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Chapter 2 Securities Markets and Transactions 15
Chapter 1
The Investment Environment
Outline
Learning Goals
I. Investments and the Investment Process
A. Attributes of Investments
1. Securities or Property
2. Direct or Indirect
3. Debt, Equity, or Derivative Securities
4. Low- or High-Risk Investments
5. Short- or Long-Term Investments
6. Domestic or Foreign
B. The Structure of the Investment Process
Concepts in Review
II. Types of Investments
A. Short-Term Investments
B. Common Stock
C. Fixed-Income Securities
1. Bonds
2. Convertible Securities
3. Preferred Stock
D. Mutual Funds
E. Exchange-Traded Funds
F. Hedge Funds
G. Derivative Securities
1. Options
2. Futures
H. Other Popular Investments
Concepts in Review
III. Making Your Investment Plan
A. Writing an Investment Policy Statement
1. Summarize your current situation
©2017 Pearson Education, Inc.
16 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
2. Specify your investment goals
3. Step 3: Articulate your investment philosophy
4. Step 4: Set investment selection guidelines
5. Step 5: Assign responsibility for selecting and monitoring investments
B. Considering Personal Taxes
1. Basic Sources of Taxation
2. Types of Income
a. Ordinary Income
b. Capital Gains and Losses
3. Investments and Taxes
4. Tax-Advantaged Retirement Savings Plans
C. Investing over the Life Cycle
D. Investments and the Business Cycle
Concepts in Review
IV. Meeting Liquidity Needs with Short-Term Investments
A. Role of Short-Term Investments
1. Interest on Short-Term Investments
2. Risk Characteristics
3. Advantages and Disadvantages of Short-Term Investments
B. Common Short-Term Investments
C. Investment Suitability
Concepts in Review
V. Careers in Finance
A. Commercial Banking
B. Corporate Finance
C. Financial Planning
D. Insurance
E. Investment Banking
F. Investment Management
Concepts in Review
Summary
Key Terms
Discussion Questions
Problems
Case Problems
1.1 Investments or Golf?
1.2 Preparing Carolyn Bowen’s Investment Plan
Excel @Investing
©2017 Pearson Education, Inc.
Chapter 2 Securities Markets and Transactions 17
Key Concepts
1. The meaning of the term investment and the implications it has for individual investors
2. Review the factors used to differentiate between different types of investments
3. The importance of and basic steps involved in the investment process
4. Popular types of investments including short-term investments, common stock, mutual funds and
exchange-traded funds, fixed-income securities such as bonds, preferred stock, and convertibles
5. Derivative securities such as options and futures
6. Other popular investments such as real estate, tangibles, and tax-advantaged investments
7. Writing an investment plan
8. Building a diversified portfolio consistent with investment goals
9. Sources of taxation, types of taxable income, and the effect of taxes on the investor
10. Developing an investment program that considers differing economic environments
and the life cycle
11. The use of short-term securities in meeting liquidity needs
12. The merits and suitability of various popular short-term investments, including deposit accounts and
money market securities
Overview
This chapter provides an overview of the scope and content of the text.
1. The term investment is defined, and the alternative investment opportunities available to investors
are classified by types.
2. The structure of the investment process is examined. This section explains how the marketplace
brings together suppliers and demanders of investment funds.
3. The key participants in the investment process—government, business, and individuals—are
described, as are institutional and individual investors.
4. Returns are defined as rewards for investing. Returns to an investor take two forms—current
income and increased value of the investment over time. In this section, the instructor need only
define return, since there will be another opportunity to develop the concept of return in Chapter 4;
also, providing information about recent investment returns always engages students’ attention.
5. Next, the following investments available to individual investors are discussed: short-term
investments common stock, fixed-income securities, mutual funds, exchange-traded funds, hedge
funds, real estate, tangibles, tax-advantaged investments, and options and futures. The text describes
their risk-return characteristics in a general way. The instructor may want to expand on the
advantages and disadvantages of investing in each, although they will be treated in greater detail in
subsequent chapters. It is vital for any investor to establish investment goals that are consistent with
his or her overall financial objectives.
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18 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
6. Writing an investment plan involves summarizing one’s current situation, specifying investment
goals, articulating an investment philosophy, setting investment selection guidelines, and assigning
responsibility for selecting and monitoring investments.
