time value of money, the
expected rate of inflation over the life of the investment, and provide a premium for the
uncertainty associated with this future flow of funds.

Q2 Discuss the three components of an investor’s required rate of return on an

investment.

An investor’s required rate of return is a function of the economy’s risk free rate (RFR),
an inflation premium that compensates the investor for loss of purchasing power, and a
risk premium that compensates the investor for taking the risk. The RFR is the pure time
value of money and is the compensation an individual demands for deferring
consumption. More objectively, the RFR can be measured in terms of the long-run real
growth rate in the economy since the investment opportunities available in the economy
influence the RFR.

The inflation premium, which can be conveniently measured in terms of the Consumer
Price Index, is the additional protection an individual requires to compensate for the
erosion in purchasing power resulting from increasing prices. Since the return on all
investments is not certain as it is with T-bills, the investor requires a premium for taking
on additional risk. The risk premium can be examined in terms of business risk, financial
risk, liquidity risk, exchange rate risk and country risk.

Q3 Briefly discuss the five fundamental factors that influence the risk premium of
an investment.

The five factors that influence the risk premium on an investment are business risk,
financial risk, liquidity risk, exchange rate risk, and country risk.

Business risk is a function of sales volatility and operating leverage and the combined
effect of the two variables can be quantified in terms of the coefficient of variation of
operating earnings.

Financial risk is a function of the uncertainty introduced by the financing mix. The

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inherent risk involved is the inability to meet future contractual payments (interest on
bonds, etc.) or the threat of bankruptcy. Financial risk is measured in terms of a debt ratio
(e.g., debt/equity ratio) and/or the interest coverage ratio.

Liquidity risk is the uncertainty an individual faces when he decides to buy or sell an
investment. The two uncertainties involved are: (1) how long it will take to buy or sell
this asset, and (2) what price will be received. The liquidity risk on different investments
can vary substantially (e.g., real estate vs. T-bills).

Exchange rate risk is the uncertainty of returns on securities acquired in a different

currency. The risk applies to the global investor or multinational corporate manager who
must anticipate returns on securities in light of uncertain future exchange rates. A good
measure of this uncertainty would be the absolute volatility of the exchange rate or its
beta with a composite exchange rate.

Country risk is the uncertainty of returns caused by the possibility of a major change in
the political or economic environment of a country. The analysis of country risk is much
more subjective and must be based upon the history and current environment in the
country.

Q4 On February 1, you bought 100 shares of stock in the Francesca Corporation for
$34 a share and a year later you sold it for $39 a share. During the year, you
received a cash dividend of $1.50 a share. Compute your Price Relative [HPR] and
Return [HPY] on this Francesca stock investment.

Ending Value of Investment (including Cash Flows)

1. HPR 
Beginning Value of Investment
39  1.50 40.50
   1.191
34 34
HPY  HPR - 1  1.191 - 1  .191  19.1%

Q5 During the past five years, you owned two stocks that had the following annual
rates of return:

Year Stock T Stock B

1 0.19 0.08
2 0.08 0.03
3 −0.12 −0.09
4 −0.03 0.02
5 0.15 0.04

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a. Compute the arithmetic mean annual rate of return for each stock. Which
stock is most desirable by this measure?
n
HPYi
5(a). Arithemetic M ean (AM )  
i 1 n
(.19)  (.08)  (.12)  (.03)  (.15)
AM T 
5
.27
  .054
5
(.08)  (.03)  (.09)  (.02)  (.04)
AM B 
5
.08
  .016
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Stock T is more desirable because the arithmetic mean annual rate of return is higher.

b. Compute the standard deviation of the annual rate of return for each stock.
(Use Chapter 1 Appendix if necessary.) By this measure, which is the
preferable stock?
n
5(b). Standard Deviation ( )   [R
i 1
i  E(R i )]2 / n

Variance T  (.19  .054)  (.08  .054)  (.12  .054) 2  (.03  .054) 2  (.15  .054) 2
2 2

 .01850  .00068  .03028  .00706  .00922

 .06574
  .06574 / 5  .01315
2

 T  .01314  .11467

 B  (.08  .016) 2  (.03  .016) 2  (.09  .016) 2  (.02  .016) 2  (.04  .016) 2
 .00410  .00020  .01124  .00002  .00058
 .01614
 2  .01614 / 5  .00323
 B  .00323  .05681

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c. Compute the coefficient of variation for each stock. (Use the Chapter 1
Appendix if necessary.) By this relative measure of risk, which stock is
preferable?

