MONARCH INSTITUTE PTY LTD

DFP Module 2
Investments

Module 2
Investment Planning

Document: Module 2: Managed Investments, Securities & Derivatives

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TABLE OF CONTENTS
1.0

INTRODUCTION

2.0

LEARNING OUTCOMES

3.0

INVESTMENT CLASSES

3.1

Cash

The return on cash

3.2

3.3

3.4

What are the risks of cash?

10

How is a cash return generated?

12

How do you invest in cash?

13

Fixed Interest

14

What are the risks of fixed interest?

15

How are the returns generated from fixed interest?

17

How do you invest in fixed interest?

17

Property

18

Residential Property

18

Commercial Property

18

How is the return on property generated?

19

How do you invest in property?

20

What are the risks of property?

22

Equities

26

The sharemarket

26

Initial Public Offerings

26

How is the return on shares generated?

27

A conceptual overview of dividends

27

What are franked dividends?

28

The 45 Day Rule

30

Shares and capital growth

35

Investing in shares for income

36

Shares can be volatile dont panic

38

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4.0

PERFORMANCE OF ASSET CLASSES

41

Weighted Returns on Investment Portfolios

43

4.1

Timing the market

44

4.2

Putting Performance into Perspective

48

4.3

Dollar Cost Averaging

51

Overcoming 'timing the market' problems

51

What is dollar cost averaging?

51

Does dollar cost averaging always work?

52

Applying dollar cost averaging to withdrawal of funds

55

Investment risk

55

What do we mean by the term 'risk'?

55

Other forms of risk

57

5.0

DIVERSIFICATION

59

5.1

Portfolio choices

59

Direct investment

59

Managed investments

60

Advantages of managed investments

60

Fund managers

62

Investment styles defined

63

Types of Managed funds

64

Managed retail funds

66

Managed wholesale funds Mastertrust or Wrap

66

Consistency of fund manager performance

67

What is an index?

69

What is an index fund?

70

Individually managed accounts or separately managed accounts

71

5.2

Exchange Traded funds

75

5.3

Investment selection

76

Strategic asset allocation

77

Tactical asset allocation

82

Investment vehicle

82

Selecting investments

82

4.4

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6.0

UNDERSTANDING CLIENT NEEDS

84

6.1

Compound interest & the time value of money

85

Time value of money

85

Compound interest

86

Case Study

100

Using spreadsheets

103

7.0

DERIVATIVES AN OVERVIEW

108

7.1

What are derivatives?

109

How does the use of derivatives reduce or eliminate risk?

109

What is the benefit to a firm of having more certainty in their cash flows?

110

What are the disadvantages of using derivatives?

110

Forward Contracts and Futures Contracts?

110

How do futures contracts work?

113

How do Futures differ from forwards contracts?

114

Marking to market

115

Hedging Foreign exchange risk

117

What are Options?

119

Who Trades Options?

121

Where are Options Traded?

123

Option Types

123

How do options protect from downside risk whilst retaining upside risk (benefit)?

124

In the money, at the money, out of the money

127

Concluding remarks

128

7.2

7.3

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APPENDIX 1 - WHAT DOES A RATINGS AGENCY DO?

APPENDIX 2 - AMP CORE PROPERTY FUND INVESTOR FLYER
APPENDIX 3 - BALANCE FUND FACT SHEETS
APPENDIX 4 - TIME VALUE OF MONEY
APPENDIX 5 - TIPS FOR USING EXCEL SPREADSHEETS
APPENDIX 6 - THE FAIR GODMOTHER AND THE MAGIC TRAIN - NOEL WHITTAKER

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1.0

INTRODUCTION
In module one, we listed a number of reasons for the increasing demand for financial
planning services in Australia. One of the areas in which financial planning advice is
most frequently sought relates to investments.
Providing good investment advice requires an understanding of a client's short term,
medium term and long term objectives, their attitude to risk, their current position,
their income needs and capital growth needs, and of course their investment time
frame. Synthesising this information to arrive at investment recommendations requires
a combination of skill and knowledge. There is often no blatantly right course of action,
but there can definitely be wrong courses of action.
This module will set out the framework relevant in helping financial advisers provide the
best possible investment recommendations for client needs. It is important to
appreciate however that this module is not the end to your learning with respect to
investments it is very much the beginning, and introductory in nature. The Advanced
Diploma of Financial Planning has a whole module dedicated to extending your
understanding and application of investments.

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2.0

LEARNING OUTCOMES
When you have completed this module, you should be able to:
Identify the key characteristics of the four main asset classes.
Understand the relative risk and return fundamentals underpinning the four main
asset classes.
Demonstrate how you can invest in each of the four main asset classes.
Understand the distinction between income and growth assets.
Understand the principles behind dollar cost averaging.
Appreciate the concept of diversification.
Recognise the different portfolio choices that are available when investing.
Distinguish between strategic asset allocation and tactical asset allocation.
Understand the principles of the time value of money.
Calculate present value and future value amounts for single sums.
Calculate present value and future value amounts for annuities.

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3.0

INVESTMENT CLASSES
One of the key basic concepts in the finance industry is that of asset classes, or
investment classes. The terms are interchangeable, and both are used in this module.
There are four investment classes. They are:
Cash
fixed interest
property
shares.
Later in this module, we will look at the practical issues investors face when weighing up
how to invest their money within the four asset classes. Key factors for consideration
include (but are not limited to):
a) The amount and frequency of income required
b) Investment time frame
c) Risk tolerance
d) Tax position
And finally, we will look at different investment strategies for investors at different life
stages (e.g. before and after retirement), taking account of the above considerations.
But first, we must look at the 4 asset classes to determine what makes them unique as
investment opportunities. In order to do that, we must take account of the following:
a) What are the returns?
b) What are the risks?
c) How is the return generated?
d) How do you invest in it?

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3.1

CASH
Cash investments include term deposits, money market securities and cash
management accounts/trusts1. Money market securities, cash management accounts
and term deposits are often capital guaranteed by the Australian government which can
be an important consideration for investors2. The Australian government provides
capital guarantees for investors balances of up to $250,000 for certain institutions cash
and term deposits. This is known as the Financial Claims Scheme and the list of
Authorised Deposit-taking Institutions (ADIs) whose products are covered by the
guarantee can be found at http://www.apra.gov.au/adi/Pages/adilist.aspx.

THE RETURN ON CASH

The returns from cash are derived from the interest rate on offer by the provider
(usually a bank). Thus cash investment returns vary with changes in interest rates. The
chart below shows cash returns as measured by the Reserve Bank of Australia.

For the purposes of this course, we will refer to Cash Management Accounts, despite some providers offering one, the

other or both options.

2

Capital guarantees became a big issue at the height of the Global Financial Crisis when there was a run on some banks

that were considered more risky than the top four banks (NAB, CBA, Westpac and ANZ). The Australian government
provided a capital guarantee on all bank deposits, including the second and third tier banks to head off panic. It is
important to know this blanket capital guarantee has been lifted so you must always do your homework and determine
whether the cash option you are considering does or does not have a capital guarantee from the Australian government
backing it.

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Australian Cash Returns (Rate)

WHAT ARE THE RISKS OF CASH?

Cash investments carry the lowest risk of all asset classes. The 90 day treasury note
interest rate is often used as a proxy or yardstick for the risk-free rate of return on offer
in Australia. Cash generally exhibits no capital volatility, unlike other investment options.
However because this also means that the capital base never rises, the returns are
dependent on the cyclical nature of interest rates. This means there is always a real risk
that a cash investment wont keep pace with inflation, and lose value in real terms
(which will be discussed in more detail in Advanced Investments).
It is also important to understand that it depends on the individual cash investment, as
to its specific risk. The best example to illustrate this is Pyramid Building Society in 1990.
1

It is important to understand that investors usually can access their investment capital from a term deposit prior to expiry.

In this situation, the interest rate would be reduced as a penalty depending on the time to maturity.
2

This situation doesnt apply when a forthcoming economic downturn is factored into fixed interest markets exhibited by

an inverse yield curve. In this situation, short term interest rates would be higher than long term interest rates.

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Case Study - Pyramid Building Society (Victoria 1990)

Pyramid Building Society based in Geelong (Victoria) in the 1980s offered a cash term
deposit that paid an interest rate of 1-2% higher than the main banks. Many investors
simply viewed this higher return on offer as Pyramid attempting to buy market share
off the competition (the big banks). They were wrong. Pyramid went bankrupt in 1990
when high risk borrowers defaulted on loans they had secured through Pyramid.
Ironically, it was these high risk borrowers that Pyramid had lent money to in the first
place, that allowed Pyramid to offer such high interest rates to investors in the first
place.
More Recently
There have been many more failed investment offerings since Pyramid. Companies such
as Fincorp, MFS and Westpoint are just some that were highlighted in the media. Whilst
each underlying investment offering was different, and some were not portrayed as
offering cash type interest rates (given their rates were so much high than cash), they
all failed and caused significant misery and distress to investors.
What is the lesson?
Generally when offered a substantially3 higher interest rate on a cash investment
compared to comparative providers, it generally reflects a higher inherent risk or a
greater burden to tie-up the investment capital for a longer time frame.

Competition means that at different times, different providers will offer higher interest rates in comparison to their peers.

This doesnt always infer a higher associated risk. However structurally, all banks invest their capital over night with the
Reserve Bank of Australia (RBA), and it is this overnight RBA cash rate that provides the basis for bank interest rates.
Because of this, and the requirement for banks to maintain a certain level of risk management over their capital, banks
generally will be quite consistent with their interest rate offers over time. A provider (particularly a second or third tier
provider) that consistently offers a higher interest rate than their peers should be a trigger for closer scrutiny to understand
how they are able to offer it.

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The cash rollercoaster interest rates have moved dramatically over the past 23 years

HOW IS A CASH RETURN GENERATED?

If you invest into a cash investment (offering say 6% per annum), have you ever
wondered how the bank is able to offer that return, and make money in the process?
Its quite simple. Firstly, a bank will use your capital you have invested or lent to the
bank (as a depositor), and they will re-lend that capital to a borrower at a higher
interest rate. Borrowers include anyone from individuals, families or businesses who
qualify based on the banks lending criteria. The purpose could include home loans,
personal loans, credit cards or a business overdraft for example.
The difference between the interest rate offered to a depositor (e.g. You the investor),
and the interest rate offered to a borrower is called the interest rate spread. At a basic
level, the banking system has generated profits via this spread since borrowing and
lending for trade and commerce first commenced thousands of years ago4.

The Australian economy has excess demand for financial capital, and Australian banks are therefore required to seek

foreign overseas funding to maintain equilibrium between demand and supply for money. This has placed banks under
pressure to borrow funds via wholesale foreign funding markets. Since the GLOBAL FINANCIAL CRISIS, foreign investors
have exhibited lower propensity for risk, and therefore have charged Australian banks a higher interest rate for the
pleasure of borrowing money from them. This has been one reason why banks have increased their interest rates (both on
deposits and loans) out of step with the RBA official increases.

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Of course it is too simplistic to think a bank is able to perfectly lend out all money on
deposit each and every day at a higher interest rate. After all, there is always money
sitting in bank vaults in branches to allow you to withdraw money from your bank
account at any given time. So how can a bank earn interest on money sitting in their
own vaults? The answer is that each bank has an account with the Reserve Bank of
Australia (RBA) known as an exchange settlement account (ESA). The bank invests its
excess money each night with the RBA and is paid an overnight interest rate by the
RBA. The RBA is the bank to the Australian Federal Government. The RBA is able to set
interest rate policy for the Australian economy (called monetary policy) by
manipulating this overnight interest rate. Traditionally, changes in RBA official interest
rates filter down into retail bank interest rate settings quickly (usually within days or at
least weeks).

HOW DO YOU INVEST IN CASH?

There are a multitude of cash options available for investors. Mainstream banks offer
term deposits and cash management accounts. Even investment banks such as
Macquarie and Goldman Sachs offer cash management accounts and often term
deposits. Cash management accounts usually invest in a range of short-term money
market investments (that usually mature in 12 months or less). Because money markets
are wholesale financial markets, a product disclosure statement (PDS) must be provided
to investors by the provider. In contrast, retail term deposits can be purchased at the
bank branch, over telephone banking or via internet banking and dont require a PDS.
You can google; Macquarie cash management account for an online Product
Disclosure Statement and more information on cash management accounts. You could
also google; term deposits with any of the major banks to find out the latest interest
rate offers.

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3.2

FIXED INTEREST
Fixed interest investments can be issued by a range of entities for the purpose of raising
capital from investors. Issuers include the Federal Government, state governments,
semi-government authorities, banks and other corporations, both locally and overseas.
Initially borrowers raise their capital they require in the primary fixed interest market
from investors. Investors are then able to sell their fixed interest investments to other
investors at any time (without waiting for repayment of interest or capital). They trade
these securities via the secondary market. The fixed interest market is also called the
debt securities or bond5 market. For the purposes of this course we will refer to fixed
interest securities as bonds.
Many people arent aware just how big the worldwide bond market is. It was estimated
in 2009 to be valued at over $80 trillion US dollars6 based on total debt outstanding. This
is nearly twice as large as the global equity market at the same time, valued at close to
$40 trillion US dollars7. Whilst the value of both markets change daily (and are different
today), the relative dominance in size of the bond market, compared to the equity
market, has not changed.
The types of fixed interest securities are as follows:
Government bonds: Issued directly by a government and are explicitly guaranteed by
that government. Implementing major government projects and managing budget
deficits are reasons governments issue such bonds.
Semi-government bonds: Not issued directly by government but may be issued by a
statutory authority empowered by government legislation. These bonds may also
include an implied guarantee of performance by the government (but not always).

The bond market can also be called the credit market interchangeably.

Outstanding World Bond Market Debt - Bank for International Settlements; Asset Allocation Advisor compilation as of

March 2009.
7

November 2008: Website Source: http://seekingalpha.com/article/99256-world-equity-market-declines-25-9-trillion

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Corporate bonds: Issued by large public companies to fund expansion and working
capital. Corporate bonds are considered to be riskier than semi-government and
government bonds, so they typically offer higher interest rates.8
Hybrids: As the name suggests, these securities have characteristics of both fixed
interest and equity. Convertible bonds9 commence as bonds but can be converted into
equity at a future date. These types of securities have higher risk than government or
corporate bonds because they are less secure, and in the event of a default, often rank
behind more senior debt issued by the corporate borrower.

WHAT ARE THE RISKS OF FIXED INTEREST?

Credit risk
The first risk inherent in a fixed interest investment is the risk of non-payment or default
by the issuer of the bond. Non-payment or default can occur across any bond. Obviously
a government has a higher propensity to honour its obligations than a corporate but
every bond and every borrower (issuer) must be assessed on their own merits. For
example, in 1991 Argentina defaulted on their government issued bonds, quite an
unprecedented step. They defaulted primarily due to the terminal prognosis of economy
at the time. More recently, European countries like Greece, Portugal, Ireland and Italy
have all exhibited problems servicing their existing government bonds. Of course strong
corporations that have low levels of debt and have strong corporate governance such as
Apple, Exxon etc. in some instances will be perceived as having a lower risk than a
problematic government borrower.
Ratings Agencies
The interest rate a borrower pays to an investor (whether that borrower is a
government, semi-government or company) is linked to the perceived risk of default (or

This is not the case when government sovereign debt risk is a relevant factor. For example in 2011, Greek debt was priced

for default, and the interest rate on Greek bonds was considerably higher than most corporate bonds, other than the most
risky corporate bonds that were considered as high or higher chance of defaulting on their debt obligations.
9

Convertible bonds can also be called convertible notes. Generally, a convertible bond will have a longer duration than a

convertible note.

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simply non-payment) back to the investor. The task of determining the risk of default in
large part is conducted by ratings agencies. Some examples are Moodys, Fitch Ratings
and Standard and Poors. Go to www.moodys.com to learn more, or go to Appendix 1 for
more information.
Ratings agencies provide a ranking system from best to worst. For example some
agencies use a reference such as AAA denoting the best or least risky investments,
down to junk which is seen as the most risky. Getting a good or bad rating will impact
on the amount of interest the market will require when a new bond is issued in the
primary market. The better the rating, the lower the interest rate, and vice versa.
Interest rate risk
The second key risk inherent in fixed interest investments is interest rates change. In
general the following rules apply to the price of an existing bond traded on the
secondary market:
1) If interest rates rise, the bond price falls. This is because investors wont buy the
bond paying the lower coupon rate (interest rate), unless the bond price falls
enough to reflect the prevailing interest rate.
2) If interest rates fall, the bond price rises. This is because owners of bonds will refuse
to sell their bonds on the secondary market at the original issue price because the
bond pays a higher coupon rate (interest rate) than the currently prevailing interest
rate. Bondholders will only rationally sell their bonds if they receive a higher price
than the issue price, to take into account the fact the new purchaser of the bond is
entitled to a higher coupon rate (interest rate) than the prevailing coupon rate.
3) The longer the time to maturity, the greater the volatility of a bond price if interest
rates change.
Inflation risk
Fixed interest investments generally have less growth potential than shares or property
(in the long run). For investors that hold their bonds to maturity, they ultimately receive
only the interest rate that existed when they acquired the bond in the first place (either
on the primary or secondary market). The effects of inflation over time on the real
return of a bond, is therefore a real risk.

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HOW ARE THE RETURNS GENERATED FROM FIXED INTEREST?

Fixed interest investments (bonds) usually have longer investment terms than cash
investments. Australian bond maturities range from one to 10 years, but US bonds
extend up to 30 years.
The underlying return of a fixed interest investment is the interest rate, known as the
coupon rate. This rate is no different to a cash investment in that it is a percentage of
the face value of the specific bond. The face value may be $100 or $100,000. The
coupon amounts are paid periodically throughout the term of the bond (e.g. semiannually on a 5 year bond). However, more complexity exists when comparing the
return of a bond to that of cash. This is because if you sell your bond prior to maturity,
the value of the bond may fluctuate just like a share. It is only when the bond reaches
maturity that the investor receives the face value of the bond.10 Prior to maturity, a
number of factors affect the bond price (and hence the return an investor would receive
if they were to sell) including:
The difference between the current interest rate in the market place and the coupon
rate offered on a bond.
The time to maturity of the bond
The number of coupon payments yet to be received by the bondholder.

HOW DO YOU INVEST IN FIXED INTEREST?

The minimum direct investment for a retail investor wanting to purchase a bond is often
prohibitive ($50,000 - $500,000) depending on the type of bond. Because of this
minimum parcel sizes, it can make it difficult to adequately diversify within the fixed
interest asset class, and also across desired maturities. Consequently, many retail
investors choose to invest indirectly into bonds via managed funds.

10

Assuming the borrowing entity doesnt default.

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3.3

PROPERTY
Some people describe property as the provision of a service - namely shelter. That of
course is a simplistic explanation. There are many types of property. Often they are
broken up into residential property and commercial property.

RESIDENTIAL PROPERTY
Residential property is property that is used for residential purposes a home.
Residential property can include houses, apartments and vacant land (zoned
residential). Some Australians invest in residential property in addition to owning their
own home. It is important to remember that all property is unique. This is because there
is only one property, in one location, and it cant be perfectly replicated. For this
reason, it is often remarked that property investment decisions can sometimes involve
an emotional element. Property often differs in the same street, as it does within a
suburb, city and state. The same principles apply with apartments, even within the same
block! Think about it for a moment. An apartment in the same block may sell for a
higher amount than an equivalent apartment in the same block, with the same footprint
(e.g. size) because it enjoys a better view. Alternatively, the same apartment may sell for
a higher price because it comparatively had a better kitchen, whether it was renovated
or just more expensive in the first place. Consequently, it is difficult to apply a brush
stroke approach when describing or valuing residential property.
At any given time, the residential property market might be booming in Port Headland,
performing in a mediocre way in Sydney or quite poorly in Canberra (or vice versa). For
this reason, the residential property market in Australia is often described as a number
of markets and sub-markets. It is only when specific research is performed within those
particular sub-markets that meaningful comparisons can be drawn.

