CHAPTER 1
THE INVESTMENT SETTING
Answers to Questions
1. 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.
2. Students in general tend to be borrowers because they are typically not
employed so have no income, but obviously consume and have expenses. The
usual intent is to invest the money borrowed in order to increase their future
income stream from employment - i.e., students expect to receive a better job
and higher income due to their investment in education.
3. In the 20-30 year segment an individual would tend to be a net borrower
since he is in a relatively low-income bracket and has several expenditures -
automobile, durable goods, etc. In the 30-40 segment again the individual
would likely dissave, or borrow, since his expenditures would increase with
the advent of family life, and conceivably, the purchase of a house. In the 40-
50 segment, the individual would probably be a saver since income would
have increased substantially with no increase in expenditures. Between the
, ages of 50 and 60 the individual would typically be a strong saver since
income would continue to increase and by now the couple would be “empty-
nesters.” After this, depending upon when the individual retires, the
individual would probably be a dissaver as income decreases (transition
from regular income to income from a pension).
4. The saving-borrowing pattern would vary by profession to the extent that
compensation patterns vary by profession. For most white-collar professions
(e.g., lawyers) income would tend to increase with age. Thus, lawyers would
tend to be borrowers in the early segments (when income is low) and savers
later in life. Alternatively, blue-collar professions (e.g., plumbers), where skill
is often physical, compensation tends to remain constant or decline with age.
Thus, plumbers would tend to be savers in the early segments and dissavers
later (when their income declines).
5. The difference is because of the definition and measurement of return. In the
case of the WSJ, they are only referring to the current dividend yield on
common stocks versus the promised yield on bonds. In the University of
Chicago studies, they are talking about the total rate of return on common
stocks, which is the dividend yield plus the capital gain or loss yield during
the period. In the long run, the dividend yield has been 4-5 percent and the
capital gain yield has averaged about the same. Therefore, it is important to
compare alternative investments based upon total return.
6. The variance of expected returns represents a measure of the dispersion of
actual returns around the expected value. The larger the variance is,
everything else remaining constant, the greater the dispersion of
expectations and the greater the uncertainty, or risk, of the investment. The
purpose of the variance is to help measure and analyze the risk associated
with a particular investment.
7. 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.
8. Three factors that influence the nominal RFR are the real growth rate of the
economy, liquidity (i.e., supply and demand for capital in the economy) and
the expected rate of inflation. Obviously, the influence of liquidity on the RFR
is an inverse relationship, while the real growth rate and inflationary
expectations have positive relationships with the nominal RFR - i.e., the
higher the real growth rate, the higher the nominal RFR and the higher the
expected level of inflation, the higher the nominal RFR.
It is unlikely that the economy’s long-run real growth rate will change
dramatically during a business cycle. However, liquidity depends upon the
government’s monetary policy and would change depending upon what the
government considers to be the appropriate stimulus. Besides, the demand
for business loans would be greatest during the early and middle part of the
business cycle.
9. 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 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.
10. The increased use of debt increases the fixed interest payment. Since this
fixed contractual payment will increase, the residual earnings (net income)
will become more variable. The required rate of return on the stock will
change since the financial risk (as measured by the debt/equity ratio) has
increased.
11. According to the Capital Asset Pricing Model, all securities are located on the Security Market Line with
securities’ risk on the horizontal axis and securities’ expected return on its vertical axis. As to the
locations of the five types of investments on the line, the U.S. government bonds should be located to
the left of the other four, followed by United Kingdom government bonds, low-grade corporate bonds,
common stock of large firms, and common stocks of Japanese firms. U.S. government bonds have the
lowest risk and required rate of return simply because they virtually have no default risk at all. U.K.
Government bonds are perceived to be default risk-free but expose the U.S. investor to exchange rate
risk. Low grade corporates contain business, financial, and liquidity risk but should be lower in risk
than equities. Japanese stocks are riskier than U.S. stocks due to exchange rate risk.
