INVESTMENT AND RISK MANAGEMENT
continued ownership. A security or a title to a specific
CHAPTER 1
1.1 Define the term investment and explain why
individuals invest.
Any asset into which cash can be deposited with
the expectation of positive income and/or increased
value is referred to as an investment. In exchange for
the use of funds, an investment offers a future benefit.
Collection of investments - portfolio
1.2 Differentiate among the following types of
investments and cite an example of each:
(a) securities and property investments
Securities are investments that represent a
financial claim on the issuer's resources and are issued
by companies, governments, and other organizations.
Stocks and bonds are the most popular types of
securities, but more unusual types such as stock options
are also available. Property, on the other hand, is made
up of real estate and tangible personal property
investments. Land, buildings, and anything permanently
affixed to the land are all considered real property.
Gold, artwork, antiques, and other treasures are
examples of tangible personal property.
- stocks, bonds, options
- real properties – land and buildings
- tangible personal property – gold, artwork,
antiques, collectible
(b) direct and indirect investments
A direct investment is one in which an investor
purchases a claim on a security or property directly
from the issuer. An indirect investment is one made in a
portfolio of securities or real estate that is managed by
a professional investor.
(c) debt, equity, and derivative securities
Debt is a loan that requires the borrower to
make periodic interest payments and repay the entire
loan amount by a specific date in the future. Bonds are
issued by firms and governments when they need to
borrow money. When you purchase a bond, you are
essentially lending money to the issuer.
Equity refers to a company's or a property's
property can be used to hold an equity investment.
Popular stock is the most common sort of equity asset.
Debt and equity are not the same thing when it comes
to derivative securities. Rather, they derive their worth
from an underlying asset or security. Stock options are
an example of an investment that provides the right to
buy (or sell) a share of a company's stock at a certain
price for a period.
(d) short-term and long-term investments.
Short-term investments typically mature within
1 year. Long-term investments have extended
maturities or have no maturity at all, such as common
stock.
1.3 Define the term risk and explain how risk is used to
differentiate among investments.
Risk refers to the uncertainty surrounding the
expected return on a given investment. The more the
risk connected with an investment, the more uncertain
the return. Low-risk investments offer a consistent, but
modest, return. High-risk investments have a
substantially greater average return, but they also have
a much higher danger of losing a lot of money.
1.4 What are foreign investments, and what role do
they play for the individual investor?
Foreign investment refers to a foreign investor's
investment in a country's local enterprises and assets.
Long-term physical investments by a corporation in a
foreign country, such as the establishing of plants or the
purchase of buildings, are known as foreign direct
investments. Corporations, financial institutions, and
individual investors purchase shares in foreign
companies that trade on a foreign stock exchange as
part of a foreign indirect investment.
1.5 Describe the structure of the overall investment
process. Explain the role played by financial
institutions and financial markets.
The investment process connects suppliers with
additional funds and demanders with a need for funds.
Typically, a financial institution or a financial market
brings together fund suppliers and fund demanders.
Financial institutions, such as banks and
insurance firms, pool government, business, and
individual savings and utilize them to create loans and
invest in assets like short-term bonds.
Financial markets are markets in which
suppliers and demanders of funds trade financial assets,
typically with the assistance of intermediaries such as
securities brokers and dealers. Financial markets trade
many forms of investments, including stocks, bonds,
commodities, and foreign currencies. Investors may
deal with one other efficiently and without suffering
costly transaction fees courtesy to financial markets,
which simplify the process of bringing buyers and sellers
together.
1.6 Classify the role of the following:
They deal in massive quantities of securities for people,
businesses, and governments. Banks, life insurance
firms, mutual funds, and pension funds are among
them.
1.8 What are short-term investments? How do they
provide liquidity?
Short-term investments have a span of one year
or less and are typically (but not necessarily) low risk.
This investment is popular with conservative investors
who are hesitant to put their money in more risky
investments. Short-term investments can provide
liquidity because they may be easily turned into cash
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
common stock shares. Convertibles combine
the fixed-income (interest) benefit of a bond
with the price appreciation (capital gain)
potential of common stock.
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
portfolios. Money market mutual funds
(sometimes known as money funds) invest
solely in short-term investments.
e. Hedge funds - Hedge funds are investment
funds that combine funds from a variety of
sources and invest it in securities. These funds
attempt to reduce or mitigate the risks they
assume. Hedge funds often cater to a smaller
number of investors than mutual funds.
Under Derivative Securities are options and
futures.
f.  Options - Options are securities that allow an
investor to sell or buy another security at a
specified price for a set period. Investors buy
options to profit from an anticipated change in
the price of ordinary stock. Calls and puts are
two typical forms of options. Call options give
you the right to purchase or sell another asset
at a predetermined price. Put options provide
you the right to sell another security at a
predetermined price.
g. Futures - Futures contracts are legally
enforceable agreements that stipulate that the
seller of the futures contract will deliver an item
to the buyer at a certain date and at a price
agreed upon at the time the contract is sold.
Could be Commodities and Financial futures.
Forward contracts- customized,
counterparty risk, held to maturity, Over the
counter
Future contracts – standardized, strong
secondary market high risk.
1.11 What should an investor establish before
developing and executing an investment program?
Briefly describe each of the seven steps involved in
investing.