COMMERCIAL PROPERTY
Commercial property is property that is used for commercial purposes generally to
operate some business or commerce from. There are many different types of
commercial property and they include:

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Offices
Factories
Industrial premises
Retail premises
Shopping centres

HOW IS THE RETURN ON PROPERTY GENERATED?

The return on a property investment is two dimensional. It comprises a rental or income
component and it also includes a capital component.
Rental
Property investors generally rely on ongoing income from rental from tenants. The
exception to this is of course vacant land or a property that is untenanted. A tenancy is
an agreement whereby the tenant of the property pays the owner (investor) an agreed
amount periodically. The over-riding agreement between tenant and owner is called a
lease. There are different types of leases, however broadly they can be described as
either residential leases or commercial leases.
A lease sets out the rights and responsibilities of both parties, and also covers the key
commercial transaction features; the lease term (months or years), the lease amount,
and how often it will be paid (weekly, monthly, quarterly etc.).
Rental Yield
When assessing a property investment, the ongoing income is often expressed as a
rental yield. Rental yield is calculated by dividing the yearly rental by the property value.
For example, if the property paid a rental of $35,000 per annum and was worth
$500,000 then the rental yield would be 7% per annum.
Capital
Property is a financial asset that is traded between market participants (buyers and
sellers). An investor that purchases property ideally would like to sell the property at a
higher future price. If they are able to do this, then the investor would make a positive
capital return. A capital return is the difference between the selling price and purchase

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price after taking into account purchase and selling costs such as agent fees, legal fees
and stamp duty. As you can see, a capital return can be positive, but it also can be
negative whereby the investor sells the property for a lower future price.
Either way, an additional piece of information that is often overlooked by property
investors when reviewing their capital return is the ongoing capital maintenance and
upkeep they have committed to the property over its life. This may include new roofs,
renovated bathrooms or kitchens etc. This cost is often substantial, and should be
factored in when calculating the real capital return a property has produced.

HOW DO YOU INVEST IN PROPERTY?

Direct
Residential property purchases and sales generally are direct transactions between
buyer and seller. It can be performed at public auction whereby certain rules and
regulations stipulate the obligations of both purchasers and vendor. State legislation
also governs conduct and responsibilities. Alternatively, many purchase and sales of
properties are conducted via private sale or treaty which is also governed by State
legislation.
Commercial property can be purchased directly (as discussed above) either via public
auction or private sale, but also it can be purchased indirectly.
Indirect
Commercial property can be purchased indirectly via listed or unlisted property trusts
and/or managed funds. The benefits of purchasing commercial property indirectly is
often the exposure (and hence diversification) you can receive. For example, you might
only want to invest $10,000 in total towards commercial property. This is generally
impossible to achieve directly. However, within an indirect or pooled trust or managed
fund, you can achieve this aim. It is possible because the investment is unitized, and you
buy the amount of units you wish (similar to shares). Most trusts dont just own one
commercial property either. This means indirect property can provide additional
protection and diversification for the investor because an investor is not relying on just
one property to deliver all the returns. Hence risks such as vacancy risk and price falls
can be reduced by purchasing multiple properties. It helps to reduce risk further if the

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types of property are different (e.g. factory combined with retail), and the properties are
within different geographical regions.
Indirect Property Investments - Listed Property versus Unlisted Property
It is important to differentiate between listed property trusts (sometimes called an AREIT11) and unlisted property investments. Listed property trusts are traded on the
Australian Stock Exchange (ASX). They can be purchased and sold like any other share.
This is in contrast to an unlisted property trust with less liquidity, where it generally
takes longer to convert the underlying investment into cash.
If investing in unlisted property or property managed funds, it is important to
investigate the liquidity of the specific unlisted property trust or property managed fund
before investing. In many cases, the fund in question will allocate a minimum amount of
cash to support redemptions of existing unit holders. In most market conditions, and
assuming all investors dont rush for the exit gates at the same time, this strategies
works and provides sufficient liquidity for unit holders. However, the Global Financial
Crisis did expose unlisted property funds and some property managed funds for their
lack of liquidity, when a sharp increase in redemptions simultaneously occurred with
falls in commercial property values. Many investors in the Global Financial Crisis, (and in
some instances beyond that period) had their money frozen and were unable to redeem
their investment until the underlying property was sold or the fund recapitalized.
Pro Tips
Go to Appendix 2 to see how a fund manager (in this case AMP) explains investing
within their own indirect property offer. For more information, you can go to the
Product Disclosure Statement (PDS) that AMP provides on its property funds (or
alternatively choose another fund manager such as Macquarie, IOOF or MLC) by
googling - AMP property and then clicking on the PDS section.

11

AREIT stands for Australian Real Estate Investment Trusts

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WHAT ARE THE RISKS OF PROPERTY?

Property is a long term investment, and has higher risks than cash and fixed interest
investments but is considered a similar risk to shares. Having just said that, in comparing
the risks of property to shares, some argue it represents a higher risk, while others say
the risk is lower.
Liquidity Risk
One of the key risks inherent with investing in direct property is liquidity risk. Liquidity
risk refers to the assets ability to be turned into cash, and how quickly this can be
achieved. The easier and quicker an investment can be transformed into cash, the lower
the liquidity risk. Direct property is not divisible, so if an investor wants to turn their
property into cash quickly, they are forced to sell the entire property. The timeframe for
selling is often lengthy too. A sale contract must be drafted, a sale campaign
implemented by a real estate agent (generally), and settlement of the property after the
sale is executed if often 30 days or more.
This is in contrast to shares which are divisible. A portion of shares can be sold at any
time (as opposed to the whole portfolio). Assuming the shares are not penny dreadful
stocks that are 1 cent for example, or shares with a restricted shareholder base, shares
generally can be turned into cash easily, and quickly whereby the funds can be received
in cash within 4 days12.
Indirect property is similar to shares in that a portion of the portfolio can be sold
(liquidated), rather than the entire investment in the case of direct property. Indirect
investments are unitized, and therefore have similar characteristics to shares in terms of
divisibility. However, the time frame that a portion (or all) of an indirect property
investment can be turned into cash does vary quite significantly. A listed property trust
provides the most liquidity whereas an unlisted property trust provides the least, sitting
at the other end of the spectrum. Managed funds that provide property exposure
generally fit within the middle of the spectrum.

12

Industry jargon refers to settlement of shares transactions by describing it as T+3 (i.e. trade date plus 3 days) to receive

payment. The 3 days refers to business days too.

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Vacancy Risk
Property that is untenanted impacts an investors immediate return and is called
vacancy risk. An untenanted property (or a property with a perceived high vacancy risk)
can impact the underlying property price too. This is because potential investors will
weigh the relative desirability of a property without a tenant against other investment
opportunities and will factor that in to how much they are willing to pay for the
property. Many factors impact vacancy risk and include:
a) Demand and supply
b) Surrounding infrastructure
c) Proximity to amenities
d) Zoning
e) Demographics
f) Type of property
g) The economy
Gearing Risk
Often indirect property investments have borrowings within the trust structure. If the
borrowings represent, say, 50% of the trust, it means that the trust return will be
magnified (in both directions!). That is gains will be accelerated but losses will too. If
rental income does not cover the interest repayments on the borrowings, or interest
rates rise, the economics of the property trust may be compromised impacting liquidity
and/or the value of the investment (which is the capital risk discussed below).
Capital Risk
A number of factors can impact the price of a property (and hence capital returns). The
list below is not exhaustive and the factors will always have different weightings of
importance in different circumstances:
a) Location
b) Land size
c) Type of property on the land
d) Street

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e) Suburb
f) Local property market
g) Regional property market
h) National property market
i) Demand and supply (at all levels)
j) The economy (at all levels)
k) Demographics
The key to understanding capital risk when it comes to property is that generally, the
longer the time frame that you hold property, the lower the capital risk. The chance of
generating a negative return on a property investment that you hold for 1 year is much
higher than if you hold the investment for 15 years for example. This is because periods
of uncertainty and volatility are invariably followed by periods of optimism and positive
news (and vice versa). The age old adage its time in the market, not timing of the
market is as relevant to property as it is to shares. Having said that, in the Advanced
Diploma of Financial Planning, we will cover how to value property and shares so that
you can make an assessment as to whether it represents comparatively good value or
not so good value.

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IMPORTANT

You must now complete Part A of your Multiple Choice assessments

for Module 2.

A few tips:

You can access the Multiple Choice Questions at

monarch.mywisenet.com.au

Press Ctrl F if you want to search the pdf course materials for any
key words or terms.

You have 2 attempts. Please note, if you require a second attempt,

the answers are shuffled so read them carefully. The highest score
counts.

If you are unsuccessful after 2 attempts, please contact our office

on 1300 738 955.

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3.4

EQUITIES
Investing in the sharemarket allows investors to participate in the growth and future
profits of Australian and international businesses. But exactly what businesses can
investors own? It is possible to purchase shares in either private or public companies,
however it is generally only possible to purchase shares in publically listed companies on
stock exchanges. Many companies are listed on stock exchanges across varying different
industries. House brands such as Apple, Toyota, Telstra and Woolworths are all
examples of companies that are listed on stock exchanges, and which investors can own.
It is important to remember that not all companies (even large companies) choose to
become public and list on stock exchanges. However the benefit of buying shares in a
publicly listed company on a stock exchange is the increased liquidity.

THE SHAREMARKET
The sharemarket or stock exchange is a market in which buyers and sellers come
together to buy and sell shares. In Australia, the leading market for shares is the
Australian Securities Exchange (ASX), however there is a Bendigo Stock Exchange (BSX)
that allows smaller companies to offer their shares to be bought and sold too for
example. The ASX is made of up of close to 2,000 companies, and is the eighth largest
sharemarket in the world. It is also the second largest in the Asia-Pacific region behind
Japan.13

INITIAL PUBLIC OFFERINGS

Companies that choose to raise capital via an Initial Public Offering (IPO), become listed
on the stock exchange in the country they choose to raise the capital from. When an
Australian company raises capital in Australia from the public, they become listed on
the Australian Securities Exchange (ASX). Companies raise capital in order to grow either
organically or via acquisition. It also allows large foundation shareholders (often the

13

st

As per MSCI World weightings at 31 December 2010 Source Perpetual

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founders) to reduce their exposure (and raise money themselves). Famous IPOs in
Australia that increased the level of share ownership amongst the nation over the last
20 years were CBA, AMP, Telstra and Qantas.

HOW IS THE RETURN ON SHARES GENERATED?

Shares returns are generally two dimensional. Firstly they (may) pay dividends to
investors, and secondly the share price may appreciate over time offering the
opportunity of a capital gain. Of course the inverse must also be considered. That is,
there is also the possibility of a company choosing not to pay a dividend at any given
time. Furthermore, if an investor chooses to sell their shares, they may make (or
crystalize) a capital loss too!

A CONCEPTUAL OVERVIEW OF DIVIDENDS

Dividends represent a distribution of the companys profits to the owners
(shareholders). Not all the companys profits are paid out as dividends. The retained
profits that are not paid out as dividends, get re-invested back into the company. The
proportion of the profits paid out in dividends is called the dividend payout ratio. There
are a variety of purposes for re-investing profits and they include improving and
upgrading technology, upgrading supply chains, hiring new staff and introducing new
internal training, purchasing new plant and equipment, upgrading premises or
purchasing new premises, expanding marketing initiatives and the list goes on.
Some argue retained profit is the underlying reason for share price growth. However, it
is more complicated than just that. In simple terms, when a company re-invests their
profit to hire new staff or improves its technology, you could say it is positioning itself to
continue to increase revenue or decrease costs into the future. Ultimately it is an
attempt to continually improve efficiency which is a good thing. In the inter-connected
global economy we now live in, companies must compete (and protect their market
share) from domestic competitors but also international ones too. This future
proofing that companies undertake by re-investing a portion of their profits allows
them to (hopefully) grow their profits and hence their dividends to shareholders over
time.

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Commentators often describe dividends from shares as the income component of a

share investment. This is because dividends generally are paid by companies periodically
(half yearly or yearly) throughout the course of owning the shares. Dividends are not
fixed and are paid at the discretion of the companys board. Just because a company
paid a dividend last year, doesnt mean the company will continue to pay a dividend this
year. It often depends on the current economic environment and individual company
profitability. However companies generally have a dividend policy that they try to
adhere to, and sometimes use part of their retained profits from previous years, to
allow them to pay dividends even in poor (or loss making) years. In fact some companies
generally try to pay quite healthy dividends (often banks), whilst some companies
generally pay lower dividends (such as resources companies), and of course some
companies pay no dividends at all.
In Australia, some companies pay dividends from after-tax profits with a tax advantaged
status (known as franking). This allows investors to receive a credit (known as an
imputation credit) for the tax the company has already paid. This avoids unfair double
taxation.

WHAT ARE FRANKED DIVIDENDS?

A franked dividend is a distribution of after-tax profits to owners (shareholders). It
would be unfair if the company paid tax on those profits at the company rate (30%) and
then shareholders also had to pay tax again once they received the dividend,
theoretically at up to 45% + 1.5% Medicare Levy in the 2013/14 financial year)14. This
would result in the ATO taxing company profits twice once to the company, and again
in the hands of investors - totalling up to 76.5%! To avoid double taxation, the ATO
allows the company profits (once taxed) to be distributed with a tax credit (known as an
imputation or franking credit). Please note that franking credits are only available for
Australian residents for tax purposes.

14

st

Please note that from 1 July 2014, the Medicare Levy will increase to 2%.

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Franking credits from dividends can eliminate or reduce the tax you have to pay on your
superannuation earnings, including any capital gains your fund may receive15. If your
fund receives any franked dividends on Australian shares, then the 30% prepaid tax on
the dividends can be offset against any tax payable by the fund.
Super funds can credit the pre-paid tax against tax payable on fund income. A super
fund in pension phase pays no tax on any earnings funding a pension income, which
means the super fund can claim a tax refund for any imputation or franking credits.
How does it work?
Lets assume you earn $1,000 of dividends from CBA shares which are fully franked. To
recap, this means that CBA has already paid tax on the profits they have earned, and this
$1,000 dividend represents a distribution of the after-tax profit for CBA. In this instance,
to determine how much the imputation credit will be, and hence how much refund (or
tax offset) the fund would receive, the following formula is used:
Imputation Credit = Dividend X (Company Tax Rate16)/(1-Company Tax Rate)
The imputation credit

= $1,000 X (0.3)/(0.7)
= $428.57

Pro Tip:
In the example above, a super fund in pension phase would pay zero tax, and hence
receive a full refund of $428.57 (a bit like an additional return). If the super fund was in
accumulation phase, and assuming there was no other tax payable, the fund would still
receive a refund, however it would only be for half the amount, because the super fund
tax rate is 15% and the company tax rate is 30%. Please note, it is beyond the scope of
this course to explain how dividends are included in tax returns, and related concepts
such as grossing up dividends etc. Refer to www.ato.gov.au for more information.

15

Please note, franking credits can eliminate or reduce the tax payable for entities outside of super as well.

16

The company tax rate is 30%.

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THE 45 DAY RULE

For a superannuation fund (or any non-super investor) to be eligible for franking credits,
a fund or investor must hold company shares for at least 45 days (plus the day of
purchase and day of disposal) to be entitled to the franking credits.
Note, the 45-day rule doesnt apply where an individuals total franking credit
entitlements for the financial year are below $5,000. The $5,000 ceiling however doesnt
apply to managed funds because managed funds (including super and non-super) are
not natural persons.
Share Prices
Many investors purchase shares for the benefit of receiving dividends, but equally they
invest in shares for the potential capital gains. Some investors (known as traders) are
primarily focused on price movements to achieve short term profits.
But could you say that a $2 share of ABC is indicative of a superior company compared
to XYZ which is trading at $1 per share? The answer is no. In fact the total company
value and quality of XYZ may be much greater than ABC even though it is trading at half
the price. A share price alone doesnt provide enough information in its own right to
determine whether a company represents a sound investment or not so you need
more information. One of the key additional pieces of information required is the
number of shares on issue. This allows analysts or investors to determine the total
market value (known as total market capitalization) of the company. This is calculated
by multiplying the current share price by the total number of shares on issue. With this
information at hand, analysts and investors are better equipped to determine if the
share price represents a sound investment by comparing apples with apples such as
peer companies within the same industry and their relative performance indicators such
as profitability, balance sheet strength, growth prospects, market capitalization etc.
So what makes share prices move? Before we can answer that, it is important to
understand how a price is achieved and quoted on a stock exchange. Below is a
screenshot of Microsoft traded on the NASDAQ in the United States. The following is an
explanation of all the factors that influence and change a price.

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Bid/Ask
The bid/ask system is the mechanism for generating a share price on the stock
exchange. The bid price is what someone who is looking to buy the stock is currently
willing to pay. The ask price is what someone who currently owns the stock is willing to
sell for. A transaction and hence an agreed price for a companys shares can only be
executed after a willing bidder agrees to purchase the shares at the sellers asking
price, or alternatively a seller decides to reduce the price to the purchasers bidding
price.
The best way to understand how the bid/ask system works is to consider an everyday
transaction at a local bakery. Let us say you enter the bakery in the afternoon with 1
hour to closing time, and see that a loaf of bread is for sale for $3.00. You go to the
owner (given you know he probably wants to get rid of it that day) and say I'll give you
$2.50 for your loaf. The owner of the store is asking $3.00 to sell the loaf (his asking
price), and you are bidding to purchase it at $2.50 (your bid price). If the owner lowers
his asking price the sale will execute, or if the bidder (you) raises the bidding price to
$3.00 the sale will execute.
Of course, the stock market is made up of many more than two people bidding and
asking. The difference between the bid and ask price is known as the spread. The
greater the spread, the less liquid or easily traded a companys shares are considered.
Large blue chip stocks generally have a bid/ask spread of sometimes 1 or 2 cents only
and hence it is easy to sell the shares without impacting the price significantly. As you
can see above, the spread for Microsoft is $4.80 representing about 18% of the total
price between buyer and seller.
This spread is likely much greater than normal for Microsoft (on a normal trading day)
because the screen shot is taken after the market has closed. However it ultimately
depends on the demand and supply of shares for a given company on given day (and the
overall sharemarket sentiment) when determining how big a spread would be.

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Last Price
The last price is the price at which Microsoft last traded. It may also be accompanied
with last trade time, which tell you the time of day when the last trade occurred.
Previous Close
The previous close is what the last price of the stock was at the close of the previous
market day.
Open Price
The open price is the price of the stock at the open of the market day.
Change / % Change
The change tells you by how much a given stock's price has increased or decreased since
the market open.
Tick
The tick is usually shown as an up arrow, down arrow or hyphen, representing the last
trade on the stock was an increase in price from the previous trade, a decrease in price
or no change in price respectively.
High/Low
There are a few variants you will come across for highs and lows on a stock quote. The
most common being the 52 Week High and 52 Week Low, which shows the highest and
lowest price for a stock over the course of the past year. Some stock quotes also show
this value over the course of the current market day (Day's High, Day's Low).
Market Capitalisation
The market capitalization (discussed above) for Microsoft is $239 billion dollars. This is
calculated by multiplying the share price $26.25 by the total number of shares on issue
9.13 billion shares which equates to $239 billion dollars.
Volume
The number of shares traded on a day is known as the volume. Ultimately, if there are
more buyers compared with sellers on a given day, this will generally lead to the price
rising because sellers will only be convinced to sell if the price is bid up higher. Vice

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versa, if there are more sellers than buyers on a given day, this will lead to the price
falling because buyers will not be convinced to buy without being able to purchase the
shares at lower prices.
Market depth
The demand and supply for shares is also shown as market depth. Market depth (shown
below) shows all the registered buyers on the stock exchange at differing prices, and all
the registered sellers at different prices too. Below is a screen shot showing market
depth for Microsoft trading on the NASDAQ. Note, disregard the column (MPID) for the
purpose of this exercise, it relates to the market participants (brokers, market makers
etc.).
You can see the highest buy order, or bid is 100 shares at $26.23 followed by 9,192
shares at $26.22. On the other hand, you can see the lowest sell order, or ask price
offered is 2,667 shares at $26.23 followed by 8400 shares at $26.24. What will happen
now is that 100 shares will be executed immediately at $26.23 meaning the buyer will
be happy. Unfortunately, the seller has an unfilled order given the seller actually
wanted to sell 2,667 shares in total at $26.23. The seller can wait for a buyer to purchase
the remaining shares at $26.23, or alternatively choose to reduce the price to $26.22
and fill the order immediately given there is a registered buyer who will purchase 9,992
shares at $26.22.

