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Chapter 6 Principles of Investing

Chapter 6 Principles of Investing. Investing in Financial Assets Investment Strategies Investing in Stocks Investing in Bond. Investment Basics. Liquidity – How accessible is your money? Risk – What is the safety involved?

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Chapter 6 Principles of Investing

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

  3. How to Determine Your Expected Return U.S. Treasury Bills Risk-free real return Very safe Risk premium Inflation Very risky Amazon.com (C) 2001 Contemporary Engineering Economics

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

  5. (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. (C) 2001 Contemporary Engineering Economics

  7. Returns from Various Investment Classes (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 (C) 2001 Contemporary Engineering Economics

  9. Dollar-Cost Averaging Concept (C) 2001 Contemporary Engineering Economics

  10. Broader Diversification Increases Return (C) 2001 Contemporary Engineering Economics

  11. 1 (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 (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 (C) 2001 Contemporary Engineering Economics

  14. What Are Your Odds? Source: Newsweek, November 10, 1997 (C) 2001 Contemporary Engineering Economics

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

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

  17. ($100-$75)* 1000= $25,000 from trade -$ 5,900 premium $19,000 profit If stock price rises to $100 Hold to maturity and trade at the strike price $5,000 from trade -$5,900 premium $ 900 loss AOL Date: Feb 13, 2001 Price: $48.09 Strike price: $75 Premium: $5,900 for 1000 shares Expiration: Jan 2003 If stock price rises to $80 If stock price rises to $90 $15,000 from trade -$ 5,900 premium $ 9,100 profit Trade for profit before option expires If stock price rises to $78 $3,000 from trade -$5,900 premium $2,900 loss Lose your premium only $5,900 loss Let the option expire If stock price drops to $70 (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 (C) 2001 Contemporary Engineering Economics

  19. Bond Price Notation Used in Financial Markets (C) 2001 Contemporary Engineering Economics

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

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

  23. Bond Quotes Maturity (2005) Trading volume AT&T 7s05 6.5% 5 million 108 1/4 Closing Market price Coupon rate of 7% Current yield $70/108.25 = 6.47% $1,082.50 (C) 2001 Contemporary Engineering Economics

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

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