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essentials of investments

Questions and Answers of Essentials of Investments

Know what required return is and its relationship to an investor’s risk aversion
Understand the various sources of risk and how to measure the risk of an asset
Compare among various interest rates (or yields) in the marketplace
Know the various ways to measure the return of an asset and the differences among them
Learn the various types or orders for securities purchases or sales
Know how to engage in margin purchases and short sales as well as be aware of their pros and cons
Understand some basic investment strategies including the dollar-cost averaging technique
passive and an active approach to investing
See the difference between
Learn various prominent investment philosophies
See how investors apply the investment process
Grasp the risk-return trade-off all investors face
Understand the two steps of the investment process
Understand some issues that arise in financial markets like agency theory, asymmetric information, and ethical investment behavior
Evaluate the role of financial information on investments alternatives
Know your investment objectives and constraints
Understand the roles of the financial markets and financial intermediaries
Know the various classes of securities
See what investment is and distinguish between real and financial assets
How many further dimensions beyond the three (interest rate, cash flow, lifespan) could realistically be handled by analysts?
What is the implication of omitting a possible state transition, for example between nonadjacent states?
What is the implication of leaving out states that are anticipated to have a low probability of occurrence?
If equations have to be set up each time an investment is analyzed, this may be off-putting to users. What is the potential for setting up a general program that can analyze any number of states
Redo the calculations in the examples in this chapter. A spreadsheet should be sufficient for this purpose. Although the approach in this chapter is very straightforward, it is very easy to make a
Using Equation (10.22), show the equivalence of fixed- and variableinterest rates on plots with axes of F and V. Within the plot, give contours of Var[rV] for different i values. Do this for
Does Equation (10.21) imply that as the variance of the interest rate rises, the lower the equivalent fixed rate becomes? Or is it the i’th root of something less than 1, meaning a higher
What degree of conservatism in investment decisions is involved in not assuming that interest rates contain uncertainty? Or is knowledge that interest rates do contain uncertainty (but not
Do option types other than vanilla call options and basic expand options agree with Summary results 2 and 3 (Section 10.2)?
Under what circumstances might the Summary results 1a, 1b, 2 and 3(Section 10.2) not apply?
For the approach given, instead of talking of Greeks, which have no direct meaning within the approach given, what sensitivities would you recommend calculating instead? Think of sensitivities that
The approach given mentions nothing about arbitrage. Should it?
Examine Black–Scholes and the book’s approach when both are at the money. What do you see?
What adjustments/refinements would you recommend in order that the book’s approach gets closer to the behaviour observed in the stock market?
What adjustments/refinements would you recommend in order that the book’s approach gets closer to the results from Black–Scholes?
Do a numerical comparison of the behaviour of the Greeks for Black–Scholes compared with the approach given. What do you conclude?
The numerical testing of the approach given against Black–Scholes is for call options. Do similarly for put options. Would you expect similar comparison accuracy between call and put options? What
Using a nonsymmetric distribution for present worth, and preventing stock prices from going negative, would improve the comparison between Black–Scholes and the approach given. What distribution,
Is it possible to first evaluate OVT and then discount this to time 0 to give OV, rather than discounting E[ST] and Var[ST] to time 0, and then evaluating OV? Would you anticipate that you would get
With the book’s approach, the distribution for ST is replaced with E[ST] and Var[ST], that is in terms of moments only. While the shape of the distribution for ST can be reflected in the choice of
Conversion between contract payment types. Commonly, projects start out with broadly defined information and this gets refined as the project progresses. Given the different characteristics and
Consider the valuation of the adaptable design of sea walls. A sea wall that is constructed today has extra preparatory work done so that it can accommodate an upgrade should it be necessary in the
Consider the provision of spare parts and the reliability of plant or equipment. Purchasing the spare parts might be considered the premium paid for the possibility of repairing the equipment in the
Assume that you were comparing the option value on two projects.One has an exercise date in 1 year, the other has an exercise date in 10 years. Are these two options directly comparable?
Suggest a procedure by which sequential options might be evaluated.Would starting with the last option and working backwards in time facilitate this evaluation?
For the case of an option involved in a convertible contract, outline what you believe are the cash flows involved in an option to convert.
For the Carbon Farming Initiative calculation of the value of flexibility in terminating, does the option value increase/decrease with T, the time to exercising the option?
Based on the road upgrade example of Section 8.5, delineate what you believe are the relevant cash flows in the evaluation of the option, and delineate the method you would use for calculating the
Based on the water supply example of Section 8.5, delineate what you believe are the relevant cash flows in the evaluation of the option, and delineate the method you would use for calculating the
Does the answer to the optimal time to delay an option always lie on a constraint in the optimization formulation? (For terminology, see Carmichael, 2013.)
Option to contract. Consider a company with two similar plants.A potential competitor may undercut this company’s product, and so the company is considering scaling back its operations through
In Section 8.3, option to abandon, let the initial investment in equipment be $500M, and this generates net positive cash flows of $80M for each of the 10 years. Should the equipment not prove
In Section 8.3, option to expand, let the cost to expand be $1M, which results in estimated net positive cash flows in the following 5 years of$0.22M each year. Use an interest rate of 5% per
How sensitive would you anticipate real option values to be with different assumptions on cash flow correlation?
Why does Black–Scholes, when applied to real options, have trouble dealing with negative cash flows?
Would you anticipate the difference between the approach given and Black–Scholes to increase with increasing feasibility, Φ, and interest rate, r?
