1. (C) 2001 Contemporary Engineering Economics 1 Chapter 6 Principles of Investing Investing in Financial Assets Investment Strategies Investing in Stocks Investing in Bond

2. (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?

3. (C) 2001 Contemporary Engineering Economics 3 Real Return2% Inflation4% Risk premium0% Total expected return6% Real Return2% Inflation4% Risk premium20% Total expected return26% How to Determine Your Expected Return Risk-free real return Inflation Risk premium U.S. Treasury Bills Amazon.com Very safe Very risky

4. (C) 2001 Contemporary Engineering Economics 4 Figuring Average Versus Compound Return 0 1 2 3 5%10% 12% Average rate of returnCompound Rate of Return

5. (C) 2001 Contemporary Engineering Economics 5 Compound Versus Average Rate of Return InvestmentCase 1Case 2Case 3Case 4Case 5 Case 6 Average return9.00% Balance at the end of year 3 $1,295$1,294$1,284$1,270$1,264$1,224 Compound return9.00%8.96%8.69%8.29%8.13%6.96% Annual Investment Yield (Base investment of $1,000) InvestmentCase 1Case 2Case 3Case 4Case 5 Case 6 Year 19%5%0% -1%-5% Year 29%10%7%0%-1%-8% Year 39%12%20%27%29%40%

6. (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.

7. (C) 2001 Contemporary Engineering Economics 7 Returns from Various Investment Classes Average Annual Return 1970-1997 Best YearWorst year U.S. Stocks13.0%37.6% (1995)-26.5% (1974) International Stocks 12.7%39.4% (1993)-26.2% (1974) Cash Equivalent6.8%14.1% (1981)3.0% (1991) Real Estate8.8%20.5% (1979)-5.6% (1991) U.S. Bonds9.3%33.5% (1982)-5.6% (1994)

8. (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

9. (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$5.00200$1,000 Month 2$1,000$4.00250$1,800 Month 3$1,000$2.50400$2,125 Month 4$1,000$3.75267$4,189 Month 5$1,000$5.00200$6,585 Totals$5,0001,317

10. (C) 2001 Contemporary Engineering Economics 10 Broader Diversification Increases Return AmountInvestmentExpected Return $2,000Buying lottery tickets -100% (?) $2,000Under the mattress0% $2,000Term deposit (CD)5% $2,000Corporate bond10% $2,000Mutual fund (stocks) 15%

11. (C) 2001 Contemporary Engineering Economics 11 OptionAmountInvestmentExpected Return Value in 25 years 1$10,000Bond7%$54,274 $2,000Lottery tickets-100%$0 $2,000Mattress0%$2,000 2 Term deposit (CD) 5%$6,773 $2,000Corporate bond10%$21.669 $2,000Mutual fund (stocks) 15%$65,838 $96,280 1

12. (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

13. (C) 2001 Contemporary Engineering Economics 13 Conceptual Stock Valuation IBM Computer: Given: Stock price as of July 20, 2001: $105.50/share Earnings growth for next 5 years: 13% Expected cash dividend in 2002: $2.00/share Expected stock price in 3 years: $230/share Required return on your investment: 10% Find: Current value of stock

14. (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 year26%18%20%37% 3 years14%28%39%19% 5 years10%31%49%10% 10 years4%42%53%1% 20 years037%63%0 Source: Newsweek, November 10, 1997

15. (C) 2001 Contemporary Engineering Economics 15 What is Financial Option? Call Option Put Option 100 shares of stock At a predetermined price On or before a predetermined date Strike (Exercise) price Expiration date AOL July Call (2001) AOL stock $50 July 20, 2001 The right To buy The right To sell Underlying asset

16. (C) 2001 Contemporary Engineering Economics 16 Call Option $1.45 $60 $39.47 Current Price (04/09/01) Option Premium Stock Price July 20, 2001 Strike Price $50 AOL Call Option July 2001 Profit: $8.55 Breakeven Price $51.45 Do Not Exercise: Loss limited to $1.45 Take partial loss

17. (C) 2001 Contemporary Engineering Economics 17 Hold to maturity and trade at the strike price AOL Date: Feb 13, 2001 Price: $48.09 Strike price: $75 Premium: $5,900 for 1000 shares Expiration: Jan 2003 Trade for profit before option expires 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 your premium only $5,900 loss

18. (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

19. (C) 2001 Contemporary Engineering Economics 19 Bond Price Notation Used in Financial Markets Corporate BondsTreasury Bonds 1/8=$1.255/8=$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=$2.503/4=$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=$5.001=$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

20. (C) 2001 Contemporary Engineering Economics 20 Coupon rate Maturity date 2005 No meaning, Spacing

21. (C) 2001 Contemporary Engineering Economics 21 Types of Bonds and How They Are Issued in the Financial Market

22. (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

23. (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 Closing Market price $1,082.50 $70/108.25 = 6.47%

24. (C) 2001 Contemporary Engineering Economics 24 Yield to Maturity

25. (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

26. (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.