Standard Deviation
5(c). Coefficien t of Variation 
Expected Return
.11466
CVT   2.123
.054
.05682
CVB   3.5513
.016

By this measure, T would be preferable.

d. Compute the geometric mean rate of return for each stock. Discuss the
difference between the arithmetic mean return and the geometric mean
return for each stock. Discuss the differences in the mean returns relative to
the standard deviation of the return for each stock.

Geometric Mean (GM) = 1/n – 1 where  = Product of the HRs

GMT = [(1.19) (1.08) (.88) (.97) (1.15)]1/5 -1

= [1.26160] 1/5 –1 = 1.04757 –1 = .04757

GMB = [(1.08) (1.03) (.91) (1.02) (1.04)]1/5 -1

= [1.07383] 1/5 –1 = 1.01435 – 1 = .01435

Stock T has more variability than Stock B. The greater the variability of returns, the
greater the difference between the arithmetic and geometric mean returns.

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Q6 Your 45-year-old uncle is 20 years away from retirement; your 35-year-old
older sister is about 30 years away from retirement. How might their
investment policy statements differ?

The 45-year old uncle and 35-year old sister differ in terms of time horizon. However,
each has some time before retirement (20 versus 30 years). Each should have a
substantial proportion of his/her portfolio invested in equities, with the 35-year old
sister possibly having more equity investments in small firms or international firms
(i.e., can tolerate greater portfolio risk). These investors could also differ in current
liquidity needs (such as children, education expenses, etc.), tax concerns, and/or
other unique needs or preferences.

Q7 What information is necessary before a financial planner can assist a person

in constructing an investment policy statement?

Before constructing an investment policy statement, the financial planner needs to

clarify the client’s investment objectives (e.g. capital preservation, capital
appreciation, current income or total return) and constraints (e.g. liquidity needs,
time horizon, tax factors, legal and regulatory constraints, and unique needs and
preferences). Data on current investments, portfolio returns, and savings plans
(future additions to the portfolio) are helpful, too.

Q8 Discuss briefly several uses of security-market indexes.

The purpose of security-market indexes is to provide a general indication of the

aggregate market changes or market movements. More specifically, the indexes are
used to derive market returns for a period of interest and then used as a benchmark
for evaluating the performance of alternative portfolios. A second use is in examining
the factors that influence aggregate stock price movements by forming relationships
between market (series) movements and changes in the relevant variables in order
to illustrate how these variables influence market movements. A further use is by
technicians who use past aggregate market movements to predict future price
patterns. Finally, a very important use is in portfolio theory, where the systematic risk
of an individual security is determined by the relationship of the rates of return for
the individual security to rates of return for a market portfolio of risky assets. Here, a

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 representative index is used as a proxy for the market portfolio of risky assets.

Q9 You are given the following information regarding prices for a sample of
stocks.

PRICE

Stock Number of Shares T T +1

A 1,000,000 60 80

B 10,000,000 20 35

C 30,000,000 18 25

a. Construct a price-weighted index for these three stocks, and compute the
percentage change in the index for the period from T to T + 1.
b. Construct a value-weighted index for these three stocks, and compute the
percentage change in the index for the period from T to T + 1.
c. Briefly discuss the difference in the results for the two indexes.

1(a). Given a three security series and a price change from period t to t+1, the
percentage change in the series would be 42.85 percent.

Period t Period t+1

A $ 60 $ 80
B 20 35
C 18 25
Sum $ 98 $140
Divisor 3 3
Average 32.67 46.67

46.67 - 32.67 14.00

Percentage change    42.85%
32.67 32.67

1(b). Period t
Stock Price/Share # of Shares Market Value

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 A $60 1,000,000 $ 60,000,000
B 20 10,000,000 200,000,000
C 18 30,000,000 540,000,000
Total $800,000,000

Period t+1
Stock Price/Share # of Shares Market Value
A $80 1,000,000 $ 80,000,000
B 35 10,000,000 350,000,000
C 25 30,000,000 750,000,000
Total $1,180,000,000

1,180 - 800 380

Percentage change    47.50%
800 800

1(c). The percentage change for the price-weighted series is a simple average of the
differences in price from one period to the next. Equal weights are applied to each price
change.

The percentage change for the value-weighted series is a weighted average of the
differences in price from one period t to t+1. These weights are the relative market
values for each stock. Thus, Stock C carries the greatest weight followed by B and
then A. Because Stock B had the greatest percentage increase (75%) and the
second largest weight, the percentage change would be larger for this series than
the price-weighted series.