Question 1
Bonds are stores of wealth. Unlike a bank deposit, bonds are fixed income assets with variable returns (bond yields). Bond yields are therefore responsive to changes in money-market interest rates. Bonds are capital market securities and as such have maturities in excess of one year ( 2000). Bonds can provide an element of stability that offsets some of the volatility of equities. However, bond values are vulnerable to economic changes that can undermine their value. The largest economic threat to bonds is rising interest rates. Previously issued bonds trading on the open market or in a bind mutual fund have a current market value. This value and interest rates are inversely proportional. The value of a bond goes down if the interest rates go up.
The risk associated with interest rates is known as interest-rate risk. Interest-rate risk is the risk that the present value of a bond will change because of a change in interest rates. When interest rates fall, the present value of bonds rises. When interest rates rise, the present value of bonds falls. Generally, the prices of fixed-income securities with longer maturities change more for a given change in interest rates than the price of short-term securities. Thus, longer-term securities generally have more interest-rate risk than short-term securities.
Interest rate risk is the risk of price movement of a bond cause by a change in interest rates. A change in interest rates occurs when investors require a different rate of return on a bond (often because the yield or return on a bond (often because the yield or return on similar bonds has changed). The required return on bonds frequently changes because of a general change in investor demand for bonds, because of a general change in supply of bonds, or both. Aggregate changes in the supply and demand for bonds are often attributed to changes in inflationary expectations, since investors typically require higher nominal returns on bond investments when purchasing power losses from inflation are expected to be high. However, changes in the supply and demand for bonds can also occur even without a change in inflationary expectations when the supply of and demand for credit changes (implying “tighter” or “looser” credit conditions and changes in the difference between nominal interest rates and inflationary expectations). Regardless of the cause, aggregate changes in bond supply and demand result in a general change in the required yield to maturity on virtually all bonds. Irrespective of the cause of a change in interest rates, bond prices will rise when the required yield on them falls, and prices will fall when required returns rise. However, because interest rates and interest rate changes vary on different bonds (such as for bonds with different maturities), changes in required returns may vary for different bonds.
Example: Changes of Bond Prices as Affected by Interest Rates
Maturity
7.5s99
6s02
5.5s28
Change in Interest Rates
Percentage Price Change
0%
0.00%
0.00%
0.00%
Up 2%
-1.94%
-6.49%
-24.53%
Down 2%
2.02%
7.05%
38.48%
Clearly, the price of the bond with the longest time to maturity (5.5s28) moves the most for each change in interest rates, while the price of the bond with the shortest time to maturity (7.5s99) moves the least for each change in interest rates. Thus, the bond with the longest time to maturity has the most interest rate risk while the bond with the shortest time to maturity has the least interest rate risk (2000).
Question 2
Marks and Spencer Plc is an international retailer with 718 locations across 34 countries. The group sells clothing, gifts, home furnishings and foods under the St. Michael trademark in its chains of 294 stores in the United Kingdom.
Over the recent years, Marks and Spencer have experienced losses and its share value decreased. With more than a hundred years of experienced and a good following, Marks and Spencer continued to be among UK’s top businesses. Even if the company is experiencing problems, I think it is still a good time to buy shares because I think the company will recover and that returns will be high in the long term.
Question 3
It is the best time to invest in real estate when the supply is scarce or when the demand of the influx of people to a geographical area will outperform the supply. If geographic locations (for example provinces or less developed cities) are being developed into a business hub where more and more businesses will be transferring and will be opening up, that is the best time to invest in housing or real estate.
It is best to invest in housing (or real estate) if an investor wants to diversify his/her investments. The stock market is more unpredictable than the real estate market. I think the best time to invest in housing is when an investor has diverse investments and is able to save 5 to 10 percent of his money for real estate. The key is diversification. In my opinion investments in stocks and housing offer both opportunities and risks. The only way to increase benefits and decrease risks is through diversification. There are several options for investing in housing or real estate. A more direct way is to buy individual commercial properties, such as apartment houses, rental homes, or office buildings. These generate income through leasing and by profits from the eventual sale of the property. Also popular are seat equity homes, where the investor buys a home, improves it, then sells the property quickly for a profit. Another way to put real estate into an investor’s portfolio is through Real Estate Investment Trusts (REITS). Real estate investment trusts have become very popular over the last decade. These companies pool investor money. REITs are traded on stock exchanges and over the counter. Because share prices are modest and shares can be bought or sold without difficulty, REITs are easier for investors to own than buying individual or limited partnership property. REITs must distribute 95% of their taxable income (excluding capital gains) to their shareholders, so they tend to be good investments for those seeking regular income. Tax rules make REITs particularly attractive. First, they are exempt from Federal corporate income taxes, and most states honor this exemption. That means there is no double taxation of income, as occurs with most corporations (1997).
Investing in housing and real estate is a good choice because practically speaking, the world is not getting any bigger. Unlike other investment options, housing is a real physical structure an investor can own and cannot disappear like intangible money that resides in stocks or bonds.
In investing in housing, the investor must consider the needs and requirements of the market which are driven by the following:
1. Rising House Prices – rapid inflation of house prices has not been matched with rise incomes creating affordability issues.
2. Demographic Change – a growing population, fuelled by increasing migration, combined with falling average household sizes continue to place increasing pressure in the supply of housing nationally.
3. Economic Change – the UK is continuing to experience a notable shift in its employment profile as a result of declining levels of employment in traditional industries and a shift to more service based employment. The wages with these jobs impact upon the type of housing required with a greater split between ‘high earners’ and ‘low earners’.
Question 4
A call option is a contract that gives its owner the right, but not the obligation, to buy something at a specified price or before a specified date. The ‘something’ that can be bought with the option is called the underlying asset. For example if an investor buys a call option (with 100 shares) from Marks and Spencer, he or she has the right to purchase 100 shares of Marks and Spencer’s common stock at a specified price, any time between the date of purchase and a pre-specified date. The fact that the call owner does not have the obligation to exercise the option means that he or she has limited liability. Should the price of the underlying asset fall, he or she can just walk away from the call contract without ever having had to acquire the underlying asset.
The call option pays off when the underlying stock goes up but does not obligate the owner when the underlying stock goes down. For this privilege, the purchaser pays a price (also called a premium) up front. The market price of the option depends on the exercise prices, the stock price, the time to maturity, the volatility of the underlying stock, the reckless interest rate and the anticipated size of dividends before maturity. The most important influence on an option’s value day-to-day is the stock’s price. The next most important influence on the option’s value is the volatility of the underlying stock price. In fact, one interesting use of option prices is to compute implied volatilities, that is the level of volatility (“vol”) implicit in the option price. The other influences either do not change on a daily basis (the exercise price and the anticipated remaining dividends) or have movements with relatively minor effect on the option price at normal maturities (time to maturity and the riskless interest rate).
The factors that affect the value (price) of a call option are:
- Current Stock Price – Call option value increases as the current stock price increases.
- Exercise Price – As the exercise price increase, a call option’s value decreases.
- Option Period – As the expiration date is lengthened, a call option’s value increases.
- Risk-Free Rate – Call option’s value tends to increase as risk-free rate increases.
- Stock Return Variance – Option value increases with variance of the underlying stock.
Credit:ivythesis.typepad.com
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