Problem Set 5 MKO Ch 4 Problems

4.1. What are the main differences between a ‘very conservative’ and a ‘very aggressive’
investor?

A very conservative investor is likely to have an unstable and insecure household income.
This would mean that they have a focus on saving their funds. It would also mean that as a
result of unstable income that they have no tolerance for loss of capital. This means that
they cannot take risks which could result in a loss of capital. The time for investment is
relatively short term and is 2 years of less. The asset mix would be 60% in cash, 30% in fixed
interest and 10% in growth investments. The allocation becomes smaller for more risky
asset classes. Unstable income means that living expenses rely on a significant portion of
cash and therefore, the cash component cannot be relied on for investment.

A very aggressive investor has a greater tendency and ability to take on more risk to have a
potentially higher return as their income is very stable and secure, able to tolerate regular
fluctuations of 20% or more in capital value and their investment time horizon is 8-10 years.
The allocation of assets would be 5% in cash, 10% in fixed interest and 85% in growth
investments. As an individual regarded as an aggressive investor has a stable income, they
have sufficient levels of cash to live on and will therefore invest into other asset classes.

4.2. What are the general features of a fixed-interest investment?

Fixed interest securities are a type of financial product which the buyer enters into an
agreement to purchase the investment with the return component being the interest
payment. The full amount is repaid at the end of the maturity period. Some fixed interest
securities have interest payments which are paid at maturity. These types of investments
have a long term horizon of 1-15 years.

4.3. What is the significance of a standard deviation and how would you explain its
meaning to a client?

Standard deviation is a measure of the riskiness of the asset. The higher the standard
deviation, the greater the likelihood of risk and tendency for the return to be different than
the expected return of the asset.

4.4. Why doesn’t a portfolio rely on assets that are positively correlated?

A portfolio will not rely on positively correlated assets for the purposes of achieving asset
diversification. If assets are positively correlated, this means that the assets will move in the
same direction based on market factors. If there are good market conditions for all
securities, all assets will move up. On the other hand, if market conditions are not
favourable, all assets will move in the same downward direction. For this reason, assets
should not be positively correlated and ensure that if one goes down, the other goes up.
4.5. What was the main feature of Gibson’s findings about multi-asset class investing?

Gibson found that an investor who invests into four different asset classes being cash,
bonds, property and shares that an investor would achieve a higher long-term average
return with a lower level of risk.

4.6. Where there is an element of uncertainty ‘people deviate from rational thinking in
making judgement’. Provide an example when a person may exhibit a sign of
overconfidence.

Investors will exhibit levels of overconfidence due to hindsight bias. This can occur when an
investor regards their successes more highly than their failures in the past. They will
attribute their failures purely to market failures rather than their impaired judgement. A
sign of overconfidence can be seen through investors who are highly speculative.

4.7. What does the efficient frontier mean for an investor who is considering a number of
investment choices?

The efficient frontier is a diagram that represents a combination of securities which are
optimal investments. Anything that falls onto the line of the efficiency frontier is highly ideal
as it has the appropriate level of risk for a given return. Any securities that fall under the
curve will represent a disadvantageous position as a security parallel to it on the efficient
frontier will provide the same return with less risk (refer to page 156).

Problem Set 6

MKO Ch 5 and 6 Problems

5.1. Why is a nominal cash return not equal to the real return on a cash
investment?

The real return on a cash investment takes into account the impact of inflation. The cash
return amount simply takes into account the amount of interest imposed on a cash
inflow. As a real return figure takes into account inflation, the amount we receive today
would not have the same buying power as the same amount we receive in the future.
For example, a return in 10 years time is expected to be $1,100 but taking into account
inflation at 5%, the real return would be $675.30.

5.3. Why does an investor gain a greater level of security with a commercial bill
compared with a corporate debenture?

- Commercial bills come with a banker’s acceptance which means that the
payment is guaranteed by the bank
- A corporate debenture is a debt instrument issued by a firm which does not
come with a payment guarantee from the bank.
- This makes a corporate debenture less secure.
5.4. Why do corporate bonds rated as BBB yield higher returns than corporate
bonds with AAA ratings?

