Beginning students will probably think of default risk and purchasing power sis very quickly. Some may be aware of interest rate risk and market risk without fully understanding these concepts (which are explained in later chapters). Other risks include political risk and liquidity risk. Students may also remember financial risk and business risk from their managerial finance course. 5. What other constraints besides risk do investors face? Return and risk form the basis for investors establishing their objectives. Some investors think Of risk as a constraint on their activities.
If so, risk is the most important constraint. Investors face other constraints, including: C] time 0 taxes 0 transaction costs C] income requirements 0 legal and regulatory constraints CLC diversification requirement 6. What are institutional investors? How are individual investors likely to be affected by institutional investors? Institutional investors include bank trust departments, pension funds, mutual funds (investment companies), insurance companies, and so forth. Basically, these financial institutions own and manage portfolios of securities on behalf of various clientèles.
They affect the investing environment (and therefore individual investors) wrought their actions in the marketplace, buying and selling securities in large dollar amounts. However, although they appear to have several advantages over individuals (research departments, expertise, etc. ); reasonably informed individuals should be able to perform as well as institutions, on average, over time. This relates to the issue of market efficiency. 7. Investors should always seek to maximize their return from investing. Agree or disagree. Disagree.
If investors sought only to maximize their returns, they would purchase the riskiest assets, ignoring the risk they would be taking. Once again, investors must seek a balance between expected return and risk. 8. What is meant by “indirect” investing? Indirect investing involves the purchase and sale of investment company shares. Since investment companies hold portfolios of securities, an investor owning investment company shares indirectly owns a pro-rata share of a portfolio of securities. 9. Do all common stocks pay dividends?
Who decides? There is no requirement for a company to pay a dividend on the common stock. Any payment is decided by the company’s board of directors, who can hang the dividend (or abolish it) at any time 10. Why is the call provision on a bond generally a disadvantage to the bondholder? The call feature is a disadvantage to investors who must give up a higher- yielding bond and replace it (to continue having a position) with a lower- yielding bond. Issuers will call in bonds when interest rates have dropped substantially (e. G. Two or three percentage points) from a period of very high rates. Of course, the bonds may be protected from call for a certain period and cannot be called although the issuer would like to do so. Generally, once unprotected, issuers will call bonds when it is economically attractive to do so, which is when the discounted benefits outweigh the discounted costs of calling the bonds. 1 1 . Of what value to investors are stock dividends and splits? Stock dividends and splits do not, other things being equal, represent additional value.
Of course, if a stock dividend is accompanied by a higher cash dividend, the stockholder gains, but this is a change in the dividend policy. Some people believe that these transactions increase the ownership of a stock by bringing it into a more favorable price range, but even if true it is fitful this would add real value. 12. Assume that a company in whose stock you are interested will pay regular quarterly dividends soon. You determine that a dividend of $3. 20 is indicated for this stock.
The board of directors has declared the dividend payable on September 1, with a holder-of-record date of August 15. When must you buy the stock to receive this dividend, and how much will you receive if you buy 150 shares? The $3. 20 dividend is the annual dividend. The stock goes ex-dividend on August 13. An investor must buy the stock on or before August 12 to receive the dividend. With 150 shares, 150 ($. 80) = $1 20 will be received (the quarterly dividend is 1/off $3. 20, or $. 80). 13. Consider a corporate bond rated AAA versus another corporate bond rated EBB.
Could you say with complete confidence that the first bond will not default, while for the second bond there is some reasonable probability of default? No, because bond ratings are relative measures of risk, not absolute measures. While a triple A rating is an indicator of very high quality, a security with such a rating could still default. 14. Why does the Treasury bill serve as a benchmark security? The Treasury bill is considered the safest of all assets because of its short maturity and the belief that the Federal government will never default on its securities.
Therefore, it serves as the building block for interest rates because other securities have longer maturities or some default risk, or both, and the Treasury bill rate is the starting point for the rate these securities must offer. ” Stocks that consistently perform well are more likely to be chosen by risk- averse investors because there is less risk tied to the stock. The amount one would anticipate receiving on an investment that has various now or expected rates of return. For example, if one invested in a stock that had a 50% chance of producing a 10% profit and a 50% chance of producing a 5% loss, the expected return would be 2. % (0. 5 * 0. 1 + 0. 5 * -0. 05). It is important to note, however, that the expected return is usually based on historical data and is not guaranteed. Realized return The return that is actually earned over a given time period. Inflationary Risk Also known as purchasing power risk, inflationary risk is the chance that the value of an asset or income will be eroded as inflation shrinks the value of a entry’s currency. Put another way, it is the risk that future inflation will cause the purchasing power of cash flow from an investment to decline.
The best way to fight this type of risk is through appreciable investments, such as stocks or convertible bonds, which have a growth component that stays ahead of inflation over the long term. Market Risk Market risk, also called systematic risk, is a risk that will affect all securities in the same manner. In other words, it is caused by some factor that cannot be controlled by diversification. This is an important point to consider when you re recommending mutual funds, which are appealing to investors in large part because they are a quick way to diversify.
You must always ask yourself what kind of diversification your client needs. Interest Rate Risk Interest rate risk is the possibility that a fixed-rate debt instrument will decline in value as a result Of a rise in interest rates. Whenever investors buy securities that offer a fixed rate of return, they are exposing themselves to interest rate risk. This is true for bonds and also for preferred stocks. Liquidity Risk Liquidity risk refers to the possibility that an investor may not be able to buy r sell an investment as and when desired or in sufficient quantities because opportunities are limited.
A good example of liquidity risk is selling real estate. In most cases, it will be difficult to sell a property at any given moment should the need arise, unlike government securities or blue chip stocks. Call Risk Call risk is specific to bond issues and refers to the possibility that a debt security will be called prior to maturity. Call risk usually goes hand in hand with reinvestment risk, discussed below, because the bondholder must find an investment that provides the same level of income for equal risk.
Call risk is most prevalent when interest rates are falling, as companies trying to save money will usually redeem bond issues with higher coupons and replace them on the bond market with issues with lower interest rates. In a declining interest rate environment, the investor is usually forced to take on more risk in order to replace the same income stream Benjamin Graham Profile: The late Benjamin Graham may be the oldest of the gurus we follow, but his impact on the investing world has lasted for decades after his death in 1976. Known as both the “Father of Value
Investing” and the founder of the entire field of security analysis, Graham mentored several of history’s greatest investors including Warren Buffet and inspired a slew of others, including John Templeton, Mario Gabriel, and another of Valise’s gurus, John Neff. Graham built his fortune and reputation after living through some extremely difficult times, including both the Great Depression and his own family’s financial woes following his father’s death when Benjamin was a young man. His investment firm posted per annum returns of about 20 percent from 1936 to 1956, far outpacing the 12. Recent average return for the market during that time. Benjamin Graham Investment Strategy: Not surprisingly, given that he lived through his family’s financial troubles and the Great Depression, Graham used a conservative, risk-averse approach that focused as much on preserving capital as it did on producing big gains. Trendy, hot stocks didn’t garner his attention; he was concerned with companies’ balance sheets and their fundamentals. How much debt did they carry? How did their stock price compare to the amount of per-share earnings they were generating?
Did the firm have Strong sales figures? This value-centric, company-focused approach may be used by a lot of investors today, but it was Graham who first popularized it. A key concept behind his approach was the “margin of safety” – – the difference between a stock’s price and the value of its underlying business. Graham focused on stocks with high margins of safety (meaning their stocks were selling on the cheap compared to what he believed to be the intrinsic value of their businesses), because their already low prices offered significant downside protection.