INVESTMENT AND RISK MANAGEMENT Equity refers to a company's or a property's

continued ownership. A security or a title to a specific

CHAPTER 1
property can be used to hold an equity investment.
1.1 Define the term investment and explain why Popular stock is the most common sort of equity asset.
individuals invest.
Debt and equity are not the same thing when it comes
Any asset into which cash can be deposited with to derivative securities. Rather, they derive their worth
the expectation of positive income and/or increased from an underlying asset or security. Stock options are
value is referred to as an investment. In exchange for an example of an investment that provides the right to
the use of funds, an investment offers a future benefit. buy (or sell) a share of a company's stock at a certain
price for a period.
Collection of investments - portfolio
(d) short-term and long-term investments.
1.2 Differentiate among the following types of
investments and cite an example of each: Short-term investments typically mature within
1 year. Long-term investments have extended
(a) securities and property investments maturities or have no maturity at all, such as common
Securities are investments that represent a stock.
financial claim on the issuer's resources and are issued 1.3 Define the term risk and explain how risk is used to
by companies, governments, and other organizations. differentiate among investments.
Stocks and bonds are the most popular types of
securities, but more unusual types such as stock options Risk refers to the uncertainty surrounding the
are also available. Property, on the other hand, is made expected return on a given investment. The more the
up of real estate and tangible personal property risk connected with an investment, the more uncertain
investments. Land, buildings, and anything permanently the return. Low-risk investments offer a consistent, but
affixed to the land are all considered real property. modest, return. High-risk investments have a
Gold, artwork, antiques, and other treasures are substantially greater average return, but they also have
examples of tangible personal property. a much higher danger of losing a lot of money.

- stocks, bonds, options 1.4 What are foreign investments, and what role do
they play for the individual investor?
- real properties – land and buildings
Foreign investment refers to a foreign investor's
- tangible personal property – gold, artwork, investment in a country's local enterprises and assets.
antiques, collectible Long-term physical investments by a corporation in a
(b) direct and indirect investments foreign country, such as the establishing of plants or the
purchase of buildings, are known as foreign direct
A direct investment is one in which an investor investments. Corporations, financial institutions, and
purchases a claim on a security or property directly individual investors purchase shares in foreign
from the issuer. An indirect investment is one made in a companies that trade on a foreign stock exchange as
portfolio of securities or real estate that is managed by part of a foreign indirect investment.
a professional investor.
1.5 Describe the structure of the overall investment
(c) debt, equity, and derivative securities process. Explain the role played by financial
Debt is a loan that requires the borrower to institutions and financial markets.
make periodic interest payments and repay the entire The investment process connects suppliers with
loan amount by a specific date in the future. Bonds are additional funds and demanders with a need for funds.
issued by firms and governments when they need to Typically, a financial institution or a financial market
borrow money. When you purchase a bond, you are brings together fund suppliers and fund demanders.
essentially lending money to the issuer.
Financial institutions, such as banks and
insurance firms, pool government, business, and
individual savings and utilize them to create loans and They deal in massive quantities of securities for people,
invest in assets like short-term bonds. businesses, and governments. Banks, life insurance
firms, mutual funds, and pension funds are among
Financial markets are markets in which
them.
suppliers and demanders of funds trade financial assets,
typically with the assistance of intermediaries such as 1.8 What are short-term investments? How do they
securities brokers and dealers. Financial markets trade provide liquidity?
many forms of investments, including stocks, bonds,
Short-term investments have a span of one year
commodities, and foreign currencies. Investors may
or less and are typically (but not necessarily) low risk.
deal with one other efficiently and without suffering
This investment is popular with conservative investors
costly transaction fees courtesy to financial markets,
who are hesitant to put their money in more risky
which simplify the process of bringing buyers and sellers
investments. Short-term investments can provide
together.
liquidity because they may be easily turned into cash
1.6 Classify the role of the following: with little or no loss of value.