7. Personal taxes are discussed in terms of types of income and tax rates. The investment process is
affected by current tax laws. Examples of tax shelters, especially tax-advantaged retirement vehicles,
and tax planning are provided.
8. Once investment goals are established, it is important to understand how the investment process is
affected by different economic environments. The chapter talks about types of investments such as
stocks, bonds, and tangibles as they are affected by business cycles, interest rates, and inflation.
9. Liquidity is defined, and short-term securities that can be used to meet liquidity requirements are
described. The discussion includes a look at short-term interest rates and the risk characteristics of
various short-term securities.
10. The next section covers the various types of short-term vehicles available to today’s investor. The text
provides enough detail about everything from passbook accounts to money market funds to
commercial paper that students should get a good grasp of the differences between the vehicles.
Information on current rates brings realism into the classroom and enhances student perception of the
lecturer as a knowledgeable instructor.
Answers to Concepts in Review
1.1 An investment is any asset into which funds can be placed with the expectation of
preserving or increasing value and earning a positive rate of return. An investment can be a security
or a property. Individuals invest because an investment has the potential to preserve or increase value
1.2 (a) Securities and property are simply two classes of investments. Securities are
investments issued by firms, governments, or other organizations that represent a legal claim on
the resources of the issuer. For example, a bond represents a loan that the borrower is legally
(b) With a direct investment, an individual acquires a direct claim on a security or property. For
example, an investment in one share of IBM stock directly provides the stockholder a proportionate
ownership in IBM. An indirect investment provides an indirect claim on a security or property.
©2017 Pearson Education, Inc.
Chapter 2 Securities Markets and Transactions 19
(c) An investment in debt represents funds loaned in exchange for the receipt of interest income and
repayment of the loan at a given future date. The bond, a common debt instrument, pays specified
interest over a specified time period, then repays the face value of the loan. (Chapters 10 and
11 cover bonds in detail.) An equity investment provides an investor an ongoing fractional
ownership interest in a firm. The most common example is an investment in a company’s
(d) Short-term investments typically mature within one year while long-term investments have
1.3 Investors expect to be paid for accepting risk. Low or no risk investments typically offer low rates of
1.4 In finance, risk reflects the uncertainty surrounding the return that an investment will generate. Risk
refers to the chance that the return from an investment will differ from its expected value. Low-risk
1.5 Foreign investments are investments in the debt, equity, derivative securities of
foreign-based companies, and property in a foreign country. Both direct and indirect foreign
1.6 The investment process brings together suppliers and demanders of funds. This may occur
directly
(as with property investments). More often the investment process is aided by a financial institution
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20 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
1.7 (a) The various levels of government (federal, state, and local) generally require more
funds for projects and debt repayment than they receive in revenues. Thus, governments are net
(b) Businesses are also net demanders, requiring funds to cover short- and long-term operating and
(c) Individuals are the net suppliers of funds to the investment process. They put more funds into the
1.8 Institutional investors are investment professionals who are paid to manage other people’s
money. They are employed by financial institutions like banks and insurance companies, by
1.9 Short-term investments usually have lives of less than one year. These investments may be
used to “warehouse” temporarily idle funds until suitable long-term investments are found. Due to
their safety and convenience, they are popular with those who wish to earn a return on temporarily
1.10 Common stock is an equity investment that represents a fractional ownership interest in a
corporation. The return on a common stock investment derives from two sources: dividends, which
1.11 a. Bonds are debt obligations of corporations or governments. A bondholder receives a stated
interest return, typically semi-annually, plus the face value at maturity. Bonds are usually issued
b. A convertible security is a fixed-income security, either a bond or preferred stock, which has a
conversion feature. Typically, it can be converted into a specified number of shares of common
c. Preferred stock is very much like common stock in that it represents an ownership interest in a
©2017 Pearson Education, Inc.
Chapter 2 Securities Markets and Transactions 21
d. A mutual fund is a company that invests in a large portfolio of securities, whereas a money
market mutual fund is a mutual fund that solely invests in short term “money market” securities .
