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iowa electronic markets personal finance and portfolio management strategies

Iowa Electronic MarketsPersonal Finance and Portfolio Management Strategies

Personal Finance Curriculum

using the

Federal Reserve Monetary Policy Market

and Computer Industry Returns Market


Personal Finance and Portfolio Management Strategies byJan E. ChristopherDelaware State UniversityandJuliet U. EluSpelman College August 2001

learning objectives
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
lecture outline personal finance and portfolio management strategies

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


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.

why financial planning is beneficial
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 one’s financial affairs.
    • Improved personal relationships.
    • A sense of freedom from financial worries.
the financial planning process
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
what variables affect the financial planning process
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
significant terminology used in the financial planning process
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.

example of the compounding process using future value
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.

example of the discounting process using present value
Example of the Discounting Process Using Present Value


(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

example of the future value interest factor for an annuity
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

example of the present value interest factor for an annuity
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

  • 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.
cash flow management
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.
money management strategies
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.
key variables in asset management strategies
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 one’s 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
key indicators of good financial management
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
the debt to equity ratio
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 one’s 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 individual’s 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.
the current ratio
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 one’s remaining liabilities.
  • For example, with rising natural gas and heating oil prices, an individual’s 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.
liquidity ratios
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 month’s 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.
debt service to income ratio
Debt Service-to-Income Ratio
  • The amount of total monthly debt payments an individual makes is considered to be the individual’s 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 individual’s 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 individual’s monthly debt payments were $2,500 and income was $5,000; the debt service-to-income ratio is 50% ($2,500/$5,000).
the savings ratio
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.
develop a debt management plan to control credit usage

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.

credit management
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, n=Number of payment periods in one year
          • P=Principal, net amount of the loan
          • I=Total dollar cost of credit
          • N=Total number of payments to pay off loan
debt management
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
signals of debt mismanagement
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
tax planning
Tax Planning

Tax Planning Strategy is the ability of an individual to effectively reduce, defer, or eliminate some taxes. Tax planning can influence an individual’s 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 one’s 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.

tax planning continued
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 one’s 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.
tax planning continued33
Tax Planning (continued)
  • Taxes on Wealth - This can be an estate or inheritance tax. The estate tax is imposed on the value of a person’s 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 individual’s or household’s income, the higher the percentage of tax that individual or household must pay. See tax rates table below:
marginal and average tax rates
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 one’s income, the lower one’s 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%.
the ways taxes are paid
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 employee’s 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 Employee’s 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.
calculating adjusted income
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 Brenda’s adjusted income? Salary Earnings $40,000Interest on Savings 800 Dividend Earnings 600 Total Gross Income $41,400 Less IRA 1,500 Adjusted Income $39,900
tax shelter strategies
Tax Shelter Strategies
  • The objective of tax strategy is to legitimately reduce one’s 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.
tax shelter strategies continued
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-taxincome 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.
tax shelter strategies continued40
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
tax shelter strategies continued41
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.
tax shelter strategies continued42
Tax Shelter Strategies (continued)
  • Investment Decisions (continued)
    • Children’s Investment. Investment incomes passed over to children (provided they are under 14) are tax exempt. Investment income over $1,300 is taxed at the parent’s rate, however, $650 is deductible, and the next $650 is taxed at the child’s 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.
tax shelter strategies continued43
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 employee’s 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.
banking services and savings plans
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.
savings plans
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.
mortgage financing
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.
real estate investment and cash flow
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.
direct and indirect real estate investment
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.
interest rate fundamentals
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.
present value
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
future value
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
the present value of an annuity
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]


  • 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
the future value of an annuity
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: FVa=PMT [ (1 + I)n - 1]