THE INVESTMENT SETTING
Answers to Questions
1. 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.
2. Students in general tend to be borrowers because they are typically not
employed so have no income, but obviously consume and have expenses. The
usual intent is to invest the money borrowed in order to increase their future
income stream from employment - i.e., students expect to receive a better job
and higher income due to their investment in education.
3. In the 20-30 year segment an individual would tend to be a net borrower
since he is in a relatively low-income bracket and has several expenditures -
automobile, durable goods, etc. In the 30-40 segment again the individual
would likely dissave, or borrow, since his expenditures would increase with
the advent of family life, and conceivably, the purchase of a house. In the 40-
50 segment, the individual would probably be a saver since income would
have increased substantially with no increase in expenditures. Between the
, ages of 50 and 60 the individual would typically be a strong saver since
income would continue to increase and by now the couple would be “empty-
nesters.” After this, depending upon when the individual retires, the
individual would probably be a dissaver as income decreases (transition
from regular income to income from a pension).
4. The saving-borrowing pattern would vary by profession to the extent that
compensation patterns vary by profession. For most white-collar professions
(e.g., lawyers) income would tend to increase with age. Thus, lawyers would
tend to be borrowers in the early segments (when income is low) and savers
later in life. Alternatively, blue-collar professions (e.g., plumbers), where skill
is often physical, compensation tends to remain constant or decline with age.
Thus, plumbers would tend to be savers in the early segments and dissavers
later (when their income declines).
5. The difference is because of the definition and measurement of return. In the
case of the WSJ, they are only referring to the current dividend yield on
common stocks versus the promised yield on bonds. In the University of
Chicago studies, they are talking about the total rate of return on common
stocks, which is the dividend yield plus the capital gain or loss yield during
the period. In the long run, the dividend yield has been 4-5 percent and the
capital gain yield has averaged about the same. Therefore, it is important to
compare alternative investments based upon total return.
6. The variance of expected returns represents a measure of the dispersion of
actual returns around the expected value. The larger the variance is,
everything else remaining constant, the greater the dispersion of
expectations and the greater the uncertainty, or risk, of the investment. The
purpose of the variance is to help measure and analyze the risk associated
with a particular investment.
7. 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.
8. Three factors that influence the nominal RFR are the real growth rate of the
economy, liquidity (i.e., supply and demand for capital in the economy) and
the expected rate of inflation. Obviously, the influence of liquidity on the RFR
is an inverse relationship, while the real growth rate and inflationary
expectations have positive relationships with the nominal RFR - i.e., the
higher the real growth rate, the higher the nominal RFR and the higher the
expected level of inflation, the higher the nominal RFR.
It is unlikely that the economy’s long-run real growth rate will change
dramatically during a business cycle. However, liquidity depends upon the
government’s monetary policy and would change depending upon what the
government considers to be the appropriate stimulus. Besides, the demand
for business loans would be greatest during the early and middle part of the
business cycle.
9. 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 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.
10. The increased use of debt increases the fixed interest payment. Since this
fixed contractual payment will increase, the residual earnings (net income)
will become more variable. The required rate of return on the stock will
change since the financial risk (as measured by the debt/equity ratio) has
increased.
11. According to the Capital Asset Pricing Model, all securities are located on the Security Market Line with
securities’ risk on the horizontal axis and securities’ expected return on its vertical axis. As to the
locations of the five types of investments on the line, the U.S. government bonds should be located to
the left of the other four, followed by United Kingdom government bonds, low-grade corporate bonds,
common stock of large firms, and common stocks of Japanese firms. U.S. government bonds have the
lowest risk and required rate of return simply because they virtually have no default risk at all. U.K.
Government bonds are perceived to be default risk-free but expose the U.S. investor to exchange rate
risk. Low grade corporates contain business, financial, and liquidity risk but should be lower in risk
than equities. Japanese stocks are riskier than U.S. stocks due to exchange rate risk.
