1. Investing in Financial Assets
Lecture No. 14
Chapter 4
Contemporary Engineering Economics
Copyright © 2016

2. 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.

3. Basic Concept: How to Determine
Your Expected Return
Real Return 2%
Inflation 4%
Risk premium 0%
Total expected return 6%
U.S. Treasury Bills
Risk-free
real return
Very safe
Risk
premium
Inflation
Real Return 2%
Inflation 4%
Risk premium
20%
Total expected return
26%
Very risky
A start-up company

4. Figuring Average versus Compound Return
12% 5%
10%
Average rate of return
Compound Rate of Return

5. Annual Investment Yield (Base investment of $1,000)
Case 1
Case 2
Case 3
Case 4
Case 5
Case 6
Year 1 9% 5% 0%
-1%
-5%
Year 2
10% 7%
-8%
Year 3
12%
20%
27%
29%
40%
Compound Versus Average Rate of Return
Investment
Case 1
Case 2
Case 3
Case 4
Case 5
Case 6
Average return
9.00%
Balance at the end of year 3
$1,295
$1,294
$1,284
$1,270
$1,264
$1,224
Compound return
8.96%
8.69%
8.29%
8.13%
6.96%

6. 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.

7. 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.

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
Month 2
$4.00
250
$1,800
Month 3
$2.50
400
$2,125
Month 4
$3.75
267
$4,189
Month 5
$6,585
Totals
$5,000
1,317

9. Broader Diversification Increases Return
Amount
Investment
Expected Return
$2,000
Buying lottery tickets
-100% (?)
Under the mattress 0%
Term deposit (CD) 5%
Corporate bond
10%
Mutual fund (stocks)
15%

10. 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.

11. 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

12. Conceptual Stock Valuation
Given:
Stock price as of May 1, 2015: $72/share
Earnings growth for next 5 years: 8%
Expected cash dividend in 2016: $2.00/share
Expected stock price in 3 years: $95/share
Required return on your investment: 10%
Find: Current value of stock

13. Valuation
Cash Flow
$95 $2 1 2 3

14. 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

15. Types of Bonds and How They are Issued in the Financial Market

16. Bond Price Notation Used in Financial Markets
Corporate Bonds
Treasury Bonds
1/8=$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

17. How To Read a Bond Notation
Maturity date
2020
No meaning,
spacing
Coupon rate

18. 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

19. Bond Quotes AT&T 7s20 6.5% 5 million 108 1/4 Maturity (2020)
Trading volume
AT&T 7s % 5 million /4
Closing
Market price
Coupon rate of 7%
Current yield
$70/108.25
= 6.47%
$1,082.50

20. 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

21. Solution (a) Yield to maturity i = 4.8422% per semiannual
(b) Current yield

22. 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?

23. Solution Semiannual interest payment = $40
Required semiannual return = 4.5%
Desired selling price of the bond (F)