- AAA ratings are more superior to BBB rated corporate bonds.

- The superiority is defined by the creditworthiness and reputation of the
corporation offering the bonds.
- AAA indicates less chance of default whilst BBB represents a higher chance of
default than AAA rated corporate bonds.
- To compensate for the additional risk taken to invest in BBB bonds rather than
AAA bonds, a higher interest is provided to investors to compensate for risk and
encourage investment.

5.5. What effect is the likely effect of the general prices of shares of an
announcement by the RBA of a decrease in the cash rate?

- When the RBA drops the cash rate, the economy is sluggish and the government
is trying to increase spending
- Lower rates = lower costs of funds/ operating costs, which raises Free Cash
Flows (FCFs)
- FCFs are passed onto investors and as a result, share prices will increase

5.6. Provide a reason why an investor might buy shares that are selling on a very
high P/E ratio.

- Shares with a high P/E ratio would be indicative of growth shares.

- A high P/E ratio would indicate the potential for future growth and such shares
should be purchased now to enjoy future gains.
- The increased demand from continuous buying of the shares would push up the
P/E ratio.
- John Maynard Keynes believes in buying for value rather than over priced stocks
but the key with doing so is to buy while the prices keep rising and sell at the
point when the share is deemed to be over-valued.
- The rationale for buying these shares is that the price will continue to rise or that
earnings will eventually catch up and the P/E will fall towards market values.

5.11. Assume that you invest $75,000 in a 1-year term deposit at 6.5%. How much
is repaid to you at maturity? If inflation is 2.75%, what is your real gain in today’s
prices?

At maturity, $79,875 would be repaid back. $9,875 is received in interest.

The real gain would be $77,737.23. This is worked out by applying the Real cash
amount formula

1 + rreal = (1 + rnominal/1 + rinflation rate) = 1.065/1.0275, so 1 + rreal = 1.0365

The real rate of return is then 3.65%, or in dollars= (0.0365 x $75,000)= $2,737.50

5.18. A 10-year bond is issued with a face value of $20,000 paying interest of $450
per annum. If market yields increase soon after the bond is issued, what happens
to the bond’s:
(a) coupon rate?

Will remain the same (It is a legally agreed fixed rate)

(b) price? Will decline. The price will go down as the investment will not be earning as
much as other bonds in the market. Market rate is greater than the coupon rate (when
comparing with other similar types of bonds)

(c) YTM?

The yield to maturity of a bond is the annualised discount rate that makes the PV of the
future cash flows just equal to the current price of the bond. It represents the IRR of the
bond at the current market price. The yield increases in line with the market yield.

Case Study 1
1. How would you describe the interest rate yield curve?

The interest rate yield curve is an inverse curve as longer term rates are lower than
shorter term rates.

2. Calculate the amount of interest that Kate would receive if she invests it all
in the three-year term.

Kate would receive interest of $36,186 if the interest is compounded each year. If it
is not then each year she would receive $11,400 or a total of $34,200.

3. Calculate the present value of the interest and return of the principal in 3
years if the inflation rate is 3% p.a.

Assuming the investment is compounded then the PV of the FV $236,186 =

$216,143.65.

4. Suppose Kate decides to take the highest return and invests all her money
for 30 days. What risk does she take when the term matures and she then
needs to reinvest the funds?

The risk that Kate takes if she invests all her money for 30 days at 6.3% is that at the
end of 30 days the interest rates for any succeeding period may have fallen so that
for the next 30 days the rates might not be 6.3% but less than 6.3% and may even be
less than 6.2%. Given that there is an inverse yield curve it is likely that short term
rates will fall at some point.
 5. Suggest a possible solution to assist Kate with her investment plans.

A possible solution for Kate is to use an average method whereby she might invest
some amount for 30 days, some for 60 months, some for 12 months and so on. In
that way Kate can lock in some amounts for the longer term at 5.9% and 5.7% but
also gain some of the higher rates in the shorter term.