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SHARES AND CAPITAL GROWTH

If investors are prepared to take a medium to long term perspective, an investment in
shares can increase in value over time offering capital growth. Capital growth is simply
an increase in total investment value due to the share price positively increasing.
Under normal market conditions, the movement in a companys share price reflects
changing expectations of growth prospects and profits. That is, earnings per share (or
profit per share) will influence a companys price per share.
Earnings (or profit) per share
Earnings per share ( which means profit per share) is calculated by dividing the
companys earnings by the total shares on issue. The measure to describe earnings is
generally NPAT (net profits after tax) however sometimes EBIT (earnings before interest
and tax) is used. These ratios will be addressed in more detail in the Advanced Diploma
of Financial Planning.
Shares: Income and growth explained
Shares have different characteristics some shares may provide more income, while
others may provide more growth. As the light blue line in the graph below
demonstrates, if you were to look at the wider ASX 200 Accumulation Index (top 200
companies listed on the ASX based on market capitalization), it shows that if you had
invested $10,000 on 1 July 1982, the value of your money would have increased to more
than $360,000 over the 30 years to 30 June 2013 assuming you re-invested the
dividends17.

17

Source: Vanguard https://static.vgcontent.info/crp/intl/auw/docs/.../index_chart.pdf?

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Growth of $10,000 invested 1 July 1982 June 2013

INVESTING IN SHARES FOR INCOME

Shares can provide capital growth, but did you know that they can also provide you with
a strong and steady income over the long term? They may also be tax-effective.
The income you receive from shares is in the form of dividends. Dividends can grow over
time as the capital value of your investment also grows. For example, if you invested
$10,000 in Westpac fifteen years ago, the income (or dividend) that you received in the
first year was $438. Over time, the share price of Westpac has risen, and so too has your
dividend income. At the end of 2012, your annual dividend income had grown to $1,691.

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A growing income stream

When it comes to an investment that pays regular income, you may think first of a term
deposit. Although a term deposit can provide regular income, its important to
remember that it doesnt offer any capital growth, so the income doesnt grow over
time as it does for shares.
Figure 6 shows the growth in the dividend component of distributions and the growth in
the capital value of the Perpetual Industrial Share Fund, compared to the interest and
capital value of term deposits over the past 20 years.
If you had invested $100,000 in the Fund at the end of December 1990, you would have
earned over $200,000 from tax-effective dividends by the end of December 2010, while
the value of your investment would have increased around 5 times. However, if you had
invested in term deposits they would have earned around $111,000 in interest and the
value of your investment would have stayed the same.18

18

Source: Perpetual: http://www.perpetual.com.au/pdf/28987_Real_value_Shares-WL.pdf

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The best of both worlds

Clearly, the total income and capital gain earned from the Perpetual Industrial Share
Fund over the period far exceeds the total income and capital gain earned from term
deposits, even though the initial investment was the same19.

SHARES CAN BE VOLATILE DONT PANIC

The Australian sharemarket fluctuates every day, because every day thousands of
buyers and sellers of shares trade them. Sometimes, specific events will cause the value
of certain shares to rise or fall. You may remember some positive events that caused the
sharemarket to rise (e.g. tech boom, resources boom). You might also remember some
negative events that caused it to fall (Asian financial crisis, Tech Wreck and global

19

ibid

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financial crisis). But overall, the value of the Australian sharemarket has risen
substantially over time20.
Historically, markets have always recovered
The Australian sharemarket began trading in 1875. It has delivered positive annual
returns in 97 out of 135 years. This is 72% of the years. Of these positive returns, most
were between 0% and 20% pa (Figure 10).
There are, of course, years when the sharemarket has delivered extraordinary positives
(over 40%) or negatives (under -40%). But its important to remember that these results
are rare.
While the swings in the market might look extreme over one year, they are less
pronounced over the long term. Traditionally sharemarkets have recovered from shortterm setbacks with significantly higher gains21.

20

Source: Perpetual: http://www.perpetual.com.au/pdf/28987_Real_value_Shares-WL.pdf

21

ibid

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4.0

PERFORMANCE OF ASSET CLASSES

Within the four investment classes listed at the beginning of this module, further
subcategories can be made. For example, shares can be classified as Australian or
International. Property can be listed or unlisted.
Of the four asset classes:
cash is the least risky (as defined by volatility in returns) and in theory generates the
lowest returns in the long term
fixed interest is slightly riskier, and generates greater returns than cash
property is riskier again and in theory generates higher returns than either cash or
fixed interest
shares are arguably the riskiest of the asset classes with strong returns in some years
and significant declines in others. For Australian investors, Australian and
international shares have been the most volatile asset classes, experiencing best
performance and worst performance more often than property, cash or bonds.
Table 2b looks at the performance of each asset class over the period 1993-2012. The
shaded area signifies the asset class which was the best performer for the year.
Table 2b: Assets class performances, 1993-2012
Australian

Listed

International

Australian

shares

property

shares

bonds

Dec-93

45%

30%

24%

16%

5%

Dec-94

-9%

-6%

-8%

-5%

5%

Dec-95

20%

13%

27%

19%

8%

Dec-96

15%

14%

7%

12%

8%

Dec-97

12%

20%

42%

12%

6%

Dec-98

12%

18%

33%

10%

5%

Dec-99

16%

-5%

18%

-1%

5%

Dec-00

4%

18%

2%

12%

6%

Dec-01

10%

15%

-10%

5%

5%

Dec-02

-8%

12%

-27%

9%

5%

Dec-03

16%

9%

-0%

3%

5%

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Cash

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Australian

Listed

International

Australian

Cash

shares

property

shares

bonds

Dec-04

28%

32%

10%

7%

6%

Dec-05

21%

13%

17%

6%

6%

Dec-06

25%

34%

12%

3%

6%

Dec-07

18%

-8%

-2%

3%

7%

Dec-08

-40%

-55%

-24%

15%

8%

Dec-09

40%

10%

0%

2%

3%

Dec-10

3%

-1%

-2%

6%

5%

Dec-11

-11%

-2%

-5%

11%

5%

Dec-12

19%

33%

14%

8%

4%

Average annual

10%

7%

5%

8%

6%

20 year return
Source: https://www.vanguardinvestments.com.au/adviser/adv/research-and-education/tools/index/IndexChart.jsp

REVIEW
a) Which asset class performed best in any one year as indicated in Table above from
1993 to 2012?
b) Which asset class performed worst in any one year?
c) In which years was cash the best performing asset class?
d) In which years was fixed interest the best performing asset class?
e) In which years was property the best performing asset class?
f) In which years were shares the best performing asset class?
g) What was the most volatile asset sector?

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WEIGHTED RETURNS ON INVESTMENT PORTFOLIOS

Most investment portfolios do not invest in one specific investment or asset class.
For example, a share portfolio may contain 15 shares or someone may invest their
wealth into a portfolio of 5 different managed funds or possibly invest some funds in
cash and the residual in shares or funds. Each component of the portfolio (e.g. each
share, managed fund or cash) may perform differently over time and the investor
may invest different amounts of money in each investment component.
Consider the following example portfolio:
Investment

Amount Invested

Return over Year 1

$5,000 (5%)

3%

Share A

$10,000 (10%)

-5%

Share B

$15,000 (15%)

20%

Managed Fund A

$30,000 (30%)

12%

Managed Fund B

$40,000 (40%)

7%

$100,000 (100%)

9.05%

Cash Account

Total

As shown above, each investment in the portfolio performed differently. How can we
work out how the total portfolio performed? This is not as simple as obtaining the
average of each investments return as the importance on the portfolio of each
investment differs based on how significant the allocation to that particular
investment represents. For example, more emphasis should be placed on the
performance of Managed Fund A which has $30,000 invested (30% of the portfolio)
than Share A which has only $10,000 invested (10% of the portfolio).
The concept of weighted return is that a portfolios return is weighted by
importance based on the size of each investment out of the total portfolio with
consideration being provided for each investments returns over the period.
Weighted return is determined by the sum of each investments percentage
allocation multiplied by those investments returns.

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In the above example, the weighted return is calculated as follows:

(5% * 3%) + (10% * -5%) + (15% * 20%) + (30% * 12%) + (40% * 7%) = 9.05%
Another way of interpreting this figure is that the total return for the $100,000
portfolio was 9.05% (or $9,050) over the first year, as shown below:

Amount Invested
$5,000
$10,000
$15,000
$30,000
$40,000
$100,000

4.1

Return over Year 1 (%)

3%
-5%
20%
12%
7%
9.05%

Return over Year 1 ($)

$150
-$500
$3,000
$3,600
$2,800
$9,050

TIMING THE MARKET

If financial planners were able to 'time' the market, they would of course be able to
advise their clients when it was best to have a large proportion of investments in cash,
fixed interest, property or shares. The problem is that it is exceedingly difficult to know
when different asset classes are going to perform well and when they are going to
underperform.
In the Table above it was evident that last years best performing asset class can easily
become next years worst.
In the following example we can see what happens to an investment of $100,000 if the
investor chases the winning asset class of the previous 12 months.
Use the Table (below) to trace the figures for the 20 year period in the example.
Example 2.1
An investor invests $100,000 over a 20 year period from December 1990 to December
2010. Each year, the investor invests the money in the best performing asset class of
the previous 12 months. Whilst not shown in the table below, the best performing asset
class in 1990 was Australian bonds. Therefore, in December 1990, the sum of $100,000

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was invested in Australian bonds, that being the best performing asset class of the
previous 12 months.
At the end of 1991, the investor withdrew the money, now worth $125,000, and
invested it in the best performing asset class of that year, e.g. Australian shares. At the
end of 1992, the investor withdrew the money, now worth $122,500, and invested it in
the best performing asset class of that year, i.e. Australian bonds, and so on.
Using this strategy, after 20 years, the $100,000 investment would then be worth
$394,377. This represents an average 7.1% pa return. These figures exclude any tax and
transaction costs.

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Investing $100,000 in the previous years best performing asset class

Australian
Dec 90

bonds

Listed
$100,000

Dec 01

Australian
Dec 91

shares

bonds

$125,000

Dec 02

shares

property

$345,073

Australian
$122,500

Dec 03

Australian
Dec 93

$308,101

Listed

Australian
Dec 92

property

shares

$376,129

Listed
$142,100

Dec 04

property

$481,446

Australian
Dec 94

Cash

$129,311

Dec 05

International
Dec 95

shares

shares

$139,656

Dec 06

shares

$149,432

Dec 07

shares

$680,042

shares

$625,638

Australian
$167,364

Dec 08

International
Dec 98

property
Australian

International
Dec 97

$544,033

Listed

Australian
Dec 96

shares

bonds

$375,383

Australian
$222,594

Dec 09

International

shares

$382,891

Australian

Dec 99

shares

$262,660

Dec 10

bonds

$394,377

Dec 00

Listed property

$267,914

Average annual 20 year return 7.1%

Source: Data Stream & Perpetual Investments

Instead of chasing last years best performing asset class, a more sensible strategy is to
invest in a range of asset classes and not to panic if one particular market fails. The
principles of market timing are particularly applicable to share investments. Australian
and international shares have been the most volatile asset classes, experiencing best
performance and worst performance more often than property, cash or bonds. Trying to
time when these markets are at a high point or low point is virtually impossible.

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A balanced approach
Managed funds will be discussed in detail later in this module, however just to make a
point here, the Table below shows you an example of how three different balanced
funds allocate their investments across a range of asset classes.

Australian

Listed

International

Fixed

Shares

property

shares

interest

Cash

Other

(Bonds)
BT Multi-manager

33%

6%

24%

15%

10%

12%

22%

10%

18%

35%

5%

10%

32%

6%

28%

10%

8%

16%

Balanced Fund
United Capital
Balanced Fund
Perpetual Balanced
Growth Fund

Had you invested your $100,000 in December 1990 and held any of these balanced
funds until December 2010, you would have earned a return that was higher than
investing in (chasing the winner of) the previous years best performing asset class.
If we assume the other category for each of these funds is equally split between
Australian shares, listed property, international shares, fixed interest and cash, the
returns would have been as follows:

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Average annual

Value at Dec 2010*

20 year return*
BT Multi-manager Balanced Fund

7.82%

$450,803

United Capital Balanced Fund

7.72%

$442,514

Perpetual Balanced Growth Fund

7.68%

$439,239

* These specific funds were not necessarily available in 1990. A balanced fund from 1990 that maintained that same asset
allocation over the 20 year period described in these actual funds would have provided these results.

Refer to Appendix 3 to see the fact sheets for these three balanced funds. As you will
see, they all have a slightly different asset allocation, but equally they have all beaten a
strategy of chasing last years best performing asset class, and in many years have taken
less risk. There is another hidden benefit in maintaining a longer term investment
strategy requiring lower switching (turnover). This benefit relates to lowering taxation
leakage, and transaction costs.

4.2

PUTTING PERFORMANCE INTO PERSPECTIVE

Clients seem to be very performance focussed. Its a natural desire to make as much
money as one can. As an adviser, you need to be able to communicate why a certain
investment strategy you are recommending is likely to be most suitable for their needs.
In relation to performance, clients will often ask you why you have recommended a
particular asset allocation and you need to give them a credible explanation.
So what are some of the issues you need to explain to clients? It is always advisable to
provide factual information to clients to support any recommendation. Your opinion on
the share market is largely irrelevant, but the facts about share market performance
over time are very relevant. Its an educational journey, along which you will often take
your clients!

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The following facts have been sourced from BT Funds Management22:

Over the last 50 years, one year returns from the Australian share market have ranged
from negative 39% to positive 45% - thats quite a range.
If youd invested your money for one year during that period, youd have had a one in
four chance of making a loss (or depending on how you look at it, a three in four chance
of making a gain).
But if you had invested for any ten year period over those 50 years, youd have avoided
a negative return, and always made a profit an average annual return of 12.7%.
So is it better to grow your wealth by investing in shares, or by putting your money into
cash? History shows a diversified portfolio of Australian shares can generate far stronger
returns than a cash investment as much as 80% more since 1990.
A quick look at the numbers shows that when it comes to long term returns, shares are a
clear front runner over cash.
Investing is a long term process. Even a retiree aged in their sixties cant afford to
overlook the fact they could live for another 20, even 30 years, making a long term
outlook essential.
But too often we fail to match our long term outlook with a long term investment. And
its an oversight that can cost you dearly.
Cash security equals low returns
Cash, for instance, is an excellent short term investment. Youll earn a known return and
your capital is very secure. Deposit a dollar today, and chances are a dollar will still be
there in one, two even ten years time.
The trouble is, this sort of security comes at a price. With such a low level of risk
involved, cash investors also earn a low return. Thats not an issue over short periods.
But it becomes a snowballing problem over longer periods, and it means cash investors
are denying themselves far bigger returns.

22

Source: When is the right time to invest? BT July 2011 http://www.bt.com.au/bt-market-insights/bt-latest-

updates/2011/07-july/when_is_the_right_time_to_invest.asp

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Over time the difference is significant

To see how this is the case, lets say an investor deposits $100,000 into cash at the start
of 1990. Assuming our investor reinvests any interest earnings, by the end of December
2010 that same investment could have grown to around $376,000.
However if our investor had invested the same $100,000 in a diversified portfolio of
Australian shares in 1990, over the two decades since that initial investment would have
grown to around $679,000.
The difference of $302,000 is extraordinary more so because the time frame spans the
Global Financial Crisis, a period that saw the Australian share market drop by 39%.
Its hard to imagine an investor saying no thanks to an extra $302,000. But thats
exactly what happens when cash rather than shares dominates a long term portfolio.
Valuable capital growth
The reason shares generate a far healthier return over time is simple. Shares provide
ongoing dividend income plus valuable capital growth. Put your money in cash on the
other hand, and your money will only earn interest typically at a low rate.
As weve seen in recent years, shares can swing in value over short periods, sometimes
dramatically. This is why shares are regarded as a long term asset. Indeed, the longer
the investment period, the greater the chance of enjoying strong returns on shares. As a
guide, over investment periods of ten years the Australian share market has never
23

returned a negative result.

23

Ibid.

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4.3

DOLLAR COST AVERAGING

OVERCOMING 'TIMING THE MARKET' PROBLEMS

Some managed investments enable investors to contribute regular amounts to the
funds which is much cheaper (especially for small amounts) than paying share
brokerage. Say for example an investor wanted to invest $100 per month of savings into
shares, online brokerage is around $16 as a minimum per transaction representing a
16% (minimum) entry cost to the investor. In contrast, a managed fund can either offer
a smaller entry cost (of say up to 3%) but some funds waive the entry fee entirely. This
facility encourages investors to save on a regular basis. The price of the units in
managed investments fluctuates to a lesser degree than share prices but nonetheless
they do fluctuate. If they had perfect foresight, investors would elect to buy units when
the unit prices were at their lowest and sell when the unit prices were at their highest.
This is of course unlikely. The inability of investors to perfectly 'time' the market means
that investing large sums at a given point in time may prove to be less than optimal.
One of the advantages of contributing regular amounts to a managed fund is that the
difficulty of 'timing the market' is overcome. Investors can benefit by what is termed
dollar cost averaging.

WHAT IS DOLLAR COST AVERAGING?

Dollar cost averaging relies on the idea that if regular amounts are invested, more units can
be purchased when the price is low and fewer units can be purchased when the price is high.
The effect of this strategy is that on average, investors will be acquiring units at a lower
average price and will therefore generate higher returns. Consider the following figures:

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Month

Investment amount

Unit price

Number of units

$200

$10

20

$200

$8

25

$200

$5

40

$200

$8

25

$200

$10

20

Total

$1000

130 units

Looking at the table above, you can see that each month $200 is invested. The number
of units that an investor can buy depends on the unit price at the time of purchase. In
month one for example, the unit price is $10 so a $200 investment will enable the
investor to purchase 20 units. In month two, the same $200 investment can buy 25 units
because the unit price has fallen, so the investor naturally can buy more. In total the
investor has spent $1,000 and over the 5 month period has acquired 130 units.

REVIEW
What is the average unit price over the five months? (hint: its the total investment
divided by the number of units)
Would have you been better off had you invested your entire $1,000 in month 1, and
held it for 5 months?
How much profit have you made from using dollar cost averaging?

DOES DOLLAR COST AVERAGING ALWAYS WORK?

In the example above, dollar cost averaging clearly was advantageous for the investor.
What would have happened however if unit prices didnt fall then recover, but rather,
rose and then fell again as in the table below? What you can see is that dollar cost
averaging would have been detrimental in this instance compared to investing the
entire $1,000 either at month 1 or in month 5.

