Iowa Electronic Markets Personal Finance and Portfolio Management Strategies

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Iowa Electronic MarketsPersonal Finance and
Portfolio Management Strategies

• Personal Finance Curriculum
• using the
• Federal Reserve Monetary Policy Market
• and Computer Industry Returns Market

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Personal Finance and Portfolio Management
Strategies byJan E. ChristopherDelaware
State Universityand Juliet U. EluSpelman
College August 2001
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Learning Objectives

• Objectives -- Students should be able to
• Understand how the IEM can be used to make
  rational investment decisions
• Explain the relationship between the IEM,
  financial responsibility, and mortgage and asset
  acquisition
• Explain how the IEM predicts the movement of
  financial markets such as the stock, bonds and
  alternative investment markets
• Use the IEM as a framework to track existing
  portfolios and predict movements in the equity
  markets

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Lecture OutlinePersonal Finance and Portfolio
Management Strategies

• 1. Introduction
• Personal Finance Planning
• Budgeting and Cash flow Management
• Money Management Strategy
• Credit and Debt Management
• Tax Planning
• 2. Providers of Financial Services and
  availability of Funds Banking Services and
  Savings Plan
• Mortgage and Tangible Assets Financing
• Interest Rate Fundamentals
• Stocks, Bonds and Mutual Fund Quotations
• Insurance Services and Hedging Strategies
• 3. Investment Decisions
• Understanding the Relationship between Personal
  Finance and Investment
• Using the IEM to make Rational Investment
  Decisions
• Trading and Tracking Stocks using the IEM
• Predicting Future Trades Based on Historical
  Trends
• Understanding Risk and Return
• 4. Summary

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Lecture NotesPersonal Finance and Portfolio
Management Strategies
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Introduction

• The Personal Finance and Portfolio Management
  Strategies module seeks to define the correlation
  of money management strategies with economic and
  political activities using the IEM. Students
  will be introduced to classroom materials that
  enable them to understand the impact of consumer
  credit and debt as they apply to personal
  financial management strategies. The IEM will be
  used to predict and forecast market outcomes.
• Upon completing a series of assignments, students
  will be able to understand the importance of
  personal financial planning and economic
  activities. In addition, Internet activities
  will be assigned to explain why banking services,
  developing personal savings plans, and
  interpreting payment accounts are paramount to
  personal financial management strategies.

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Why Financial Planning Is Beneficial

• Personal financial planning is the process of
  managing your money to achieve personal economic
  satisfaction.
• There are several advantages of personal
  financial planning
• Increased effectiveness in obtaining, using, and
  protecting financial resources.
• Increased control over ones financial affairs.
• Improved personal relationships.
• A sense of freedom from financial worries.

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The Financial Planning Process

• Assess your current financial situation
• Set financial goals
• Identify alternative courses of action
• Evaluate alternatives
• Create and implement a financial action plan
• Reevaluate and revise your plan regularly

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What Variables Affect the Financial Planning
Process?

• Opportunity cost of money the trade-off
  between present and future consumption
• Risk assessment variables such as inflation
  risk, interest rate risk, loss of income,
  personal risks, and liquidity premium
• Realistic financial time frames near-tern,
  short run, long run for investments based on
  financial needs
• Personal values size of households, marital
  status, divorces, general norms and ethics
• Economic forces Federal Reserve policy, global
  influences, and market forces
• Changing economic conditions Consumer prices,
  spending habits, interest rates, Gross Domestic
  Product (GDP), balance of trade, and fluctuations
  in stock market indexes

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Significant Terminology Used in the Financial
Planning Process

• The time value of money is the increase in an
  amount of money that results from interest earned
  on an investment. The time value of money is
  usually categorized into two components the
  present value and the future value.
• The future value of money is a compounding
  process over time, i.e., the amount to which a
  sum invested can increase over time based on the
  number of years invested.
• The present value of money is the reverse of
  the future value and involves a discounting
  process that reflects what the investment is
  worth in current dollars.

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Example of the Compounding Process Using Future
Value

• FV PV(1 i)n
• where n number of years
• The future value of 100 at an 8 interest rate
  to be received in 1 year is
• FV 100(1.08)1 108
• Note to take advantage of the compounding
  process, present consumption must be sacrificed.

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Example of the Discounting Process Using Present
Value

• PV FV
• (1 i)n
• where n number of years
• The present value of 100 to be received at the
  end of one year at an 8 interest rate is
• PV 100
• (1.08)1 92.59

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Example of the Future Value Interest Factor for
an Annuity
The future value interest factor for a one-dollar
annuity discounted at i percent for n periods of
1000 to be received at the end of three year at
an 6 interest rate is FVIFA 6,3 (1.06)2
(1.06)1 (1.06)0
1.1236 1.06 1 3.1836 FV
of the Annuity PMT(FVIFAi,n) 1,000 x 3.184
3,184
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Example of the Present Value Interest Factor for
an Annuity
The present value interest factor for a
one-dollar annuity discounted at i percent for n
periods of 1000 to be received at the end of
three year at an 6 interest rate is PVIFA 6,3
___1___ __1__ ___1___
(1.06)1 (1.06)2
(1.06)3
.9433 .88999 .83961 2.673 PV
of the Annuity PMT(PVIFAi,n) 1,000 x 2.673
2,673
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Budgeting and Cash Flow Management
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Budgeting

• Budgeting is the process of projecting,
  organizing, monitoring, and controlling future
  income and expenditures. Items such as cash,
  credit purchases, savings, transportation,
  homeownership and living arrangements are within
  the parameters of the budgeting process. A
  budget should project actual income and
  expenditures, which are presented on an income
  statement. Financial planning consists of
  creating a balance sheet showing assets,
  liabilities, and net worth. Effective financial
  management requires reconciliation of the income
  statement and balance sheet.
• Financial planning and budgeting are positively
  correlated, and are paramount to personal
  financial planning process.

