Download PRINCIPLES OF INVESTMENT MAY 2012

PRINCIPLES OF INVESTMENTS MAY 2012 MODEL ANSWERS
SECTION A
Question 1
1.1 a)
Investors are Individuals and firms who spare some of their finances from immediate
use for use in the immediate or indefinite future. This may also be done on a
continuous basis with aim of building-up their future reserves. (3 marks)
1.1 b)
The required rate of return is the minimum rate of return (expressed as a
percentage) that an investor requires before investing capital. The degree of risk
associated with an investment is reflected in the required rate of return. Investors
and analysts often use the required rate of return as a discount rate for future cash
flows from an investment. (3 marks)
1.1 c)
Capital Asset Pricing Model (CAPM) is a sophisticated mathematical method of
formulating a relationship between expected risk and expected return. In essence,
Capital Asset Pricing Model is built on a pervasive investment theory, in which
Capital Asset Pricing Model claims that higher risk justifies higher returns. Building
upon that assertion, Capital Asset Pricing Model states that the return on an asset or
security is equal to a risk-free return, plus a risk premium. Thus, according to the
Capital Asset Pricing Model, the projected return must be on par with or above the
required return to rationalize the investment. End calculation of the Capital Asset
Pricing Model is conveyed graphically by the security market line (SML). Capital
Asset Pricing Model is a fairly complicated device used primarily by trained financial
practitioners to calculate the pricing of high-risk securities. (3 marks)
1.1 d)
Setting the Investment Objective is the first step for the investor to set the investment
objective. This would vary for individuals, pension and mutual funds, banks, financial
institutions, insurance companies, etc. For instance the objective for a pension or
mutual fund or insurance company may be to have a cash flow specification to
satisfy liabilities at different dates in the future. These liabilities would include
redemption, dividends or claim settlement payouts. For a bank it may be to lock in a
minimum interest spread over their cost of funds. For the individual investor the
objective may be to maximize return on investment. (3 marks)
1.1 e)
Primary markets are markets dealing in the issue of new securities. These can be
initial public offerings (IPOs) for public companies, government bonds or other
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private and public sector funding programs. In a primary market, the security is sold
directly to the investor from the company or organization itself. As in the case with
IPOs, it is a purchase between the company and the investor. In the case of
municipal bonds, it is the purchase of the debenture directly from the municipality.
Primary markets are a vital part of the capital markets and underlying strength of the
economy. (3 marks)
Question 2
2.1 a)
Output, the most important concept of macroeconomics, refers to the total amount of
goods and services a country produces, commonly known as the gross domestic
product. The figure is like a snapshot of the economy at a certain point in time. When
referring to GDP, macroeconomists tend to use real GDP, which takes inflation into
account, as opposed to nominal GDP, which reflects only changes in prices. The
nominal GDP figure will be higher if inflation goes up from year to year, so it is not
necessarily
indicative
of
higher
output
levels, only of higher
prices.
The one drawback of the GDP is that because the information has to be collected
after a specified time period has finished, a figure for the GDP today would have to
be an estimate. GDP is nonetheless like a stepping stone into macroeconomic
analysis. Once a series of figures is collected over a period of time, they can be
compared, and economists and investors can begin to decipher the business cycles,
which are made up of the alternating periods between economic recessions (slumps)
and
expansions
(booms)
that
have
occurred
over
time.
From there we can begin to look at the reasons why the cycles took place, which
could be government policy, consumer behaviour or international phenomena,
among other things. Of course, these figures can be compared across economies as
well. Hence, we can determine which foreign countries are economically strong or
weak. Based on what they learn from the past, analysts can then begin to forecast
the future state of the economy. It is important to remember that what determines
human behaviour and ultimately the economy can never be forecasted completely.
(5 marks)
2.1 b)
The unemployment rate tells macroeconomists how many people from the available
pool of labour (the labour force) are unable to find work. Macroeconomists have
come to agree that when the economy has witnessed growth from period to period,
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which is indicated in the GDP growth rate, unemployment levels tend to be low. This
is because with rising (real) GDP levels, we know that output is higher, and, hence,
more labourers are needed to keep up with the greater levels of production. (5
marks)
2.1 c)
The third main factor that macroeconomists look at is the inflation rate, or the rate at
which prices rise. Inflation is primarily measured in two ways: through the Consumer
Price Index (CPI) and the GDP deflator. The CPI gives the current price of a selected
basket of goods and services that is updated periodically. The GDP deflator is the
ratio of nominal GDP to real GDP.
If nominal GDP is higher than real GDP, we can assume that the prices of goods and
services have been rising. Both the CPI and GDP deflator tend to move in the same
direction and differ by less than 1%. (5 marks)
Question 3
3.1
Calculation using an FV factor: (5 marks)
FV = PV x (1.00 + i)n
FV = $10,000 x (1.00 + 0.02)4
FV = $10,000 x (1.02)4
FV = $10,000 x (1.02 x 1.02 x 1.02 x 1.02)
FV = $10,000 x (1.0824)
FV = $10,824
3.2
Using the PV of 1 Table to find the (rounded) present value figure at the
intersection of n = 12 (3 years x 4 quarters) and i = 2% (8% per year ÷ 4
quarters). Insert the factor into the formula: (5 marks)
PV = FV [PV of 1 factor for n = 12 quarters; and i = 2% per quarter]
PV = $5,000 x [0.788] ← PV of 1 factor from PV of 1 Table
PV = $3,940.00
3.3
Interest – bearing instruments are instruments that pay interest on the initial
investment amount to the holder. They include: (5 marks)
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
Overnight/time/term deposits