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Month

Investment amount

Unit price

Number of units

$200

$10

20

$200

$12.5

16

$200

$20

10

$200

$12.5

16

$200

$10

20

Total

$1000

82 units

So the question is, if dollar cost averaging only works when share prices fall and then
recover, why is it such a commonly used strategy in financial planning? The reason is
because in general, the long term trend (over say 7-10 years) for shares is an upward.
Whilst shares are volatile and do rise and fall and then rise and fall again, because the
general trend is upward, dollar cost averaging benefits investors over the long term
because purchasing at cheaper price, inevitably over time will translate to those prices
recovering. This is best shown in the following example.
Example
Examine the graphs on the following page. The example considers what would happen
in 2 different market scenarios, to a strategy based on investing $1000 each month for
10 years, regardless of market conditions at the time. (The market can apply to any
asset class or individual assets.)
Scenario 1 shows a steadily increasing market, where unit prices start at $5 per unit and
rise to $10 per unit at the end of the 10 years, giving a compound growth rate of about
7% per year. The investor will, by the end of the decade, have a portfolio worth
$172,500. This amount represents a 43% gain on the $120,000 invested. The
explanation lies in the fact that on the downward plunges the price per unit is lower, so
that the investors $1,000 buys more units that month.
Scenario 2 shows a market that has the same long-term upward trend, but is highly
volatile in the short term. Unit prices start once again at $5 per unit, but collapse to $3
in the first year. They then fluctuate up and down, finishing at $10 at the end of the
decade. Unlikely though it may seem, the volatility significantly improves the

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performance of the portfolio which, at the end of the period, will be worth $220,620: an
83% gain on the $120,000 invested.

Fluctuating Unit Prices

11.0
10.0

Unit Price ($)

9.0
8.0
7.0
6.0
5.0
4.0
3.0
0

Year

Figure 2.b: Example of dollar cost averaging

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APPLYING DOLLAR COST AVERAGING TO WITHDRAWAL OF FUNDS

Dollar cost averaging can work in the same way if the investor wished to withdraw
funds. Investors can average in or average out - this would reduce the investors
exposure to an untimely sudden downturn in the markets.
This is an issue particularly for retirees when they stop working and require income from
their investments to fund their day to day lifestyle needs. Often a retirees retirement
capital doesnt generate enough income in its entirety to meet their needs. This means a
retiree is forced to take a combination of investment income plus some of their
underlying capital to meet their day to day lifestyle needs. Dollar cost averaging in this
instance is applied in reverse whereby the retiree is better off taking small amounts of
capital out at different unit prices, rather than trying to guess the best time.

4.4

INVESTMENT RISK

WHAT DO WE MEAN BY THE TERM 'RISK'?

Some of the more common definitions of risk are:
a) the chance of loss of capital
b) the chance of loss of purchasing power
c) the variability of the returns associated with the given asset

Return is the total gain or loss experienced by the owner of a financial asset or
investment over a given period of time.
Chance of loss
The first definition of risk, the chance of loss of capital, varies for different asset classes.
In the past 25 years, a cash investment has always resulted in a positive return to
investors albeit small in some years. There has been no chance of loss of value. Having
said this, it is also of interest to note that investments in cash do not always generate a
return which maintains its purchasing power. This occurs when the returns are not

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greater than inflation - the second definition of risk. Consequently, an investment in

cash may result in a negative real return.
Investments in shares can result, and have resulted, in a loss of value over some time
periods. Shares are therefore considered to be riskier than investments in cash. Share
investments, whilst generating negative returns over some time periods, have a
decreasing likelihood of negative returns as the time period increases. That is, as the
length of time for the investment increased, the chance of a loss of capital for share
investments decreased.
What about share investments and inflation?
Compared with cash investments, shares have a greater probability of generating
returns that beat inflation, i.e. maintaining their purchasing power. Whilst an
investment may produce positive returns in nominal terms (before consideration of
inflation), if inflation exceeds the nominal return, the investor will experience a loss of
purchasing power, i.e. negative real returns (i.e. negative returns after consideration of
inflation). For example, if a cash account generates a return of 3% nominal return) but
inflation is 5%, the investors real return after inflation is actually negative 2% as fewer
funds would be available for the investor when the proceeds are discounted back to
todays dollars basis.
Variability of returns
The third definition of risk refers to the variability of returns. That is, the risk that the
actual returns will be different to those that we expect. For example, if the average
return for Australian shares since 1990 has been 11.0% p.a. (before tax), we might
expect that next years return on Australian shares is also 11.0%. The actual return
might however turn out to be quite different to 11.0%. It might be a little higher, much
higher, a little lower or much lower than the average 11.0%. The extent of the
difference between that actual return and the average return is what we describe as the
variability of the returns. We will look at this definition of risk in detail in the Advanced
Diploma of Financial Planning where we address portfolio construction in detail.

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OTHER FORMS OF RISK

We have looked briefly at three commonly used measures of risk. They are:
a) loss of capital value (market risk)
b) loss of purchasing power (inflation risk)
c) actual returns are different to expected returns (variability or volatility of returns)

There are a number of other important definitions of risk that investors should be aware
of before they undertake an investment strategy. These types of risk include:
risk of not diversifying: the possibility that if the client puts all of their investment
capital into one basket, e.g. the share market, a fall in that market will adversely affect
all of their capital. Diversification is a deliberate strategy aimed at reducing the impact
that volatility in one asset class, sector or single product will have on the overall
portfolio of assets.
re-investment risk: the possibility that if a client invests in a fixed rate investment, e.g.
bonds, the client may have to re-invest maturing money at a lower rate of interest if
rates generally decline during the life of that investment.
liquidity risk: the possibility that the client may not be able to readily access their funds
when they want or need them most, because they are invested in illiquid assets, e.g.
real estate.
credit risk: the possibility that an institution holding the capital, e.g. a debenture issuer,
may fail to pay interest or return that capital.
regulatory risk: the possibility of government policy changes, negatively affecting the
financial strategy, e.g. changes to the treatment of Capital Gains Tax.
timing risk: the possibility that a strategy of trying to time entry and exit of markets will
expose the client to greater short term volatility.
value risk: the possibility that the client will pay too much for a particular product or
that it will be sold too cheaply.
manager risk: the possibility that the client will invest in a fund manager based primarily
on their recent past performance, without regard to their fundamental ability to cater to

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the particular needs of the client or performance expectations over the time frame in
mind.
currency risk: the possibility that investments held in other countries may rise or fall in
value compared to the value of the currency held relative to the domestic currency.
This risk can be minimised by hedging foreign currency exposure by the use of
derivatives which can reduce the impact of exchange rate movements on the underlying
portfolio return. For example, an unhedged international share funds returns would
comprise the underlying investments performances plus or minus any exchange rate
movements of the underlying investments compared to the portfolios currency.
However, a portfolio which is hedged will negate much of the exchange rate risk (in
either positive or negative directions) so that the returns will approximate the
underlying investments performances less any fees associated with hedging. The actual
methods which fund managers use to hedge this risk are beyond the scope of this
course.

REVIEW
Your client, aged 46 years, is very cautious about any investment in shares. Your client
knows that some investors have lost money in share investments. However, because of
a need to accumulate sufficient funds for retirement, your client is considering an
investment in shares.
What evidence can you provide to help allay your client's concerns about the risk
associated with share investments and to justify the decision to invest in shares?

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5.0

DIVERSIFICATION

5.1

PORTFOLIO CHOICES
In portfolio theory, investors are not rewarded for having investments which are not
fully diversified. Consequently, having some funds in each of the asset classes may be
appropriate. This is called diversification: not putting all your eggs in one basket. We
look at the implications of this in detail within the Advanced Diploma of Financial
Planning.
The extent to which a client is willing to diversify will depend in part upon the client's
risk profile or risk attributes which we discussed in module 1.

DIRECT INVESTMENT
The four main asset classes in which investors could place their funds are cash, fixed
interest, property and shares. In each of the asset classes, the investment can be direct
or indirect. A direct investment may involve the investor placing money in a cash
deposit in their own name or joint names, purchasing a fixed interest bond in their own
name or joint names, buying a property site or purchasing specific shares in their name
or joint names.
Problems with direct investments mainly relate to the limitation of adequate funds to
achieve adequate diversification. They include the following:
Within Asset class
If the amount of funds is limited, the investor may be restricted in the amount of
diversification that can be obtained through direct investment within an asset class.
For example, it is unusual for an investor to have sufficient capital on hand to be able to
invest in a number of properties, let alone the option of investing in each of the
property classes: residential, commercial, and industrial. And of course within
commercial, there are further opportunities to diversify e.g. office, retail and
supermarkets etc.

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Geographical diversification
Often due to limited funds or the inability to practically access investment opportunities
overseas, investors will not be able to adequately diversify their investments
geographically. For example if an investor wanted to invest in a large successful IT
related company listed on the Australian Stock Exchange (ASX), few options would exist.
Most IT brands that Australians use such as Apple, Dell or Microsoft etc. are listed on
overseas stock exchanges. In order to diversify investment across key IT companies,
ultimately an investor would probably require overseas exposure to invest in the
companies mentioned.
An alternative to direct investments is to use indirect investments or managed
investments.

MANAGED INVESTMENTS
In managed investments, individual investors pool their funds with other investors into a
professionally managed fund from which investments are purchased, dependent on the
nature and objectives of the fund.
As a result of pooling funds with other people, an investor holds a proportionate
amount of the pool according to the amount of the investment. As a result, the investor
receives a proportionate share of income and/or capital growth. The investor does not
own any particular asset within the managed investment but rather owns units in the
managed investment. These units determine the proportion of the income or capital
growth to which the investor is entitled. The managed investment is overseen by a
trustee who is responsible for abiding by the conditions set out in the trust deed. For
these reasons, managed investments are sometimes referred to as managed funds or
simply unit trusts.

ADVANTAGES OF MANAGED INVESTMENTS

Managed investments have many benefits for investors. They include:
professional investment management: effective management of any investment
portfolio is a complex and time consuming task. Individual investors find it increasingly
difficult to keep up with the rapidly changing investment market. Most managed funds

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are run by skilled professionals in a competitive market and should be able to provide
better results than unskilled individuals
diversification: there is a wide choice of managed funds with a broad range of products
across the asset classes. This provides diversification for a small investment. The
managed funds themselves spread their investment so that diversification is increased
still further. This can spread the risk and provide a reasonable return
ready access to funds: managed funds offer buy back facilities which can offer cash
usually at very short notice. Thus the investor does not have to find a buyer to cash in
the investment.
reduced paperwork: fund managers do an enormous amount of paperwork for the
investor. Administrators of managed funds process all the complex factors associated
with share markets; taking up bonus and rights issues, share splits, subscribing to floats
and placements, participating in dividend reinvestment plans and processing dividends.
Therefore the decision to use managed funds or not for share market investing is driven
by the convenience factor; a fund manager makes it easier for investors to diversify their
investments
better time management: for many people, time is their most valuable asset. When an
investor buys into a share fund, they are paying for time and expertise of an investment
professional - the investor is making the implicit decision that they do not want to be
involved in the fine detail of buying and selling shares; that is the fund managers job
access to institutional offers: frequently, placements of discounted shares and new
share floats are offered to institutional investors only, with retail investors almost totally
excluded. Managed investments have access to these shares
depths of research coverage fund managers will typically draw on research from a wide
range of areas including stockbroking and investment banking analysts. They will also
employ their own analysts who filter the information into broader parameters for
buying or selling companies within their portfolio.

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FUND MANAGERS
The dilemma faced by clients and financial advisers is that investors have a choice of
thousands of managed funds, and hundreds of fund managers. How do you choose
between them? As with diversification across asset classes, it is also important to
diversify across fund managers. This is because different fund managers have very
different investment management styles. History tells us that no one particular style
will consistently outperform all others, during every phase of the economic cycle.
The main investment styles (although not exhaustive) are summarised in Diagram 2a.
Diagram 2a: Investment management styles

Investment management styles

PASSIVE

ACTIVE

Technical

Fundamental

Contrarian

Value
investing

Top-down
(macro)

Bottom-up
(micro)

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Quantitative

Growth
investing

Top-down
(macro)

Bottom-up
(micro)

63

INVESTMENT STYLES DEFINED

The investment styles listed in Diagram 2a can be defined as follows:
passive / index: this is an investment style that seeks to attain the performance equal to
the market or index, e.g. All Ordinaries. Passive management may use either index
funds (where no judgments are made about future market movements) or enhanced
index funds where the portfolio may be tilted to favour certain sectors, e.g. a resources
index.
active: an investment style where the fund managers vary their strategy depending
upon current and envisaged market conditions. The investments are reviewed on a
regular basis so that the manager can be in position to benefit from movements in the
market or from growth on the individual investments. There are two major components
to active management. They are asset allocation and stock selection. Asset allocation
requires decisions as to the proportion of funds to be placed in the different asset
classes. Stock selection requires decisions as to which specific shares to hold within the
equities (shares) asset class
fundamental: this style evaluates stocks with a view to determining mispriced stocks
which represent attractive investment opportunities
quantitative: this seeks to use statistical or numerical methods to offset efficient
portfolios with the optimum risk /return trade off
technical: the study of price and volume data with a view to predicting future market
behaviour
contrarian: these are managers who bet against popular investment trends
value: this is the term for an investment style that seeks to buy assets when they are
underpriced and take profits when they are fully priced. The value manager focuses on
the quality of the income from the investment to determine if the price is fair value.
The manager can use a 'top-down' - broad view of the world economic thematic
approach individual asset classes individual stocks: or a 'bottom-up' approach
which focuses only on individual stocks and is not as concerned with economic themes.
growth: this is an investment style that chooses stocks primarily on the basis of an
expected high level of earnings growth. Income streams are not as important, as the
emphasis is more on capital growth potential.

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Again the fund managers can concentrate on either a 'top down' or 'bottom up'
approach.
The above outline of styles shows that a wide range of approaches can be taken, and
some managers proclaim that they fit outside of this spectrum. For example Hedge Fund
managers focus on the universe of investment opportunities with a focus on total
returns. Hedge Funds are also called alternative investments and will be discussed in
more detail in the Advanced Diploma of Financial Planning.
It is always important to ensure that the recommended fund managers are carefully
chosen to ensure that they have styles which complement the client's goals and overall
profile.

TYPES OF MANAGED FUNDS

Managed funds are also termed 'managed investments' or 'unit trusts'. They can be
listed or unlisted unit trusts, managed retail funds, managed wholesale funds or index
funds.
Listed versus unlisted unit trusts
A listed unit trust is listed on the Australian Stock Exchange and the units can be traded
at the market price. This price is in turn determined by both the value of the underlying
assets and the general sentiment or mood of the market.
An example is of a listed unit trust is Argo Investments. You can refer to their website for
more information at http://www.argoinvestments.com.au/
Unlisted unit trusts are not listed on the stock exchange. Their value is determined
solely by the value of the underlying assets. Units can be bought and sold through the
fund manager who in general is obliged to repurchase any units if an investor wishes to
sell them.
You can find examples of unlisted unit trusts by googling any fund manager such as
Colonial First State, Macquarie or AXA.

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Unit trust fees

Unit trusts involve the following categories of fees:
a) entry fees
b) exit fees
c) asset management fees (often called Management Expense Ratios MER)
d) platform fees
e) administration fees
f) auditing fees
g) switching fees.
The fees that apply to unit trusts vary from fund to fund. The fee itself may be
dependent on the underlying assets. For example, an international fund will have higher
fees than a cash management trust because of the additional costs associated with
managing exchange rates, and the research and complexity associated with purchasing
overseas investments.
Tax implications
The tax liability for income distribution from a unit trust is the responsibility of the unit
holder, regardless of whether or not the income is reinvested. The trust itself pays no
tax unless it fails to distribute all income.
Any income received by the investor is assessable income and taxed at the investors
marginal tax rate. Any capital gains made upon sale of the units will be liable for Capital
Gains Tax (CGT).
If the investor makes (or crystallizes) a capital loss upon sale of the units, this capital loss
can be offset against any capital gains.
Most unit trusts accept both lump sums and regular deposits. Consequently, they can
be appropriate for clients with large sums to invest or clients who wish to commence a
savings program.

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MANAGED RETAIL FUNDS

This is the most common form of managed fund for smaller investors. These funds may
have entry fees based on a small percentage of the initial investment. Once an entry fee
is paid, there are generally no exit costs. The establishment costs generally compare
favourably with alternatives such as purchasing a direct property.
Whilst the fund manager can save considerable time and paperwork for the individual
investor, for larger sums it is prudent to consider using more than one manager. This
creates more paperwork which in turn can be overcome by investing via an
administrative platform called a Master Trust or Wrap. Master Trusts and Wraps are
generally offered to investors that choose to retain the services of a licensed financial
planner, and the underlying managed funds are wholesale (see below).

MANAGED WHOLESALE FUNDS MASTERTRUST OR WRAP

These funds are identical to their retail cousins. It is difficult to access wholesale funds
unless an investor has a lump sum of $100,000 or greater, or alternatively retains the
services of a financial adviser that accesses the wholesale funds via a Master Trust or
Wrap platform.
Master Trusts and Wraps are administrative platforms that enable individual investors
to channel money into one or more underlying wholesale managed investments
operated by professional investment managers. This means that a client can invest with
a number of different fund managers and different funds on the one application form
and receive one statement consolidating all their investments. This simplifies tax
reporting, allows investors to switch between managers and/or funds seamlessly
(generally without incurring additional entry or exit fees), and allows online access (just
like online banking) to view account balances and portfolio returns.
A Mastertrust or wrap allows the investor to:
a) use a range of fund managers
b) buy or sell direct Australian shares
c) transfer existing direct shares onto the platform (in-specie without tax implications)
d) switch between funds and/or managers

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e) have access to competitive wholesale fund pricing

f) pay their financial planner directly from the Master Trust or Wrap
g) invest smaller sums into each fund manager
h) receive consolidated reporting and tax accounting for all of the underlying funds.
A disadvantage to using a Mastertrust or Wraps is that there is an additional
administrative fee for this service. The fee varies across different Mastertrusts and
Wraps and depends on the amount invested by an investor. However, in general it is in
the order of 0.5- 1.2% pa. The ongoing fees for the individual fund managers within the
Mastertrust or Wrap are additional to this. Whilst they are wholesale fund fees, they
could range between 0.27% - 2% depending on the fund type and manager.
There is little difference between Master Trusts and Wraps, apart from the legal
framework for how the underlying assets are owned. From the end-investors point of
view, there is in effect no difference.

CONSISTENCY OF FUND MANAGER PERFORMANCE

We have said that investors can choose between thousands of managed funds and
probably hundreds of fund managers. Of these fund managers, many of the prominent
or 'big name' managers are familiar to investors in part because of their advertising
campaigns. The performance of a particular managed fund is influenced by the returns
of the underlying assets in that fund. It is the fund managers job to determine which
assets will be included in the fund and the proportions of those assets that the fund will
hold. The decisions made by the fund managers can therefore make a huge difference
to the performance of the particular managed fund. We have also stated that different
managers have different investment styles that they adopt in selecting the assets to be
included in the fund. The essential question is: how good are the managers at selecting
both the assets to be included and the proportions of those assets in the fund?
Some investors believe that particular managed funds are superior performing funds.
This may well be true at a given time period. The reality is that sometimes fund
managers change jobs and move to different firms. Fund managers are like everyone
else in that they do not possess perfect foresight. The graph in Figure 2.c provides the
ranking of 22 fund managers over 2 consecutive 3 year periods. They are ranked in
order of their funds performance as depicted by the dot points. These same managers

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are re-ranked for the second three year period. What the graph shows is how the
rankings have changed in the second three year period. The line extending from the dot
points shows whether that fund manager has improved his or her ranking or whether
their ranking has fallen. What is obvious is that over the six year period, the ranking of
these fund managers changes. This outcome is consistent with the research literature
that provides no evidence of fund manager consistency in performance.
Figure 2.c: Fund managers ranking

Where does this leave the investor how can we as financial advisers protect clients
from selecting a poor performing fund manager?
We have already referred to the importance of diversification in investments as a means
by which risk can be minimized. Similarly, diversifying across fund managers is also
important because we can reduce the risk of investing with just one manager who may
or may not perform well in selecting the assets to be included in the managed fund. The
ultimate diversification strategy is one which eliminates fund manager risk. This
strategy involves the use of index funds.

