CHAPTER 4
THE INVESTMENT SETTING
Answers to Questions
1. When an individual’s current money income exceeds his current consumption desires, he
saves the excess. Rather than keep these savings in his possession, the individual may
consider it worthwhile to forego immediate possession of the money for a larger future
amount of consumption. This trade-off of present consumption for a higher level of future
consumption is the essence of investment.
An investment is the current commitment of funds for a period of time in order to derive
a future flow of funds that will compensate the investor for the time value of money, the
expected rate of inflation over the life of the investment, and provide a premium for the
uncertainty associated with this future flow of funds.
2. Students in general tend to be borrowers because they are typically not employed so have
no income, but obviously consume and have expenses. The usual intent is to invest the
money borrowed in order to increase their future income stream from employment - i.e.,
students expect to receive a better job and higher income due to their investment in
education.
3. In the 20-30 year segment an individual would tend to be a net borrower since he is in a
relatively low-income bracket and has several expenditures - automobile, durable goods,
etc. In the 30-40 segment again the individual would likely dissave, or borrow, since his
expenditures would increase with the advent of family life, and conceivably, the purchase
of a house. In the 40-50 segment, the individual would probably be a saver since income
would have increased substantially with no increase in expenditures. Between the ages of
50 and 60 the individual would typically be a strong saver since income would continue
to increase and by now the couple would be “empty-nesters.” After this, depending upon
when the individual retires, the individual would probably be a dissaver as income
decreases (transition from regular income to income from a pension).
4. The saving-borrowing pattern would vary by profession to the extent that compensation
patterns vary by profession. For most white-collar professions (e.g., lawyers) income
would tend to increase with age. Thus, lawyers would tend to be borrowers in the early
segments (when income is low) and savers later in life. Alternatively, blue-collar
professions (e.g., plumbers), where skill is often physical, compensation tends to remain
constant or decline with age. Thus, plumbers would tend to be savers in the early
segments and dissavers later (when their income declines).
5. The difference is because of the definition and measurement of return. In the case of the
WSJ, they are only referring to the current dividend yield on common stocks versus the
promised yield on bonds. In the University of Chicago studies, they are talking about the
total rate of return on common stocks, which is the dividend yield plus the capital gain or
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, loss yield during the period. In the long run, the dividend yield has been 4-5 percent and
the capital gain yield has averaged about the same. Therefore, it is important to compare
alternative investments based upon total return.
6. The variance of expected returns represents a measure of the dispersion of actual returns
around the expected value. The larger the variance is, everything else remaining constant,
the greater the dispersion of expectations and the greater the uncertainty, or risk, of the
investment. The purpose of the variance is to help measure and analyze the risk
associated with a particular investment.
7. An investor’s required rate of return is a function of the economy’s risk free rate (RFR),
an inflation premium that compensates the investor for loss of purchasing power, and a
risk premium that compensates the investor for taking the risk. The RFR is the pure time
value of money and is the compensation an individual demands for deferring
consumption. More objectively, the RFR can be measured in terms of the long-run real
growth rate in the economy since the investment opportunities available in the economy
influence the RFR. The inflation premium, which can be conveniently measured in terms
of the Consumer Price Index, is the additional protection an individual requires to
compensate for the erosion in purchasing power resulting from increasing prices. Since
the return on all investments is not certain as it is with T-bills, the investor requires a
premium for taking on additional risk. The risk premium can be examined in terms of
business risk, financial risk, liquidity risk, exchange rate risk and country risk.
8. Two factors that influence the RFR are liquidity (i.e., supply and demand for capital in
the economy) and the real growth rate of the economy. Obviously, the influence of
liquidity on the RFR is an inverse relationship, while the real growth rate has a positive
relationship with the RFR - i.e., the higher the real growth rate, the higher the RFR.
It is unlikely that the economy’s long-run real growth rate will change dramatically
during a business cycle. However, liquidity depends upon the government’s monetary
policy and would change depending upon what the government considers to be the
appropriate stimulus. Besides, the demand for business loans would be greatest during the
early and middle part of the business cycle.