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Cash-Flow Management

• Cash Management is the task of maximizing
  interest earnings and minimizing fees and other
  costs of living. Cash management involves those
  funds that are kept readily available and
  relatively liquid for household expenses,
  investment opportunities, and emergencies.
• The primary providers of cash management services
  are banks, non-bank financial institutions,
  mutual funds, stock brokerages, licensed
  lenders, and other financial services
  institutions.
• Tools of cash management include interest-bearing
  checking accounts, savings accounts that compound
  interest daily, certificates of deposits, U.S.
  government bonds, government securities, and
  money market accounts such as super NOW accounts,
  money market mutual funds, and asset management
  accounts.

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Money Management Strategies

• Effective money management strategies include
  organizing and maintaining personal financial
  records, overseeing the household budget,
  handling the checkbook, and achieving financial
  goals based on careful planning through the
  balance sheet and cash flow statements.
• A cash-flow statement summarizes all cash
  receipts and payments for a given time frame.
  The cash flow statement provides information on
  income and spending behavior.
• A balance sheet, also known as the net worth
  statement, lists all items of value and all
  amounts owed. These are referred to as assets
  and liabilities, respectively. The balance sheet
  illustrates projected savings and expenses.
• A budget assesses the current financial
  situation, provides direction for achieving
  financial goals, creates budget allowances, and
  provides feedback for evaluating planned
  objectives.

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Key Variables in Asset Management Strategies

• Asset Management, also known as Money Management,
  is the individuals ability to select from
  different investment alternatives (tangible
  assets) that will allow the achievement of
  financial goals. The main goal of Asset
  Management is to maximize the wealth of the
  individual, including the ability to minimize
  risk, hedge against inflation, obtain financial
  stability and provide for ones family. Tangible
  Assets include
• Personal and Employment Records
• Tax Records
• Credit Records
• Consumer Purchase Records
• Housing or Rent Records
• Investment Records
• Items of Value
• Automobile Records

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Key Indicators of Good Financial Management

• Debt Ratio Liabilities/Net Worth
• Current Ratio Liquid Assets/Current
  Liabilities
• Liquidity Ratio Liquid Assets/Monthly Expenses
• Debt Payment Ratio Monthly Credit
  Payments/Take Home Pay
• Savings Ratio Amount Saved Per Year/Gross
  Annual Income

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The Debt-to-Equity Ratio

• Equity, also known as Net Worth, is the value of
  the items that individuals own. In general, Net
  Worth is the equity that remains when the
  individual owners calculate the sum of their
  assets minus the sum of their liabilities.
• Liabilities are the claims to Equity from owing
  to creditors more than the sum of ones current
  income and existing Net Worth. For example,
  liabilities can include car payments, credit card
  balances, charge card balances, insurance
  premiums, student loans, bank loans, small
  personal loans, alimony, child support,
  retroactive taxes, and loans promised to repay
  family members and friends. From a societal
  point of view, an individuals liabilities do not
  include the value of the home and the amount of
  the house payments.
• The Debt-to-Equity Ratio calculates the amount of
  consumer debt as a ratio of the assets an
  individual owns. For example, a person with
  24,000 in debts and 60,000 in assets has equity
  of 36,000 (60,000-24,000) or a Debt-to-Equity
  Ratio of 0.67 (24,000/36,000), which is
  considered high by financial solvency standards.
  If the Debt-to-Equity Ratio is close to 1 then
  the individual has reached an upper limit in debt
  obligations. As a rule of thumb, the
  Debt-to-Equity Ratio should not be more than 0.33.

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The Current Ratio

• The Current Ratio is the proportion of Current
  Assets to Current Liabilities. In personal
  finance, monthly utilities can be regarded as
  part of current liabilities. Individuals should
  know their current liabilities on a regular basis
  to understand the impact of their utility bills
  (e.g., gas, electric, water and sewage, telephone
  and wireless communications, trash collection,
  Internet and cable) on disposable income, in
  order to maintain payments on ones remaining
  liabilities.
• For example, with rising natural gas and heating
  oil prices, an individuals consumption could
  have increased from 650 per month in December
  2000 to 1,150 for the month of January 2001. If
  current liabilities were 2000 per month in
  December and 2,500 in January, then the current
  ratio will be 20 (2,000/5,000x100) in
  December and 50 (2,500/5,000x100) in January.

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Liquidity Ratios

• The Liquidity Ratio is the ability of individuals
  to turn their assets into cash with minimum or no
  transactions costs. The basic liquidity ratio
  calculates the number of months a household can
  continue to meet its expenses from monetary
  assets after a total loss of income.
• Examples of liquid assets include, Certificates
  of Deposit, interest and dividends earned from
  assets, mutual funds, and the selling of assets,
  including the selling of stocks and bonds.
• For example, if total expenses for the month of
  January 2001 were 2,500 and monetary liquid
  assets necessary to pay the January expenses were
  4,000, then the basic Liquidity Ratio would be
  1.6 (4,000/2,500). This ratio shows that the
  individual only has monetary assets to support
  about one and one-half months expenses.
  Research demonstrates that individuals should
  have at least three months in monetary cash
  reserves for emergency purposes. Consumption
  patterns may vary however, the higher the
  liquidity ratio, the better.

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Debt Service-to-Income Ratio

• The amount of total monthly debt payments an
  individual makes is considered to be the
  individuals debt service. The debt service is
  calculated on gross income when mortgage payments
  are taken into consideration, yet are calculated
  on net income when house payments are excluded
  (since mortgages are classified as long-term
  liabilities).
• When the debt service amount is compared to the
  individuals disposable income, a benchmark of
  20 or less is used. Individuals who spend more
  than 20 of their monthly income on debt
  obligations have no flexibility in their monthly
  budget expenses.
• For example, in January 2001 an individuals
  monthly debt payments were 2,500 and income was
  5,000 the debt service-to-income ratio is 50
  (2,500/5,000).