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WHAT IS AN INDEX?
In Australia when you wake up in the morning, you might hear people discuss what
happened to Wall Street the night before. That is because there is a time difference
between the US stock market opening times and that of Australia. When referring to
Wall Street (based in New York), they often refer to an index describing the movement
in the share market of listed companies in the United States.
It would be too difficult to track every single security trading in the country. To
overcome this, a smaller sample of the market is taken that is representative of the
whole. Thus, just as pollsters use political surveys to gauge the sentiment of the
population, investors use indexes to track the performance of the stock market. Ideally,
a change in the price of an index represents an exactly proportional change in the stocks
included in the index.
Charles Dow created the first and, consequently, most widely known index in 1896. At
that time, the Dow index contained 12 of the largest public companies in the U.S. Today,
the Dow Jones Industrial Average (DJIA) contains 30 of the largest and most influential
companies in the U.S. The S&P500 is often described as a more robust index of the US
share market because it incorporates 500 of the largest companies as opposed to just
30. The S&P reference refers to Standard and Poors; a ratings company that
constructs the index.
In Australia a widely used index is the S&P/ASX 200. This index comprises the top 200
companies listed on the Australian Stock Exchange (ASX) based on market capitalization
(price multiplied by number of shares on issue). However, probably the most commonly
referred to index in Australia is the All Ordinaries index that comprises the top 500
companies listed on the ASX. Other commonly quoted international share indices are
the Hang Seng (Hong Kong), FTSE (UK), DAX (Germany) and the Nikkei (Japan).
Most indices weight companies based on market capitalization. If a company's market
cap is $1,000,000 and the value of all stocks in the index is $100,000,000, then the
company would be worth 1% of the index. These types of systems are made possible by
computers - most are calculated to the minute (in fact second), so they are very
accurate reflections of the market.
It is important to note that indices apply to all asset classes, not just shares. There are
bond indices, property indices and cash indices. Furthermore, within a specific asset

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class, sub-indices exist. For example, within the Australian share market, there are
industrial company indices, resource indices and small company indices.
There are also indices that represent global share market performances such as the
MSCI Inc. (formerly Morgan Stanley Capital International). The MSCI World is a stock
market index of over 6,000 'world' stocks. The index includes a collection of stocks of all
the developed markets in the world, as defined by MSCI Inc. The index
includes securities from 24 countries but excludes stocks from emerging and frontier
economies making it less worldwide than the name suggests. A related index, the MSCI
All Country World Index (ACWI), incorporates both developed and emerging countries.
MSCI Inc. also produces a Frontier Markets index, including another 31 markets.

WHAT IS AN INDEX FUND?

An index fund is a portfolio that is managed by an index manager so that the proportion
invested in any security in the portfolio is identical to, or as close as possible to, the
proportion that the security is held in a defined target index, e.g. All Ordinaries.
If a particular index fund had as its objective to replicate the All Ordinaries, then if
Telstra, say, made up 6% of the All Ordinaries, it would also make up 6% within the
defined index fund.
Index funds offer instant diversification within an asset class. For example, decisions do
not have to be made as to which of the telecommunications shares the fund should
hold. An index fund would hold all telecommunication shares - and hold them in the
proportion that they exist within the target index.
One of the main advantages of index funds other than the diversification advantage is
that they are low cost funds. Index fund managers do not need to employ expensive
analysts as there is no need for stock selection decisions to be made. Consequently, the
management fees for index funds are considerably lower than the fees for actively
managed funds.
When the target index rises, so does the index fund; and when the target index falls, so
does the index fund. Some investors argue that they can see the advantage of holding
an investment in an index fund in a bull market, but argue that in a bear market, they
are better off with an actively managed investment. In a bear market, the assumption is
that the active manager will know to sell before the prices fall. The problem with this

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argument is that there is no evidence that anyone can 'time' the market. After fees are
taken into account and the returns are considered relative to the risk of the investment,
index funds can be extremely attractive investments.

INDIVIDUALLY MANAGED ACCOUNTS OR SEPARATELY MANAGED ACCOUNTS

As described earlier, the two main methods to gain access to investments are via direct
exposure or via managed funds. There is a third method to gain access to investments
which comprises features from both direct and indirect (managed funds) access.
Individually Managed Accounts and Separately Managed Accounts represent the third
method.
With this type of investment access, investors select a professional manager to make
some or all of the investment decisions on behalf of the investor where the manager
buys and sells investments on their behalf based on their (the managers) investment
views. This feature is similar to that of a fund manager although the Individually
Managed Accounts or Separately Managed Accounts managers can take into
consideration the individuals tax situation and whether there are any investments
which the investor either specifies to ensure are retained or excluded from
consideration.
The feature of Individually Managed Accounts and Separately Managed Accounts which
is similar to direct investing is that when the manager buys and sells the investments on
behalf of the investor, the investments are actually held in the investors name so the
investor has full ownership of the investments as opposed to units in a managed fund.
These accounts allow the investor to view which underlying investments are invested at
any point in time rather than just seeing in which managed fund they hold units. The
investor pays the manager fees to administer and manage the investments on their
behalf.
Both forms of managed accounts offer investors a professionally managed direct share
portfolio and provide transparency while avoiding the tax distortions that come with
pooled investment vehicles such as managed funds.
However, there are some important differences between individually and separately
managed accounts and while they may sound similar, these differences can have a
significant effect on investment performance, suitability, and tax effectiveness.

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Generally, Separately Managed Accounts are a good alternative to managed funds for
many investors, but for those with $1 million or more, the benefits of an IMA become
compelling.

Differences between Separately Managed Accounts (SMAs) and Individually Managed

Accounts (IMAs)
The key difference between individually and separately managed accounts lies in their
different approach to building an investment portfolio. SMAs are constructed on a
'model portfolio' basis where each investor receives exactly the same portfolio, based
on a master portfolio assembled by the fund manager. IMAs however, are constructed
individually for each investor, although each account shares some common
holdings. These two approaches have important differences worth highlighting:
New investors in a SMA may buy stocks that have already enjoyed most of their returns,
but remain in the model portfolio to avoid realising capital gains tax. IMA investors
however will receive a portfolio that is assembled incrementally, as attractive
opportunities develop.
Similarly, new investors in Separately Managed Accounts will receive a larger holdings in
stocks that have already performed well, while IMA investors are likely to receive larger
holdings in stocks the investment manager believes will perform well in the future.
IMAs also provide the ability to tailor the portfolio to the investor's tax circumstances.
For instance, a good IMA manager may place more weight on generating franked
dividends for a SMSF, while long term capital appreciation is more valuable for a higher
marginal tax rate account.
These differences in investment management are an effort to produce the best after tax
result for each investor. As every investor in a SMA will receive the same portfolio, the
Separately Managed Account manager can not consider individual tax consequences or
other individual considerations when making investment decisions.
Both structures will allow you to transfer an existing share portfolio, with the IMA
structure providing some additional flexibility and tax advantages. When importing an
existing portfolio into a SMA, only those shares contained in the model portfolio will be
retained and only to the proportion the transferred shares are held in the model
portfolio. This means new investors may still realise substantial capital gains when

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entering an SMA. Conversely, a diligent IMA manager will migrate the existing portfolio
over time and with consideration to the tax consequences of any sales.
If the investor provides instructions to exclude any particular stocks or sectors, an
Individually Managed Account manager will hold alternative positions, while an SMA
investor will generally hold additional cash in lieu of the excluded positions. Of course,
this can have a significant impact on the portfolio's overall performance.
Other important differences include the service levels received by the investor and their
investment managers execution strategy.
Separately Managed Account investors generally receive a managed fund type service
while Individually Managed Account investors have ongoing access to the individual
responsible for managing their share portfolio and will generally receive personalised
reporting and commentary about their portfolio.
When executing trades, SMA investors will generally receive 'at market' prices on their
transactions, while an IMA manager may attempt to get best execution and/or exercise
discretion over the timing of buys and sells for their investors.

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IMPORTANT

You must now complete Part B of your Multiple Choice assessments

for Module 2

A few tips:

You can access the Multiple Choice Questions at

monarch.mywisenet.com.au

Press Ctrl F if you want to search the pdf course materials for any
key words or terms.

You have 2 attempts. Please note, if you require a second attempt,

the answers are shuffled so read them carefully. The highest score
counts.

If you are unsuccessful after 2 attempts, please contact our office

on 1300 738 955.

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5.2

EXCHANGE TRADED FUNDS

An Exchange Traded Fund (ETF) is a special type of managed fund as it is listed on an
exchange such as the Australian Stock Exchange. ETFs invest in certain types of
investments such as shares (listed property trusts, international shares and Australian
shares), currencies or commodities which replicate an index (e.g. S&P/ASX 200 Index).
ETFs therefore allow investors to gain an index exposure by buying units in the listed ETF
like they would for direct shares.
ETFs can be classified under two broad categories - Conventional ETFs and Synthetic
based ETFs:

Conventional ETFs invest in either all of the securities or a representative sample

of the securities included in the index (e.g. S&P/ASX 200 Index).

Synthetic based ETFs also aim to replicate the performance of the index
although the way these ETFs gain exposure is synthetically by holding
derivatives to simulate the investment performance of the index rather than
directly owning various shares.

Investors, via their brokers or administration platform, can place orders to buy or sell
ETFs similar to buying shares. Similar to buying and selling shares, investors incur
brokerage charges for these services. An example of ETFs listed on the ASX are iShares
by BlackRock. Google iShares BlackRock for more information.
The brokers transact with either appointed Authorised Participants or other brokers to
execute the trades on behalf of investors. Authorised Participants have agreements with
the ETF Issuers (fund managers) to enable the Authorised Participants to create and
cancel units directly. ETF issuers issue and cancel units at the fund level and can
exchange either ETF units or underlying securities with Authorised Participants.
Authorised Participants provide price competition and ensure a balance between supply
and demand for the ETFs. ETFs trade at prices close to their underlying net asset value.
ETFs have lower ongoing management costs than managed funds whilst allowing
investors the ability to gain exposure to a diversified underlying parcel of shares.
However, because brokerage is paid each time ETFs are bought, just like any listed
share investment, regular small investments into managed funds often are more cost
effective then regular small investments into ETFs.

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ETFs also allow for taxation benefits due to low portfolio turnover (low levels of trading
shares in the fund), which minimises the impact of realised capital gains in the
distributions. Investors can earn returns through capital appreciation and/or
distributions. Investors may also enhance after tax returns from franking credits from
Australian share ETFs.
Unlike unlisted managed funds, ETFs report their holdings on a continuous basis,
providing investors with transparency regarding their positions.
ETFs are passive investments, similar to index managed funds, where the managers do
not try to use any skills to outperform the market. There is no regard given to the
valuation or investment outlook of the underlying stocks purchased in the index which
means that investors may buy some overvalued stocks theoretically.
Listed Investment Companies (LIC), like ETSs, are also listed on an exchange such as the
ASX; however, LICs are actively managed where the managers aim to outperform the
relevant index. LICs generally charge higher management fees than ETFs to reflect the
costs of their research and the charges for their management skills. Examples of large
LICs on the ASX are AFIC, Argo and Milton. Google them for more information.

5.3

INVESTMENT SELECTION
How do financial planners select appropriate investments for their clients?
We have seen that the first step in the financial planning process involves obtaining as
much information about the client as possible. To recap, we need to address the
following:
a) define clients objectives (prioritize these so that the time horizon is clear)
b) concern for future living standards and security
c) willingness to sacrifice short term needs to ensure future security
d) assessment of liquidity vs growth needs
e) concern with security
f) concern with volatility
g) concern with ease of management

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h) concern with inflation

i) concern with tax.
Financial planning advisers receive massive amounts of technical updates and research
from fund managers, their licensed dealer group, professional associations, research
houses and government bodies. Much of this information relates to investments. An
example of the research that licensed dealer groups may provide is a monthly update on
top performing funds, performance updates on all managed funds and indices,
recommended strategic asset allocation for various client profiles and the addition of a
fund to or removal of a fund from what is called a recommended list. The research
information can be a valuable tool for financial planners in the advice they provide to
clients. However, it is important to be aware of the basis on which some of the fund
measures are made.
The investment decision itself involves the financial planner in four main considerations.
They are:
a) strategic asset allocation
b) tactical asset allocation
c) investment vehicle
d) investment selection.

STRATEGIC ASSET ALLOCATION

The single most important investment decision an investor will make is how to allocate
their funds between the four asset classes. How is this strategic asset allocation to be
determined? There are two main techniques which are used. Strategic asset allocation
can be determined by using software packages such as EXCEL or specific financial
planning software. Popular financial planning software include Xplan and VisiPlan
(owned by Iress) and Coin (owned by Macquarie).
Strategic asset allocation can also be determined by using intuitive approaches based on
the key characteristics of the various classes of assets, which include the following:
a) security/risk (short term volatility)
b) flexibility

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c) correlation with other asset classes

d) long run returns
e) ability to beat inflation
f) tax effectiveness for high income earners
g) suitable time horizon.
Considering these features, the planner should find that it is possible to begin
structuring the asset allocation to suit particular investor types.
A second tier to this process requires consideration of the client's overall profile,
including:
a) current position (assets, income, liabilities, expenses)
b) income wants
c) tax profile
d) risk tolerance
e) time horizon.
Analysis of these inputs provides guidance as to:
a) how much money will be available to invest, and when
b) how much income will be required from the investment and when
c) where the investor is comfortable on the risk/return tradeoff.
We will look in more detail at portfolio construction issues (which impacts strategic
asset allocation) in the Advanced Diploma of Financial Planning.
Once the strategic asset allocation decision has been made, small adjustments to the
allocation can be made in order to diversify away country risk, industry risk and firm
specific risk if decided. This technique is known as tactical asset allocation.

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Example: Strategic Asset allocation

Adrian seeks your advice as to how best to invest $200,000. You recommend that he
invest 50% of his funds in Shares and 50% of his funds in Fixed Interest.24 Looking at the
pie chart on figure 1, you can see the initial asset allocation. Now assume 12 months
later, you are reviewing Adrians portfolio (which most financial planners do at least
once per year).

Figure 1

Figure 2

From Figure 2, the returns on the fixed interest were 5%, and the returns on shares
were 15% (a good year in anyones books). The total value of the portfolio has now
increased to $220,000. However, the proportion of the fixed interest and shares is now
no longer what you recommended 12 months ago (e.g. 50% in each of fixed and shares).
Instead, fixed interest comprises almost 48% of the portfolio, and shares comprise the
remaining 52%. In effect the portfolio has become too risky.

24

For the purpose of this exercise we are not drilling down into how many shares are

purchased, or whether the shares are Australian or International shares, nor whether
they are purchased directly or indirectly. This exercise is only looking at the overall
performance outcomes. The same applies for the fixed interest investment component.

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What do you do?

Applying strategic asset allocation, often referred to as rebalancing, it is necessary to
ensure that Adrians portfolio is once again reflective of his risk profile and your
recommendations. This requires that the share component is reduced (via selling $5,000
worth of shares), and simultaneously buying $5,000 worth of fixed interest. This would
mean that each component would now be $110,000 representing 50% of the portfolio.
It is important to understand that this process is conducted without a need to be either
bullish or bearish about a particular asset class. It is simply a process that brings the
investors portfolio back to their desired asset allocation that should reflect their
objectives and risk profile.
In a different scenario, if fixed interest increased by 5% but share prices had fallen by
15% (instead of rising), the portfolio would look like figure 3 after 12 months. As you can
see, the total value of the portfolio has reduced to $190,000. Fixed interest comprises
approximately 55% of the portfolio, and the share component makes up 45%. In effect,
the portfolio has become too conservative.

Figure 3

What do you do?

In this scenario, you would sell $10,000 of fixed interest, and simultaneously buy
$10,000 of shares.

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Whats the message?

You will notice in both examples, that the process of applying strategic asset allocation
decision making (as opposed to your own), has actually created a situation where the
investor has approached his portfolio counter-intuitively. Why is this so? In the first
scenario, the share market had been performing very well, so naturally many investors
would want to invest more into shares, rather than less. It is not uncommon to be in a
12 month review meeting in the midst of bull market to hear investors say... put more
in to shares! Of course, applying Strategic Asset Allocation means that you are
recommended the exact opposite. In effect you are selling a strong performing asset
class and taking profits.
In the second scenario the opposite situation occurs. In this instance, you are telling a
client to purchase more shares (despite their very poor short term performance) when
in many instances, investors may be asking why you arent recommending selling the
entire share allocation altogether. Once again, you are applying a counter intuitive
approach to investing by buying low and selling high. In this instance, the shares are
cheap so a good time to buy in order to restore the portfolio to match the investors risk
profile. There is a famous investment saying by one of the worlds most successful
investors Warren Buffett. He says, buy when people are fearful and sell when they
are greedy. Those statements as well as buy in gloom and sell in boom are all
consistent with the application of Strategic Asset Allocation.
How often should you rebalance?
There is no right or wrong optimal amount of time to wait in order to rebalance a
portfolio between market movements. The factors that should be considered are the
taxation implications (i.e. capital gains tax by buying and selling) as well as transaction
costs (brokerage and switching fees25 etc.). Most research literature on this matter
suggests that Strategic Asset Allocation should be conducted no more regularly than
every 12 months and some literature suggests closer to 2-3 years. Ultimately it depends
on the tax structure of the individual investor, and the costs of implementing Strategic
Asset Allocation when determining how often to rebalance.

25

Even though many fund managers dont charge to switch between investment options, ultimately a charge is extracted

via a buy sell spread. This is similar to the bid/offer system discussed in the share section earlier in this module.

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TACTICAL ASSET ALLOCATION

Tactical asset allocation is a fine tuning exercise. It determines a range of a few
percentage points either side of the strategic asset allocation to allow for changes in
assumptions about market conditions and specific needs of the investor.

INVESTMENT VEHICLE
The third step in the investment decision is the choice of the investment vehicle.
Investment vehicles to be considered include the following:
direct investment
managed investment
superannuation and/or
insurance bond.

SELECTING INVESTMENTS
The fourth step in the investment decision is the specific investment selection.
For the purposes of this topic, let us assume that the investment vehicle choice is
managed funds. The question then becomes: given the huge number of possible
managed funds, how is the actual selection made.
As an adviser, research is readily available on the characteristics of the various funds.
Most licensed dealer groups provide advisers with information as to the research results
of the funds performance, risk, key features, management styles etc. It is also common
for licensed dealer groups to provide advisers with recommended blends of managers
appropriate to the different investor types.
In order for financial advisers to have a thorough grasp of the recommendations
provided by licensed dealer groups, it is necessary for them to understand how
investment risk is measured. In the Advanced Investment module in the Advanced
Diploma of Financial Planning, we will consider how investment risk is measured and

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also look at how this understanding can be applied to a strategic asset allocation
decision.

Case study
Trudy and Thomas, both aged 57 years, have recently inherited $150,000 from Trudy's
parents. Trudy and Thomas live in rented accommodation in Melbourne and would like
to own their own home. Trudy works full time as a travel consultant earning $30,000
pa, and Thomas works part time in a call centre earning $18,000 pa.
Trudy would like to retire in 3 years' time and buy a house in the country, as she
believes that the money they have inherited will be sufficient to buy a small property
outside of Melbourne. She is cautious about the idea of investments, and at present has
the $150,000 in a savings account in Westpac. She would consider placing part of the
money in equities if she felt more certain that the market had already hit rock bottom
and would now go up again.
Thomas has no strong feeling about the need to own his own home. He is more
concerned about having sufficient funds in their retirement to supplement the age
pension on which they will eventually rely. He is keen on investing in shares, particularly
resource stocks about which he knows a little from his former working days with EL Gas
Ltd.
Trudy and Thomas seek your advice about the best way to invest their funds for the next
three years until Trudy's retirement.
a) Outline to Trudy and Thomas their options as to investment classes; point out what
factors they need to consider in making an investment decision.
b) If Trudy and Thomas decide to forgo buying a house and decide instead to invest
their funds for their retirement years, i.e. 65 years onwards, explain how dollar cost
averaging might assist them and why it might help Trudy to allay her fears that this
might not be the time to invest in equities.
c) If Trudy and Thomas decide to invest $40,000 in equities, explain how the use of
managed funds might be an advantage to them.