(a) government – Governments run budget 1.9 What is common stock, and what are its two
surpluses, allowing them to invest excess fund. sources of potential return?
It is a net demander of funds meaning it
Common stock is a type of equity investment
demands more funds than it supplies because
that symbolizes a company's ownership. Each share of
government spending often exceeds tax
common stock reflects a portion of the company's
revenues. To finance long-term projects such as
ownership. Dividends and capital gains are the two
the development of public facilities and to keep
sources of return on common stock investments.
the government working, large amounts of
money are required. Dividends are payments made by a corporation
to its shareholders; however, not all corporations are
(b) business – Like government it is a net
compelled to do so. When the stock price rises above an
demander of funds, however they require large
investor's initial purchase price, capital gains occur.
sums of money to support operations. To fund
There are two types of capital gains: realized and
their short- and long-term needs, companies
unrealized. A capital gain occurs when you sell a stock
issue a broad range of debt and equity
for more than you bought for it. You have an unrealized
securities.
capital gain if you keep the stock instead of selling it.
(c) individuals as net suppliers or net
1.10 Briefly define and differentiate among the
demanders of funds - Individuals need money
following investments. Which offer fixed returns?
in the form of loans to pay for things like houses
Which are derivative securities? Which offer
and cars, as well as education. Individuals
professional investment management?
contribute more to the financial system than
they take out through their savings. Under Fixed-income securities are bonds,
convertible securities, and preferred stocks.
1.7 Differentiate between individual investors and
institutional investors. a. Bonds - are long-term debt instruments
issued by corporations and governments. A
Individual investors manage their own funds to
bondholder has a contractual right to periodic
achieve their financial goals. They usually concentrate
interest payments as well as the face value of
on earning a return on idle funds, building a source of
the bond upon maturity (from the date issued).
retirement income, and providing security for their
You may be able to buy or sell a bond before it
families.
matures, depending on the bond.
Institutional investors are the ones who were
b. Convertible securities - Convertible securities
hired by individuals, who has time and expertise to
are a sort of fixed-income investment that is
make an investment decision. Managing other people's
unique. It includes a feature that allows the
money is how investment professionals make a living.
investor to convert it into a certain number of Forward contracts- customized,
common stock shares. Convertibles combine counterparty risk, held to maturity, Over the
the fixed-income (interest) benefit of a bond counter
with the price appreciation (capital gain)
Future contracts – standardized, strong
potential of common stock.
secondary market high risk.
c. Preferred stock – Preferred stock is a type of
stock that has no maturity date and symbolizes
a company's ownership interest. The dividend
rate on preferred shares is fixed, and it may also
yield capital gains. Firms are often required to
pay preferred share dividends before they are
allowed to pay ordinary share dividends.

d. Mutual funds – A mutual fund is a portfolio

of stocks, bonds, or other assets purchased with
a pool of funds provided by many different
investors and managed on behalf of its clients
by an investment company. Without requiring
investing a large sum of money, mutual funds
allow investors to build well-diversified 1.11 What should an investor establish before
portfolios. Money market mutual funds developing and executing an investment program?
(sometimes known as money funds) invest Briefly describe each of the seven steps involved in
solely in short-term investments. investing.

e. Hedge funds - Hedge funds are investment Investing can be done instinctively or according
funds that combine funds from a variety of to well devised plans to attain certain objectives. It
sources and invest it in securities. These funds starts with identifying a set of broad financial objectives,
attempt to reduce or mitigate the risks they followed by developing and implementing an investing
assume. Hedge funds often cater to a smaller strategy that is aligned with those objectives. Here are
number of investors than mutual funds. the seven steps in investing:

Under Derivative Securities are options and Step 1: Meet investment prerequisites. Be
futures. certain that you have adequately provided for the
necessities of life before investing, such as setting funds
f.  Options - Options are securities that allow an for food, housing, transportation, clothing, and taxes.
investor to sell or buy another security at a Have enough insurance coverage against common risks,
specified price for a set period. Investors buy such as life, health, property, and liability insurance.
options to profit from an anticipated change in
the price of ordinary stock. Calls and puts are Step 2: Establish investment goals. The
two typical forms of options. Call options give financial objectives you want to achieve through
you the right to purchase or sell another asset investing are known as investment goals. These include
at a predetermined price. Put options provide building up retirement assets, increasing income,
you the right to sell another security at a putting money aside for significant purchases, and
predetermined price. avoiding paying taxes on income.

