WEEK ONE
REVIEW QUESTIONS
Introduction to Investments
Do the following textbook questions to review your readings. Then check your answers below.
Chapter 1, pages 22 to 23: Questions 1-6, 1-9, 1-13, 1-18 and 1-24.
Chapter 2, pages 50 to 51: Questions 2-11, 2-12, 2-14, 2-16, 2-19 and 2-22.
ANSWERS TO REVIEW QUESTIONS
CHAPTER 1
1-6. Expected return is the anticipated return by investors for a future time period, whereas realized return is the actual return on an investment for a previous period of time.
1-9. An active investment strategy involves identifying and investing in securities that the investor believes are underpriced. An investor would concentrate on identifying and purchasing these securities in an attempt to outperform the market.
A passive investment strategy is based on the belief that most securities are fairly priced. With this strategy, an investor would attempt to construct a portfolio that mirrors the market index and would concentrate instead on reducing transaction costs and taxes.
1-13. Investment, in the final analysis, is simply a risk-return tradeoff. In order to have a chance to earn a return above that of a risk-free asset, investors must take risk. The larger the return expected, the greater the risk that must be taken (see Figure 1-1).
1-18. Efficient markets are ones in which the prices of securities quickly and correctly reflect information about securities. In such a market, the prices of securities do not depart for long from their justified economic values.
1-24. Four external factors that affect the decision process are:
(1) Uncertainty
(2) The investing environment (institutional investors vs. individual investors)
(3) The globalization of the investing process
(4) The issue of market efficiency.
The most important factor investors must deal with is uncertainty. Uncertainty dominates investments, and always will, since the realized return on a risky asset will almost always be different (sometimes quite different), from the expected return.
CHAPTER 2
2-11. Advantages of investing in Government of Canada bonds versus corporate bonds include lower risk and better liquidity.
Disadvantages of investing in Government of Canada bonds versus corporate bonds include lower yields and no convertibility features.
2-12. A Canada Savings Bond is non-marketable, non-transferable, and may be cashed in at any time for its full par value plus accrued interest.
A Government of Canada long-term bond is marketable and transferable. It fluctuates in price over time, and may sell above or below its stated par value.
2-14. A derivative security is a security that derives its value from other more basic underlying assets, such as securities, commodities, or currencies. Derivative securities are also referred to as contingent claims.
The major determinant of the price of a derivative security is the price of the underlying asset.
2-16. The convertible feature of a bond is advantageous to a bondholder because it gives the bondholder the option to convert the bond into shares of the underlying stock of the company at a predetermined price. This gives the investor the ability to participate in any upside movement in the stock.
The retractable feature of a bond is advantageous because it allows a bondholder to sell the bond back to the issuing company at predetermined prices at specific times.
Bondholders pay for these privileges by paying more for the bonds. In other words, they accept a lower rate of return.
2-19. The $3.20 dividend is the annual dividend. The stock goes ex-dividend on August 13 (assuming August 13 and August 14 are regular business days). An investor must buy the stock on or before August 12 to receive the dividend.
With 150 shares, 150 ($.80) = $120 will be received. (The quarterly dividend is 1/4 of $3.20, or $.80.)
2-22. The retractable feature of a bond might be utilized if interest rates rise substantially above the coupon rate on the bond.
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