  • 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
determining a car payment
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.
  • Payment=PV/Present Value Interest Factor for an Annuity(PVIFA8%, 4)
  • Annual Payments ($18,000/3.3121)=$5,534.62 per year
  • Monthly Payments = $5,534.62/12=$452.88
  • Total Payment = $21,738.24
  • Total Interest = $ 3,738.24
determining a mortgage payment
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.
  • Payment=PV/Present Value Interest Factor for an Annuity(PVIFA8%, 30)
  • Annual Payments ($114,000/11.2578)=$10,126 per year
  • Monthly Payments = $10,126.21/12=$844
  • Total Payment = $303,840
  • Total Interest = $189,840
computing present and future values
Computing Present and Future Values
  • FV=The future value for one dollar compounded at i percent for n periods.
  • FVIFA=The future value interest factor for a one-dollar annuity compounded at i percent for n periods.
  • PV=The present value for one dollar discounted at i percent for n periods.
  • PVIFA=The present value interest factor for a one-dollar annuity discounted at i percent for n periods.
  • 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.
investment bankers
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.
individual investors
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.
portfolio and investment management
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 Moody’s using an Aaa to Baa scale; and Standard & Poor’s (using the AAA to BBB to F scale). Such information is available through Value Line, Morningstar, Moody’s, S&P, and on the Internet.
  • 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 Moody’s Investors Service and Standard and Poor’s 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.
bond valuation
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
mutual funds
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.
classification of mutual funds
Classification of Mutual Funds
  • Mutual funds can be classified as closed-end or open-end. A closed-end fund’s 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 fund’s 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 fund’s portfolio minus the mutual fund’s 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.
insurance and hedging strategies
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.
risk and insurance
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.
types of insurance
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.
types of insurance continued
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.

types of insurance continued73
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.
types of insurance continued74
Types of Insurance (continued)

The replacement-cost-requirement can be estimated as:

R = (L – D) x 1/(RV x 0.80 or 1.00)


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)]


P = purchase price of the property

CA= current price of the property

LE = life expectancy of the property in years

types of insurance continued75
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.

types of insurance continued76
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.
types of insurance continued77
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.
types of insurance continued78
Types of Insurance (continued)
  • Property Liability Insuranceprotects 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.
types of insurance continued79
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.
types of insurance continued80
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.

types of insurance continued81
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 the members of the group.
    • Supplemental group insurance is needed when an individual’s major insurance fails to cover major components of the individual’s medical bill, hospital charges, or surgical charges, primarily due to pre-existing conditions.
    • Disability income, Medicare supplement and long-term care are also classified as health and medical insurance.
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Types of Insurance (continued)
  • Health care providers are managed differently. For example, the Health Maintenance Organizations (HMOs) have contracts with selected physicians to provide individuals with health care services for a fixed prepaid monthly premium. Preferred Provider Organizations (PPOs) offer health services at discount rates. Blue Cross and Blue Shield plans are statewide organizations similar to commercial health insurance companies. These providers cover different types of health care coverage which includes, but is not limited to:
    • Hospital expense insurance where the insurance covers all or part of hospital bills for room, board, and other charges.
    • Surgical expense insurance pays all or part of the surgeon’s bill for an operation.
    • Physician expense insurance pays physicians’ bills that do not involve surgery.
    • Major medical insurance protects against large expenses of a serious injury or a long-term illness.
    • Comprehensive major medical insurance has a lower deductible and is offered without a basic plan.
    • Hospital indemnity policies cover benefits only when a person is hospitalized.
types of insurance continued83
Types of Insurance (continued)
  • Dental expense provides reimbursement for the expense of dental services.
  • Vision care insurance covers part of the expenses incurred from eye-related health care.
  • For personal finance purposes, individuals’ needs differ tremendously, and for full protection, combination or supplemental policies might be necessary to minimize risk especially with the rising costs of health and medical care.
types of insurance continued84
Types of Insurance (continued)
  • Disability Insurance

Disability Insurance is designed to protect individuals from loss of income due to unforeseen circumstances such as accident, illness, or pregnancy. Disability affects one’s ability to earn income and this insurance provides regular cash income to the insured. Disability can be short or long term and disability insurance usually is provided by the employer, under Social Security, and through workers’ compensation.

As a rule, if the Social Security and other disability benefits provided by the employer are insufficient to support your family, it is advisable to buy additional disability insurance to make up the difference.

types of insurance continued85
Types of Insurance (continued)
  • Life Insurance

The purpose of life insurance is to protect loved ones who depend on you from financial loss caused by death. The insurance company promises to pay a sum of money at the time of the policyholder’s death in return for the insured’s agreement to pay periodic premiums. Age and gender reflect the premium that one pay.

