INSTRUCTOR SOLUTIONS MANUAL
FUNDAMENTALS OF INVESTING
1ST CANADIAN EDITION
CHAPTER NO. 1:THE INVESTMENT ENVIRONMENT
FAMOUS FAILURES IN FINANCE: CRITICAL THINKING QUESTION
Ethical Failure—Massaging the Numbers
Why do you think Lehman engaged in Repo 105 transactions?
The ability to borrow short-term funds at low interest rates was critical to Lehman Brothers
operations. By disguising these repurchase agreements as sales of assets rather than very short-
term loans, Lehman inflated revenues and made their balance sheet look much stronger than it
actually was. At this point in its history, Lehman was highly leveraged and facing declining
liquidity. The inability to obtain cheap, short-term loans would mean the death of the company
which, of course, did ensue. For the individuals involved, large sums in the form of bonuses and
investments in the firm were riding on the firm’s survival. It might be worth mentioning that the
practice was borderline acceptable under British law, but it did not conform to U.S. GAAP.
ANSWERS TO CONCEPTS IN REVIEW
1.1 An investment is any asset into which funds can be placed with the expectation of
preserving or increasing value and earning a positive rate of return. An investment can be a
security or a property. Individuals invest because an investment has the potential to preserve
or increase value and to earn income. It is important to stress that this does not imply that an
investment will in fact preserve value or earn income. Investing often involves taking risk,
so an investment’s actual performance will often differ from its expected performance.
1.2 (a) Securities and property are simply two classes of investments. Securities are
investments issued by firms, governments, or other organizations that represent a legal
claim on the resources of the issuer. For example, a bond represents a loan that the
borrower is legally obligated to repay, and a stock represents a proportionate ownership
in a firm. An option, on the other hand, represents the legal right to either buy or sell an
asset at a predetermined price within a specified time period. Property constitutes
, investments in either real property (land and buildings) or tangible personal property
(e.g., Rembrandt paintings, Ming vases, or gold coins). These days, some students are
likely to ask about cryptocurrencies, which have characteristics of both transactional
currencies and speculative security investments.
(b) With a direct investment, an individual acquires a direct claim on a security or property.
For example, an investment in one share of BCE stock directly provides the stockholder
a proportionate ownership in BCE. An indirect investment provides an indirect claim on
a security or property. For example, if you buy one share of RBC Growth Fund (a
mutual fund) or an ETF that tracks the S&P 500 index, you are in effect buying a
portion of a portfolio of securities owned by the fund. Thus, you will have a claim on a
fraction of an entire portfolio of securities. Many funds also invest in a variety of debt
instruments.
(c) An investment in debt represents funds loaned in exchange for the receipt of interest
income and repayment of the loan at a given future date. The bond, a common debt
instrument, pays specified interest over a specified time period, then repays the face
value of the loan. (Chapters 10 and 11 cover bonds in detail.) An equity investment
provides an investor an ongoing fractional ownership interest in a firm. The most
common example is an investment in a company’s common stock. We will study equity
instruments in greater detail in Chapters 6 through 8. Derivative securities are securities
derived from debt or equity securities and structured to exhibit characteristics and value
based upon the underlying securities. Options are derivative securities that allow an
investor to sell or buy another security or asset at a specific price over a given time
period. For example, an investor might purchase an option to buy Facebook stock for
$50 within nine months.
(d) Short-term investments typically mature within one year while long-term investments
have longer maturities, including common stock, which has no maturity at all. However,
long-term investments can be used to satisfy short-term financial goals.
1.3 Investors expect to be paid for accepting risk. Low or no risk investments typically offer
low rates of return while riskier investments, meaning that returns are less predictable, tend
to offer potentially higher returns.
1.4 In finance, risk reflects the uncertainty surrounding the return that an investment will
generate. Risk refers to the chance that the return from an investment will differ from its
expected value. Low-risk investments are those considered safe with respect to the return of
, funds invested and the receipt of a positive rate of return. High-risk investments are those
that have more uncertain future values and levels of earnings.
