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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 A qualification examined by the Institute of Bankers in Malawi Page 1 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, A qualification examined by the Institute of Bankers in Malawi Page 2 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) A qualification examined by the Institute of Bankers in Malawi Page 3 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 A qualification examined by the Institute of Bankers in Malawi Page 4 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. A qualification examined by the Institute of Bankers in Malawi Page 5 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. A qualification examined by the Institute of Bankers in Malawi Page 6 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 A qualification examined by the Institute of Bankers in Malawi Page 7 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- A qualification examined by the Institute of Bankers in Malawi Page 8 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) A qualification examined by the Institute of Bankers in Malawi Page 9 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) A qualification examined by the Institute of Bankers in Malawi Page 10