  • Types of Life Insurance:
    • Term life insurance is protection for a specified period of time, usually 1, 5, 10, 20 years or up to age 65. There are provisions for renewal, convertibility into whole life, and decreasing term coverage over the life of the policy.
types of insurance continued86
Types of Insurance (continued)
  • Whole life insurance is the most commonly purchased form of life insurance policy, where there are specified premiums on an annual basis as long as the insured lives. There is provision for Cash Value which gives the insured the right to receive the increases in the amount paid over time if the insured decides to give up the insurance.
  • There is also the Non-forfeiture clause which allows the insured to forfeit all accrued benefits, but retain the cash value of the life insurance policy upon surrender. Under the Whole Life classification there are various types of policies available to individuals such as the:
    • Limited payment policy - premiums are paid for a stipulated period of time, but the insured remains insured for life.
    • Variable life insurance policy - the cash values of a variable life insurance policy can fluctuate with the prevailing market rate of interest.
    • Adjustable life insurance policy- allows for changes to be made as financial needs change.
types of insurance continued87
Types of Insurance (continued)
  • Flexible Premium Life Insurance
    • Universal life insurance policy- is a flexible version of the life insurance policy where individuals can combine term insurance and investment elements for maximum return.
  • Life insurance is imperative if your death will cause financial stress for your spouse, children, parents, or anyone you want to protect. The amount of life insurance is subjective and should be based on personal need and life style.
making a claim
Making a Claim
  • The advantage of having any kind of insurance is the fact that one is certain that the insurance company will reimburse or alleviate some or all of their financial losses. For insurance companies to adequately compensate you for your losses, you must provide proper documentation such as pictures and all relevant verifications, file your claim with the insurance company, and finally sign a release affirming the settlement amount.
keys to choosing an investment
Keys to Choosing an Investment
  • A variety of investment options are available. The investor must decide whether he or she wants to lend money or own an asset. Investors must also decide whether they want to make short-term investments or long-term investments.
  • When investors lend money, they receive some promise of future income. Investments of this type include depositing money in a savings account in commercial banks, credit unions, and other financial institutions that offer certificates of deposit. Investors may lend to governments by purchasing treasury bonds, treasury notes, savings bonds, and state and local municipal bonds. Investors may lend to businesses through corporate bonds. They may also lend by investing in mortgage-backed securities and life insurance company annuities. These lending investments usually offer a fixed maturity repayment date and a fixed rate of return for use of the principal. The return to these investments are somewhat assured. The investor only receives the fixed return promised at the time of the initial investment, however.
investing through ownership
Investing through Ownership
  • Investors can buy assets outright or purchase them on credit. These types of investments are called equities. Equity ownership can be obtained through purchasing common or preferred stock, shares in a mutual fund, real estate, commodity futures, or investment-quality collectibles. This can also include starting one’s own business and becoming an entrepreneur. There is no limit to the potential returns in this case.
purchasing short or long term investments
Purchasing Short- or Long-Term Investments
  • Investments that are made for less than one year are referred to as short-term investments. Most gains from short-term investments are offset by commissions, fees and penalties. Short-term investments can include NOW accounts, savings accounts, money market accounts, certificates of deposits (CDs), treasury notes, savings bonds, and corporate bonds that mature in less than two years.
  • Long-term investments, on the other hand, can be for two or more years. Long-term investments can include corporate bonds, Ginnie Mae bonds, stocks paying high dividends, long-term bonds, long-term CDs, growth funds, mutual funds, growth stocks, precious metals, commodities, options, aggressive growth funds, and income mutual funds.
  • Investments that have the potential for higher returns but high risk to the investor are: futures contracts, call options, speculative stocks, junk bonds, collectibles, limited partnerships, put options, real estate, and aggressive-growth mutual funds.
understanding the relationship between personal finance and investments
Understanding the Relationship between Personal Finance and Investments
  • Learning the language of personal finance will help the investor understand the complexities of life today as well as alleviate the burden of making poor financial decisions. The lack of knowledge of personal finance is evident in those persons who have excessive consumer debt, spend money frivolously, are victims of financial scams, purchase the wrong kind of insurance, or are unable to reach their financial goals. To understand the intricacies of personal finance, one needs to have a basic understanding of the economy, including a knowledge of interest rates, inflation, government, and the general political and economic environment, including an understanding of the time value of money, taxes, costs and benefits. Personal finance, therefore, is the process of managing one’s money with the goal of safeguarding and investing one’s financial resources through tax management, budgeting, cash management, risk management, retirement and estate planning, the use of credit cards, and borrowing for major expenditures. Investments are merely one component of personal finance.
using the iem to make rational investment decisions
Using the IEM to make Rational Investment Decisions
  • The Iowa Electronic Market (IEM for short) is a series of computerized markets on which financial contracts can be traded (bought or sold).
  • The Federal Reserve Monetary Policy Market is a real-money futures market where contract payoffs are determined by monetary policy decisions made at regularly scheduled meetings of the Federal Reserve’s Federal Open Market Committee (FOMC).
  • The practice of the FOMC, initiated on May 18, 1999, has been to release a public announcement shortly after each regular meeting describing the funds rate target decision. This public announcement will be the official source of FOMC policy decisions for purposes of making rational estimates of the prevailing interest rate.
background on the fomc
Background on the FOMC
  • The Federal Open Market Committee (FOMC) is comprised of the seven members of the Board of Governors of the Federal Reserve System (Fed), the President of the Federal Reserve Bank of New York, and four other Reserve Bank presidents. The committee meets at frequent intervals to determine the Federal Reserve System’s open market policy. To carry out its policy, the Committee directs the purchase or sale of U.S. Government securities in the open market to influence the supply and availability of money and credit in the economy. The Committee designates the Federal Reserve Bank of New York to act as its agent in executing transactions for the Federal Reserve System. Typically the Fed adjusts interest rates to influence demand in the economy. By targeting asset-based demand the Fed is able to quickly affect consumption, the money supply, and credit. The most effective tool that the Fed has to adjust interest rates is the FOMC-controlled federal funds rate. In general, the federal funds rate is the price banks charge each other for overnight loans.
background on the fomc continued
Background on the FOMC (continued)
  • Overnight loans between banks are often used to maintain the appropriate level of reserves that are required by the Fed through mandated Reserve Requirements.
  • When the Fed buys and sells U.S. Treasury Securities in the open market, it guides the level of the federal funds rate. The federal funds rate is the benchmark for all short-term borrowing and is the basis for each individual bank’s prime lending rate.
  • When the FOMC “tightens” interest rates, this implies that it is increasing the federal funds rate, and ultimately the prime rate and other rates of credit to consumers. On the other hand, when it lowers interest rates, this implies a “loosening” of money, credit, and resulting monetary economic activity.
  • The Fed did not officially target the federal funds rate until the late 1980s. Prior to that time, Open Market Operations were used to establish an acceptable range for the funds rate. Presently, the funds rate is a good indicator of the Fed’s monetary policy goals and results.
fomc policy decisions and the iem
FOMC Policy Decisions and the IEM
  • The Federal Reserve Monetary Policy Market consists of three basic contracts. After every FOMC meeting, existing contracts in the series are liquidated and payments are made based on the decisions reached regarding the federal-funds rate target—to raise the target, to lower the target, or to leave it unchanged.
  • If the decision of the FOMC remains unclear even after three consecutive Wall Street Journal issues following the lack of an official press release by the Fed, the outcome “fed-funds target remains unchanged” will be declared the result for purposes of determining liquidation values.
  • Trading in a set of contracts on the IEM will continue for as much as two days beyond the end of the meeting on which those contracts are based. If an official announcement of the FOMC decision is made at the end of the meeting or within two days thereafter, the market will close and contracts will be liquidated as soon as is possible after the appearance of that announcement.
fed policy contract description
Fed Policy Contract Description

