Summary INV 2601 STUDY NOTES

INVESTMENT 2601 TOPIC 1: THE INVESTMENT SETTING STUDY UNIT 1: THE INVESTMENT SETTING Investment is the current commitment of dollars for a period of time in order to derive future payments that will compensate the investor for (1) the time the funds are committed, (2) the expected rate of inflation, and (3) the uncertainty of the future payments. Return is a profit on an investment. Rate of return is a profit on an investment over a period of time. Required Rate of Return, the minimum return the investor will accept for a particular investment. The required rate of return is supposed to compensate the investor for the riskiness of the investment. If the expected return of an investment does not meet or exceed the required rate of return, the investor will not invest. 2. Discuss the components of an Investor’s required rate of return: - The Real-risk free interest rate: return investor can earn without any risk, guaranteed rate - An Inflation Premium: the rate added to an investment to adjust for the markets expectation of future inflation. Example a 1 year bond interest rate will be lower than that of a 30 year bond because in the short run the inflation will be low and could raise in the future due to budget deficits, etc. - A Liquidity Premium: Family controlled company with stocks and bonds would require this if buyers are scarce. This is to ensure that should buyers not pay full value for an asset, the liquidity premium would compensate them for this loss. -Default Risk Premium: When investors see a company in trouble. The shares and bonds will collapse because the investors will request for the default risk premium. If the default risk premium is too large, investors can make a great deal of money because they purchased shares at a lower price than initially worth. -Maturity premium: Closer to the maturity of the bonds, the greater the price will fluctuate when the interest rate changes and this is the maturity premium. Just say for 30 years your bond is locked at 7% and at maturity its 9%. No investor will pay for the lower interest rate. Therefore there is greater risk with bonds with longer maturity. Real rate of return Rate of return after adjusting for inflation. Risk-free rate of return, often denoted in formulas as rf, is the rate of return associated with an asset that has no risk (that is, it provides a guaranteed return). Risks There are three types of risks that a firm might face and needs to overcome. 1. Business Risk: risks are taken by business enterprises themselves in order to maximize shareholder value and profits. As for example: Companies undertake high cost risks in marketing to launch new product in order to gain higher sales. 2. Non- Business Risk: These types of risks are not under the control of firms. Risks that arise out of political and economic imbalances. 3. Financial Risk: risk that involves financial loss to firms due to instability and losses in the financial market caused by movements in stock prices, currencies, interest rates and more. The risk and return principle: The greater the risk, the higher the investor’s required rate of return. The trade-off between risk and return (risk/return principle) In the investing world, risk is the chance that an investment's actual return will be different than expected. This is measured in statistics by standard deviation. Risk means you have the possibility of losing some, or even all, of your original investment. Low levels of uncertainty (low risk) are