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6.0

UNDERSTANDING CLIENT NEEDS

When will I be able to retire? Will my investments provide me with sufficient income for
my retirement? How much will I need to invest so that I can afford to send my children
to private schools? If I have $300,000 in my superannuation in eight years, what is that
equivalent to in todays money terms? Is it preferable to pay off my mortgage or invest
any surplus funds?
Financial planners are constantly faced with questions such as these. In order to provide
answers to such questions, it is necessary for financial planners to have a strong working
knowledge of fundamental mathematical concepts which relate to investment and
retirement planning. The skills required include a basic understanding of the nature of
compounding and the time value of money.
An understanding of these concepts will enable financial planners to determine both
present and future values of capital amounts and to assess alternative income streams
so that different investment options can be compared. In practice, financial planners
can often access computer packages which, with the click of the mouse, will determine
present and future capital values and compare alternative income streams. What
computer packages cannot do is equip financial planners with the skills to explain to
clients the basis on which their advice is determined. To be able to do this, the financial
planners must understand the concepts of compounding and the time value of money.
Financial planning is a relationship profession built on trust and responsibility. It is
imperative that financial planners not only provide clients with solutions but also
provide clients with the assurance that the advice given is based on a thorough
understanding of the factors that give rise to these solutions.

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6.1

COMPOUND INTEREST & THE TIME VALUE OF MONEY

TIME VALUE OF MONEY

Most financial decisions involve benefits and costs that are spread out over time. The
concept of the time value of money establishes a relationship between cash flows
received and/or paid at different points in time. If you are offered the alternative of
receiving $1,000 at the end of four years or receiving $1,000 today, a rational response
would be to choose to receive the money today. There are at least three reasons why
you might prefer the money today. They are:
firstly, the person promising you the money in four years may not fulfil the promise there is an element of risk in that there is some uncertainty that you will receive the
money in four years time
secondly, if you have the money now, you can invest the $1,000 and earn a return. If
you wait for four years, there is an opportunity cost foregone
thirdly, if you have the money now, you can use it for present consumption.
Because there is risk, an opportunity cost and the postponement of present
consumption, people prefer cash now rather than later. This is called the time
preference for money and it highlights the idea that a dollar today is worth more than a
dollar to be received in some future period of time. In order for us to be indifferent to
the receipt of the $1,000 now or in four years time, we would need to be compensated
for undertaking the risk, foregoing the opportunity to invest the money now and for
delaying our ability to use the funds for consumption.
The compensation we require is equal to our opportunity cost, i.e. the best rate of
return or interest we could earn from investing the $1,000 for four years. If we could
earn 8% pa from investing these funds for four years, our opportunity cost would be 8%
pa. This compensation or opportunity cost is often described as the interest rate
required, the rate of return required, the discount rate or the time preference rate.
So we see that a dollar in hand today is worth more than a dollar to be received at some
future date. It is the same gold coin but it has more value today than it does at some
future date.

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If we know what our opportunity cost or rate of return requirement is, we can
determine what amount of money we would require in four years' time in order for us
to be indifferent about receiving the $1,000 now or receiving the $1,000 plus
compensation in four years' time. This can be termed the future value of our investment.
This sum of money comprises the initial sum of money, $1,000 plus interest earned over
the four year period.

Initial sum

$1000.00

Interest in year 1 = 8% x $1,000

$80.00

Interest in year 2= 8% x ($1,000 + $80)

$86.40

Interest in year 3= 8% x ($1,000 + $80 + $86.40)

$93.31

Interest in year 4= 8% x ($1,000 + $80 + $86.40 + $93.31)

$100.78
$1,360.49

We are now in a position to say that if we had $1,000 today and we invested it in an
account that earned 8% interest each year, the value of this investment in the future (at
the end of 4 years) would be $1,360.49.
In summary, we would be indifferent to being offered $1,000 today, or $1,360.49 in 4
years time they have an equivalent value!

COMPOUND INTEREST
From the example above, we can see that in years two, three and four, we are earning a
return not only on the original capital sum, but also on any accumulated interest, i.e. in
year two we earn interest on year ones interest, in year three we earn interest on the
interest from years one and two, and in year four we earn interest on the interest
earned in years one, two and three. This is the nature of compounding. The longer the

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time that funds are invested, the more significant is the effect of compounding on the
value of those funds at some future period of time.
The graph below highlights the power of compounding. It assumes that an investor
saves $100 each month and the interest is 10% p.a. (calculated monthly). The dark bars
represent the total accumulated value of the $100 amounts saved each month. After 12
months (1 year) the accumulated value of the savings is $1,200. After 15 years the
accumulated value is $18,000.
Now look at the light coloured bars. These represent the amount of interest that has
been added to the account not by the investor but by the bank or fund manager.
You can see that in the early years, there is very little interest earned on the savings. In
the later years however, the amount of interest grows significantly. By the time we
reach year 5 the investor has deposited a total of $6,000 (5 x $1,200). The accumulated
interest by the end of year 5 is $1,744. By year 15, the investor has saved a total of
$18,000 (15 x $1,200) but the accumulated value of the interest is now $23,477! That is
after 15 years, the investor has saved $18,000 but the investment is worth a total of
$41,447. By year 20, the investor has saved a total of $24,000 (20 x $1,200) but the
accumulated value of the interest is now a whopping $51,937! That is after 20 years,
the investor has saved $24,000 but the investment is worth a total of $75,937. This is
why compounding is so powerful. The longer the time frame in which money can earn a
return (interest) the greater the impact of compounding.

How Compound Interest Works

$75,937
Interest = $51,937
Contributions = $24,000

$80,000
$41,447
Interest = $23,477
Contributions = $18,000

$70,000
$60,000
$50,000

$7.744
Interest = $1,744
Contributions =

$40,000
$30,000
$20,000
$10,000
$0
1

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To see how powerful compounding can be, consider the example of John and Mary,
twins aged 18 years. Mary on her 18th birthday started a savings program whereby she
deposited $2,000 into an account that paid 10% p.a. She continued to deposit $2,000
each year for 13 years until she was 30 years of age. After age 30, Mary did not make
any more deposits but she left the money in the account to accumulate interest until
her retirement at age 65.
Marys twin brother John decided to spend his money on entertainment when he was
age 18. It was not until John was 30 years of age that he realised the importance of
saving. On his 30th birthday, John decided that he would commence a savings program.
His first deposit of $2,000 was made when he turned 31 and he continued to invest
$2,000 every year until he was 65 years old. The savings account paid 10% interest p.a.
This is how much of their own money Mary and John had invested in total.
Age

Mary

18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51

$2,000
$2,000
$2,000
$2,000
$2,000
$2,000
$2,000
$2,000
$2,000
$2,000
$2,000
$2,000
$2,000

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John

$2,000
$2,000
$2,000
$2,000
$2,000
$2,000
$2,000
$2,000
$2,000
$2,000
$2,000
$2,000
$2,000
$2,000
$2,000
$2,000
$2,000
$2,000
$2,000
$2,000
$2,000

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Age
52
53
54
56
57
58
59
60
61
62
63
64
65
Total saved

Mary

John

$26,000

$2,000
$2,000
$2,000
$2,000
$2,000
$2,000
$2,000
$2,000
$2,000
$2,000
$2,000
$2,000
$2,000
$70,000

Even though Mary only invested $26,000 of her own money, the accumulated value in
her account at age 65, is a staggering $1,378,296. Mary has received total interest of
$1,352.296 this is the remarkable power of compounding.
What about Johns savings account? He has invested almost 3 times as much of his own
money compared to his sister. Will he have more in his account than Mary? Less? The
same?
The accumulated value in Johns account at age 65 is only $542,049. Johns account is
worth less than half that of Marys. Why? Even though John contributed more of his
own money, he started his savings plan later than Mary and the important power of
compounding is affected by the length of time money has to accumulate. Johns
account had far less time to accumulate the benefits of compound interest compared to
Mary.
Noel Whittaker, a renowned finance journalist has a very interesting take on
compounding The Fairy Godmother and the Magic Train. We have included this story
in this module, replicated from More Money with Noel Whittaker. Refer to Appendix
6 to read this insightful short childrens story, written for adults to understand the true
power of compounding.
Applying the power of compounding and time value of money in financial planning
With an understanding of the time value of money, and the impact of compounding, we
can answer questions such as if I wish to retire at age 63, how much do I need to have
available if I intend to spend $45,000 each year until age 90? Or a client wishes to save
enough each year for the next 12 years in order to have $700,000 for their retirement.

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If the client currently has $250,000 saved, how much will need to be saved each year in
order for them to reach their goal?
These questions and all other time value of money related questions can be solved with
the use of a financial calculator or the use of formulae. Examples with instructions on
how to use a financial calculator and various formulae are provided in Appendix 4. The
examples in the Appendix are for your information only.
What you are required to do is to be able to explain to clients the basis on which any
advice is determined. To assist you with this, a Time Value of Money excel spreadsheet
has been provided for your use. It requires you to input the relevant factors such as
when the cash is invested or withdrawn, what is the discount rate (interest rate or
required rate of return) and what is the relevant time period. The formulae are
embedded in the spreadsheet so your focus can be on providing a solution to a question
and then being able to explain the impact of any changes in assumptions about interest
rates or amounts to be saved or withdrawn.
The Time Value of Money excel spreadsheet can be accessed from the Module 2 section
of your course in the Monarch LMS. Simply enter any values in the spreadsheet to
calculate the outcome.
To see how easy it is to use this excel spreadsheet, consider the following examples.
Finding the future value of a single lump sum deposited today
Suppose we invest $100 today in an investment that yields a rate of interest of 6% per
cent per annum. What would this be worth in say 5 years time? The future value of the
investment is the accumulated value or the amount that the investment is worth after a
period of 5 years, taking into account the interest that is re-invested.
So what is the future value of this investment in 5 years is the key question. To answer
the question we need to know 3 things:
1) The lump sum to be invested today ($100). We call this the present value (PV) as the
value of this lump sum investment in todays money terms is $100
2) the interest rate (6%)
3) the time period over which the investment will earn interest (5 years).

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Using the excel spreadsheet, we can input these values and the future value will be
shown in the red box.
Here is a screenshot of the data we would input into the spreadsheet and the answer
that will be calculated from the data.

Future value of a single lump sum

where the funds are invested today
Input the lump sum to be invested today

$100
Input an interest rate
(discount rate, required rate of return)

6.0%
5

Select time period in which the funds earn interest

Future value

$133.82

From our example the future value (or accumulated value) of investing $100 today for a
period of 5 years when the interest rate is 6 per cent p.a., will be $133 .82.
Question
Using the original data from the example above, answer the following questions. Note,
each question below is independent of each other. For example dont include the
information from question a) when attempting question b).
What is the impact on the future value if:
a) the interest rate is 8 per cent?
b) you invest $140 today instead of $100?
c) the initial $100 can be invested for 12 years instead of 5 years?
d) How much will you accumulate if you invest $500 today for a period of 7 years when
the interest rate is 10 per cent?

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Answer
a) $146.93
b) $187.35
c) $201.22
d) $974.36
Pro Tip:
These calculations are usually performed using the financial planning software that you
use, or your para-planner uses. The reason why you need to determine a future value of
a lump sum, might be, for example, if a client came to you and asked you the following
types of questions:
Will my current savings of $59,000 at my current interest rate of 6% be enough for a
deposit on a house in 3 years time? I think I will need a deposit of $70,000.
Im currently 55 years old and retired, however my wife still works and her income is
enough for us to live on at the moment. I have ceased contributing to my
superannuation account. What will the likely value of my super be in 5 years time,
when my wife intends to retire too? My super is currently worth $420,000 and I
would like to assume that it earns an average return of 7% each year.
As you can see, these questions are both different but the common thread is the same.
Your client wants you to calculate the future value of an amount of money available for
investment today. Using the process (via the excel spreadsheet or formula contained in
the appendix), you will now be able to answer those questions for your client.
Finding the present value of a single lump sum to be received at some future point in
time
Suppose we are expecting to receive $2,000 four years from now. If the interest rate is
6% per cent per annum, what value does that $2,000 represent in todays money terms?
Another way of saying this, is to ask what is the present value of the $2,000 we expect
to receive in four years time?
To answer the question we need to know 3 things:

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1) The lump sum to be received at some point in the future ($2,000). We call this the
future value (FV) as this lump has a value of $2,000 in four years time.
2) the interest rate ( 6%)
3) the time period until we receive the funds (4 years).
Using the excel spreadsheet, we can input these values and the present value will be
shown in the green box.
The Time Value of Money excel spreadsheet can be accessed from the Module 2 section
of your course in the Monarch LMS. Simply enter any values in the spreadsheet to
calculate the outcome.
Here is a screenshot of the data we would input into the spreadsheet and the answer
that will be calculated from the data.

Present value of a single lump sum

where the future value is known
Input the cash to be paid/received in the future

$2,000
Input an interest rate
(discount rate, required rate of return)

Select time period when lump sum will be paid/received

Present value

6.0%
4
$1,584.19

From our example, the present value (the value in todays money terms) of receiving
$2,000 in four years time when the interest rate is 6 per cent p.a. will be $1,584.19.
Question
Using the original data from the example above, answer the following questions. Note,
each question below is independent of each other. For example dont include the
information from question a) when attempting question b).
What is the impact on the present value if:

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a) the interest rate is 8 per cent?

b) you receive $3,000 in four years time instead of $2,000?
c) the initial $2,000 will not be received until 10 years instead of 4 years?
d) If you are to receive $12,500 in 6 years time and the interest rate is 7.5 per cent,
what is the value of these funds in todays money terms?
Answer
a) $1,470.06
b) $2,376.28
c) $1,116.79
d) $8,099.52
Pro Tip:
These calculations are usually performed using the financial planning software that you
use, or your paraplanner uses. The reason why you need to determine a present value
of a lump sum, might be, for example, if a client came to you and asked you the
following types of questions:
I need to have $60,000 available for university fees for my twin daughters in 4 years
time. If I can earn an interest rate of 6.5% on my money, what lump sum would I
need to deposit today in order to reach my goal?
We want to renovate our house in 6 years time when I retire. We estimate we will
need $280,000 to refurbish the kitchen, bathroom whilst adding a new family room
and deck. We currently have saved $110,000 and we are earning 7.2% on our money.
Will we have enough to reach our renovation goal, and if not, how much extra do we
need to invest today to reach our goal?
As you can see, these questions are both different but the common thread is the same.
Your client wants you to calculate the present value of an amount of money required at
some future point in time. Using the process (via the excel spreadsheet or formula
contained in the appendix), you will now be able to answer those questions for your
client.

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So far we have looked at the impact on the future value of a single lump sum if there is a
change in the interest rate, change in the size of the lump sum invested or a change in
the time period over which the investment can earn interest.
We also looked at the impact on the present value of a single lump sum to be received
at a future point in time if there is a change in the interest rate, a change in the size of
the lump sum to be paid/received in the future and a change in the time period until
that lump sum will be paid/received.
Annuities
Often we are interested in calculating either a future value or a present value when
there are regular payments to be made or received rather than just one lump sum. If
the funds to be paid (or received) each and every period for a given time frame are
identical in amount, we call this an annuity.
The following time line shows an example of a 5 year annuity where a regular cash
amount of $250 can be invested each year commencing at the end of the first year.
Over the 5 year period, we will invest a total of $1,250. However, because money has a
time value, the lump sum that accumulates in the future will be larger than $1,250
because the funds will be accumulating interest over the 5 year period.

year
Cash flow

$250

$250

$250

$250

$250

Finding the future value of an annuity

Suppose we invest $250 at the end of each year for the next 5 years in an investment
that yields a rate of interest of 7% per cent per annum. The future value of the annuity
investment is the accumulated value or the amount that the investment is worth after a
period of 5 years. What is the future value of this investment? To answer the question
we need to know 3 things:
1) The regular cash flow, i.e. the annuity amount each period which in this example is
$250
2) the interest rate (7%)

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3) the time period over which the investment will earn interest (5 years).
Using the excel spreadsheet, we can input these values and the future value will be
shown in the red box.
The Time Value of Money excel spreadsheet can be accessed from the Module 2 section
of your course in the Monarch LMS. Simply enter any values in the spreadsheet to
calculate the outcome.

Future value of an annuity

where the first cash flow is at the end of period 1
Input the amount of the regular cash flow

$250

Input an interest rate

7.0%

(discount rate, required rate of return)

Select number of time periods in which the

funds earn interest

Future value

$1,437.68

From our example the future value (or accumulated value) of investing $250 each and
every year for a period of 5 years when the interest rate is 7 per cent p.a., will be
$1,437.68.
Question
Using the original data from the example above, answer the following questions. Note,
each question below is independent of each other. For example dont include the
information from question a) when attempting question b).
What is the impact on the future value if:
a) the interest rate is 14 per cent?
b) you invest $750 each year instead of $250?
c) the annuity can be invested for 11 years instead of 5 years?

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d) How much will you accumulate if you invest $1,500 each and every year for a period
of 9 years when the interest rate is 8.4 per cent?
Answer
a) $1,652.53
b) $4,313.05
c) $3,945,90
d) $19,047.03
Pro Tip:
These calculations are usually performed using the financial planning software that you
use, or your para-planner uses. The reason why you need to determine a future value of
an annuity, might be, for example, if a client came to you and asked you the following
types of questions:
Weve done a budget and we have estimated that we can save $11,000 each year.
Our daughter is currently 1 year old, and we want to have available sufficient funds
to pay for her secondary schooling which is 12 years from now. Assuming we can
earn 7.4% on our money, how much will be available for her education when she
starts secondary school if we make deposits of $11,000 at the end of each year, for
the next 12 years?
My wife doesnt work and has no superannuation. If I want to build up her super
account by investing $2,500 at the end of each financial year, how much will be in
her account after 10 years assuming she earns an average of 7% per annum?
As you can see, these questions are both different but the common thread is the same.
Your client wants you to calculate the future value of an amount of money invested
each and every period, over a certain period of time. Using the process (via the excel
spreadsheet or formula contained in the appendix), you will now be able to answer
those questions for your client.
Finding the present value of an annuity
Suppose we expect to receive $300 in payments at the end of each and every year for
the next 10 years. The rate of interest is 6% per cent per annum. Although we will
receive an amount of money that adds to $3,000, ($300 x 10 years), the value of the

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funds will be worth less in todays money terms because money has a time value and
money received in the future is not worth as much as money available today.
To find the present value of this annuity or the equivalent value of this annuity in
todays money terms, we need to know 3 things:
1) The regular cash flow, i.e. the annuity amount each period which in this example is
$300
2) the interest rate ( 6%)
3) the time period over which the funds will be received (10 years).
Using the excel spreadsheet, we can input these values and the present value will be
shown in the green box.
The Time Value of Money excel spreadsheet can be accessed from the Module 2 section
of your course in the Monarch LMS. Simply enter any values in the spreadsheet to
calculate the outcome.

Present value of an annuity

where the first cash flow is at the end of period 1
Input the amount of the regular cash flow

$300

Input an interest rate

6.0%

(discount rate, required rate of return)

Select number of time periods that funds will be

received

Present value

10

$2,208.0
3

From our example, the present value (or the value in todays money terms) of receiving
a dividend of $300 each and every year for 10 years when the interest rate is 6 per cent
p.a., will be $2,208.03.