1.5 Foreign investments are investments in the debt, equity, derivative securities of foreign-
based companies, and property in a foreign country. Both direct and indirect foreign
investments sometimes provide investors more attractive returns or lower-risk investments
compared to purely domestic investments, but beyond that they are useful instruments to
diversify a purely domestic portfolio.
1.6 The investment process brings together suppliers and demanders of funds. This may occur
directly (as with property investments). More often the investment process is aided by a
financial institution (such as a bank, savings and loan, savings bank, credit union, insurance
company, or pension fund) that channels funds to investments and/or a financial market
(either the money market or the capital market) where transactions occur between suppliers
and demanders of funds.
1.7 (a) The various levels of government (federal and provincial) generally require more funds
for projects and debt repayment than they receive in revenues. Thus, governments are
net demanders of funds. The term net refers to the fact that, while governments both
supply and demand funds in the investment process, on balance they demand more than
they supply.
(b) Businesses are also net demanders, requiring funds to cover short- and long-term
operating and investment (growth) needs. While business firms often supply funds, on
balance they also demand more than they supply.
(c) Individuals are the net suppliers of funds to the investment process. They put more
funds into the investment process than they take out. Individuals play an important role
in the investment process—supplying the funds needed to finance economic growth and
development.
1.8 Institutional investors are investment professionals who are paid to manage other people’s
money. They are employed by financial institutions like banks and insurance companies, by
nonfinancial businesses, and by individuals. Individual investors manage their own personal
funds in order to meet their financial goals. Generally, institutional investors tend to be
more sophisticated because they handle much larger amounts of money, and they tend to
have a broader knowledge of the investment process and available investment techniques.
1.9 Short-term investments usually have lives of less than one year. These investments may be
used to store temporarily idle funds until suitable long-term investments are found. Due to
, their safety and convenience, they are popular with those who wish to earn a return on
temporarily idle funds or with the very conservative investor who may use these short-term
investments as a primary investment outlet. In addition to their storage function, short-term
investments provide liquidity—they can be converted into cash quickly and with little or no
loss in value. This characteristic is very useful when investors need to meet unexpected
expenses or take advantage of attractive opportunities.
1.10 Common stock is an equity investment that represents a fractional ownership interest in a
corporation. The return on a common stock investment derives from two sources: dividends,
which are periodic payments made by the firm to its shareholders from current and past
earnings, and capital gains, which result from selling the stock at a price above the original
purchase price. Because common stock offers a broad range of return-risk combinations, it
is one of the most popular investments.
1.11 a. Bonds are debt obligations of corporations or governments. A bondholder receives a
stated interest return, typically semi-annually, plus the face value at maturity. Bonds are
usually issued in $1,000 denominations, pay semi-annual interest, and have 10 - to 30-
year maturities. Bonds offer fixed/certain returns, if held until maturity.
b. A convertible security is a fixed-income security, either a bond or preferred stock,
which has a conversion feature. Typically, it can be converted into a specified number
of shares of common stock. Convertible securities are quasi-derivative securities, as
their market value would depend on the price of the common stock and the conversion
ratio.
c. Preferred stock is very much like common stock in that it represents an ownership
interest in a corporation. But preferred stock pays only a fixed stated dividend, which
has precedence over common stock dividends, and does not share in other earnings of
the firm.
d. A mutual fund is a company that invests in a large portfolio of securities, whereas a
money market mutual fund is a mutual fund that solely invests in short term “money
market” securities. Investors might find mutual funds appealing because a large, well-
diversified portfolio may be more consistent with their investment goals in terms of risk
and return. As we will see later, a mutual fund offers the investor the benefits of
diversification and professional management. Mutual funds do not offer fixed/certain
returns. Exchange-traded funds are similar to mutual funds but are traded throughout the
day on exchanges and priced continuously.