Investors might find mutual funds appealing because a large, well-diversified portfolio may be
e. Similar to mutual funds, hedge funds pool investors’ funds to invest in securities, but hedge funds
are open to a narrower group of investors than mutual funds. Hedge funds may employ high-risk
f. Options are derivative securities that provide holders the right to buy or sell another security
g. Futures represent contractual arrangements in which a seller will deliver or a buyer will take
delivery of a specified quantity of an asset at a given price by a certain date. Unlike an option,
1.12 Before establishing an investment program, an investor should write down an Investment Policy
Statement. The elements of this statement include an overview of the investor’s current situation, a
1.13 Federal income taxes are charged against all income individuals receive from all sources (with the
exception of interest received on some bonds issued by state and local governments).
a. Active (ordinary “earned”) income is the broadest category and includes income from wages,
b. Portfolio (investment) income is earnings generated from various types of investment holdings.
For the most part, it consists of interest, dividends, and capital gains earned on most types of
c. Capital gains are the profits earned on the sale of capital assets—pleasure or investment. They
are measured by the amount by which the proceeds from the sale of the capital asset exceed its
d. A capital loss is the amount by which the proceeds from the sale of a capital asset are less than its
e. Due to the opportunities and challenges created by the tax laws, tax planning is an important part
of the investment process. Tax planning involves looking at an individual’s current and projected
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22 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
f. In general, tax-advantaged retirement plans allow individuals to defer taxes on the contribution
1.14 Investors tend to follow different investment strategies as they move through different stages of their
life cycle.
a. Young investors, ages 20 to 45, tend to prefer growth-oriented investments that stress capital
b. By middle age, ages 45 to 60, there is a consolidation taking place as family demands and
responsibilities change. While growth-oriented securities are still used, investing becomes less
c. As the investor moves into the retirement years, age 60 on, preservation of capital and current
income become the principal concerns. High-quality stocks and bonds and money market
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Chapter 2 Securities Markets and Transactions 23
1.15 Stocks and equity-related securities (such as mutual funds and convertibles) are highly responsive to
the economic cycle. During recovery and expansion, stock prices are up. As the decline approaches,
1.16 An asset is liquid if it can be converted to cash (sold) easily and quickly, with little or no loss in
value. You would want to hold liquid assets as emergency funds or to accumulate funds for some
specific purpose. IBM stock is a liquid investment. IBM common shares are heavily traded, and
1.17 Purchasing power risk for short-term investments occurs when the rate of return on these investments
falls short of the inflation rate. This generally happens to fixed-rate investments such as passbook
savings accounts. Most other short-term investments have managed to provide rates of return about
equal to the inflation rate when one looks at these short-term rates over long periods of time. Default
(nonpayment) risk is very small with most high quality or money market short-term investments. The
1.18 Passbook savings accounts and NOW accounts (a checking account), offered by banks, generally pay
a low rate of interest and have no minimum balance. Passbook savings and NOW accounts are
primarily used by investors as savings accounts, providing the investor with a highly liquid pool of
1.19 a. I bonds are savings bonds issued by the U.S. Treasury. They earn interest at a rate that
b. U.S. Treasury bills are short-term (less than one year) debt obligations of the federal government.
T-bills are exempt from state and local income taxes. They are regarded as the safest but
c. Certificates of deposits (CDs) are savings instruments that must remain on deposit for a specified
period. Premature withdrawals incur interest penalties. Because of the requirement that they
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24 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
d. Commercial paper is unsecured short-term debt issued by corporations with very high credit
standings. The secondary market for commercial paper is very limited and yields are comparable
e. Bankers’ acceptances are short-term credit arrangements between business firms and banks.
Firms use banker’s acceptances to finance transactions, most often involving firms in foreign
f. Money market mutual funds (MMMFs) pool capital of many investors and invest it exclusively in
high-yielding, short-term securities, such as T-bills, large CDs, commercial paper, and other
similar “money market” securities. Because these high-yielding securities are in denominations
1.20 The senior managers in a corporation, such as the chief financial officer (CFO), have the primary
responsibility of managing the firm’s capital resources and investments. Because so much of the
1.21 Because insurance companies have large sums of investment capital under management, they require
the skills of a highly trained finance person in investment principles. Since this person is asked to
©2017 Pearson Education, Inc.