Note: Contracts will be designated using a tickersymbol and a letter denoting up, down, or the same

and the month of contract liquidation. The contracts traded in this market for liquidation will have a

unique date denoted by month “MM” and year “YY”.

assignment one
Assignment One
  • Calculating Present and Future Value of Money
  • In this assignment, you will study how to determine the time value of money using present and future values. You will study simple interest calculations, compounding and discounting, as well as annuities.
  • Conduct at least one trade in the FedPolicy market between ___________ and __________. At the end of each liquidation date, if the federal funds rate increases, this means that the prime rate will also increase. Adjust the rate on the previous variables used in Assignment One based on the appropriate increase or decrease in the federal funds rate.
assignment two
Assignment Two
  • Calculating Mortgage Investments
  • In this assignment, you will study how to calculate mortgage investment strategies. Many frequently asked questions can be explored using this assignment, such as: Am I better off renting or buying? What home can I afford? How much will my payments be? Which is better, a 15 or 30 year mortgage? Is it better to own or rent if I am only going to stay in a location for less than five years? What is my required down payment?
  • Conduct at least one trade in the FedPolicy market between ___________ and __________. At the end of each liquidation date, if the federal funds rate increases, this means that the prime rate will also increase. Adjust the rate on the previous variables used in Assignment Two based on the appropriate increase or decrease in the federal funds rate.
trading on the iem
Trading on the IEM

You can access the IEM through its web-site address:

In the Federal Reserve Monetary Policy Market (i.e., FRupMMYY, FRsameMMYY, and FRdownMMYY), a bundle can be purchased from or sold to the IEM system at any time at the price of $1.00 per bundle. A unit portfolio is a set of bundles, such as AAPLm, IBMm, MSFTm and SP500m, where the investor purchases one share of each stock in the bundle. You can always buy or sell such portfolios for $1.00 each. Thus, when you start to trade and do not own any contracts, you can buy a unit portfolio and then start to trade. (To do this, select the appropriate contract under “Buy Bundles” or “Sell Bundles” in the “Market Order” drop down menu. Enter a quantity and press the “Market Order” button.) Note that, regardless of the settlement value of stocks in the bundle, the liquidation values of the contracts in a bundle will total $1.00, the same as the price at which the bundles can be bought or sold. The bundles will be designated FR1$MMYY, where the suffix MMYY identifies the month of the FOMC meeting.