9. The five factors that influence the risk premium on an investment are business risk,
financial risk, liquidity risk, exchange rate risk, and country risk.
Business risk is a function of sales volatility and operating leverage and the combined
effect of the two variables can be quantified in terms of the coefficient of variation of
operating earnings. Financial risk is a function of the uncertainty introduced by the
financing mix. The inherent risk involved is the inability to meet future contractual
payments (interest on bonds, etc.) or the threat of bankruptcy. Financial risk is measured
in terms of a debt ratio (e.g., debt/equity ratio) and/or the interest coverage ratio.
Liquidity risk is the uncertainty an individual faces when he decides to buy or sell an
investment. The two uncertainties involved are: (1) how long it will take to buy or sell
this asset, and (2) what price will be received. The liquidity risk on different investments
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, can vary substantially (e.g., real estate vs. T-bills). Exchange rate risk is the uncertainty
of returns on securities acquired in a different currency. The risk applies to the global
investor or multinational corporate manager who must anticipate returns on securities in
light of uncertain future exchange rates. A good measure of this uncertainty would be the
absolute volatility of the exchange rate or its beta with a composite exchange rate.
Country risk is the uncertainty of returns caused by the possibility of a major change in
the political or economic environment of a country. The analysis of country risk is much
more subjective and must be based upon the history and current environment in the
country.
10. The increased use of debt increases the fixed interest payment. Since this fixed
contractual payment will increase, the residual earnings (net income) will become more
variable. The required rate of return on the stock will change since the financial risk (as
measured by the debt/equity ratio) has increased.
11. According to the Capital Asset Pricing Model, all securities are located on the Security
Market Line with securities’ risk on the horizontal axis and securities’ expected return on
its vertical axis. As to the locations of the five types of investments on the line, the U.S.
government bonds should be located to the left of the other four, followed by United
Kingdom government bonds, low-grade corporate bonds, common stock of large firms,
and common stocks of Japanese firms. U.S. government bonds have the lowest risk and
required rate of return simply because they virtually have no default risk at all.
Expected
Return Security Market Line
Common Stock of Japanese Firms
Common Stock of Large Firms
Low Grade Corporate Bonds
U.K. Government Bonds
NRFR U.S. Government Bonds
RFR
Expected Risk
12. If a market’s real RFR is, say, 3 percent, the investor will require a 3 percent return on an
investment since this will compensate him for deferring consumption. However, if the
inflation rate is 4 percent, the investor would be worse off in real terms if he invests at a rate
of return of 4 percent - e.g., you would receive $103, but the cost of $100 worth of goods at
the beginning of the year would be $104 at the end of the year, which means you could
consume less real goods. Thus, for an investment to be desirable, it should have a return of
7.12 percent [(1.03 x 1.04) - 1], or an approximate return of 7 percent (3% + 4%).
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, 13. Both changes cause an increase in the required return on all investments. Specifically, an
increase in the real growth rate will cause an increase in the economy’s RFR because of a
higher level of investment opportunities. In addition, the increase in the rate of inflation will
result in an increase in the nominal RFR. Because both changes affect the nominal RFR,
they will cause an equal increase in the required return on all investments of 5 percent.
The graph should show a parallel shift upward in the capital market line of 5 percent.
Expected
Return New SML
NRFR* Old SML
NRFR
RFR
Expected Risk
14. Such a change in the yield spread would imply a change in the market risk premium
because, although the risk levels of bonds remain relatively constant, investors have changed
the spreads they demand to accept this risk. In this case, because the yield spread (risk
premium) declined, it implies a decline in the slope of the SML as shown in the following
graph.
Expected
Return Original SML
New SML
NRFR
RFR
Expected Risk
15. The ability to buy or sell an investment quickly without a substantial price concession is
known as liquidity. An example of a liquid investment asset would be a United States
Government Treasury Bill. A Treasury Bill can be bought or sold in minutes at a price
almost identical to the quoted price. In contrast, an example of an illiquid asset would be a
specialized machine or a parcel of real estate in a remote area. In both cases, it might take a
considerable period of time to find a potential seller or buyer and the actual selling price
could vary substantially from expectations.
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