Investment and Rate

1. Suppose you discover a treasure chest of RM10 billion in cash a. Is this a real or financial asset?

Answer:
Yes. 10 billion cash is the financial asset. This is because financial assets only obtain its monetary value from a contractual agreement of what it represents. In contrast, real asset itself has the physical value. b. Is society any richer for the discovery?

Answer:
No. This is because the cash does not contribute to the productive capacity of the economy. c. Are you wealthier?

Answer:
Yes. You would become wealthier with RM10 billion cash.
d. Is anyone worst off as a result of the discovery?

Answer:
Yes. The society as a whole is worse off. This is because cash is the financial asset and it becomes is a liability of the government upon the time you found the cash. So, the taxpayers will have to make up for the government liability. 2. The average rate of return on investment in large stocks has outpaced that on investments in T-Bills by about 8% since 1926 in US. Why, then, does anyone invest in T-Bills? Answer:

This is because T-bill is regarded as an almost risk free asset as it is backed by the government. Therefore, it has lowest volatility as compared to stocks. This is also a reason that people tend to invest in T-bills instead of stocks. 3. You see an advertisement for a book that claims to show how you can make RM1 million with no risk and with no money down. Will you buy the book? Why? Answer:

No. It is impossible to make RM1million with no risk and with no money down. This is because only a person who takes risk would be compensated with return. Even T-bills which is backed by the government also has low risk and it is impossible to earn RM1million with no risk at all. 4. You are bullish on Telekom stock. The current market price is RM50 per share, and you have RM5,000 of your own to invest. You borrow an additional RM5,000 from your broker at an interest rate of 8% per year and invest RM10,000 in the stock. a. what will be your rate of return if the price of Telekom stock goes up by 10% during the next year? (ignore dividend) Answer:

Return: 10,000 x 10%= RM 1,000
Interest to Pay: 5,000 x 8%= RM 400
Total Return: RM1,000- RM400= RM600
Rate of Return = [600/5,000] x 100%
= 12%
b. How far does the price of Telekom stock should have fall for you to get a margin call if your maintenance margin is 30% of the value of the short position? Answer:
RM10,000/50 = 200 shares
Let P be the stock price,
Value of Share= 200P
Equity = 200P-5000

|Margin=Equity/Current Market Value of shorted security |
(200P-5000)/200P =0.30
1-0.30 =5000/200P
200P =7142.86
P = RM 35.71 (Price When Margin Call Occurs)
5. The composition of the Fingroup Fund portfolio is as follows: |Stock |Shares |Price (RM) |
|A |200,000 |35 |
|B |300,000 |40 |
|C |400,000 |20 |
|D |600,000 |25 |
The fund has not borrowed any funds, but its accrued management fee with the portfolio manager currently totals RM30,000. There are 4 million shares outstanding. What is the net asset value of the fund? Answer:

Step 1: Market Value of Asset= [(200,000 X RM35)+(300,000 X RM40)+(400,000 X RM20)+(600,000 X RM25) =RM42,000,000
Step 2: Liabilities= RM 30,000 ; Shares Outstanding= 4,000,000 Step 3: Net Asset Value of the Fund (NAV)=
(Market Value of Asset –Liabilities)/ Shares Outstanding
= (RM42,000,000-RM30,000)/ 4,000,000
= RM10.49
6. You are considering the choice between investing RM50,000 in a conventional 1-year bank FD offering an interest rate of 5% and a 1 year “Inflation-Plus” FD offering 1.5% per year plus the rate of inflation. a. Which is the safer investment?

Answer:
1 year “Inflation –Plus” FD is the safer investment because it guarantees the purchasing power of the investment. As real rate equals the nominal rate minus the inflation rate, so 1 year “Inflation –Plus” FD provides a real rate of 1.5% regardless of the inflation rate. b. Which offers the higher expected return?

Answer:
The expected return depends on the expected rate of inflation over the next year. If the rate of inflation is less than 3.5% then the conventional FD will provides higher real return than the “Inflation-Plus” FD. However, if inflation is more than 3.5%, the “Inflation-Plus” FD will provide higher real return. c. If you expect rate of inflation to be 3% over the next year, which is the better investment? Why? Answer:

A conventional 1-year bank FD is the better investment as it provides 5% return. While, 1 year “Inflation –Plus” FD will only provides 4.5% (1.5%+3%) return. d. If we observe a risk-free nominal interest rate of 5% per year and a risk free real rate of 1.5% on inflation-indexed bonds, can we infer that the market’s expected rate of inflation is 3.5% per year? Answer:

No. We cannot infer that the market’s expected rate of inflation is 3.5% per year. Under fisher formula: |Nominal rate = real rate + inflation premium |
|5% = 1.5% + i |
|Inflation= 3.5% |
But, we cannot assume that the entire difference between the risk-free nominal rate of 5% and the real risk-free rate of 1.5% is the expected rate
of inflation. This is because part of the difference should include the risk premium as there is an uncertainty surrounding the real rate of return. So, the expected rate of inflation should be less than 3.5% per year. 7. You purchased a share of stock for $30. One year later you received $1.50 as dividend and sold the share for $32.25. What was your holding period return? Answer:

Holding Period Return (HPR) = ($32.25-$30+$1.50)/RM30= 12.5%
8. You have been given this probability distribution for the holding period return for KMP stock: [pic]
a. What is the expected holding period return for KMP stock? b. What is the expected standard deviation for KMP stock? c. What is the expected variance for KMP stock?
Answer:
a. Expected Holding Period Return = (0.30 X 18%)+(0.50 X 12%)+(0.20 X -5%) = 10.4%
b. Expected Variance = [0.30 X (18%-10.4%)2]+ [0.50 X (12%–10.4%)2] + [0.20 X (-5%-10.4%)2]
= 66.04%
c. Expected Standard Deviation = [66.4]1/2
= 8.13%

9. A portfolio has an expected rate of return of 0.15 and a standard deviation of 0.15. The risk-free rate is 6 percent. An investor has the following utility function: U = E(r) – (A/2)s2. What is the value of A which makes this investor indifferent between the risky portfolio and the risk-free asset? Answer:

E(r)= 0.15 ; Rf =6%
Standard Deviation = [S2]1/2
(0.15)2 = S2
Variance, S2 =0.0225
U = E(r) – (A/2) S2
0.06 = 0.15- (A/2) 0.0225
A = 8

10. Discuss briefly the advantages and disadvantages of common stock ownership, relative to other investment alternatives. Answer:

Advantages:

• The risk to hold the common stock is higher as compared to other investment alternatives such as bond. However, common stocks have the advantage of having high earning potential than other alternative investments such as bonds and certificates of deposits (CD). • Most of the common stocks are very liquid. Therefore, the common stockholders can be bought and sold the shares on hand quickly at a fair price. • Common stock has the voting rights that the bondholder or preferred stockholders do not have. • Unlike bondholder who receives only the fixed coupon payment (fixed income). Common stockholder has the right to share the company’s profit (in the form of dividend) Disadvantages:

• In case the company is liquidated (went bankrupt), common stockholder is the last to get anything that is left over. So bonds are safer in this respect. This is because a company would pay to its employees, suppliers, and creditor first. The common stockholders are the last one to claim on any money left. • If the company issue only a small amount of dividend. The common stockholders may receive only a little portion or even nothing from the dividend payment after the preferred stockholders has received it. 11. Discuss some reasons why an investor with a long time horizon might choose to invest in common stocks, even though they have historically been riskier than government bonds or T-bills. Answer:

This is because based on historical data, common stocks provide for the best growth in the purchasing power. Even it is riskier than government bonds or T-bills, an investor with a long time horizon can somehow more comfortable and can tolerate with the fluctuations in the stock return. 12. Calculate the arithmetic men and geometric mean returns of the following: | Year |Annual Return (%) |

| 1 |12.5 |
|2 |9.7 |
|3 |-4.5 |
|4 |1.5 |
|5 |3.5 |
|6 |-6.4 |
|7 |7.5 |
|8 |9.5 |
|9 |10 |
|10 |8.5 |
Answer:
Arithmetic mean returns:
=[(12.5%)+(9.7%)+(-4.5%)+(1.5%)+(3.5%)+
(-6.4%)+(7.5%)+(9.5%)+(10%)+(8.5%)] / 10
=51.8% / 10
=5.18%

Geometric mean returns:
= [ (1+0.125)(1+0.095)(1-0.045)(1+0.015)(1+0.035)
(1-0.064)(1+0.075)(1+0.095)(1+0.10)(1+0.085)]1/10 – 1
= (1.125 X 1.097 X 0.955 X 1.015 X 1.035 X 0.936 X 1.075 X 1.095 X 1.1 X 1.085)1/10 – 1 = 5%
13. Over the past year you earned a nominal rate of interest of 8 percent on your money. The inflation rate was 4 percent over the same period. The exact actual growth rate of your purchasing power was: Answer:

Actual growth rate = [(1+8%)/(1+4%)]-1= 3.85%
14. Toyota stock has the following probability distribution of expected prices one year from now:
If you buy Toyota today for $55 and it will pay a dividend during the year of $4 per share, what is your expected holding-period return on Toyota? Answer:
Expected Holding Period Return:
= 0.25[($50-$55+$4)/$55] + 0.40[($60-$55+$4)/$55] + 0.35[($70-$55+$4)/$55] = 18.18%