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Transcript of Principles of Finance Part 5. Requests for permission to make copies of any part of the work should...
Principles of FinancePart 5
Requests for permission to make copies of any part of the work
should be mailed to: Thomson/South-Western
5191 Natorp Blvd.Mason, OH 45040
Chapter 16
Investment Concepts
Investment Concepts
Investors individuals who purchase investments with
current savings in anticipation of relatively stable growth on average, or in the long term
Investment Concepts
Speculators individuals who search for mispriced
securities in an effort to earn abnormal returns
Investment Concepts
Speculatorsgamble on whether the prices of financial
assets believed to be mispriced will adjust accordingly in the market
Investment objectives1. Retirement planning
The Investment Process
Investment objectives2. Supplement current income
The Investment Process
The Investment Process
Investment objectives3. Shelter current income from taxes
The Investment Process
Investment objectives4. Achieve future goals
The Investment Process
Income securitiespreferred stock corporate bonds steady dividend or interest payments
The Investment Process
Investor’s attitude toward risk risk tolerance level
an investor’s ability and willingness to tolerate, or accept, risk
Implementation to Achieve Investment Objectives
Transaction costs the costs associated with trading securities,
which include the costs of time, effort, and phone calls, as well as brokerage commissions that are incurred
Investment portfolioa combination of investment instruments
Stock
Bond
Real Estate
Implementation to Achieve Investment Objectives
Asset allocation the proportion of funds invested in various
categories of assets, such as money market instruments, long-term debt, stocks, and real estate
Implementation to Achieve Investment Objectives
Implementation to Achieve Investment Objectives
Monitoring the investment positions1. to make sure goals are met
2. to adjust to changing economic and legal conditions
3. to include new investment instruments
Securities Transactions
Brokerage firms versus financial intermediariesbroker
agent (middleman) who helps investors trade financial instruments such as stocks, bonds, and derivatives
investors directly provide funds to users of those funds
Securities Transactions
Brokerage firms versus financial intermediariesfinancial intermediaries
banks, credit unions, and S&Lsmanufacture financial products such
as mortgages, automobile loans, NOW accounts, or pension funds
allow savers to indirectly provide funds to borrowers
Securities Transactions
Brokerage firms full-service brokerage firm
offers a variety of services to its clients, including research information, monthly publications that contain investment recommendations, advisory services, etc...
Securities Transactions
Brokerage firmsdiscount brokerage firm
offers clients only the basic services associated with trading securities
provides trade execution and related reporting requirements
Securities Transactions
Trading securities
trading quantitiesround lots -multiples of 100 sharesodd lots - trades with shares that
are not in multiples of 100
Securities Transactions
Trading securities types of orders
market orderan order to execute a transaction at the
best price available when the transaction reaches the market
stop orderan order that specifies the price at which
an order to buy or sell at the market price (a market order) is initiated
Securities Transactions
Trading securities types of orders
limit orderan order to buy or sell a stock at no worse
than a specified priceday order (DO)
instruction to cancel an order if the price conditions are not met by the end of the trading day
Securities Transactions
Trading securities types of orders
good ‘til cancelled (GTC)indicates an order is active until the
price limitations are met or until the investor cancels it
fill or kill orderinstructs the broker to cancel the order
if it cannot be executed immediately
Securities Transactions
Trading securitiesevidence of ownership
physical possession of shares registered in your name
brokerage firm holds shares in street name (registered to the brokerage firm)
Securities Transactions
Trading securitiessecurity insurance
provided by most brokerage firmsSIPC limit of $500,000additional limits from private
organizations
Investment Information
Value Line Investment Survey
Moody’s Investment Services
Standard and Poor’s
Investment Information
Newspapers New York Times The Wall Street Journal Barron’s Investor’s Business Daily
Magazines Business Week Forbes Fortune Money
Investment Information
Stock Quotes
Investment Information
Bond Quotes
Investment Information
Treasury Quotes
Individual security
01 P - P INC
investment of investment of received return
value Beginning - value Ending Income Dollar
Computing Investment Returns
Computing Investment Returns
Holding period return (HPR) the return earned over the period of time an
investment is held
Rate of k
Income Ending value - Beginning value
of investment of investment
Beginning value of investment
return
INC P1 - P0
P0
Holding period
return
(HPR)
Dividend yield the part of the total return associated with
the dividends paid by the firm computed by dividing the amount of
dividends paid by the stock price
Capital gain (loss) change in the market value of a security
Computing Investment Returns
Annualized rate of return
k INC P1 - P0
P0
360
T
Computing Investment Returns
Simple arithmetic average return computed by summing each return and
then dividing by the number of returnsdoes not consider compounding
Computing Investment Returns
Simple arithmetic average return
k A k1 k2 kn
n
kt
t1
n
n
Computing Investment Returns
Computing Investment Returns
Geometric average return computed by taking the nth root of the
growth multiple and subtracting 1.0 takes into account compounding
Geometric average return
k G 1 k1 1 k2 1 kn 1
n 1.0
1 kt t1
n
1
n
1.0
Computing Investment Returns
Computing Investment Returns
Computing the return on a portfolio
kp
Value of
Security 1
Portfolio
value
k1
Value of
Security 2
Portfolio
value
k2
Value of
Security N
Portfolio
value
kn
w1k1 w1k1 w nkn
w jk j
j1
n
Indexes Measuring Market Returns
Dow Jones Industrial Average (DJIA) 30 largest industrial firms in U. S.
Standard & Poor’s family of indexes S&P 500, S&P 400, S&P Industrials
Exchange indexes NYSE, AMEX, NASDAQ
Russell 3,000 Wilshire 5,000
Indexes Measuring Market Returns
Market capitalization the total market value of a firm’s stock computed by multiplying the number of
shares outstanding by the market price per share
Indexes Measuring Market Returns
Bull market rising stock market
Bear market falling stock market
Alternative Investment Strategies
Buy-and-hold strategyStrategy where investors purchase
securities with the intent of holding them for a long period, perhaps a number of years
Alternative Investment Strategies
Margin trading type of trade that allows an investor to
borrow from his or her broker some portion of the funds needed to purchase an investment
Alternative Investment Strategies
Margin requirement the minimum percent of the total purchase
price an investor must have to buy stock (or other investments) on margin
Alternative Investment Strategies
Hypothecation agreementassigns securities as collateral for a margin
loan
Alternative Investment Strategies
Broker loan rate the rate charged by brokers to borrow
funds for margin trading
Alternative Investment Strategies
Actual margin the percentage of investor’s equitymust meet the margin requirement when
the stock is purchased
Alternative Investment Strategies
Actual margin
investment of valueMarket
equity sInvestor'
share
per Price shares #
borowed
Amount
share
per Price shares #
Alternative Investment Strategies
Margin calla call from the broker to add more funds to
a margined account
Maintenance margin the lowest actual margin the broker will
permit margined investors to have at any time
Alternative Investment Strategies
Short selling type of trade that allows an investor to
borrow the stock of another investor and then sell it, but with a promise to replace the stock at a later date
cannot sell short on a downtick
Alternative Investment Strategies
Downticka decrease in price from one trade to
another
Alternative Investment Strategies
Uptickoccurs when the price of the most recent
trade is higher than the previous trade
Alternative Investment Strategies
Zero-plus tick occurs when the price of the latest trade equals
the price of the previous trade, but exceeds the price from one trade earlier
Shorting against the box occurs when an investor short sells a stock he or
she also owns refers to having the securities in a strong, or safe
deposit, box
End of Chapter 16
Investment Concepts