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The Savings Ratio

• From an economic perspective, saving is the
  difference between disposable income and
  consumption. In other words, income not spent on
  current consumption is saved.
• The savings ratio is the proportion of the total
  annual amount of savings to total annual
  disposable income. A high savings ratio
  indicates lower debt service. A high income
  does not necessarily indicate a high savings
  ratio, however. High income individuals may spend
  additional income on tangible assets or
  investments and low income individuals may spend
  a disproportionate amount on debt service. At
  low incomes most individuals have a zero savings
  ratio.
• Hence, the savings ratio may depend on individual
  consumption patterns. On a monthly basis, the
  savings ratio is the amount saved each month
  divided by total monthly gross income.
  Individuals should save at least 10 of their
  income. For example, if total gross income is
  5,000 per month, then the expected savings
  should be 500 for that month.

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Credit and Debt Management
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Develop a Debt Management Plan to Control Credit
Usage

• Develop a plan to manage debt.
• The major sources of consumer credit are
  financial institutions such as commercial banks,
  building and loan associations, licensed lenders,
  credit unions, credit card banks, risk managers,
  and insurers. Other sources of credit are
  non-financial, including governmental agencies,
  families, friends, and community-based
  organizations.
• Debt management is the ability to meet debt
  obligations in both the short term and the long
  term.

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Credit Management

• The cost of credit includes the finance charge
  quoted as the Annual Percentage Rate (APR).
• Interest payments represent part of the finance
  charge. Other components of the finance charge
  can include service charges, appraisal fees,
  credit-related insurance premiums, and punitive
  interest rates levied on certain borrowers.
• The Annual Percentage Rate (APR) reflects the
  actual rate of borrowing. It expresses the
  relative cost of credit on a yearly basis and is
  the key to comparing costs between and among
  lenders.
• Approximate APR 2 x n x I
• P(N 1)
• where, nNumber of payment periods in one year
• PPrincipal, net amount of the loan
• ITotal dollar cost of credit
• NTotal number of payments to pay off
  loan

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Debt Management

• Debt can be a serious problem if not controlled
  properly. Evidence of debt mismanagement can
  include, but is not limited to
• Emotional problems
• Loss of income
• Keeping up with Jones Keeping Ahead of the
  Smith
• Overindulgence
• Instant gratification
• Using money to punish or to comfort
• Sickness and Long-term Illness
• Unemployment
• Overextending
• Miscommunication and misunderstanding of finance
  charges

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Signals of Debt Mismanagement

• According to the Consumer Credit Education
  Foundation, some of the warning signals of a
  potential debt problem
• Paying only the minimum balance on a credit card
  bill each month
• Missing payments
• Paying late
• Paying some bills this month and others next
  month
• Intentionally using the overdraft or automatic
  loan feature on a checking account
• Putting off medical and dental visits because you
  cannot afford them right away
• Unable to handle unexpected expenses
• Depending on overtime or moonlighting to meet
  everyday expenses
• Taking frequent cash advances on credit cards

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Tax Planning
Tax Planning Strategy is the ability of an
individual to effectively reduce, defer, or
eliminate some taxes. Tax planning can influence
an individuals spending, savings, borrowing, and
investment decisions. An understanding of the
tax laws and maintenance of appropriate records
can assist an individual to take advantage of
some tax shelters. To successfully achieve this
goal, it is essential to determine ones current
tax liability and the impact of the liability on
financial transactions. Personal income tax is
assessed on taxable income and the objective is
to legally pay your fair share of taxes while
taking advantage of the tax benefits appropriate
to your personal financial situation.
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Tax Planning (continued)

• Administration and Classification of Taxes -
  Taxes are compulsory charges imposed by the
  Federal, State, and Local governments on
  citizens. Taxes are major sources of revenue for
  the government and as such are mandatory and
  affect ones personal finance decision.
• There are four distinct types of taxes
• Taxes on Purchase - These are taxes imposed by
  state and local governments that are added to the
  purchase price of the product such as a sales
  tax. With the exceptions of (Alaska, Delaware,
  Montana, New Hampshire, and Oregon) all states
  have a sales tax. Another form of purchase tax
  is the excise tax that is a tax levied on
  specific goods and services, such as gasoline,
  cigarettes, alcoholic beverages, air travel, and
  tires.
• Taxes on Property - These are taxes imposed by
  local governments on real estate and serve as a
  major source of revenue for the municipality.

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Tax Planning (continued)

• Taxes on Wealth - This can be an estate or
  inheritance tax. The estate tax is imposed on
  the value of a persons property at the time of
  his or her death, while the inheritance tax is
  levied on the property bequeathed by a deceased
  person.
• Taxes on Earnings - These are taxes imposed by
  the Federal government on income earned from
  wages, interest earnings from bonds, dividend
  earnings from stocks, all capital gains from
  tangible and non-tangible assets, and any other
  income received from miscellaneous employment.
  The income tax levied by the Federal government
  is the largest tax component paid by individuals,
  and it serves as a major source of revenue for
  the Federal government and, as such, is based on
  the ability-to-pay concept. The federal income
  tax is progressive in nature which means that the
  higher an individuals or households income, the
  higher the percentage of tax that individual or
  household must pay. See tax rates table below

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Tax Rate Table
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Marginal and Average Tax Rates

• The concepts of marginal and average tax rates
  explain why some individuals choose to maximize
  income, whereas others choose to remain in lower
  tax brackets to minimize their overall tax
  liabilities.
• The marginal tax rate is the tax paid on
  additional income earned and it is used to ensure
  the progressive nature of the income tax. The
  average tax rate is the total tax liability as a
  percentage of income. As a rule, the marginal
  tax rate will be greater than the average tax
  rate. If the average tax rate is greater than
  the marginal tax rate, then it is a regressive
  tax which implies that the higher ones income,
  the lower ones tax liability.
• Example A single individual with a taxable
  income of 45,000 will pay a tax of 5,390?
  (45,000 - 25,750(.28) (Refer to tax the table
  above.) The average tax rate is 12
  ?(5,390/45,000 x 100).
• The marginal tax is 28 and the average tax is
  12.