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Question
Using the original data from the example above, answer the following questions. Note,
each question below is independent of each other. For example dont include the
information from question a) when attempting question b).
What is the impact on the present value if:
a) the interest rate is 8 per cent?
b) you receive $425 each year instead of $300?
c) the annuity will continue for 12 years instead of 10 years?
d) If you are to receive $280 each year for the next 7 years and the interest rate is 8.5
per cent, what is the value of these funds in todays money terms?
Answer
a) $2,013.02
b) $3,128.04
c) $2,515.15
d) $1,433.18
Pro Tip:
These calculations are usually performed using the financial planning software that you
use, or your paraplanner uses. The reason why you need to determine a present value
of an annuity, might be, for example, if a client came to you and asked you the following
types of questions:
We are trying to decide between leasing a motor vehicle or purchasing one outright.
If we lease it, we have been told the repayments will be $7,400 per year for the next
6 years at an interest rate of 8.8% per annum, with no balloon (or residual amount
owing) at the end of the 6 years. The alternative is to buy the car outright and pay
$35,000 today. How do I determine the real cost in todays money terms of making
those lease payments?

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I am presently negotiating the sale of my business which I believe is worth in excess

of $1 million. I have two interested parties. One party is only willing to pay me over a
period of 3 years via vendor finance. That potential purchaser is proposing to pay me
$450,000 at the end of each of the next three years. The other party is prepared to
pay $1.1 million today. Assuming I could earn 8% per annum on my money, which is
the better offer?
As you can see, these questions are both different but the common thread is the same.
Your client wants you to calculate the present value of a series of regular payments.
Those payments could be paid to you, or by you, it makes no difference.
Using the process (via the excel spreadsheet or formula contained in the appendix), you
will now be able to answer those questions for your client.

CASE STUDY
Financial Planners use financial mathematics in both simple and more complicated ways
to conduct client scenario-based analysis.
While scenario-based analysis is commonly now performed via specific financial
planning software, the software is still performing financial mathematics. And like any
program, it is important not to blindly trust an answer, but to actually understand the
building blocks of the software that produces the answer. That process starts with
understanding financial maths.
A typical question clients ask financial planners is Am I on track to reach my retirement
goals?
Clients often want to know whether they are on track to be able to retire. In order to be
able to provide that answer for a client, you will need to ask the right questions. The
questions that need to be asked, the calculations involved and the issues to be aware of
are provided at the end of Appendix 4. Read this if you would like to see how this
commonly asked question is addressed.
If you have a financial calculator any time value of money questions can be answered
very easily and very quickly. If you do not have a financial calculator, there are several
that are free online. For example have a look at

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http://www.calculator.net/financecalculator.html?ctype=endamount&ctargetamountv=0&cyearsv=10&cstartingprinciplev
=20000&cinterestratev=6&ccontributeamountv=1000&ciadditionat1=end&printit=0

With this online calculator as with a hand held financial calculator you need to choose
the inputs required and then click calculate. Click on the tab indicating what you are
wishing to determine.

if you want to know the future value of either the starting principal or an
annuity click the FV tab.

if you want to know the present value of either a future sum or an annuity
click the Starting Investment tab (on some online calculators this will be
called PV for present value)

if you want to know the size of the annuity value of either the starting
principal or the annuity amount for a future sum, click the PMT tab.

This particular online calculator requires you to input a value for 4 of the following 5
values. If there is no amount to be entered, still enter zero where applicable. Also only
input numeric values.

Present value (Starting principal)

Interest per period (I/Y)

Number of compounding periods (N)

Annuity amount (PMT)

Future sum (FV)

Example
Bobby's grandmother deposited $100 in a savings account for him when he was born.
The money has been earning an annual rate of 12% interest, compounded quarterly for
the last 25 years. He is getting married and would like to take his new bride on a
fabulous honeymoon. How much does he have in this account to use?

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Solution
We want to know the future value of this single $100 value so click the FV tab. The
inputs are:

Present value (Starting principal) = $100

Interest per period (I/Y) 3% (12% compounded quarterly)

Number of compounding periods (N) = 100 (25 years x 4 quarters)

Annuity amount (PMT) = 0

Click the Calculate button

Bobby will have $1,921 .86

Example
Andrea's grandmother deposited $1,000 in a savings account on her 1st birthday, $1,000
on her second birthday and continued to deposit $1,000 until Andrea turned 18 years. If
the money has been earning an annual rate of 8% interest compounded annually how
much would be in Andreas account on her 18th birthday?
Solution
We want to know the future value of an annuity so click the FV tab. The inputs are:

Present value (Starting principal) = $0

Interest per period (I/Y) 8%

Number of compounding periods (N) = 18

Annuity amount (PMT) = $1000

Click the Calculate button

Andrea will have $37,450.24 on her 18th birthday

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USING SPREADSHEETS
As an adviser, you will frequently need to prepare materials for your clients that are in
the form of a spreadsheet. A spreadsheet is useful because for example, you might
prepare some cash flow scenarios for your client and during a client meeting, they might
decide that some of the figures in your scenario are either higher or lower than they first
thought. Instead of redoing all the work involved in preparing the figures for your client,
you can set up the spreadsheet so that when you change any of the key numbers in the
scenario, all the resulting figures will automatically adjust.
A spreadsheet is a program designed to allow you to automatically calculate numbers
and dates. Lets suppose you have made a list with 30 items of expenditure for a budget.
At the bottom of the list after carefully calculating it, youve put the total. Now suppose
7 of the items end up costing amounts different from those on your list. Youd have to
recalculate the total again wouldnt you? Not with a spreadsheet. If you put your list in a
spreadsheet and entered a simple formula at the bottom of it for the total, all youd
need to do would be to enter the adjusted amounts and the new total would be
updated.
Suppose from the total you wanted to extract a percentage, or maybe a percentage
from all the items individually. Thatll take time to work out and then correct. With a
spreadsheet set up correctly its all done automatically.
There are many spreadsheets available but Microsoft Excel is the industry standard.
The first thing youll notice about a spreadsheet is the grid like window. Each rectangle is
called a cell. A cell can contain any number, date, text or formula. You can format a cell
or any group of cells also with background colours and borders.

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Each cell has a unique reference. Along the top of the page youll see letters A-Z then
AA-AZ then BA-BZ and so on. Down the left are numbers. A cell is referenced by these
two co-ordinates. For example the upper left cell is A1. The cell below it is A2 and the
cell next to A2 is B2.
Enter in cell A1 the number 10. Now go to A2 and enter the number 5. By putting the
formula A1 + A2 in A3 (or any other cell for that matter) you are causing that cell to
automatically calculate the contents of A1 and A2. All formulas start with =. Note in the
example below the total is shown in cell A3 and in the formula bar (just below the font
size drop down) the actual formula (=A1+A2) is shown. You can click this bar with your
mouse an edit the formula if needed.

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Some conventions need explaining, namely *means multiply, / means divide. Other
than that, the basic rules of maths apply. For example the contents in brackets are
calculated first, multiplication and division are calculated before addition and
subtraction, etc. A spreadsheet can easily handle thousands of formulas. You'll notice in
the final screenshot below a more formatted example. As we have a small list here, I've
used a different formula to calculate the total. Note the formula bar again. This time
we've used the calculator SUM. When SUM is used as is here only the start and finish
cell need to be specified separated by a colon. The alternative here would be the
formula =C2+C3+C4+C5 Obviously with more cells involved such a formula as =SUM() is
far superior.

You can also build charts from spreadsheet data, get averages, extend formulas over
several sheets (sheets are the tabs at the bottom of the page) transpose cells
automatically from one place to another and much more. If you are not familiar with
using excel spreadsheets, there is an excellent series of youtube videos that explain step
by step how to use excel spreadsheets.
Excel 2003 Tutorial Video for Beginners
This link is the first of 23 videos training beginners on how to use Excel.
http://www.youtube.com/watch?v=8L1OVkw2ZQ8

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Excel 2007 Tutorial Video for Beginners

This link is the first of 24 Videos on how to use Excel 2007. From there you can navigate
yourself to see the author's other tutorial videos.
http://www.youtube.com/watch?v=X3jB4wncJp4

In Appendix 5 we have also provided you with some tips on how to use excel
spreadsheets.

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IMPORTANT

You must now complete Part C of your Multiple Choice assessments

for Module 2

A few tips:

You can access the Multiple Choice Questions at

monarch.mywisenet.com.au

Press Ctrl F if you want to search the pdf course materials for any
key words or terms.

You have 2 attempts. Please note, if you require a second attempt,

the answers are shuffled so read them carefully. The highest score
counts.

If you are unsuccessful after 2 attempts, please contact our office

on 1300 738 955.

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7.0

DERIVATIVES AN OVERVIEW
It All Starts With One Simple Concept:
Risk - the possibility of losing some or all profits or investment return due to external
market factors.
If you buy everyday products, own property, run a business or manage money for
investors, risk is all around you, every day. For some, risk stands between them and
progress. For others, risk represents an opportunity to invest.
What does risk look like in the real world?

If you are in the business of making cornflakes, you are at risk of corn prices
rising and cutting your profits, simply because a hot dry summer reduced the
seasons harvest.

Australian car manufacturers might buy parts from the USA. They are worried
that the $US is going to rise, making the car parts needed here in Australia more
expensive.

QANTAS could be worried about rising fuel prices as they would eat into
forecasted profits.

Because we dont know the future, there is always risk. But trading derivatives helps
create a safety net in case prices move in the wrong direction.
For every product you buy, there are a number of outside factorsdemand, weather,
transportation and global politicsthat impact price movements along the supply chain.
Derivatives take all those factors into account ahead of time, so that prices can remain
relatively predictable and consistent when the product reaches the market.
In the next section we continue with an overview of how the derivatives markets
operate and we will explain in greater detail in section 8.2

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7.1

WHAT ARE DERIVATIVES?

Derivatives can be defined as financial instruments or financial arrangements, which
essentially derive their value from, or whose prices are based upon, some underlying
stock, bond, commodity or various other assets. Where Australian exchanges are
concerned, there are a wide variety of derivative products available to trade, including,
most commonly, futures, options and warrants. Derivatives are usually used as a form of
insurance to hedge or transfer risk but they can also be used for speculative purposes by
some investors. Derivatives trade both on exchanges (where contracts are
standardised) and over-the-counter (where the contract specification can be
customised).
Derivatives trading helps businesses around the world navigate risk and uncertainty.
Because they can plan for predictable prices, firms are better equipped to take on new
opportunities, act more quickly and decisively, grow their businesses and ultimately help
reduce costs for the consumer.
Since the Global Financial Crisis, derivatives have received some adverse press but there
is no doubt that derivative products provide a number of useful functions in the areas of
risk management and investments. In fact, derivatives were originally designed to
enable market participants to eliminate risk.
Wheat farmers, for example, can fix a price for their crop even before it is planted,
eliminating price risk. An exporter can fix a foreign exchange rate even before beginning
to manufacture the product, eliminating foreign exchange risk. If misused, however,
derivative securities are also capable of dramatically increasing risk.

HOW DOES THE USE OF DERIVATIVES REDUCE OR ELIMINATE RISK?

Forward contracts and futures contracts enable the buyer of such contracts to lock-in
a definite price or profit or return. Regardless of whether the underlying asset (shares,
share price index, greasy wool, wheat, oil, foreign exchange currency etc.) increases in
actual value or decreases in actual value, the buyer of these contracts will be certain of
the price (or profit or return) that they will receive at a future date.
This certainty means that the cash flows to the business are not as volatile and
consequently, their cost of capital will be reduced as they will be considered to be less

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risky. It is the cost of capital that is used as the discount rate

(interest rate) when determining the value of any share or project or firm value in any
project evaluation calculation.

WHAT IS THE BENEFIT TO A FIRM OF HAVING MORE CERTAINTY IN THEIR

CASH FLOWS?
If the cost of capital (the discount rate) is reduced because a firm is less risky (because
the cash flows are more certain), when determining the value of the firm as a whole,
this will result in a higher firm value.

WHAT ARE THE DISADVANTAGES OF USING DERIVATIVES?

With forward contracts and futures contracts, locking in the price might turn out to be
advantageous if prices move adversely (e.g. wheat prices fall for a wheat seller, or oil
prices rise for Qantas). If however prices move in a favourable direction (e.g. wheat
prices increase for a wheat seller, or oil prices fall for Qantas), then locking in the price
might turn out to be disadvantageous. Given the uncertainty of what will actually occur
at a future point in time, buyers of forward and futures contracts are happy to forego
the possible upside had they not hedged (bought derivatives), in order to protect
themselves from possible downside risk.
As we will see shortly, the use of a different type of derivative options, can be used to
either lock in prices in the future or they can be used to protect the firm form
downside risk whilst retaining all the upside benefits from price movements. There is
an upfront cost to use options and this cost is known as the option premium. Lets now
look at derivatives in more detail.

7.2

FORWARD CONTRACTS AND FUTURES CONTRACTS?

Forward contracts and futures contracts are simply agreements between buyers and
sellers for the sale and purchase of a product in the future at a price agreed upon today
(hence the name "forwards and futures").

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Unlike options (which we discuss below), buyers and sellers of forwards and futures
contracts are obligated to take or make delivery of the underlying asset or make cash
settlement on a specified date.

Example 1: Forward contracts

A wheat farmer has just planted a crop that is expected to yield 3,000 bushels 6 months
from now. To eliminate the risk of a decline in the price of wheat before the harvest, the
farmer can sell the 3,000 bushels of wheat forward. A flour miller who uses wheat in the
products they manufacture may be willing to take the other side of the contract. The
two parties agree today on a forward price of $4.50 per bushel ($13,500 in total), for
delivery six months from now when the crop is harvested. No money changes hands
now. In six months, the farmer delivers the 3,000 bushels to the flour miller in exchange
for $13,500. Note that this price is fixed and does not depend upon the spot price
(actual price) of wheat at the time of delivery and payment.
If the spot price (actual price) of wheat in six months time turned out to be $5.00 a
bushel, the flour miller will be delighted that they had locked in an agreed price of only
$4.50. The wheat farmer on the other hand will be somewhat disappointed as had they
chosen to not lock in a price they would have received an extra $0.50 per bushel.
However, if prices had fallen to say $3.00 per bushel, it would now be the wheat farmer
who would be rejoicing that they had locked in the price.
Using derivatives contracts reduces the risks that both parties face - an important
requirement in managing cash flows.

What sets futures contracts apart from forward contracts is that forward contracts are
traded over-the-counter rather than on exchanges. The over-the-counter market is an
informal market involving trades between a buyer and a seller of a security. Often one
of the parties is an investment bank. The terms of the contract (size, timing etc.) are
customised for the client. Performance of the contract is not guaranteed by any third
party, so each party bears the credit risk of the other (i.e. the risk that the other party
will default).
Futures contracts are traded on exchanges and are standardised contracts. Transactions
occur between two traders with an exchange clearing house providing a guarantee of

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performance for both parties. The clearing house acts as middle-man in a futures
transaction in order to make sure the buyer ultimately buys as agreed and the seller
sells as agreed. On top of that, what makes futures contracts so powerful is the fact that
performance on the contract is GUARANTEED by the clearing house who will be
responsible for making sure both parties fulfil their obligations.

In the broadest sense, there are four key components that make a futures exchange
operate.
1. Futures traders: hedgers and speculators
These two types of traders go hand in hand, ensuring the flow of trades back and forth
and bringing balance to the market.
Lets say that a cattle farmer is concerned about lower prices at the time his animals will
be ready to bring to market. He uses the futures market to hedge, or attempt to
minimize, his price risk. He can calculate the cash price he needs for his livestock, and
then sell live cattle futures at the futures exchange to lock in that price. This will ensure
his profitability, despite any declines in the market price for his herd.
Now, on the other side of the transaction are the individual and institutional traders
who are willing to absorb the risk being transferred by the cattle farmer. They speculate,
or invest with intent to profit, by buying and selling cattle contracts.
2. Trading technology
Electronic trading platforms enable exchanges to operate on a global scale, providing a
steady level of speed, access and transparency for everyone.
Electronic trading has achieved much more than enabling the open-outcry traders of
yesterday to do business in the comfort of their own home. Because it frees futures
trading from the confines of a physical exchange, electronic trading enables futures
exchanges to operate on a global scale, with 24/7 access to markets around the world.
Todays electronic futures trading platforms are some of the most advanced
technologies in the world of finance. The speed and constant activity they enable adds
ever-greater liquidity to the marketsso the worlds economies can move more quickly,
more decisively and more confidently.

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3. Clearing house
Clearing houses stand at the centre of every trade, acting as the buyer for every seller
and the seller for every buyer, ensuring that each side can make good on the terms of
the trade and protecting the integrity of the market.
4. Liquidity
Liquidity is the ability for every buyer to find a seller, and every seller to find a buyer, so
that trading activity can remain consistent and reliable.

HOW DO FUTURES CONTRACTS WORK?

The best way to understand how futures work is to think about them in terms of
something tangible. Let's say you own a large bakery company and you need to buy
wheat to make your product. Every business day, the price of wheat goes up and down.
You want to buy wheat for the lowest price possible so you can make the most profit
when you sell your finished product. But you realize that the price of wheat today might
be very different to the price a year from now. So you enter into a futures contract with
a farmer to buy his wheat at a specific price on a certain future date. This way you can
lock in a definite price and you will know exactly what your costs will be regardless of
the daily changes in wheat prices.
The farmer needs to make money, too, so he's not going to agree on a price that's way below
the current market value. So you'll agree to a fair price to ensure that both of you will be
happy with the transaction in a year. It won't be the highest or the lowest price, but neither
one of you will be affected by any major market fluctuations.

Share market futures work in much the same way. Two parties enter into a contract to
buy or sell a specific amount of shares for a certain price on a set future date. The
difference between share market futures and tangible commodities like wheat, corn,
wool and pork bellies, is that share market futures contracts are almost never held to
expiration date. The contracts are bought and sold on the futures market based on their
relative values.
In Australia, you can buy and sell single share futures or share price index futures contracts based on the performance of an index like the S &P/ASX 200.

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When you buy or sell a share market futures contract, you're not buying or selling an
actual share certificate. You're entering into a share market futures contract, an
agreement to buy or sell the actual shares at a fixed price on a certain date. Unlike a
traditional share purchase, you dont own the shares, so you're not entitled to dividends
and you're not invited to shareholders meetings. In traditional share market investing,
you make money only when you receive a dividend and/or the price of your share goes
up. With share market futures, you can make money even when the market goes down.
Here's how it works. There are two basic positions on share market futures: long and
short. The long position agrees to buy the actual shares when the contract expires. The
short position agrees to sell the actual shares when the contract expires. If you think
that the price of the actual shares will be higher in three months than it is today, you
want to go long (buy a futures contract). If you think the share price will be lower in
three months, then you'll go short (sell a futures contract).
Example
Let's look at an example of going long (buying a futures contract). It's January and you
enter into a futures contract to purchase 100 shares of BHP shares at $35 a share on
April 1. The contract has a price of $3,500 (100 shares x $35). But if the market value of
BHP goes up before April 1, you can sell the contract early for a profit. Let's say the
price of BHP rises to $37 a share on March 1. If you sell the contract for 100 shares,
you'll fetch a price of $3,700, and make a $200 profit.
The same goes for going short (selling a futures contract). You enter into a futures
contract to sell 100 shares of BHP at $35 a share on April 1 for a total price of $3,500.
But then the value of BHP shares drop to $33 a share on March 1. The strategy with
going short is to buy the contract back before having to deliver the shares. If you buy
the contract back on March 1, then you pay $3,300 for a contract that's worth $3,500.
By predicting that the share price would go down, you've made $200.

HOW DO FUTURES DIFFER FROM FORWARDS CONTRACTS?

A futures contract is similar to a forward contract except for two important differences.
First, we have discussed the fact that futures contracts are traded on organised
exchanges with standardised terms whereas forward contracts are traded over-thecounter (customised one-off transactions between a buyer and a seller). Second with

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futures contracts, intermediate gains or losses are posted each day during the life of the
futures contract. This feature is known as marking to market. The intermediate gains or
losses are given by the difference between todays futures price and yesterdays futures
price.

