BAC3684 Tutorial Chapter 1

1-1 Define the term “investments.”

Investments is when one acquires an asset with the expectation of a future benefit or financial gain.

1-2 Describe the broad two-step process involved in making investment decisions.

Security analysis and valuation

This involves the evaluation of individual securities, such as stocks or bonds, to determine their
investment potential. Fundamental analysis examines factors like financial statements, management
quality, competitive positioning, and industry trends for stocks, while credit analysis is crucial for
assessing the creditworthiness of bonds. In this step, the investor analyses the expected returns of
the security and the risks associated with the securities.

Portfolio management

Portfolio management is where strategic decisions about asset allocation is made and evaluated.
This involves determining the optimal mix of asset classes (e.g., stocks, bonds, cash) based on the
investor's financial goals, time horizon, and risk tolerance. Constant evaluations are made to the
portfolio to adjust to news on the securities and to maintain the portfolio mix if required.

1-4 Distinguish between a financial asset and a real asset.

Real assets are tangible assets where value can be derived due to their physical attributes. Examples
include commodities and real estate.

Financial assets are intangible assets that are highly liquid as compared to real assets. Financial
assets include stocks and bonds.

1-7 “A risk-averse investor will not assume risk.” Agree or disagree with this statement, and
explain your reasoning.

Disagree, all investments require a person to take a certain degree of risk, the amount of risk is
determined by how much the individual is able to handle, their circumstances and goal for investing.
Taking low-risk investments would entail investments with lower return such as sukuks and bonds.
Higher risk investments could be cryptocurrencies, where prices could fluctuate wildly and the
returns on investment may be high, but is not guaranteed.

I think that any risk-averse investors are investors that manage their risk properly and hence place
their investments in places where returns may be lower than most investments, but the risk to
return ratio is high for the investor.

1-9 Distinguish between expected return and realized return.

Expected Return

Expected return is the anticipated or average return on an investment, calculated based on the
probabilities of different possible outcomes and their respective returns.

Expected Return=∑(Probability × Return)

Total Amount Received−Initial Investment

Risk refers to the variability of returns associated with an investment. It includes the possibility that
the actual returns on an investment may differ from the expected returnsC

Market/systematic risk - Riska associated with the overall market or economy. Examples: recession,
interest rate changes, geopolitical events.

Credit risk - Risk of financial loss accredited to borrowers unable to repay their debts.

Liquidity risk - Risk that an asset is unable to be bought or sold quickly in the market without
affecting its price. Real estate with high value can be less liquid compared to a more affordable
house.

Political risk - Risk associated with political events and news that may impact investments. Examples
include elections, new legislation and political uncertainty or confidence.

Currency risk - Risk in the fluctuating currency that impact the investors/institutions that deal with
many currencies. Negative news, changes in economic situations of countries may impact currency
valuations that in turn impact investments and their value.

1-12 Are all rational investors risk-averse? Do they all have the same degree of risk aversion?

No, as many different investors may have varying different risk profiles and tolerance. Depending on
the objectives and strategy of the investors, they will take different degrees of risk on their
investments. An example of a rational investor who may take high risk would be someone who
usually invests in other financial instruments besides simply buying spot, examples include taking
short contracts, derivatives and futures. Another example can be an activist investor from a hedge
fund.

Age is a factor in which risk aversion comes into play amongst individual investors. Younger investors
tend to be less risk averse compared to older investors and, hence tend to invest in higher-risk assets
with expected higher returns while older investors may be satisfied with something as secure as
bonds as an investment.

1-13 What is meant by an investor’s risk tolerance? What role does this concept play in investor
decision-making?

An investor's risk tolerance refers to their ability and willingness to withstand fluctuations in the
value of their investments. It is an individual's comfort level with the uncertainty and potential for
loss that comes with investing. Risk tolerance is influenced by various factors, including financial
goals, time horizon, investment knowledge, income, and the investor's psychological and emotional
disposition.

1-14 What external factors affect the decision process? Which do you think is the most important?
 1. Emotions. Investors can be affected by emotions when making investment decisions which
could lead to terrible consequences.
2. Economic conditions
3. Market conditions
4. Regulatory environment
5. Technological advancements
6. Environmental factors
7. Competitive landscape
8. Global events
9. Crisis situations

1-15 What are institutional investors? How are individual investors likely to be affected by
institutional investors?

Institutional investors are organisations or companies that invest money on behalf of their clients
and members, this also includes individual investors. Some examples of institutional investors are
hedge funds, pension funds and sovereign wealth funds.

Some institutional investors have an impact on traded securities due to the sheer volume in which
they trade, causing movement upon any changes or decisions institutional investors make in the
market. Examples of the biggest institutional investors are BlackRock and Vanguard, which operates
many funds and ETFs that individual investors may put their money into.

1-16 Why should the rate of return demanded by investors be different for a corporate bond and a

Treasury bond?

This is due to the difference in several factors which includes various forms of risk.

Credit risk: Corporate bonds are issued by companies which is more risky to invest in compared to
bonds issued by the government. Government bonds are viewed as risk-free.

Default risk premium: Corporate bond owners demand a premium in taking a risk that the company
may face financial difficulties in paying interest to the bondholders.

Liquidity risk: Corporate bonds may be less liquid than a government-issued bond as it is tied to the
well-being of the company. Government-issued bonds on the other hand are widely traded and
highly liquid, making transaction costs very low. Lower liquidity risk contributes to lower expected
return from investors.