tracking shares on the iem
Tracking Shares on the IEM
  • Investors can also purchase individual contract shares on the IEM.
  • Investors can buy or sell using a "Market Order." On the market screen, you will see that some individuals have posted an order to buy or to sell a contract (e.g., MSFTg, the contract for July liquidation in the Computer Industry Returns Market) at a specific price. If you believe that a posted order represents a good deal, you can buy or sell at the posted price.
  • To place a market order, select the appropriate contract under “Buy at Best Ask” or “Sell at Best Bid” in the “Market Order” drop down menu. Enter a quantity and press the “Market Order” button.
buying and selling limit orders on the iem
Buying and Selling Limit Orders on the IEM
  • Investors can buy or sell using a "Limit Order." To do so, you state the price at which you are willing to buy or sell a contract and post a limit order on the screen.
  • In doing so, you are waiting for someone who is willing to buy or sell at your stated price. In this manner, when your order executes, it will execute at your stated price, not at somebody else’s. The negative is that the order may never execute because nobody likes your price because it is too high or low.
  • To place a Limit Order, select the appropriate contract under “Post a Bid” or “Post an Ask” in the “Limit Order” drop down menu. Enter a price, quantity and expiration date and press the “Limit Order” button.
accessing contracts on the iem
Accessing Contracts on the IEM
  • Access to contracts on the IEM can be achieved via the “Market Selection” pull down menu.
  • Funds in a trader’s cash account are fungible across all contracts, so new investment deposits are not required to trade in more than one market.
charting trends
Charting Trends
  • Stocks may be charted on such web sites as by knowing the stock ticker symbol. If the ticker symbol is not known, then Value Line, for example, gives the investor the ability to look up the ticker symbol before requesting a quote or charting. It is recommended that all publicly traded stocks be charted, so that the investor can look at the historical trends over time.
  • Stocks may also be charted by using such software as EXPO, that is located in many university trading rooms, or through self-charting using Microsoft Excel.
assignment three
Assignment Three
  • Budgeting to Achieve Financial Success
  • In this assignment, you will study how to budget in order to enhance your investment strategies. The Federal Reserve Bank of Chicago’s Web site on consumer finances is the best place to begin. Go to
  • Use the worksheet provided to create your own monthly budget.
  • Conduct at least one trade in the Computer Industry Returns Market between ___________ and __________. At the end of each liquidation date, if the returns are higher for IBM, Microsoft, Apple or if the S&P500 market index is the highest, then purchase shares of the winning stock at the market price listed in the Wall Street Journal or the average price as quoted on Analyze and chart past liquidation values for the winners of the Computer Industry Returns Market for the months of March, April, May, and June, 2001. Adjust the savings and income categories of your budget accordingly.
understanding the relationship between risk and return
Understanding the Relationship between Risk and Return
  • In personal finance, understanding risk and return is an important decision for investment purposes. Return on investment is earned from current income such as interest payments, dividends, rent, and capital gains which results from an increase in the value of an investment. Investment is pivotal to achieving financial goals such as a down payment on a home, a car, education and other tangible assets, increasing current income, future consumption, unexpected expenditures, wealth accumulation and financial security. Individuals can invest only if they make rational consumption and financial decisions such as:
  • Living within their budget, i.e., daily and monthly operating expenses must not exceed income. In this aspect, maintaining proper budget and financial control is imperative.
risk and return continued
Risk and Return (continued)
  • Establishing a savings program, which implies sacrificing present consumption for future investment. The ability to save regularly, build emergency funds, and invest periodically accrued savings can maximize wealth in the long-run.
  • Maintaining a good credit rating and having an adequate line of credit to cover emergencies can help facilitate investment strategy and decision. In other words, using credit cards to pay for emergencies can minimize the amount of liquid cash held in the form of savings and increase investment.
  • Having adequate liability insurances such as property, health, and life insurance for protection of your assets and lifestyle in the event of unexpected financial burdens.
  • Establishing investment goals as a priority and working towards that goal.
determining your own investment
Determining Your Own Investment
  • An individual investment is based on how speculative risk is perceived. Risk represents the uncertainty that the yield on an investment will deviate from what is expected and speculative risk is built on the potential for gain or loss resulting from an investment. There are two types of risk in the market, namely systematic and unsystematic risks.
  • Systematic or unavoidable risk, also known as market risk, is inherent in the market and is independent of an investor’s decision. Systematic risk is caused by events such as economic, social, and market conditions. For example, increases in inflation will automatically affect the value of securities and the real return on the investment.