MARKING TO MARKET
The following example illustrates the marking to market mechanics using December gold
futures contracts on the Sydney Futures Exchange. Suppose the current futures price, on
March 2, is $800 per ounce. The contract size is 100 ounces, which indicates the buyer
has contracted to buy a total of 100 ounces gold in December at this price. The broker
requires the investor to deposit funds in an account called a margin account. The initial
margin required to be put in the account might be $5,000 per contract. At the end of
each trading day, the margin account is adjusted to reflect the investors gain or loss, i.e.
marking to market the account.
Suppose that by the end of March 3, the futures price has fallen from $800 to $795.
Change in the futures contract is 100 $5 = $500. Since the buyer has bought the
futures contract and the price has gone down, he or she has lost money on the day and
his or her broker will immediately take $500 out of his or her account. Where does the
$500 go? On the opposite side of the buyers buy order, there was a seller who has
made a gain of $500 (note that futures trading is a zero-sum game: whatever one party
loses, the counterparty gains). The $500 is credited to the sellers account. Suppose that
at the close of the following day March 4, the gold futures is $802. Since the buyer has
bought the futures and the price has gone up on the day from $795 to $802 an increase
of $7, he or she makes money. In particular $700 (i.e. 100 $7 = $700) is credited to his
account. This money comes from the sellers account.
Margin rules are stated in terms of initial margin (which must be posted when entering
the contract) and maintenance margin (which is the minimum acceptable balance in the
margin account). If the balance of the account falls below the maintenance level, the
exchange makes a margin call upon the individual, who must then restore the account
to the level of initial margin before the start of trading the following day.
If we return to our example, suppose the initial margin is $5,000 and the maintenance
margin is $4,000. Lets say that on March 11 gold prices dropped from $795 to $788 per
ounce. The buyer starts the day with a margin balance of $4,500 and the marking to

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market cash flow is $700, leaving $3,800. So a margin call is triggered and the investor
must restore the balance to the initial level. This requires a cash payment of $1,200.
Date

Futures
price

Daily
gain/loss

Beginning margin
account balance

Margin call

Closing margin
account balance

March 2

800

March 3

795

-500

5,000

4,500

March 4

802

700

4,500

5,200

March 5

800

-200

5,200

5,000

March 6

803

300

5,000

5,300

March 9

801

-200

5,300

5,100

March 10

795

-600

5,100

4,500

March 11

788

-700

4,500

3,800

March 12

788

3,800

March 13

794

600

5,000

5,600

March 16

789

-500

5,600

5,100

March 17

789

5,100

5,100

5,000

1,200

5,000

Note that when the margin balance falls to the maintenance margin, it must be restored
to the initial margin level. Note also that when the futures price moves favourably, the
marking to market cash inflow can be immediately withdrawn; it need not remain in the
margin account.
This concept of marking to market is standard across all major futures contracts.
Contracts are marked to market at the close of trading each day until the contract
expires. At expiration, there are two different mechanisms for settlement, cash
settlement and physical delivery.
Many financial futures (such as share price index futures) are cash settled. This is
because it is inconvenient or impossible to deliver the underlying assets. When a
contract is settled in cash, it is simply marked to market at the end of the last trading
day and all positions are declared closed. The settlement price on the last trading day is

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normally the closing spot price of the underlying asset (actual price of the underlying
asset on that day).

HEDGING FOREIGN EXCHANGE RISK

Importers and exporters are often concerned that contracts made with overseas buyers
and sellers will result in unfavourable outcomes if the exchange rate between the A$
and the overseas currency moves in an unfavourable direction. To reduce this risk,
importers and exporters might use derivatives to lock in foreign currency exchange
rates for future delivery of goods. The following example highlights how locking in
these exchange rates will ensure a definite cash flow outcome regardless of whether the
Australian dollar depreciates or appreciates relative to the foreign currency.

Example
You are an exporter of sheepskin products to the US. You will deliver the products to
the US in 3 months time. When you are paid, you receive US dollars. Your concern is
that the Australian dollar will appreciate against the US dollar (or alternatively, the US
dollar will depreciate against the Australian dollar). If this happens, the US dollars you
receive will not be worth as many Australian dollars as they are now. At the current
exchange rate of US$0.80 / A$1.00, US$1 million in revenue is equivalent to US$1 million
0.8 = A$1,250,000. Given you cannot foresee what the exchange rate will be in 3
months time, you are happy to buy a forward contract to lock in an exchange rate.
The forward contract that you agree on is one that expires in 3 months time and the
exchange rate is US$0.84 / A$1.00. At that rate you know now that you will receive
exactly A$1,190,476 in revenue. This is called hedging your exposure using forward
contracts and the exporter will sell US dollars forward (to exchange them for Australian
dollars).
The opposite applies for importers. If a company imports from the US then their
expenses are often denominated in US dollars. Australian importers are concerned
about the Australian dollar depreciating against the US dollar.
Lets say the actual (spot) exchange rate in 3 months time is US$0.92 / A$1.00.

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Question
What would be your export revenue if you hedge using a forward contract that locked
in the exchange rate of US$0.84 / A$1.00?
Answer
The value of export revenue if it is hedged at US$0.84 / A$1.00 would be US$1 million
0.84 = A$1,190,476.
Question
What about if you remain unhedged?
Answer
The value of export revenue if it is unhedged at US$0.92 / A$1.00 would be US$1 million
0.92 = A$1,086,957.
Question
What is your gain or loss from the hedge?
Answer
The gain (or loss) from the hedge here is $1,190,476 $1,086,957 = A$103,519
Question
Suppose the spot exchange rate in 3 months time is actually US$0.77 / A$1.00. What
would be your export revenue if you hedge using the forward?
Answer
The value of export revenue if it is hedged at US$0.84 / A$1.00 would be US$1 million
0.84 = A$1,190,476.
Question
What about if you remain unhedged?
Answer
The value of export revenue if it is unhedged at US$0.77 / A$1.00 would be US$1 million
0.77 = A$1,298,701.
Question
What is your gain or loss from the hedge?

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Answer
The gain (or loss) from the hedge here is A$1,190,476 $1,298,701 = -A$108,225

Australian dollar

Australian dollar

APPRECIATES

DEPRECIATES

to US$0.92 / A$1.00

to US$0.77 / A$1.00

Unhedged revenue

A$1,086,957

A$1,298,701

Gain (loss) on hedge

A$103,519

-A$108,225

Hedged revenue

A$1,190,476

A$1,190,476

What we can see from this example is that using a derivative (in this case a forward
contract), the exporter of sheepskin products will receive a certain A$1,190,476 in
revenue regardless of whether the exchange rate between the Australian dollar and the
US dollar moves favourably or unfavourably.

7.3

WHAT ARE OPTIONS?

An option contract is an agreement between two parties to buy/sell an asset (share or
futures contract as an example) at a fixed price and fixed date in the future.
It is called an option because unlike a futures contract, the buyer is not obliged to carry
out the transaction. If, over the life of the contract, the asset value decreases, the buyer
can simply elect not to exercise his/her right to buy/sell the asset. One of the key
differences between options and forward/futures contracts is that options as part of a
wider derivatives strategy can enable the investor to lock in a specified price if they
wish (as do forwards/futures contracts) but options can protect an investor from
downside risk whilst retaining all the upside risk (benefit). To have this flexibility, there
is a fee for the use of options which is payable upfront this is the option premium. It is

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the buyer of an option that incurs the cost of the option premium. The seller also
referred to as the writer of the option receives the option premium. The seller of an
option is the one who bears all the risk that the option buyer will exercise their option
resulting in the option seller having to fulfil the contract.
There are two types of option contracts - Call options and Put options. A Call option
gives the buyer the right to buy the underlying asset, while a Put option gives the buyer
the right to sell the underlying asset.
Example:
Amanda buys a Call option contract from Brett. The contract states that Amanda will
buy 100 Woolworths shares from Brett on the 3rd July for $25. The current share price
for Woolworths is $30.
Note: this is an example of a Call option as it gives Amanda the right to buy the
underlying asset.
If the share price of Woolworths is trading above $25 on the 3rd July, then Amanda will
exercise the option and Brett will have to sell her the Woolworths shares for $25. With
Woolworths trading anywhere above $25 Amanda can make an instant profit by taking
the shares from Brett at the agreed price of $25 and then selling the shares on the open
market for whatever the current share price is and making a profit.
The $25 value, which is stated in the agreement, is referred to as the Exercise (or Strike)
Price. This is the price at which the asset will be exchanged.
The date (in this case 3rd July) is known as the Expiry (or Maturity) Date. This date is the
deadline for the option contract. At this date, the option buyer is to decide if a
transaction of the underlying asset is to occur.
If at the expiration date, Woolworths is trading at $30, then Amanda will buy the shares
from Brett at the agreed $25 and then she can sell them back on the open market for
$30 and make an instant $5.
Alternatively, if Woolworths is trading at $20, then buying the shares from Brett at $25
is too expensive as she can buy them on the open market for $20 and save $5. In this
situation, Amanda would choose not to exercise her right to buy the shares and let the
options contract expire worthless. Her only loss would be the amount that she paid to
Brett when she bought the contract, which is called the Option Premium. Brett would,
however, keep the option premium received from Amanda as his profit.

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In the real world of exchange traded options, transactions don't really take place
between two people like weve explained above. You simply Buy or Sell an option
contract from the exchange without knowing who is on the other side.

Options can be further classified according to when they may be exercised.

European options may only be exercised on the expiration day, while American
options may be exercised at any time up to and including the expiration day. Most
options that trade on organised exchanges throughout the world are of the
American kind. European options trade primarily in the over-the-counter market.

WHO TRADES OPTIONS?

Two broad categories of players exist in the option markets: risk seekers and risk
avoider's.
A risk seeker, also known as a speculator, is the type of trader that is trying to profit
from a prediction in market direction. A speculator will have his or her own method of
analysing the market and then use the options market to make a bet on his/her analysis.
A risk avoider, also known as a hedger is in the market because s/he is trying to transfer
risk to the speculator. A hedger will use the option market to create insurance for
his/her physical position against an adverse market movement.
Hedgers will almost always engage in simultaneously buying and/or selling different
options/shares together to provide an ideal risk/reward profile. The mechanics of these
transactions are beyond the scope of this course.
All kinds of people come to futures exchanges to buy and sell futures and options
contracts. They may work for banks, corporations or governments. They may be
livestock farmers, investment managers, construction planners or food manufacturers.
Really, futures trading involves just about anyone in the world who wants either to
manage the risk of fluctuating prices, or profit from those fluctuations. But whoever
they are, and wherever they came from, these traders are interested in two types of
trading: HEDGING and SPECULATING.
The hedger buys futures contracts in order to protect him/herself from price swings in the
future. By using futures to lock in a future price for a product, the costs and profits are
more predictable. In other words, the trading of futures drives risk OUT of the business.

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But that risk doesnt just disappear into thin airit gets transferred to the speculator.
The speculator accepts price risk in pursuit of profit. Speculators have no interest in
owning the product being traded, but they are interested in the CONTRACTS for
those products. Think of it like investingbuying and selling futures contracts in order
to make a profit when prices move in the right direction.
Hedgers and speculators go hand in handif you took one away, there simply would be
no market. Hedgers transfer risk, and speculators absorb that risk. It takes both types of
traders to bring balance to the market and keep trades moving back and forth.

Example - Questions
Read the following scenarios and decide if they would be the actions of a hedger or
those of a speculator?
1. Carol buys a home with hopes to sell it when the market value exceeds the original
price. Hedger or speculator?
2. Paul is a superannuation fund manager. He contributes to a shared pool of
investments in hopes of adding value to the clients portfolio. Hedger or speculator?
3. ChocChoc Pty Ltd is a chocolate maker wanting to lock in next years cocoa supplies
in case extreme weather decreases the cocoa crop. Hedger or speculator?
4. KMart Sets up shops in new places so that increased profits will exceed operating
costs. Hedger or speculator?
5. ISD Ltd a steel distributor orders large inventories of hot rolled coil so that theyre
paid for and ready when production spikes. Hedger or speculator?

Answers:
1. Carol is speculating. She is accepting real estate market risk in exchange for the
opportunity to profit.
2. Paul is speculating. He is interacting with the markets in ways that may maximize his
clients retirement fund.
3. ChocChoc Pty Ltd is hedging. Whatever happens to next years cocoa crop, the
company has locked in a stable supply at a predictable price.

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4. Kmart is speculating. The company is putting down capital and resources with the
intent to profit off its investments.
5. ISD Ltd is hedging. The factory is locking in profits by ensuring that they have the
supply needed to meet impending demand.

WHERE ARE OPTIONS TRADED?

Option contracts are traded either;
a) on a public stock exchange (also known as ETO's (Exchange Traded Options))
b) implicitly agreed between two parties (also known as OTC's (Over The Counter
options)).
The OTC market is a complicated one, where traders from large institutions can create
and trade non-standard option derivatives. They can, for example, add their own special
rules such as: if the underlying stock trades as high as $x then the contract terminates
and the option is then worthless.

OPTION TYPES
There are two types of option contracts: Call Options and Put Options.
Call Options give the option buyer the right but not the obligation to buy the underlying
asset.
Put Options give the option buyer the right but not the obligation to sell the underlying
asset.
The previous example provided a scenario for a call options i.e. Amanda had the right to
buy the underlying asset. What if Amanda had wanted to sell the shares instead of buy
them at $25? That is why these two types of option contracts (Calls and Puts) exist.
In the previous example, Amanda bought a call option from Brett. Amanda also could
have bought a put option from Brett. Buying a put option means that Amanda buys the
right to sell Woolworths shares at $25 on the 3rd of July. Therefore Amanda will make a
profit if the market is below $25 on the day of expiration.

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Buying put options enables investors to profit when the markets fall without having to
sell (short) stock.
The ASX operates an increasingly diversified range of Futures and Options markets
including markets for equities and interest rates as well as agricultural, energy and
environmental markets that are rapidly evolving in response to market needs.

HOW DO OPTIONS PROTECT FROM DOWNSIDE RISK WHILST RETAINING

UPSIDE RISK (BENEFIT)?
Consider a scenario where a fund manager has a share portfolio that mimics the
S&P/ASX200 index. This portfolio has a value of $50 million today and the index has a
value of 4,000 points.
The fund manager concerned that the value of the index might fall by the end of the
year buys 500 put option contracts with an exercise price of 4,000 points. The premium
for these contracts is $1,125,000 (2.25% of the portfolio). This will ensure that even if
the S&P/ASX200 (and consequently the share portfolio) falls in value, the net position of
the fund manager will not fall below $50 million (less the cost of the option premium)
whilst if the market does well, the fund manager can retain all the upside benefit. When
buying or selling options contracts on the S&P/ASX 200, the one contract is denoted as
being 25 times the value of each index point. When the fund manager buys 500
contracts on the S&P/ASX200 with an exercise price of 4,000 points this is equivalent to
buying call options with a value of 500 x 25 x 4,000 = $50 million.

Scenario 1 By year end the value of the S&P/ASX200 has fallen from 4,000 to 2,800.
The share portfolio is now worth only a fraction of its initial $50 million. In fact it is
worth exactly $35 million (2,800/4,000 x $50 million). Fortunately, the fund manager
can exercise the options to sell at the agreed exercise price of 4,000. The fund manager
will receive from the seller of these option contracts the difference between the
exercise price (4,000 points) and the spot (actual value) price of 2,800.

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At year end ignoring the cost of the option premium for now, the fund managers net
position is:
Year end
Value of the portfolio

$35 million

Value of the options

500 contracts x 25 x (4,000 2,800)

$15 million

Net position

$50 million

The market has fallen but the fund manager has been protected from this fall by using
put options to offset the loss sustained in the share portfolio. The fund managers net
position has remained the same as it was when the market was 4,000 points. That is,
the net position is still $50 million.
Recall that options whilst having the ability to lock in prices can be used to ensure that
any upside benefit is retained. Lets look at how this works.

Scenario 2 By year end the value of the S&P/ASX200 has risen from 4,000 to 5,500.
The share portfolio is now worth much more than its initial $50 million. In fact it is
worth exactly $68.75 million (5,500/4,000 x $50 million). In this instance, the fund
manager would not exercise the options to sell at the agreed exercise price of 4,000.
Rather, the fund manager would simply let the options expire as worthless. At year end
ignoring the cost of the option premium for now, the fund managers net position is:
Year end
Value of the portfolio

$68.75 million

Value of the options

$0

Net position

$68.75 million

The market has risen, and the fund manager whilst protecting against a fall has been
able to retain the upside benefit of a rising market.
In the table below, we have summarised the net position of the fund manager who has
purchased put options under two scenarios, a falling market and a rising market. You

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can see that even with the cost of the options premium, the fund manager has been
able to manage their risk and retain the upside benefit that option contracts can offer.

S&P/ASX200

S&P/ASX200

DECREASES

INCREASES

to 2,800

to 5,500

Share portfolio

$35 million

$68.75 million

Put options

$15 million

Nil

Combined position

$50 million

$68.75 million

Less upfront premium

$1.125 million

$1.125 million

Net position

$48.875 million

$67.625 million

Of course in reality, the option premium must always be considered.

Example
If a writer sells a put with a strike price of $120 at $3.50 per share, what is his profit or
loss if the underlying stock at expiration is selling at $122?
a.

$2

b.

$3.50

c.

-$2

d.

-$5.50

At expiration, the buyer of the put option will not want to exercise the option to sell at
$120 given that the underlying stock can be sold for $122. This is of no consequence to
the writer (seller) of the option. The writer has generated a profit of $3.50 per share
when they sold the option in the first place.

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Example
Suppose an investor buys a put for $2.50 a share which matures in 3 months with a
strike price of $50. What is the rate of return if the stock price falls to $46 on the
expiration date?
a. 40%
b. 50%
c. 55%
d. 60%
In this example, if the price falls to $46, the buyer of the put will exercise the put option.
The investor will have made a profit of $4 per share if they sell for $50 but we must
remember to deduct the cost of the option premium - $2.50 per share. This emans the
total profit for the investor is $4 less $2.50 = $1.50.
The rate of return is profit/investment = $1.50/$2.50 = 60%

IN THE MONEY, AT THE MONEY, OUT OF THE MONEY

The term in the money, at the money and out of the money are used to describe the
possible relationships between the spot price in the market and the strike price on an
options contract.
For example, a call contract is in the money if the price of the underlying security is
higher than the options contract's strike price. Conversely, a put contract is in the
money if the price of the underlying security is lower than the options contract's strike
price.

A call contract is at the money if the price of the underlying security is equal to the
options contract's strike price. Conversely, a put contract is at the money if the price of
the underlying security is equal to the options contract's strike price.
A call contract is out of the money if the price of the underlying security is lower than
the options contract's strike price. Conversely, a put contract is out of the money if the
price of the underlying security is higher than the options contract's strike price.

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Example - In the money

If March greasy wool futures are trading at $12.75, then any March greasy wool call
option with a strike price of less than $12.75 is considered to be in the money. A put
option with a strike price greater than $12.75 is considered to be in the money.
Example - At the money
If September wheat futures are trading at $40.20, then any September wheat call
option with a strike price of $40.20 is considered to be at the money. A put option with
a strike price of $40.20 is considered to be at the money.
Example - Out of the money
If December crude oil futures are trading at $75.50, then any December crude oil call
option with a strike price greater than $75.50 is considered to be out of the money. A
put option with a strike price less than $75.50 is considered to be out of the money.

CONCLUDING REMARKS
The key take away for this section on derivatives is that they help in transferring risk. In
our global market environmentdriven by constant and changing market risks,
instantaneous information flows, and sophisticated technologyderivatives are an
essential instrument of finance.

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IMPORTANT

You must now complete the remaining Multiple Choice assessments

for Module 2

A few tips:

You can access the Multiple Choice Questions at

monarch.mywisenet.com.au

Press Ctrl F if you want to search the pdf course materials for any
key words or terms.

You have 2 attempts. Please note, if you require a second attempt,

the answers are shuffled so read them carefully. The highest score
counts.

If you are unsuccessful after 2 attempts, please contact our office

on 1300 738 955.

Once you complete this Multiple Choice assessment, you should complete
the workplace simulation and the assignment for Module 2.

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