Chapter 10 introduces uncertain interest rates. The approach given applies to any assumptions on interest rates. How would you anticipate option values to change with changing uncertainty in interest
Few users of real options tools would have the mathematical background to understand the basis of the derivation of the Black–Scholes equation. Comment on the dangers of using Black–Scholes as a
Increasing the variance of the cash flows and other analysis input variables increases the variance of the present worth, which in turn increases the option value. Comment on the potential for abuse
does the transfer occur for an options calculation – from being needed to not being needed?
Where an investment has E[PW] positive (Φ > 0.5), an analysis might not be done of the option, because it would be a viable investment irrespective of any option value. Investments with Φ close to
What does volatility mean in a real options sense? Or does it have no meaning?
How do users of financial options methods applied to real options cases argue about the applicability of arbitrage, volatility and geometric Brownian motion?
Assume some suitable numerical values and test the accuracy of the approach given when compared with Black–Scholes.
from the diagrams.The calculations show the influence of different assumptions concerning individual and collective feasibility on overall feasibility.Would you anticipate that the trends indicated
for each of the various project assumptions considered in the case example. Estimate the times to reach a level of
For all the results given in Section 6.8, construct a table showing the time taken to reach a feasibility level of
for separable projects, plot feasibility versus number of projects. Plot the incremental decline in months to feasibility with increasing number of projects. Show that the feasibility of the whole
is reached.For the data given in Section
feasibility level, that is, the investor is interested in the time by which a feasibility level of
For the multiproject case (Section 6.8) assume that the investor has specified a required
For the multiproject case (Section 6.8), how might the calculations be inverted, such that the project cash flow requirements and/or the number of projects could be determined and/or the project
For the multiproject case (Section 6.8), examine the appropriate choice of owner-selected feasibility levels and their meaning in terms of investment risk.
For the wind power project of Section 6.7, consider the sensitivity of the results to changes in the cash flow variance, intercomponent correlation and intertemporal correlation assumptions:a. Cash
Based on Section 6.7. A weakness with deterministic CDM project proposals and their justification is that estimates of project output and cash flows (and emissions) can be manipulated to a certain
For the additionality calculations of Section 6.7, ideas such as an‘under-benchmark probability’ (UBP) and an ‘over-benchmark probability’ (OBP) might be introduced. UBP and OBP have
For the managed investment in primary production results given in Section 6.6, suggest a summary approach for an investor to follow, in evaluating the risk associated with any managed agribusiness
For the managed investment in primary production results given in Section 6.6, how might the effect of any tax concessions and taxation on money earned be taken into consideration by suitably
For the managed investment in primary production results given in Section 6.6, the P[Gain] curve is seen to have two transitions and three regions. Suggest a distinction between lower and higher risk
and 0.09.c. Consider different interest rates of 5%, 10% and 15% per annum.d. Consider different ratios of standard deviation/mean of 5%, 10%, 20%.e. Consider different distributions for the return
assumptions, namely – standard deviations 10% of mean; Xn = 2X0; n1 = n2; N1 = N2.a. Consider different ratios of return/initial investment of 1.5, 2 and 2.5.b. Consider different business failure
For the managed investment in primary production results given in Section 6.6, conduct some trends and sensitivity calculations related to magnitude of return Xn, business failure rate λ, interest
What distribution shape would you anticipate would best describe payback period, and why?
Would you anticipate that estimating correlations between cash flows based on your physical understanding of what the cash flows represent and their origins, to be better or worse than any
Under what conditions would Φ1, Φ2, Φ3and Φ4 (Equations 5.5) be equal?
Derive approximate expressions for the expected value and variance of the function Z = B/C, in terms of expected values and variances of B and C. Here B stands for benefits and C costs; hence Z is
Derive expressions for the expected value and variance of the function Z = B – C, in terms of expected values and variances of B and C. Here B stands for benefits and C costs; hence Z is similar to
What distributions other than normal might be suitable to characterize present worth, where present worth can take both positive and negative values? Of these, which are asymmetric with longer tails
Considering the approximation formulae given in Equations (5.6) for feasibility and mean of distribution upside, and assuming a normal distribution, how many vertical ‘strips’ are necessary to
Given the equation describing a normal distribution, and assuming that the associated random variable can take both positive and negative values, derive closed-form expressions for feasibility and
Estimates for optimistic, most likely and pessimistic values of stock price are $13.86, $9.90 and $5.94 respectively. Calculate an expected value and variance of this stock price. You wish to fit a
Given an expected value of –$3250 and a variance of 26280 $2, and you wish to fit a normal distribution to this, calculate:• The values of the distribution parameters μ and σ2• The area under
Ideally, the processes of societal or public decision making should try to maximize the interests of the community at large rather than just those of the investment’s proponent.Consider the case of
How do you take geographical/distributional effects into account in an appraisal?
How is triple bottom line and similar reporting dealt with in terms ofa. Accounting standards?b. Reporting for stock exchange purposes?There is a trend toward greater transparency and accountability
How does triple bottom line (TBL) and similar reporting treat intangibles?
Would trading in pollution credits be the best way to curtail emissions of all pollutants? Will emissions other than carbon be treated similarly in the future if or when they start to threaten the
Is it likely that a carbon-trading scheme will have a flow-on effect to other environmental resources such that organizations begin to examine their water and material use together with waste
What influence do carbon credits and carbon trading have on the way environmental intangibles are valued?
If things are regarded as ‘priceless’ or ‘invaluable’, will they end up being regarded as worthless (that is, worth zero dollars) if they are not at least given some value?
There have been suggestions that money should not be used as the unit of measurement in appraisal. For example, in agriculture why aren’t crops measured in terms of the quantity of water consumed

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