g. Futures - Futures contracts are legally Step 3: Adopt an investment plan. Create an
enforceable agreements that stipulate that the investment plan, which is a written document that
seller of the futures contract will deliver an item details how you want to invest your money. For each
to the buyer at a certain date and at a price long-term goal, you can create a series of supporting
agreed upon at the time the contract is sold. investment goals.
Could be Commodities and Financial futures.
 Step 4: Evaluate investments. Assess the d. Capital loss - A capital loss occurs when the
possible return and risk of each investment choice while value of a capital asset, such as an investment or real
evaluating investments. estate, decreases. This loss is not realized until the asset
is sold at a lower price than when it was purchased.
Step 5: Select suitable investments. Consider
factors like expected return, risk, and tax implications. e. Tax planning - Tax planning is the process of
Successful investing necessitates careful investment guiding your investment activities so that you can
selection. achieve maximum after-tax returns for an acceptable
amount of risk over time. It entails analyzing your
Step 6: Construct a diversified portfolio. To
earnings, both current and projected, and implementing
meet your investment objectives, you'll put together
solutions to defer and minimize taxes.
and diversify an investment portfolio of acceptable
investments. f.  Tax-advantaged retirement investments –
Tax-advantaged retirement investments are plans that
Step 7: Manage the portfolio. Calculate how
allow employees to suspend their payment of taxes on
actual behavior compares to expected results. You may
funds that they save and invest during their working
need to take corrective action if the investment results
years until they withdraw those funds during retirement
do not match your objectives.
PERA is a 3-1 investment, savings and
1.12 What are four common investment goals?
retirement account designed to provide financial
The financial objectives you want to achieve security and tax benefits.
through investing are known as investment goals. The
first is to build up retirement assets, the second is to
increase income by generating dividends or interest, the
third is to save for significant purchases, and the fourth
is to protect money from taxes.

1.13 Define and differentiate among the following.

Explain how each is related to federal income taxes.

a. Active income – Active income refers to

earnings from a work as well as most other types of
non-investment income. Wages and salaries, as well as
bonuses, tips, pension income, and alimony, are all
examples of active income.