Investing can be done instinctively or according
to well devised plans to attain certain objectives. It
starts with identifying a set of broad financial objectives,
followed by developing and implementing an investing
strategy that is aligned with those objectives. Here are
the seven steps in investing:
Step 1: Meet investment prerequisites. Be
certain that you have adequately provided for the
necessities of life before investing, such as setting funds
for food, housing, transportation, clothing, and taxes.
Have enough insurance coverage against common risks,
such as life, health, property, and liability insurance.
Step 2: Establish investment goals. The
financial objectives you want to achieve through
investing are known as investment goals. These include
building up retirement assets, increasing income,
putting money aside for significant purchases, and
avoiding paying taxes on income.
Step 3: Adopt an investment plan. Create an
investment plan, which is a written document that
details how you want to invest your money. For each
long-term goal, you can create a series of supporting
investment goals.
 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
many forms of investments are included in portfolio and
passive income. This category includes the majority (but
not all) of investment options and futures, including
savings accounts, stocks, bonds, and mutual funds.
Interest, dividends, and capital gains make up most of
the portfolio income. While passive income is a type of
income produced mostly from real estate, limited
partnerships, and other tax-advantaged investments, it
is a distinct category of income.
c. Capital gain - It represents the amount by
which the proceeds from the sale of a capital asset
exceed its original purchase price. Capital gains are
appealing because they are not taxed until you realize
them
1.14 Describe the differing investment philosophies
typically applied during each of the following stages of
an investor’s life cycle.
a. Youth (ages 20 to 45) – Young investors are
those who prefer growth-oriented and speculative
investments, especially high-risk common stocks that
emphasize capital gains over current income.
b. Middle age (ages 45 to 60) – Family
obligations and duties, such as school costs and
retirement payments, grow more essential when people
reach middle age. Stocks such as high-grade bonds,
preferred stocks, convertibles, and mutual funds are
frequently used to move to a less aggressive posture.
 c. Retirement years (age 60 and older) – The
preservation of capital and current income become
their principal concerns. They construct their portfolios
to provide consistent cash flow with a low risk profile.
This is the stage in life when investors begin to reap the
benefits of their years of saving and investing.
1.15 Discuss the relation between stock prices and the
business cycle.
Stock prices rise prior to periods when business
is excellent and profit is high, making stocks a leading
indicator of the business cycle. Because stock prices
represent investor perceptions about a company's
prospects, it moves ahead of changes in the business
cycle. Income and employment fall during the downturn
phase of the business cycle, and stock prices fall as
companies struggle to maintain profitability.
1.16 What makes an asset liquid? Why hold liquid
assets? Would 100 shares of IBM stock be considered a
liquid investment? Explain.
Liquidity of an asset is determined on its ability to be
converted into ready cash without affecting its market
price. The most important advantage of holding liquid
assets is that they keep your cash on hand whenever
you need it for emergencies occur without warning.
Investors are frequently recommended to keep some
assets in their portfolio so that they can access their
funds quickly in the event of an emergency. In terms of
IBM stock, I can’t consider if it is a liquid investment
even tough this kind of stock is easily sold, for with
stocks we can’t be sure if we can quickly sell the stock
without taking a loss.
1.17 Explain the characteristics of short-term
investments with respect to purchasing power and
default risk.
Short-term investments are not extremely risky in terms
of purchasing power. Primary risk results from inflation
risk are when the rate of return of a short-term
investment is less than the inflation rate. While short
term investment in terms of its risk of default, is almost
nonexistent since this kind of investment is mostly
issued by highly reputable institutions and government
agencies insure deposits.  more.
1.18 Briefly describe the key features and differences
among the following deposit accounts. a. Passbook
savings account b. NOW account CONCEPTS IN REVIEW
Answers available at www.pearsonhighered.com/
smart
a. A passbook savings account is a no-minimum-balance
deposit account that is used for convenience or by
investors who lack enough money to buy other short-
term investments.
b. The NOW account is a time deposit account that has
no to low legal minimum balance requirements and
pays interest on its balances. It also allows for unlimited
withdrawals.
c. Money market deposit accounts are less liquid than
above deposit accounts because withdrawals were
usually made in a minimum amount set. A money
market deposit account, like a NOW account, has no
legal minimum balance requirement but does have a
higher minimum balance requirement.
d. Asset management account is a deposit account that
combines banking and investment services at a bank or
other financial organization. Unlike other deposit-type
accounts, it has a minimum balance requirement, yet it
pays a similar interest rate to money market deposit
accounts.
1.19 Define, compare, and contrast the following
short-term investments.
a. I bonds - I bonds is a security issued by U.S
Treasury in dominations, earns interest, and is
exempted from state and local taxes. It's a risk-
free investment with a 30-year maturity period
that can be redeemed after a year.
b. U.S. Treasury bills - U.S. Treasury bills are
also issued by the US treasury weekly at auction
and sold at a discount value, however unlike
bonds are issued in denominations and earn
interest. It also matures in a year or less.
c. Certificates of deposit - Certificates of
deposit is a not so liquid investment because it's
really dead redemption involves an interest
penalty. Commercial banks issue it, and it is
specialized to the demands of investors.
Certificates of deposit might be for a month or
d. Commercial paper - A commercial paper
note is an unsecured note issued by a
creditworthy company. It's like bonds that it
 comes in smaller denominations but greater
amounts, and it's also similar to certificate of
deposits in that it has a higher risk and returns
the most recent security issues. The maturity
period can range from 3 to 270 days.
enough cash to fulfill the financial promises it made to
them, in which is not a simple task to do, it require
tedious analysis regarding investments.

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