determining your own investment continued
Determining Your Own Investment (continued)
  • Unsystematic or avoidable risk is when an investor has the ability to diversify risk and can determine the outcome of the return provided that the investor has more than one security in the portfolio. A well-diversified portfolio can minimize risk, however, an investor’s attitude toward risk will reflect the return. High risk will yield high return and low risk will yield low return. An investor is either risk averse (conservative investment philosophy), risks neural (moderate investment philosophy), or risk seeking (aggressive investment philosophy).
  • If you are a risk averse investor who wants minimum risk, it will be appropriate to invest in low yield securities such as government securities (e.g., treasury bills, notes, and bonds, and municipal bonds), high quality (blue-chip) corporate stocks and bonds, balanced mutual funds (combination of stocks and bonds), certificates of deposit, and fixed annuities.
determining your own investment continued114
Determining Your Own Investment (continued)
  • A risk neutral investor will invest in securities such as dividend-paying common stock, growth and income mutual funds, high quality corporate bonds, government bonds, variable annuities, and real estate.
  • A risk seeking investor will invest in securities such as common stocks of new or fast-growing companies, high yield junk bonds, aggressive-growth mutual funds, limited real estate partnerships, underdeveloped land, precious metals, gems, commodity futures, stock index futures, and other collectibles.
  • The appropriate strategy is to have a well-diversified portfolio with a combination of low, medium, and high risk of assets and securities so as to minimize risk and maximize the rate of return.
strategies for portfolio management
Strategies for Portfolio Management
  • Investors invest for short-term or long-term, however, most people try to invest for the long-term which is usually five years or more. Long-term investment requires discipline and possibly employing a professional to manage your portfolio. But recently, small investors are forming investment clubs and are managing their portfolios by pooling their resources together. Some of the investment clubs have succeeded in effectively diversifying their portfolios. If you are planning to be a long-term investor, a moderate or conservative investment strategy must be implemented. In addition, some understanding of the securities markets such as the bear market (when prices of securities are falling) and the bull market (when prices of securities are rising) is essential. Some of the major strategies for portfolio management include, but are not limited:
strategies for portfolio management continued
Strategies for Portfolio Management (continued)
  • Business-Cycle Timing is when an investor recognizes the phases of the business cycle (peak, recession, trough, and recovery) and takes advantage of the market when prices are falling. The timing of the business cycle is important and the investor wants to be in the market for the long haul and, as such, can acquire stable stocks at a reasonable price. The problem is that most investors are skeptical during a recession and it takes courage to buy at this time.
  • Dollar-Cost Averaging is when an investor invests a fixed amount of money in the same stock or mutual funds at regular intervals over a long period of time regardless of price. The objective is to collect more shares at lower prices and fewer shares at higher prices depending on the business cycle, and eventually most of the shares will be accumulated at below-average costs.
strategies for portfolio management continued117
Strategies for Portfolio Management (continued)
  • Portfolio Diversification is the selection of different investment instruments such as stocks, bonds, mutual funds, and real estate that are negatively correlated and have dissimilar risk-return characteristics. This is an effective long-term strategy because it minimizes the volatility of individual investment returns.
  • Asset Allocation is deciding what portion of the investment portfolio to allocate to various categories of assets: stocks, bonds, and cash. As a part of portfolio diversification, it is rational to increase return and decrease risk by allocating a fixed proportion of your asset to different investment instruments.
making the right decision
Making the Right Decision
  • Making the right decision when to sell your investment can increase your earnings and portfolio. The decision to sell considering the volatility in the market is based on individuals’ intuition and risk assimilation. As a rule of a thumb, it is safe to sell when you feel that you have earned a satisfactory profit. Minimize losses by selling securities that you do not feel comfortable within your portfolio. A temporary drop in price does not necessarily indicate a bad investment, however, it may be better to sell at a loss rather than hold on to a loser. A well-diversified portfolio can always minimize risk, and as you review your portfolio, eliminate securities that are positively correlated and use the proceeds to purchase another security.
  • Generally speaking, risk and return are positively correlated. An individual’s portfolio reflects the willingness to undertake risk and, as such, rates of return; however, a well-diversified portfolio can minimize risk and maximize return.
Learning Objectives (Slide 3)