FUNDAMENTALS OF INVESTING
1ST CANADIAN EDITION
CHAPTER NO. 1:THE INVESTMENT ENVIRONMENT
FAMOUS FAILURES IN FINANCE: CRITICAL THINKING QUESTION
Ethical Failure—Massaging the Numbers
Why do you think Lehman engaged in Repo 105 transactions?
The ability to borrow short-term funds at low interest rates was critical to Lehman Brothers
operations. By disguising these repurchase agreements as sales of assets rather than very short-
term loans, Lehman inflated revenues and made their balance sheet look much stronger than it
actually was. At this point in its history, Lehman was highly leveraged and facing declining
liquidity. The inability to obtain cheap, short-term loans would mean the death of the company
which, of course, did ensue. For the individuals involved, large sums in the form of bonuses and
investments in the firm were riding on the firm’s survival. It might be worth mentioning that the
practice was borderline acceptable under British law, but it did not conform to U.S. GAAP.
ANSWERS TO CONCEPTS IN REVIEW
1.1 An investment is any asset into which funds can be placed with the expectation of
preserving or increasing value and earning a positive rate of return. An investment can be a
security or a property. Individuals invest because an investment has the potential to preserve
or increase value and to earn income. It is important to stress that this does not imply that an
investment will in fact preserve value or earn income. Investing often involves taking risk,
so an investment’s actual performance will often differ from its expected performance.
1.2 (a) Securities and property are simply two classes of investments. Securities are
investments issued by firms, governments, or other organizations that represent a legal
claim on the resources of the issuer. For example, a bond represents a loan that the
borrower is legally obligated to repay, and a stock represents a proportionate ownership
in a firm. An option, on the other hand, represents the legal right to either buy or sell an
asset at a predetermined price within a specified time period. Property constitutes
, investments in either real property (land and buildings) or tangible personal property
(e.g., Rembrandt paintings, Ming vases, or gold coins). These days, some students are
likely to ask about cryptocurrencies, which have characteristics of both transactional
currencies and speculative security investments.
(b) With a direct investment, an individual acquires a direct claim on a security or property.
For example, an investment in one share of BCE stock directly provides the stockholder
a proportionate ownership in BCE. An indirect investment provides an indirect claim on
a security or property. For example, if you buy one share of RBC Growth Fund (a
mutual fund) or an ETF that tracks the S&P 500 index, you are in effect buying a
portion of a portfolio of securities owned by the fund. Thus, you will have a claim on a
fraction of an entire portfolio of securities. Many funds also invest in a variety of debt
instruments.
(c) An investment in debt represents funds loaned in exchange for the receipt of interest
income and repayment of the loan at a given future date. The bond, a common debt
instrument, pays specified interest over a specified time period, then repays the face
value of the loan. (Chapters 10 and 11 cover bonds in detail.) An equity investment
provides an investor an ongoing fractional ownership interest in a firm. The most
common example is an investment in a company’s common stock. We will study equity
instruments in greater detail in Chapters 6 through 8. Derivative securities are securities
derived from debt or equity securities and structured to exhibit characteristics and value
based upon the underlying securities. Options are derivative securities that allow an
investor to sell or buy another security or asset at a specific price over a given time
period. For example, an investor might purchase an option to buy Facebook stock for
$50 within nine months.
(d) Short-term investments typically mature within one year while long-term investments
have longer maturities, including common stock, which has no maturity at all. However,
long-term investments can be used to satisfy short-term financial goals.
1.3 Investors expect to be paid for accepting risk. Low or no risk investments typically offer
low rates of return while riskier investments, meaning that returns are less predictable, tend
to offer potentially higher returns.
1.4 In finance, risk reflects the uncertainty surrounding the return that an investment will
generate. Risk refers to the chance that the return from an investment will differ from its
expected value. Low-risk investments are those considered safe with respect to the return of
, funds invested and the receipt of a positive rate of return. High-risk investments are those
that have more uncertain future values and levels of earnings.