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The Ways Taxes Are Paid

• Taxes are paid through payroll withholding and
  estimated taxes. The most common is the payroll
  withholding method which is where the employee
  authorizes the employer to withhold a portion of
  the employees income for tax purposes. The
  amount withheld is based on the amount of income
  earned, the number of exemptions, the number of
  dependents reported by the employee on Form W-4
  (the Employees Withholding Allowance
  Certificate), and the possible estimated tax
  liability. The estimated tax method is for
  self-employed individuals where tax liability is
  estimated and paid in quarterly installments.
  Form 1040-ES (Estimated Tax for Individuals) must
  be filed.

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Calculating Adjusted Income

• The federal income tax is based on the earned
  taxable income, adjusted for allowable
  deductions, from which net taxable income is
  computed. Gross income includes, but is not
  limited to, wages, profits, interest payments,
  dividends, alimonies, child support, gaming and
  lottery incomes, commissions, property rentals,
  and all other monetary awards. Deductions
  include standard deductions and exemption, or
  itemized deductions and exemptions. The gross
  income less deductions is equal to the net
  taxable income (see tax table above for tax
  brackets).
• Example Brenda Charles had earnings from her
  salary of 40,000, interest on savings of 800, a
  contribution to an Individual Retirement Account
  (IRA) of 1,500, and dividend earnings of 600.
  What is Brendas adjusted income? Salary
  Earnings 40,000 Interest on Savings
  800 Dividend Earnings 600
  Total Gross Income 41,400 Less
  IRA 1,500 Adjusted
  Income 39,900

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Tax Shelter Strategies

• The objective of tax strategy is to legitimately
  reduce ones tax burden and concurrently not to
  evade paying tax. Some of the strategies related
  to tax planning include, but are not limited to
• Consumer purchasing strategy - In personal
  finance, one of the biggest tax shelters for
  consumers is the purchase or ownership of real
  estate (residential and otherwise). The cost of
  financing which is the same as the interest
  payment for real estate property and mortgages is
  tax deductible (as itemized deductions). People
  with equity in their homes can consolidate their
  finances by obtaining home equity loans (second
  mortgages) to purchase other tangible items, such
  as cars, furniture, and even payoff credit card
  bills, while taking advantage of the low interest
  rates on second mortgages and the ability to
  deduct taxes paid at the end of the year.
  Individuals are allowed to deduct interest on
  loans of up to 100,000 secured by their primary
  or secondary home up to actual dollar amounts
  invested in the home.

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Tax Shelter Strategies (continued)

• Job-Related Expenses as itemized deductions. The
  current tax law allows individuals to deduct
  business-related expenses such as travel
  expenses, membership dues, education costs, job
  search expenses, and miscellaneous expenses
  associated with professional development
  activities.
• Investment Decisions
• Tax-exempt Investment Instruments. Most
  municipal bonds that are issued by state and
  local governments are tax exempt. Even though
  they have lower interest rates, for people in the
  28 percent tax bracket and above, the after-tax
  income may be higher when compared to investing
  in a taxable instrument. For example, a 200
  investment owned by an individual in the 28
  percent tax bracket would be worth more than a
  taxable investment of 250. The 250 would have
  an after-tax value of 180 250 less 70 (28
  percent of 250) for taxes.

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Tax Shelter Strategies (continued)

• Investment Decisions (continued)
• Tax-Deferred Investment Instruments. These are
  investments whose incomes can be taxed at a later
  date such as treasury bonds and retirement plans.
  For example, capital gains (profits from the sale
  of stocks, bonds, and real estate) can be
  deferred. Taxes are not due until the asset is
  sold and taxes are based on the income bracket
  and how long the assets are held. Effective
  January 2001, individuals in the 15 percent tax
  bracket with capital gains on assets held for a
  year or less are taxed at the ordinary income tax
  rate of 15 percent, gains on assets held for more
  than 1 year but less than 5 years are taxed at 10
  percent, and gains on asset held for more than 5
  years are taxed at 8 percent. For individuals
  in the 28 percent to 39.6 percent tax bracket
  with capital gains on assets held for a year or
  less, capital gains are taxed at the ordinary
  income tax rate, gains on assets held for more
  than 1 year but less

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Tax Shelter Strategies (continued)

• Investment Decisions (continued)
• than 5 years are taxed at 20 percent, and gains
  on asset held for more than 5 years are taxed at
  18 percent. Capital gains of 500,000 (couple
  filing jointly) and 250,000 (for singles) on the
  sale of a home may be excluded if used as a
  primary resident however, this is allowed only
  once every two years.
• Self-Employment. Business owners such as sole
  proprietors and partnerships have tax advantages
  because they can deduct expenses such as health
  and life insurance as business expenses. But they
  also have to pay self-employment tax, in addition
  to their regular income tax.

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Tax Shelter Strategies (continued)

• Investment Decisions (continued)
• Childrens Investment. Investment incomes passed
  over to children (provided they are under 14) are
  tax exempt. Investment income over 1,300 is
  taxed at the parents rate, however, 650 is
  deductible, and the next 650 is taxed at the
  childs rate of 15 percent.
• Retirement Plans. The use of tax-deferred plans
  such as IRAs, Roth IRAs, Keogh plans, and 401(k)
  plans are highly encouraged for those people who
  do not participate in employer-sponsored
  retirement plans. People with adjusted gross
  income of 41,000 for singles and 61,000 for
  couples can establish the traditional IRA account
  of 2,000 per year which is tax deductible. Only
  in cases of emergencies such as death or
  disability, medical expenses, and qualified
  higher education expenses, will there be an
  exception to the rule, otherwise early
  withdrawals (before age 60) are subject to a 10
  percent penalty.

