investing in financial assets investment strategies investing in stocks investing in bond

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(C) 2001 Contemporary Eng ineering Economics 1 Investing in Financial Assets Investing in Financial Assets Investment Strategies Investment Strategies Investing in Stocks Investing in Stocks Investing in Bond Investing in Bond Lec. 9 Investing in Financial Investing in Financial Assets Assets Investment Strategies Investment Strategies Investing in Stocks Investing in Stocks Investing in Bond Investing in Bond PRINCIPLES OF INVESTING PRINCIPLES OF INVESTING

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PRINCIPLES OF INVESTING. Investing in Financial Assets Investment Strategies Investing in Stocks Investing in Bond. Investing in Financial Assets Investment Strategies Investing in Stocks Investing in Bond. Lec. 9. Investment Basics. Liquidity – How accessible is your money? - PowerPoint PPT Presentation

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Page 1: Investing in Financial Assets  Investment Strategies  Investing in Stocks  Investing in Bond

(C) 2001 Contemporary Engineering Economics

1

Investing in Financial AssetsInvesting in Financial Assets Investment StrategiesInvestment Strategies Investing in StocksInvesting in Stocks Investing in BondInvesting in Bond

Lec. 9

Investing in Financial AssetsInvesting in Financial Assets Investment StrategiesInvestment Strategies Investing in StocksInvesting in Stocks Investing in BondInvesting in Bond

PRINCIPLES OF INVESTINGPRINCIPLES OF INVESTING

Page 2: 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?

- money markets funds and saving accounts are very liquid

- mutual funds are growth investments

• Risk – What is the safety involved?

- biggest risk is not investing at all

• Return – How much profit will you be able to expect from your investment?

Page 3: Investing in Financial Assets  Investment Strategies  Investing in Stocks  Investing in Bond

(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

Treasury Bills

Maxis.com

Very safe

Very risky

Page 4: Investing in Financial Assets  Investment Strategies  Investing in Stocks  Investing in Bond

(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

Page 5: Investing in Financial Assets  Investment Strategies  Investing in Stocks  Investing in Bond

(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%

Page 6: Investing in Financial Assets  Investment Strategies  Investing in Stocks  Investing in Bond

(C) 2001 Contemporary Engineering Economics

6

How to Determine Expected Financial Risk

• Risk: the chance that some unfavorable event will occur.- volatility and changing market condition

• 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.

Page 7: Investing in Financial Assets  Investment Strategies  Investing in Stocks  Investing in Bond

(C) 2001 Contemporary Engineering Economics

7

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

Page 8: Investing in Financial Assets  Investment Strategies  Investing in Stocks  Investing in Bond

(C) 2001 Contemporary Engineering Economics

8

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

Page 9: Investing in Financial Assets  Investment Strategies  Investing in Stocks  Investing in Bond

(C) 2001 Contemporary Engineering Economics

9

Broader Diversification Reduces Risk

• “Don’t put all your eggs in one basket”

• Diversification – best protection against risk

• Money markets; stocks; bonds; mutual funds

• Within equity investments – two similar assets; two different assets; multiple assets

• Reduce market volatility

Page 10: Investing in Financial Assets  Investment Strategies  Investing in Stocks  Investing in Bond

(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%

Page 11: Investing in Financial Assets  Investment Strategies  Investing in Stocks  Investing in Bond

(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

Page 12: Investing in Financial Assets  Investment Strategies  Investing in Stocks  Investing in Bond

(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

Page 13: Investing in Financial Assets  Investment Strategies  Investing in Stocks  Investing in Bond

(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

Page 14: Investing in Financial Assets  Investment Strategies  Investing in Stocks  Investing in Bond

(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

Page 15: Investing in Financial Assets  Investment Strategies  Investing in Stocks  Investing in Bond

(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

Page 16: Investing in Financial Assets  Investment Strategies  Investing in Stocks  Investing in Bond

(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

Page 17: Investing in Financial Assets  Investment Strategies  Investing in Stocks  Investing in Bond

(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

Page 18: Investing in Financial Assets  Investment Strategies  Investing in Stocks  Investing in Bond

(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

Page 19: Investing in Financial Assets  Investment Strategies  Investing in Stocks  Investing in Bond

(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

Page 20: Investing in Financial Assets  Investment Strategies  Investing in Stocks  Investing in Bond

(C) 2001 Contemporary Engineering Economics

20

AT& T 7s05

Closing price: 108 1 / 4

$1,082.50

Coupon rate

Maturity date2005

No meaning,Spacing

Page 21: Investing in Financial Assets  Investment Strategies  Investing in Stocks  Investing in Bond

(C) 2001 Contemporary Engineering Economics

21

Types of Bonds and How They Are Issued in the Financial Market

Page 22: Investing in Financial Assets  Investment Strategies  Investing in Stocks  Investing in Bond

(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

Page 23: Investing in Financial Assets  Investment Strategies  Investing in Stocks  Investing in Bond

(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%

Page 24: Investing in Financial Assets  Investment Strategies  Investing in Stocks  Investing in Bond

(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

Page 25: Investing in Financial Assets  Investment Strategies  Investing in Stocks  Investing in Bond

(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

Page 26: Investing in Financial Assets  Investment Strategies  Investing in Stocks  Investing in Bond

(C) 2001 Contemporary Engineering Economics

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• 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.