Negotiable certificate of deposit

Reserve bank debentures

Repurchase agreements

Roads board bridging bonds
Question 4
20 marks
4.1
The money market is a market in which liquid, low risk short term debt
instruments are traded. Generally, the instruments traded in this market have
a maturity of one year or less. In some countries, money market instruments
are classified to have a maturity of not more than three years.
The money market is a subsection of the fixed income market. We generally
think of the term fixed income as being synonymous to bonds. In reality, a
bond is just one type of fixed income security. The difference between the
money market and the bond market is that the money market specializes in
very short-term debt securities (debt that matures in less than one year).
Money market investments are also called cash investments because of their
short maturities.
Money market securities are essentially IOUs issued by governments,
financial institutions and large corporations. These instruments are very liquid
and considered extraordinarily safe. Because they are extremely
conservative, money market securities offer significantly lower returns than
most other securities. One of the main differences between the money market
and the stock market is that most money market securities trade in very high
denominations. This limits access for the individual investor. Furthermore, the
money market is a dealer market, which means that firms buy and sell
securities in their own accounts, at their own risk. Compare this to the stock
market where a broker receives commission to acts as an agent, while the
investor takes the risk of holding the stock. Another characteristic of a dealer
market is the lack of a central trading floor or exchange. Deals are transacted
over the phone or through electronic systems. The easiest way for us to gain
access to the money market is with a money market mutual fund, or
sometimes through a money market bank account. These accounts and funds
pool together the assets of thousands of investors in order to buy the money
market securities on their behalf. However, some money market instruments,
like Treasury bills, may be purchased directly. Failing that, they can be
acquired through other large financial institutions with direct access to these
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markets.
The money market can be classified into two categories:

The retail market.

The wholesale market
The retail market involves smaller amounts of funds, usually not more than
K20 million. Most individuals, small and medium enterprises are active
participants in the retail market because of the smaller amounts involved.
Typical instruments that are used in this market include call accounts, notice
deposits, motor vehicle finance and overdrafts.
The wholesale market involves larger amounts of more than K20 million. Most
participants in this market are banks, corporate and government. According to
(Clayton, 2004) individuals can participate indirectly in the following ways:

Money market deposit account: A deposit account that gives the
investor a high rate of interest for as long as funds are invested in the
account. It also provides easy access to money and the flexibility of
transacting from the account.

Money market unit trust fund: A fund that pools investors’ funds
through the retail market and invests them in money market securities.

Money market life products: Similar to money market unit trust funds,
the only difference being the holding structure through which the investor’s
money is held.
The money market essentially serves as platform from which funds that are
available for short periods of time (from lenders) can be made available to
those who need the funds (borrowers). The money market also allows
institutions with surplus funds to invest them in highly liquid assets, thereby
allowing them to realise cash easily, should the need arise. In addition, the
money market is a mechanism, which the central bank uses to influence
money supply through the purchase or sale of financial instruments. Finally,
the money market is actively used by the government to borrow funds to
finance its budget.
In the financial markets, trading is conducted through organised, formal
exchanges as well as through informal exchanges commonly known as overthe – counter (OTC) exchanges. Malawi Stock Exchange is the formal
exchange in Malawi. Trading on the money market is conducted informally
through telephonic contact and over the counter, meaning that trading occurs
directly between parties. Unlike electronic settlement systems used in formal
exchanges, money market trading utilises physical settlement procedures.
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The participants in the money market consist largely of:

individuals

Small to medium sized companies

Corporate companies

Banks

Government, through the central bank

Parastatals
SECTION B
Question 5

Setting the Investment Objective
The first step for the investor is to set the investment objective. This would
vary for individuals, pension and mutual funds, banks, financial institutions,
insurance companies, etc. For instance the objective for a pension or mutual
fund or insurance company may be to have a cash flow specification to satisfy
liabilities at different dates in the future. These liabilities would include
redemption, dividends or claim settlement payouts. For a bank it may be to
lock in a minimum interest spread over their cost of funds. For the individual
investor the objective may be to maximize return on investment. A more
appropriate word would be ‘optimize’. As the individual would achieve
optimum return at optimum risk. To maximize return would imply the
maximization of risk, which would not be practical or sustainable. (5 marks)

Establishing Investment Policy
Setting policy begins with asset allocation amongst the major asset classes
available in the capital market. Which range from equities, debt, fixed income
securities, real estate, and foreign securities to currencies. While setting the
investment policy the constraints of the environment and that of the investor
have to be kept in perspective. The environment would include: government
rules and regulations (or restrictions); another would be the operating system
of the market place. Individual constraints would include financial capability,
availability of time to undertake the exercise, risk profile and the level of
understanding the investor has of the investment environment. (5 marks)

Selecting the Portfolio Strategy
The portfolio strategy selected would have to be in conformity with both the
objectives and policy guidelines. Any contradiction here would result in a
systems break down and losses.
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Let’s consider a person with a job that keeps him busy for 10-12 hours a day,
five days of the week. On Saturday he helps the family with household
chores. On Sunday he takes the day off and enjoys himself. Now with such a
busy life, we cannot expect him to obtain optimal returns from investments in
the equity market. Where is the time for thought, analysis and action? He
would at best be playing a game of Blantyre sports. For a person with such a
busy life schedule it would be best to invest in fixed income securities. These
would include RBM bonds, Bank deposits, insurance, etc.
Where there is a lower but assured return. However, if this average, hard
working and successful person still wants to invest in the equity market for a
relatively higher rate of return. Then he would have to create the time for the
thought, analysis and action required for success in this endeavor.
Portfolio strategies are mainly of two types: Active strategies and Passive
strategies. Active strategies have a higher expectation about the factors that
are expected to influence the performance of the asset class. While Passive
strategies involve a minimum expectation input. The latter would include
indexing which would require the investor to replicate the performance of a
particular index. Between these two extremes we have a range of other
strategies which have elements of both active and passive strategies. In the
fixed income segment, structured portfolio strategies have become popular.
Here the aim would be to achieve a predetermined performance in relation to
a benchmark. These are frequently used to fund liabilities. (5 marks)

Selecting the Assets
It is of importance for the investor to select specific assets to be included in
the portfolio. It is here that the investor or manager attempts to construct an
optimal or efficient portfolio. This would give the expected return for a given
level of risk, or the lowest risk for a given expected return.
The asset classes can be chosen from:
 Equity
 Fixed income securities (which would include bonds, shares and bank
deposits)
 Debt instruments
 Real estate
 Art objects
 Rare stamps
 Currencies
The investor would ideally have all the above in his investment portfolio. This
would then require the investor to rebalance the various components of his
overall portfolio from time to time, depending on his objectives with respect to
this portfolio. These objectives may be time based or asset price based or a
combination of both. (5 marks)