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Tax Shelter Strategies (continued)

• The Roth IRA also has limited adjusted gross
  income guidelines. Roth IRAs are not tax
  deductible, but the earnings are tax deductible
  after five years and individuals can withdraw
  from it before retirement. The advantage of the
  Roth IRA is that the investment grows in value on
  a tax-free basis, and withdrawals are exempt from
  federal and state taxation.
• The Keogh Plan is for self-employed individuals
  who are allowed to contribute up to 25 percent
  (maximum of 30,000) of their annual income on a
  retirement plan. The 401(k) plan authorizes a
  tax-deferred retirement plan sponsored by the
  employer. The employer contributes about 50
  cents for each dollar to the employees
  retirement plan, and the employee is allowed to
  match it, if desired.
• The retirement plan is a good way to minimize tax
  liability for people in low and middle income
  brackets. For people in the high income
  bracket, tax-deferred investments are the
  appropriate strategy for tax shelter.

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Providers of Financial Services and Availability
of Funds
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Banking Services and Savings Plans

• Banks provide four basic types of services
• Savings accounts
• Payment accounts and transfer of funds
• Loans and credit alternatives
• Other services, such as funds available for real
  estate, insurance, portfolio or investment
  management, tax assistance, financial planning,
  trust fund management, and asset management
  services.
• The categorization of banks consists primarily of
  full service banks, wholesale banks, credit card
  banks, federal savings banks, state savings
  banks, trust companies, and non-deposit trust
  companies.
• Cyberbanking provides computerized financial
  services using multimedia such as the telephone,
  the personal computer, and the Internet.
  Electronic banking includes such services as
  direct deposit, electronic funds and wire
  transfers, transfers of funds between accounts,
  electronic payments, point-of-sale transactions,
  stored-value cards, Automated Teller Machines
  (ATM), electronic cash (cybercash), and applying
  for loans online.

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Savings Plans

• Savings plans are financial services offered by
  commercial banks, building and loan associations,
  federal savings banks, credit unions, mortgage
  companies, life insurance companies, and mutual
  savings banks.
• Types of savings plans include, regular savings
  accounts, certificates of deposit, money market
  savings accounts, money market mutual funds,
  annuities, U.S. government securities, flexible
  and whole life insurance policies, and Negotiated
  Order of Withdrawal (NOW) accounts.

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Mortgage and Tangible Asset Financing
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Mortgage Financing

• Mortgage financing has evolved to include
  mortgage-backed securities, Real Estate
  Investment Trusts (REITs), security debt and
  other financial instruments used to make home
  mortgages more affordable.
• Other innovations in the mortgage markets include
  standardized mortgage documents, automated
  underwriting, automated tools to determine credit
  risks, and the creation of a market for
  conventional mortgage securities.

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Real Estate Investment and Cash Flow

• Real Estate Investments are a form of savings and
  are expected to generate positive cash flow when
  the amount received is greater than the expenses
  paid.
• If rental property is owned, the amount of rental
  income remaining after paying all operating
  expenses including repairs and mortgage expenses
  is also called Cash Flow.
• Positive cash flow is determined by current
  income. It is analogous to cash dividends
  received by owners of common stock and mutual
  funds.

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Direct and Indirect Real Estate Investment

• Direct Real Estate Investment
• The investor holds the title to the property.
• Home ownership is the major form of direct
  investment. Homeownership is a major asset of
  most households.
• There are tax advantages and possible hedging
  against inflation with direct real estate
  investment.
• Other forms of direct real estate investment can
  include land ownership, ownership of commercial
  rental property, and ownership of vacation homes
  and time shares.
• Indirect Real Estate Investment
• Real estate syndicates are usually organized as a
  corporation, trust, or limited partnership.
• Real Estate Investment Trusts (REITs), which are
  similar to mutual funds, are a real-estate based
  investment tool.
• First and second mortgages may be packaged as
  investments.
• Participation certificates are equity investments
  in a pool of mortgages that have been purchased
  by a government agency.

51
Interest Rate Fundamentals

• The Interest Rate is the payment made to
  borrowers or lenders to compensate them for the
  costs of money that is borrowed or lent.
• The Present Value is a discounting process
  comparing a dollar received today with a dollar
  received at some point in the future.
• The Future Value of money is the compounded sum
  when the current value is increased by an amount
  of interest based on a certain interest rate over
  a specific time frame.
• There is an inverse relationship between the
  Present Value and the Future Value.
• The effective rate of interest is determined by
  the frequency of compounding. Loans that are
  compounded more frequently have a higher finance
  charge. Savings and Investments that are
  compounded more frequently have a higher yield.

52
Present Value

• To calculate the present value of money it is
  necessary to know the current interest rate. In
  addition, the dollar amount to be borrowed or
  saved, also known as the Principal and the
  length of time, are required to complete the
  calculation. To calculate the Present Value, the
  Principal and the interest rate must be known.
• The Present Value is equal to the Future Value
  
  (1 r)n
• The present value of 1,000 to be received two
  years from today based on a 7 percent interest
  rate is 873.44
• 873.44 1,000
  (1 .07)2
• At 7 At 9 At 11
• 873.44 841.68 811.62

53
Future Value

• To calculate the Future Value of money it is
  necessary to know the current interest rate. In
  addition, the dollar amount to be borrowed or
  saved, also known as the Principal and the
  length of time, are required to complete the
  calculation. To calculate the Future Value, the
  face value of the amount plus the interest and
  the number of compounding periods must be known.
• The Future Value is equal to the Present Value
  times (1 r)n
• The Future value of 1,000 to be received two
  years from today based on a 7 percent interest
  rate is 1,144.90
• 1,144.90 1,000(1 .07)2
  