1.5 Foreign investments are investments in the debt, equity, derivative securities of foreign-
based companies, and property in a foreign country. Both direct and indirect foreign
investments sometimes provide investors more attractive returns or lower-risk investments
compared to purely domestic investments, but beyond that they are useful instruments to
diversify a purely domestic portfolio.
1.6 The investment process brings together suppliers and demanders of funds. This may occur
directly (as with property investments). More often the investment process is aided by a
financial institution (such as a bank, savings and loan, savings bank, credit union, insurance
company, or pension fund) that channels funds to investments and/or a financial market
(either the money market or the capital market) where transactions occur between suppliers
and demanders of funds.
1.7 (a) The various levels of government (federal and provincial) generally require more funds
for projects and debt repayment than they receive in revenues. Thus, governments are
net demanders of funds. The term net refers to the fact that, while governments both
supply and demand funds in the investment process, on balance they demand more than
they supply.
(b) Businesses are also net demanders, requiring funds to cover short- and long-term
operating and investment (growth) needs. While business firms often supply funds, on
balance they also demand more than they supply.
(c) Individuals are the net suppliers of funds to the investment process. They put more
funds into the investment process than they take out. Individuals play an important role
in the investment process—supplying the funds needed to finance economic growth and
development.
1.8 Institutional investors are investment professionals who are paid to manage other people’s
money. They are employed by financial institutions like banks and insurance companies, by
nonfinancial businesses, and by individuals. Individual investors manage their own personal
funds in order to meet their financial goals. Generally, institutional investors tend to be
more sophisticated because they handle much larger amounts of money, and they tend to
have a broader knowledge of the investment process and available investment techniques.
1.9 Short-term investments usually have lives of less than one year. These investments may be
used to store temporarily idle funds until suitable long-term investments are found. Due to
, their safety and convenience, they are popular with those who wish to earn a return on
temporarily idle funds or with the very conservative investor who may use these short-term
investments as a primary investment outlet. In addition to their storage function, short-term
investments provide liquidity—they can be converted into cash quickly and with little or no
loss in value. This characteristic is very useful when investors need to meet unexpected
expenses or take advantage of attractive opportunities.
1.10 Common stock is an equity investment that represents a fractional ownership interest in a
corporation. The return on a common stock investment derives from two sources: dividends,
which are periodic payments made by the firm to its shareholders from current and past
earnings, and capital gains, which result from selling the stock at a price above the original
purchase price. Because common stock offers a broad range of return-risk combinations, it
is one of the most popular investments.
1.11 a. Bonds are debt obligations of corporations or governments. A bondholder receives a
stated interest return, typically semi-annually, plus the face value at maturity. Bonds are
usually issued in $1,000 denominations, pay semi-annual interest, and have 10 - to 30-
year maturities. Bonds offer fixed/certain returns, if held until maturity.
b. A convertible security is a fixed-income security, either a bond or preferred stock,
which has a conversion feature. Typically, it can be converted into a specified number
of shares of common stock. Convertible securities are quasi-derivative securities, as
their market value would depend on the price of the common stock and the conversion
ratio.
c. Preferred stock is very much like common stock in that it represents an ownership
interest in a corporation. But preferred stock pays only a fixed stated dividend, which
has precedence over common stock dividends, and does not share in other earnings of
the firm.
d. A mutual fund is a company that invests in a large portfolio of securities, whereas a
money market mutual fund is a mutual fund that solely invests in short term “money
market” securities. Investors might find mutual funds appealing because a large, well-
diversified portfolio may be more consistent with their investment goals in terms of risk
and return. As we will see later, a mutual fund offers the investor the benefits of
diversification and professional management. Mutual funds do not offer fixed/certain
returns. Exchange-traded funds are similar to mutual funds but are traded throughout the
day on exchanges and priced continuously.