Measuring and Evaluating Performance
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This step would involve the measuring and evaluating of portfolio performance
relative to a realistic benchmark.
We would measure portfolio performance in both absolute and relative terms,
against a predetermined, realistic and achievable benchmark. Further, we
would evaluate the portfolio performance relative to the objective and other
predetermined performance parameters.
The investor or manager would consider two main aspects; namely risk and
return. He would measure and evaluate, whether the returns were worth the
risk, or whether the risk was worth the return. The issue here is, whether the
portfolio has achieved commensurate returns, given the risk exposure of the
portfolio.
Measuring and evaluating portfolio performance, would be used to give the
investor or manager feedback. And would help the investor or manager in
improving the quality and performance of both the portfolio and its
management process in the future. (5 marks)
Question 6 (20 marks)
7.1
Once something has gone through its offering in the primary market, it will
then be made available in secondary markets such as stock exchanges and
through brokerage firms. There may be a specified period before the issue
can be sold on a secondary market to allow it to preserve the strength and
integrity of the offering as in cases with IPOs. Once securities are on the
aftermarket, they can be bought and sold based on demand. Securities
exchanges are the "store" that these securities are sold with sales forces
extending through brokerage firms. The information presented on the nightly
news with market ups and downs is referring to the secondary markets most
often. (5 marks)
7.2
National Stock Exchanges; These exchanges trade numerous issues of
diverse shares to a wide number of investors. A national stock exchange
operates as an auction market where buyers and sellers are driven by
price. The New York Stock Exchange (NYSE) and the American Stock
Exchange (AMEX) are examples of national stock exchanges in the U.S. The
London Stock Exchange (LSE) is an example of a national stock exchange in
the UK. A national stock exchange typically has stringent qualifications a
stock must meet in order to be listed. (5 marks)
A regional exchange is similar to the national stock exchanges except
regional exchanges serve smaller markets and typically trade smaller
issues. A company that cannot list its shares on a national stock exchange
because it does not meet the requirements may choose to list its share on a
regional exchange. The Boston exchange is an example of a regional
exchange in the U.S. (5 marks)
An OTC market is a less formal exchange. Both listed stocks and unlisted
stocks can trade in the OTC market. The OTC market operates as an order-
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driven market where buyers and sellers submit bids and a dealer buys or sells
the stock from his own inventory. Unlike a national exchange where a broker
matches buyers and sellers, an OTC market comprises any securities for
which there is a market. As a result, the OTC market is also referred to as a
negotiated market. In the U.S., the NASDAQ system is used as the quotation
system for the OTC market.
It is important to understand the relationship between exchanges and
companies and the ways in which the requirements of different exchanges
provide protection to investors. (5 marks)
Question 7
(a)
Efficient Market Hypothesis – EMH; An investment theory that states it is
impossible to "beat the market" because stock market efficiency causes
existing share prices to always incorporate and reflect all relevant information.
According to the EMH, this means that stocks always trade at their fair value
on stock exchanges, making it impossible for investors to either purchase
undervalued stocks or sell stocks for inflated prices. As such, it should
be impossible to outperform the overall market through expert stock selection
or market timing, and that the only way an investor can possibly obtain higher
returns is by purchasing riskier investments. (10 marks)
(b)
Horizontal Analysis or Trend Analysis:
Comparison of two or more year's financial data is known as horizontal
analysis, or trend analysis. Horizontal analysis is facilitated by showing
changes between years in both dollar and percentage form.
Horizontal analysis of financial statements can also be carried out by
computing trend percentages. Trend percentage states several years'
financial data in terms of a base year. The base year equals 100%, with all
other years stated in some percentage of this base. (5 marks)
Vertical Analysis:
Vertical analysis is the procedure of preparing and presenting common size
statements. Common size statement is one that shows the items appearing
on it in percentage form as well as in dollar form. Each item is stated as a
percentage of some total of which that item is a part. Key financial changes
and trends can be highlighted by the use of common size statements. (5
marks)
Question 8
The net present value (NPV) is found by subtracting a project’s initial investment
(Cfo) from the present value of its cash flows (CFt) discounted at a rate equal to the
firm’s cost of capital (r)
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NPV = Present value of cash inflows – Initial investment
When NPV is used, both inflows and outflows are measured in terms of present
Kwachas. Because we are dealing only with investments that have conventional
cash flow patterns, the initial investment is automatically stated in terms of today’s
kwachas. If it were not, the present value of a project would be found by subtracting
the present value of outflows from the present value of inflows. (5 marks)
Decision Criteria
When NPV is used to make accept – reject decisions, the decision criteria are as
follows:


If the NPV is greater than 0, accept the project.
If the NPV is less than 0, reject the project.
If the NPV is greater than 0, the firm will earn a return greater than its cost of capital.
Such action should increase the market value of the firm, and therefore the wealth of
its owners by an amount equal to the NPV. (5 marks)
The internal rate of return (IRR) is probably the most widely used sophisticated
capital budgeting technique. However, it is considered more difficult than NPV to
calculate by hand. The IRR is the discount rate that equates the NPV of an
investment opportunity with 0 (because the present value of cash inflows equals the
initial investment). It is the compound annual rate of return that the firm will earn if it
invests in the project and receives the given cash inflows. (5 marks)
Decision Criteria
When IRR is used to make accept – reject decisions, the decision criteria are as
follows:


If the IRR is greater than the cost of capital, accept the project.
If the IRR is less than the cost of capital, reject the project.
These criteria guarantee that the firm will earn at least its required return. Such an
outcome should increase the market value of the firm and therefore the wealth of its
owners. (5 marks)
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