• At 7 At 9 At 11
• 1,144.90 1,188.10 1,232.10

54
The Present Value of an Annuity

• An annuity is a series of equal dollar payments
  for a specific number of years. The present
  value of a series of equal amounts is also known
  as the Present Value of an Annuity. An ordinary
  annuity requires payment at the end of each
  period. A deferred annuity requires payment at
  the beginning of the period.
• To calculate the present value of an annuity
  PVa PMT 1- (1 i)n
• 
  
  
  I
• Alternatively, the Present Value Interest Factor
  of an Annuity (PVIFA) may be used, where PVa
  PMT (PVIFAi, n)
• The Present Value for a 1,000 annuity discounted
  at 7 at the end of two years would be 1,808.
• At 7 At 9 At 11
• 1,808 1,759 1,713

55
The Future Value of an Annuity

• The Future Value of a series of equal amounts is
  also known as the Future Value of an Annuity.
• To calculate the Future Value of an annuity
  FVaPMT (1 I)n - 1
• i
• Alternatively, the Future Value Interest Factor
  of an Annuity (FVIFA) may be used, where FVa
  PMT (PVIFAi, n)
• The Future Value for a 1,000 annuity compounded
  at 7 at the end of two years would be 2,070.
• At 7 At 9 At 11
• 2,070 2,090 2,110

56
Determining a Car Payment

• Let us assume that the amount borrowed is 22,000
  with a 4,000 down payment. If you borrow with
  an 8 percent interest rate to be repaid in 48
  equal monthly payments, the payments will be
  452.88.
• PaymentPV/Present Value Interest Factor for an
  Annuity(PVIFA8, 4)
• Annual Payments (18,000/3.3121)5,534.62 per
  year
• Monthly Payments 5,534.62/12452.88
• Total Payment 21,738.24
• Total Interest 3,738.24

57
Determining a Mortgage Payment

• Let us assume that the amount borrowed is
  120,000 with a 6,000 down payment. If you
  borrow with an 8 percent interest rate to be
  repaid in 30 years, the payments will be 844 per
  month.
• PaymentPV/Present Value Interest Factor for an
  Annuity(PVIFA8, 30)
• Annual Payments (114,000/11.2578)10,126 per
  year
• Monthly Payments 10,126.21/12844
• Total Payment 303,840
• Total Interest 189,840

58
Computing Present and Future Values

• FVThe future value for one dollar compounded at
  i percent for n periods.
• FVIFAThe future value interest factor for a
  one-dollar annuity compounded at i percent for n
  periods.
• PVThe present value for one dollar discounted at
  i percent for n periods.
• PVIFAThe present value interest factor for a
  one-dollar annuity discounted at i percent for n
  periods.

59
Stocks, Bonds, and Mutual Funds
60
Stocks

• The interest rate is a major determinant of the
  direction of the stock market.
• A stock represents ownership (equity) in a
  corporation. Stocks are issued to potential
  investors by different companies who are trying
  to raise capital (money) for investment purposes.
• The amount of assets owned by the company
  determines its standing as classified by the
  Standard Poor (S P) Stock Index.
• Stocks are bought and sold in the primary market
  consisting of newly issued securities and the
  secondary markets, consisting of existing
  securities.
• Organized exchanges, such as the New York Stock
  Exchange, the Chicago Mercantile Exchange, and
  the American Stock Exchange, provide a means by
  which investors can buy and sell efficiently
  matched orders that the brokers buy and sell on
  their behalf.

61
Investment Bankers

• In most cases, Investment Bankers (such as
  Goldman Sachs and Salomon Brothers) act as
  middlemen on behalf of investors and
  corporations. The investment banker assists the
  corporation as an intermediary in the buying and
  selling of securities in an attempt to raise
  capital.
• Stocks may be issued in the primary markets
  through investment bankers as Initial Public
  Offerings (IPOs), which are newly issued
  securities sold to the public.
• Mortgage bankers also use the secondary markets
  for resale of existing securities.
• An investment banker must be registered with the
  Security Exchange Commission (SEC) to have access
  to, or be a part of, the exchange.

62
Individual Investors

• Individual investors can purchase stocks in three
  ways
• Full Service Brokerage - employed by one of the
  investment bankers. All pertinent (relevant)
  information about the company will be provided by
  the broker. The broker will provide the investor
  a Prodigy and trend analysis about the stock. A
  6 percent fee is assessed on such transactions
  based on the number of shares purchased or the
  amount spent.
• Discount Brokerage - employed by one of the
  investment bankers. All pertinent (relevant)
  information about the company will be done by the
  investor. The broker will only act as an
  intermediary and purchase the stock for the
  investor. A two-to-three percent fee is assessed
  on such transactions based on the number of
  shares purchased or amount spent.
• E-trade - investors can purchase stocks directly
  from the company for a flat fee of 29, but for
  most companies, the investor must have an account
  with the company before they can trade and there
  is also a minimum trade allowed.

63
Portfolio and Investment Management

• A portfolio is the number of different stocks
  held by an individual or a club. The risk
  determines the return. A stable stock, usually
  belonging to a large corporation, is usually less
  risky because it can rebound in a volatile
  market. On the other hand, mini caps, usually
  very small companies, are very risky but with
  higher return. Rational investors diversify
  their portfolios with different stocks from
  different industries. For a well-diversified
  portfolio, an individual investor needs about
  seven to ten stocks in their portfolio. A
  well-diversified portfolio, however, has about
  forty stocks from different industries.
• Risk (probability of default) is assessed using
  the debt-to-equity ratio as compared to the
  industry average, the coverage ratio (the ability
  of the company to make interest payments), and
  with general cash flow analysis. These ratings
  are conducted by Moodys using an Aaa to Baa
  scale and Standard Poors (using the AAA to
  BBB to F scale). Such information is available
  through Value Line, Morningstar, Moodys, SP,
  and on the Internet.