b. Portfolio and passive income - Earnings from 1.14 Describe the differing investment philosophies
many forms of investments are included in portfolio and typically applied during each of the following stages of
passive income. This category includes the majority (but an investor’s life cycle.
not all) of investment options and futures, including
savings accounts, stocks, bonds, and mutual funds. a. Youth (ages 20 to 45) – Young investors are
Interest, dividends, and capital gains make up most of those who prefer growth-oriented and speculative
the portfolio income. While passive income is a type of investments, especially high-risk common stocks that
income produced mostly from real estate, limited emphasize capital gains over current income.
partnerships, and other tax-advantaged investments, it
b. Middle age (ages 45 to 60) – Family
is a distinct category of income.
obligations and duties, such as school costs and
c. Capital gain - It represents the amount by retirement payments, grow more essential when people
which the proceeds from the sale of a capital asset reach middle age. Stocks such as high-grade bonds,
exceed its original purchase price. Capital gains are preferred stocks, convertibles, and mutual funds are
appealing because they are not taxed until you realize frequently used to move to a less aggressive posture.
them
 c. Retirement years (age 60 and older) – The Answers available at www.pearsonhighered.com/
preservation of capital and current income become smart
their principal concerns. They construct their portfolios
a. A passbook savings account is a no-minimum-balance
to provide consistent cash flow with a low risk profile.
deposit account that is used for convenience or by
This is the stage in life when investors begin to reap the
investors who lack enough money to buy other short-
benefits of their years of saving and investing.
term investments.
1.15 Discuss the relation between stock prices and the
b. The NOW account is a time deposit account that has
business cycle.
no to low legal minimum balance requirements and
Stock prices rise prior to periods when business pays interest on its balances. It also allows for unlimited
is excellent and profit is high, making stocks a leading withdrawals.
indicator of the business cycle. Because stock prices
c. Money market deposit accounts are less liquid than
represent investor perceptions about a company's
above deposit accounts because withdrawals were
prospects, it moves ahead of changes in the business
usually made in a minimum amount set. A money
cycle. Income and employment fall during the downturn
market deposit account, like a NOW account, has no
phase of the business cycle, and stock prices fall as
legal minimum balance requirement but does have a
companies struggle to maintain profitability.
higher minimum balance requirement.
1.16 What makes an asset liquid? Why hold liquid
d. Asset management account is a deposit account that
assets? Would 100 shares of IBM stock be considered a
combines banking and investment services at a bank or
liquid investment? Explain.
other financial organization. Unlike other deposit-type
Liquidity of an asset is determined on its ability to be accounts, it has a minimum balance requirement, yet it
converted into ready cash without affecting its market pays a similar interest rate to money market deposit
price. The most important advantage of holding liquid accounts.
assets is that they keep your cash on hand whenever
1.19 Define, compare, and contrast the following
you need it for emergencies occur without warning.
short-term investments.
Investors are frequently recommended to keep some
assets in their portfolio so that they can access their a. I bonds - I bonds is a security issued by U.S
funds quickly in the event of an emergency. In terms of Treasury in dominations, earns interest, and is
IBM stock, I can’t consider if it is a liquid investment exempted from state and local taxes. It's a risk-
even tough this kind of stock is easily sold, for with free investment with a 30-year maturity period
stocks we can’t be sure if we can quickly sell the stock that can be redeemed after a year.
without taking a loss.
b. U.S. Treasury bills - U.S. Treasury bills are
1.17 Explain the characteristics of short-term also issued by the US treasury weekly at auction
investments with respect to purchasing power and and sold at a discount value, however unlike
default risk. bonds are issued in denominations and earn
interest. It also matures in a year or less.
Short-term investments are not extremely risky in terms
of purchasing power. Primary risk results from inflation c. Certificates of deposit - Certificates of
risk are when the rate of return of a short-term deposit is a not so liquid investment because it's
investment is less than the inflation rate. While short really dead redemption involves an interest
term investment in terms of its risk of default, is almost penalty. Commercial banks issue it, and it is
nonexistent since this kind of investment is mostly specialized to the demands of investors.
issued by highly reputable institutions and government Certificates of deposit might be for a month or
agencies insure deposits.  more.
1.18 Briefly describe the key features and differences d. Commercial paper - A commercial paper
among the following deposit accounts. a. Passbook note is an unsecured note issued by a
savings account b. NOW account CONCEPTS IN REVIEW creditworthy company. It's like bonds that it
 comes in smaller denominations but greater enough cash to fulfill the financial promises it made to
amounts, and it's also similar to certificate of them, in which is not a simple task to do, it require
deposits in that it has a higher risk and returns tedious analysis regarding investments.
the most recent security issues. The maturity
period can range from 3 to 270 days.

e. Banker’s acceptances - Banker’s acceptances

Is a bank-issued security. Bankers' acceptance
has a risk and return profile in the same way as
CDs and commercial paper but is greater than
treasury issues. It is somehow the same to
postdated check turn on the front but with
overdraft protection due to the bank
guarantees payment and it makes a trade a
tradable instrument. Maturity takes 30 to 180
days as well.

f.  Money market mutual funds (money funds)-

Professional portfolio management companies
issue money market mutual funds. These funds,
unlike other non-government issues, offer
immediate liquidity (B+) and are professionally
managed portfolios of marketable securities.
The maturity duration, like that of CDs, may be
determined by the wishes of investors.

1.20 Why is an understanding of investment principles

important to a senior manager working in corporate
finance?

Corporate finance professions are usually concerned

with a company's long-term objectives, such as
enhancing its value through sound business decisions. A
senior manager's job is to oversee and guarantee that
all aspects of a company's operations, from financial
goals to investment decisions to strategy development,
are running smoothly. Understanding investment
principles is one of the professional skills that a senior
manager must possess to evaluate where the company
should invest and make sound decisions in order to
achieve higher returns.

1.21 Why do insurance companies need employees

with advanced training in investments?

Insurance companies requires employees with

advanced training in this industry since it necessitates a
high level of investment proficiency and familiarity with
management to benefit the company and its clients.
Insurers collect premiums and fees for the services they
provide and invest those funds in assets so that when
consumers file claims, the insurance company has