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Econ 1710 Investments I Spring 2018 - KUO Homework #1 Homework is due on Monday, January 29 by the start of class. Late homework (graded on the basis of half credit) will be accepted until Wednesday, January 31 by the start of class. As stated on the syllabus, homework is graded on completion and good faith effort, determined at my discretion. Note also that I refer to a table in the 10th edition of the textbook (Investments by Bodie, Kane and Marcus) that you need to complete Q5 and Q6. There are TWO copies on 3-hour reserve at Rockefeller Library (“the Rock”). Question 1) Useful for you. Most of you will be investing in financial markets either through your own savings (brokerage account) or through your retirement savings. Hopefully upon graduating, you will have a job and face this decision. This question is intended for you to get a jump start on your decision-making, and you will get the most out of this assignment if you try to put yourself as much as possible in the shoes of the future you and act the way that the future you would act. There is no right or wrong answer to this question. Credit will be received by being thoughtful about the questions in 3-5 sentence answers. Suppose you just graduated from Brown and receive a fulltime position with a guaranteed salary of $60,000 per year, ignoring any bonuses that you could receive. It turns out that you qualify immediately for your company’s 401(k) retirement plan, under which they will match the first 6% contributed by you at 50%. For example, your company contributes to your 401(k) as follows: Your contribution (as % of salary) 0% 1% 2% 4% 6% 7% Max out

Company’s contribution (50% match rate) 0% 0.5% 1% 2% 3% 3% 3%

The maximum contribution limit1 given by the IRS for 2018 is $18,500 commonly referred to as the “401(k) plan limit.” For you to “max out,” you would be contributing 18,500/60,000 = 31% of salary. (a) What are the benefits to investing within a 401k plan, rather than investing the same amount in a brokerage account (saved from your take-home pay)? How do those benefits differ as your pay (and tax bracket) increase? List some online references that you used. (1a) The benefit of investing in a 401(k) retirement plan is that your contributions are made with """"""""""""""""""""""""""""""""""""""""""""""""""""""""""""" 1 This is the limit for a worker under age 50. Workers aged 50 and above are permitted “catch-up” contributions as they are close to retirement.

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pre-tax dollars rather than after-tax dollars (e.g. your take home pay) which translates into more money in your pocket. ALSO - Even though you eventually pay taxes on the savings in a 401k, it is only upon withdrawal (when you retire), so you may be in a lower tax bracket than your current one. More importantly, under a 401k plan, your gains accumulate tax-free (even if you buy and sell different funds) while buying and selling in a taxable brokerage fund triggers capital gains taxes for every transaction. In other words, even if your tax bracket is the same while working (while making contributions) and after retirement (when you go to withdraw), when you get taxed doesn’t matter, but your gains along the way are not taxed (which is not the case if you are investing in a typical brokerage account when you need to pay capital gains taxes). (b) Think about your potential living expenses, student loan payments, and other obligations you might have. Think about what your take home pay is, and how you would like to live. How much are you going to contribute to retirement (as a % of salary) and why? Open ended

(c) Let’s think about how you would invest these retirement savings, using Brown University as an example since we can access the retirement information that it provides its employees. Go to: [https://www.brown.edu/about/administration/human-resources/benefits/retirementplans-faculty-and-non-union-staff], scroll down and click on TIAA. If you were a new employee at Brown, you would have the “Deferred Vesting Retirement Plan” so click on (view plan details) for that plan on the TIAA-CREF website. Look around this page to find the mutual fund investment choices (as a new employee would). What investment choices are you making with your retirement and why? (If you are not contributing anything from part (b), assume now that you are making some contribution, and make hypothetical investment choices). Describe how and why you made these choices (and list any source that you used to make this choice – did you look through the internet, call your parents for advice, ask your fellow classmates for advice, perform research (what and how). Open ended

Question 2) Wall Street firms have traditionally compensated their traders with a share of the trading profits that they generated. What kind of impact could this practice have on traders’ willingness to assume risk? What kind of agency problem has arisen from this practice?

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Allowing traders to share in the profits increases the traders’ willingness to assume risk. Traders will share in the upside potential directly but only in the downside indirectly (poor performance = potential job loss). Shareholders, by contrast, are affected directly by both the upside and downside potential of risk

Question 3) The average rate of return on investments in large stocks (i.e. S&P 500) has outpaced that on investments in Treasury bills by about 7% per year since 1926. If this is the case, why would anyone bother investing in Treasury bills? Treasury bills serve a purpose for investors who prefer a low-risk investment. The lower average rate of return compared to stocks is the price investors pay for predictability of investment performance and portfolio value.

Question 4) The textbook notes that financial assets do not contribute directly to GDP, whereas real assets (such as land, factories, and technology) constitute the true productive capacity of an economy. However, it is hard to imagine a modern economy that does not have well-developed financial markets with many kinds of securities. Suppose there were no markets in which one could trade financial assets. How might the productive capacity of the U.S. economy be affected? Financial assets make it easy for large firms to raise the capital needed to finance their investments in real assets. If Ford, for example, could not issue stocks or bonds to the general public, it would have a far more difficult time raising capital. Contraction of the supply of financial assets would make financing more difficult, thereby increasing the cost of capital. A higher cost of capital results in less investment and lower real growth.

Question 5) Refer to Figure 2.3 (in Chapter 2, page 35) which lists quotes of Treasury bonds and notes. **Please use the 10th edition version of the textbook (available on reserve at the Rock). a) What were the bid price (in $), asked price (in $), and yield to maturity on a $1000 par value 4.5% February 2036 bond? What was its (asked) price (in $) on the previous day? Maturity February 15, 2036 BID = $1,380.46 ASK = $1,381.50 YTM = 2.378% Ask price the previous day: $1,390.63 b) Look at the Treasury bond maturing in May 2042. i) How much would you have to pay to purchase one of these notes? ii) What is its coupon rate? iii) What is the current yield on the note? $1,083.59 -- Coupon $30.00/year or payments of $15.00 paid semiannually. -- Current yield = 2.77% ©"2018"Sylvia"Kuo."All"rights"reserved."This"material"may"not"be"reproduced,"displayed,"modified"or"distributed"without"the" express"prior"written"permission"of"the"copyright"holder."For"permission,"contact"[[email protected]]"

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Question 6) Refer to Figure 2.8 (in Chapter 2, page 43) which lists quotes of various stocks traded on the New York Stock Exchange (NYSE), and look at the listing for the Gap stock. a) How many shares could you buy for $2,500? b) What would be your annual dividend income from those shares? c) What are the earnings per share (EPS) for the company? d) What was the company’s closing price on the day before the listing? (a) 87 shares. (b) Your annual dividend income = $43.50 per year EPS = $1.69 (c) yesterday’s close = $27.97

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