64
Bonds

• A bond is an interest-bearing debt instrument
  that promises to pay the bondholder interest
  payments over the life of the loan provided there
  is no call-provision, and to repay the face (par)
  value, at maturity. The quality and the risk of
  the bond are rated by Moodys Investors Service
  and Standard and Poors Corporation.
• The two main types of bonds issued are government
  bonds and corporate bonds.
• Government bonds are issued by the Federal
  government, States, and municipalities and are
  usually zero-coupon bonds. These bonds have low
  yields, low risk, and are attractive because they
  can provide a tax shelter for investors in the
  high income brackets.
• Bonds issued by corporations provide higher
  returns based on their risks. The higher the
  risk, the higher the return.
• Bonds that are traded above par value are
  regarded as premium bonds, and those that are
  traded below par value are regarded as discount
  bonds.

65
Bond Valuation

• Bonds are issued in three ways at face value,
  which is the amount the investor will receive
  when the bond matures at a discount below face
  value and at a premium above face value.
• Bond Value Interest x Present Value Interest
  Factor of an Annuity (PVIFA i,n) the Face Value
  x (PVIF i,n)
• For example, IEM Industries, Inc. has outstanding
  a 1,000 par-value bond with an 8 coupon
  interest rate. The bond has 12 years remaining
  to its maturity. If the interest is paid
  annually, find the value of the bond when the
  required return is 7, 8, and 10.
• Bond Value Yield x (PVIFA 7,12) Par Value x
  (PVIF 7,12)
• Using the present value interest factors for an
  annuity of 7.9427, 7.5361, and 6.8137 and the
  Present Value Interest Factors of 0.4440, 0.3971,
  and 0.3186 for 7, 8 and 10, respectively with
  the yield to maturity of 80 (1,000 x 8), the
  bond values are
• At 7 At 8 At 10
• 1,079 1,000 864
  Premium
  Par
  Discount

66
Mutual Funds

• Mutual funds are managed by financial
  intermediaries that channel the funds of savers
  into a variety of assets. These funds allow
  small investors to purchase shares in a
  diversified portfolio of stocks, bonds, or other
  types of assets.
• Money Market Mutual Funds are investments in
  various kinds of short-term debt of businesses
  and governments as well as investments in
  certificates of deposit.

67
Classification of Mutual Funds

• Mutual funds can be classified as closed-end or
  open-end. A closed-end funds shares are issued
  by the investment company only when the fund is
  originally organized. Consequently, only a
  certain number of shares of these funds are
  available to the general public. After the
  initial offering, an investor can purchase a
  share only if the original owner is willing to
  sell. Closed-end mutual funds tend to appreciate
  faster.
• Open-end funds shares are issued and redeemed by
  the investment company at the request of the
  investors. Investors buy and sell net asset
  values at will. The net asset value is equal to
  the current market value contained in the mutual
  funds portfolio minus the mutual funds
  liabilities divided by the number of shares
  outstanding.
• A no-load fund is a mutual fund where investors
  pay no sales charges or commissions. The
  investor trades directly with the investment
  company. A load-fund in when investors pay
  commission each time they purchase shares.

68
Insurance Services and Hedging Strategies
69
Insurance and Hedging Strategies

• Insurance Services and Hedging Strategies are
  individuals abilities to minimize risk and
  uncertainty. They are used to guide against
  unforeseen circumstances and financial loss.
  Investors are exposed to potential financial loss
  from either speculative risk or pure risk.
  Speculative risk is the probability of some gain,
  whereas pure risk is when there is no potential
  gain. Risk management is the ability to
  identify, foresee and evaluate potential risk
  through advanced awareness, planning, and
  effectively minimizing the impact. The risk
  management process requires that an individual
  identify sources of risk, evaluate potential
  losses, identify strategies to handle risk such
  as risk avoidance, risk transfer, risk reduction,
  risk assumption, and risk shifting administer a
  risk management program, and evaluate the program.

70
Risk and Insurance

• Risk and the need for insurance are positively
  correlated. Pure risk is based on uncertainty
  and insurance is meant to protect against
  uncertainty and possible financial loss resulting
  from risk. Insurance is designed to transfer and
  reduce risk through shared collective financial
  losses suffered by members of the group. Each
  individual in the group (the insured or policy
  holder) is required to pay a premium that
  reflects the share of their losses to an
  insurance company (the insurer). Insurance
  companies offer policy holders peace of mind
  knowing that all will not be lost in case of
  unexpected occurrences such as a hazard (peril
  which leads to a possible loss) or a moral hazard
  (when an individual causes a peril). Individuals
  must have an insurable interest, i.e., they must
  stand to suffer a loss. The principle of
  indemnity always applies, which states that
  insurance will pay no more than the actual
  financial loss suffered. Examples of perils
  include, but not are limited to, fire,
  lightening,windstorms, hail, smoke damage,
  vandalism, malicious mischief, theft, glass
  breakage, volcanic eruption, and so on. Policy
  holders can choose between full coverage (100
  percent), partial comprehensive coverage (80
  percent coverage), or simple liability coverage.

71
Types of Insurance

• Homeowners Insurance
• Homeowners Insurance is designed to protect
  homeowners in case of losses incurred to their
  dwelling and its content. Homeowners insurance
  is a combination of property insurance, personal
  liability insurance, supplemental living expense
  coverage, replacement cost coverage, and medical
  expense coverage. There are three major types of
  homeowners insurance - for people who own homes,
  for owners of condominiums, and for renters. The
  objective is to protect all individuals from
  liability and property losses. Some examples of
  liability coverage include personal comprehensive
  liability insurance, no-fault medical payments,
  and no-fault property damage. Examples of
  property coverage include the home and any other
  attached buildings, detached buildings, personal
  property, loss of use, marine coverage, and
  itemized personal articles insurance.