Chapter 6

6.1. If you were planning to invest in property as a general asset class, list three
positive characteristics and two negative characteristics that property
investments are likely to possess.

Advantages
- It is a tangible asset which provides a sense of security. Houses are not likely
to lose their value as dramatically as other forms of investment.
- Provides regular income and potential capital gain. Average long-term
return from property is 3-5% above inflation.
- Land is a scarce commodity and as a result, demand is always increasing
which means returns in the future will be high.

Disadvantages
- High acquisition cost. A typical dwelling will cost 10-20 times a wage
earner’s annual savings.
- Interest rate risk can create cash flow problems especially if they increase to
rates which are not management as experienced in the 80s.
- Illiquid form of investment. Demand is not consistently high as unique features
of a property may make a property more appealing to the market.
- High fixed costs- Managing agent fees, rates, tax, bad debts, repair, maintenance
- Need a good knowledge of various markets
-

6.2. Jodie wants to invest in an unlisted property trust. Explain how the units are
valued.

An unlisted property trust's units are valued by dividing the net asset value (NAV) by
the number of units (i.e., assets minus liabilities divided by the number of units on
issue). The assets are determined by the market value of property held by the fund,
whilst liabilities are any mortgage debt or other liabilities outstanding. The unit price
will have a manager's fee deducted for handling the redemption or transfer of units.

6.3.Compare the features of investing in an A-REIT and a UPT.

A-REIT and UPT as investment vehicles are similar - they are structures to hold
property assets managed by a responsible entity on behalf on unit holders who receive
distributions from the property assets.

How A-REIT and UPT differ is that A-REITs are listed on the ASX while UPT are not.
Being listed on the ASX means A-REIT are relatively more liquid than a UPT as units or
bought or sold on the stock exchange are between public buyers and sellers. This
compares with UPT where units are bought and sold (redeemed) from the responsible
entity which may result in delays in processing the requests, especially during periods
of crisis or when UPTs have cash flow problems (e.g. from holding too much debt).

A-REITS have a greater chance of price movements as they are publicly traded on the
ASX. UPSs are illiquid as they take a greater time to adjust in value. UPSs are more stable
than A-REITS when it comes to investing.

6.4. Why might an A-REIT that holds a number of commercial properties in its
portfolio be considered to be a safer investment than one that holds a single
commercial property.

This is due to diversification benefits. Not all properties will have the characteristics’
that will attract high demand. The greater the number of properties, the greater the
chance to see returns rather than more losses.

6.10. Edwina bough her house in Septemer 1984 for $54,000. She died in 2012
and left the house to her only daughter, Claire. Claire wants to rent it but is
worried about the CGT implications. What advice would you give her?

The sale of the house will attract CGT if sold by the daughter after renting it out for a
period. The cost base of the house will be the market value at the time of the transfer of
ownership to the daughter.

CASE STUDY 1

RETIREMENT INCOME STREAMS

QUESTIONS

1. What sort of property funds might suit Victor’s investment wishes?

Either UPTs or A-REITs would suit Victor’s needs as they both offer diversified
portfolios and they are both managed funds.

2. Suggest reasons why Victor might consider investment into A-REITs

rather than UPTs.

Victor might consider investing into A-REITs rather than UPTs as they might be
considered to be more stable in unit pricing as they are less subject to share market
influences.

3. Consider whether investing $1,000 per month into the same fund is a
reasonable investment decision.

A regular investment into the same fund might be a reasonable investment decision as it
is a simple and straightforward exercise. However, by investing into the same fund may
not be wise because an investment should be monitored from time to time without an
automatic increase in exposure to the same fund/portfolio of assets.

4. Do you agree with Victor’s view that investing in assets that suffered severe
price falls in the global financial crisis would prove to be a wise investment
decision?

It is a reasonable view that investing into assets that suffered a severe price fall is a
good investment. However, an investor should consider whether the assets were over
inflated in terms of value prior to the crisis and how long it may take before the assets
recover their pre-crisis value. It may take a number of years before the assets recover
their value but if the investor is buying them at a low value then any rise in value will
represent a gain for the investor.