FIN3140 Final Test Spring 2015 Investments Basic Financial Rules SAVE YOUNG Risk and Return investing is about future expectations where no one knows the future with absolute certainty risks involved Liquidity this is a characteristic of an investment that describes if and how quickly you can an investment into cash 1 you can get money out whenever you wish 2 money taken out has to be a reasonable amount Ex you have a mutual fund share it is very liquid because you can easily sell your share to the fund manager and get cash for your investment Default Risk this is the chance that a firm will not be able to meet its legal financial obligations Interest Rate Risk the chance that interest rates will move against you not in your favor Time the length of the investment maturity is a characteristic of the investment vehicle investment horizon the amount of time before the investor needs to liquidate his investment turn it into cash Investing 2 broad categories 1 Equity securities something you can trade ownership stock returns returns from stock come from 1 Capital gains these are the difference between what you purchased the stock for and what you sold it for 2 Dividends a partial return to when companies share profits with shareholders these are typically paid out 4 times per year and it is always the option of the company to pay or not pay them out Usually more wealthier mature companies are more likely to pay dividends 2 Debt securities something you lend lending money CD s Bonds Treasuries returns returns come from 1 Capital gains on bonds you get a 50 bond and after 30yrs its worth 100 you made the difference 2 Interest earned on the money you leant Transaction Costs costs incurred in buying OR selling ALL of these costs reduce your returns Investments GENERALLY stock prices move in the same direction up or down together debt security prices move in the same direction bond prices and bond yields always move in opposite directions ex when you buy a bond they represent debt an IOU buy a bond for a low price and it yields a higher price Debt Securities these securities pay interest interest rates depend upon 1 the cost of the money at the time of the investment market rate 2 the size or amount of the investment 3 the maturity of the investment ex 30yr versus 15yr investment 30yr is less liquid and has a higher interest rate more can change in 30yrs so it is considered riskier 4 the default risk of the investment Types of Debt Securities CD Certificate of Deposit this is a specific dollar amount for the deposit and for a specific amount of time there is a early withdrawal penalty Tips Do not allow CD to have automatic rollovers and compare rates because your APY can change a lot 1 Fixed rate CD s these have a constant rate over a securities life 2 Variable rate CD s these have a changing rate over the securities lifetime Bonds Some things to note bonds represent debt an IOU ex you buy a bond from bank gov t and it will gain value over the life of the bond when you want to get cash from it whoever you bought the bond from owes you the cash bonds typically pay you interest payments every 2 years if you sell your bond early you will probably have to sell it for less money bonds are more popular during a bad economy stocks are more popular during good economy Corporate Bonds Government Issued Bonds this is the simplest type of bond the face price is the money amount that the firm has issued that amount is to be paid at the maturity of the bond these bonds are tradable they are publicly tradable with investors you don t have to keep up with them until they mature these are US treasury securities and make up a HUGE market bonds have the longest maturities anywhere from 0 100yrs then notes then bills bonds are riskiest because they span the longest amount of time US savings bonds cannot be traded US treasuries are very liquid corporate bonds are not MMDA Money Market Deposit Accounts these are offered by bank credit unions and deal in short term less than 4yrs securities High liquidity low risk low return Depository accounts are usually FDIC insured operates by paying variable interest rates in coherence with variable economy there is usually a minimum required balance and a penalty if you fall below that balance you may have limited check writing abilities MMMF Money Market Mutual Funds not insured by FDIC also holds short term highly liquid low risk investments Index a group of specified securities typically these are diversified around a characteristic the more data points the more meaningful Indexes help investors gauge market conditions and compare their returns to the index like a benchmark they are a forecast for future behavior EXAMPLES CPI consumer price index measures inflation bond index stock index DOW 30 firms S P 500 NASDAQ 3 000 firms usually newer firms or tech firms With indexes you must compare percentage returns NOT numeric levels and it must be compared over the same time period you can often use these to benchmark your investment performance can you beat the index Returns and Debt Securities Fixed interest debt securities you know exact returns for these assuming you have no default and hold them to their maturity US treasuries low default risk low returns and high liquidity low returns Corporate Bonds high risk bonds higher interest returns lower liquidity than U S bonds uncertain returns when sold before maturity interest rates upon selling impacts selling price US Savings Bonds not marketable illiquid Common Stocks Outstanding Debt Holders VS Shareholders Debt Holders entitled to a return for lending their money interest entitled to a return of the money they lent principal borrower must legally pay back interest and principal Shareholders represent residual ownership have stock equity in a firm shareholders can loose the total investment debt holders get paid before shareholders Investment Returns capital gain selling price purchase price capital gain comes from stocks when they are sold capital gain comes from bonds if they are sold before maturity otherwise none are received current income current income comes from stock in the form of dividends these again are a share of the firm s profits paid to the owners and are completely up to the firm s board of directors if they want to pay them out or not current income comes from debt in the form of interest General Market Conditions have strong impacts on movements of securities Bull Market our current market occurs