72
Types of Insurance (continued)

• Renters Insurance
• The main purpose is to protect renters against
  financial loss due to damage or loss of personal
  property. The coverage includes personal
  property protection, additional living expenses,
  and personal liability related coverage. Renters
  Insurance is typically a peril policy that covers
  17 major peril items with liability protection.
  It is reasonably less expensive and also provides
  protection from losses to dwelling contents and
  personal property.
• Condominium Insurance
• Condominium Insurance covers losses to contents
  and personal property, losses due to additional
  living expenses that may arise if one of the
  covered perils occurs, and liability losses. The
  condominium owner can provide coverage for
  dwelling and losses resulting from structural
  alterations such as book shelves, electrical
  fixtures, and wall or floor coverings.

73
Types of Insurance (continued)

• Homeowners insurance usually covers dwelling,
  peril, liability, and personal property such as
  furniture, appliances, and furnishings.
  Homeowners insurance can have 80 or 100 percent
  coverage with replacement cost and actual cash
  value for property damage. Some of the variables
  that affect the cost of homeowners insurances
  are the location of the property, the policy
  type and coverage, accessories in the home such
  as smoke detectors, fire alarm system, burglary
  alarm system, and competition among the insurance
  companies. As a policy holder, it pays to
  compare prices and choose the best policy for
  your personal need. In case of property loss,
  replacement is based on the value of the asset,
  with the applicable deductible taken into
  consideration.

74
Types of Insurance (continued)

• The replacement-cost-requirement can be
  estimated as
• R (L D) x 1/(RV x 0.80 or 1.00)
• where,
• R reimbursement payable
• L the amount of loss
• D deductible, if any
• I amount of insurance actually carried
• RV replacement value of dwelling
• Actual Cash value (ACV) is estimated as
• ACV P - CA x (P/LE)
• where,
• P purchase price of the property
• CA current price of the property
• LE life expectancy of the property in years

75
Types of Insurance (continued)

• For example What amount would Vivian Jones
  receive with cash value coverage for a
  two-year-old T.V. destroyed by fire? The T.V.
  would cost 1,000 to replace today and had an
  estimated life of five years.
• ACV 1,000 - (1,000 / 5) x 2 600
• The insurance premium reflects the homeowners
  policy choice, but standard policies typically
  provide 100,000 of personal liability coverage,
  1,000 of no-fault medical expenses coverage, and
  250 of no-fault property damage coverage. It is
  advisable for policyholders to purchase
  supplemental coverage depending on need.

76
Types of Insurance (continued)

• Automobile Insurance
• Driving an automobile exposes individuals to
  disastrous financial losses. Automobile
  insurance protects consumers from financial
  losses that might result from accidents. In some
  states it is mandatory to have automobile
  insurance to cover motorists in case of an
  accident. The different types of coverage
  include liability insurance such as bodily
  injury, liability and property damage, medical
  coverage for passengers, uninsured or
  under-insured motorist, and physical damage such
  as collusion and comprehensive insurance.
• Insurance quotes reflect the premium paid by the
  policy holder. The coverage may be
  50/100/250/300 that is a 50,000, 100,000,
  250,000, or 300,000 per accident limit that
  will be paid for all bodily injury. Uninsured or
  under-insured motorists coverage protects the
  insured motorist from bodily and property damage
  in case of an accident and is either 50/100 that
  is 50,000 or 100,000 coverage for one or
  multiple bodily injury resulting from one
  accident.

77
Types of Insurance (continued)

• Automobile Insurance (continued)
• Comprehensive automobile insurance also protects
  against property damage and is written on an open
  peril other than collusion. Comprehensive
  insurance usually has a deductible ranging from
  100 to 500.
• Other coverage includes towing where a disabled
  car can be transported to a repair location, and
  rental reimbursement which provides car rental
  with a limited amount of 20 to 30 a day for the
  insured when the car is been repaired.
• The coverage can be a family automobile policy
  where members of the family or household are
  covered under the policy, or personal automobile
  policy designed for an individual who is insured
  as the only driver.

78
Types of Insurance (continued)

• Property Liability Insurance protects individuals
  from property and liability losses that are not
  covered by homeowners or automobile policies.
  Some of the property liabilities include, but are
  not limited to
• Floater Policies provide insurance coverage for
  theft losses to movable personal property
  irrespective of where the loss occurred.
  Personal properties such as clothing, camera, and
  miscellaneous items are covered under this plan.
  Unscheduled floater policies cover all movable
  property transported from automobiles owned by
  the insured.
• Professional Liability or malpractice insurance
  protects professionals such as doctors,
  accountants, etc. who provide services to
  consumers. Professional liability insurance
  varies in coverage, deductible, liability, and
  premium depending on the profession involved.

79
Types of Insurance (continued)

• Property Liability Insurance (continued)
• Comprehensive Personal Liability insurance
  protects from liability and from losses that
  might arise out of activities that are unrelated
  to business or the use of an automobile such as
  accidents occurring in recreational areas that
  might harm a third party or the individual
  directly.
• Umbrella Liability insurance covers all aspects
  of general catastrophes such as automobile,
  homeowners, and professional liabilities. These
  policies cover above and beyond the basic
  stipulations of the original policies and help to
  shield individuals from unexpected financial
  losses.

80
Types of Insurance (continued)

• Health and Disability Insurance
• Health Insurance is the ability of an individual
  to protect themselves against economic loss due
  to illness, accident, or disability. With rising
  health care costs, the purpose of health
  insurance is to alleviate financial burdens
  suffered by individuals in the form of medical
  expense coverage and disability income.
• Health and medical insurance can be purchased
  directly or is provided by employers through
  private insurance companies and Blue Cross and
  Blue Shield organizations. Most health insurance
  coverage comes from companies operating as HMOs,
  PPOs, or under a system of deductibles and
  copayments made directly to private physicians
  and hospitals.

81
Types of Insurance (continued)

• There are several basic types of health insurance
  coverage
• Individual health care insurance covers either
  one person or a family and coverage varies from
  employer to employer. Individuals may receive
  coverage under a basic medical expense insurance
  plan or a major medical insurance plan.
• Group health care insurance varies from plan to
  plan and provides blanket coverage to