Lecture Outline (Slide 4)

Personal Finance and Portfolio Management Strategies - Lecture Notes (Slide 5)

Introduction (Slide 6)

Why Financial Planning Is Beneficial (Slide 7)

The Financial Planning Process (Slide 8)

What Variables Affect the Financial Planning Process? (Slide 9)

Significant Terminology Used in the Financial Planning Process (Slide 10)

Example of the Compounding Process Using Future Value (Slide 11)

Example of the Discounting Process Using Present Value (Slide 12)

Example of the Future Value Interest Factor for an Annuity (Slide 13)

Example of the Present Value Interest Factor for an Annuity (Slide 14)

Budgeting and Cash Flow Management (Slide 15)

Budgeting (Slide 16)

Cash-Flow Management (Slide 17)

Money Management Strategies (Slide 18)

Key Variables in Asset Management Strategies (Slide 19)

Key Indicators of Good Financial Management (Slide 20)

The Debt-to-Equity Ratio (Slide 21)

The Current Ratio (Slide 22)

Liquidity Ratios (Slide 23)

The Debt Service-to-Income Ratio (Slide 24)

The Savings Ratio (Slide 25)

Credit and Debt Management (Slide 26)

Developing a Debt Management Plan to Control Credit Usage (Slide 27)

Credit Management (Slide 28)

Debt Management (Slide 29)

Signals of Debt Mismanagement (Slide 30)

Tax Planning (Slides 31-33)

Tax Rate Table (Slide 34)

Marginal and Average Tax Rates (Slide 35)

The Ways Taxes Are Paid (Slide 36)

Calculating Adjusted Income (Slide 37)

Tax Shelter Strategies (Slides 38-43)

Providers of Financial Services and Availability of Funds (Slide 44)

Banking Services and Savings Plans (Slide 45)

Savings Plans (Slide 46)

Mortgage and Tangible Asset Financing (Slide 47)

Mortgage Financing (Slide 48)

Real Estate Investment and Cash Flow (Slide 49)

Direct and Indirect Real Estate Investment (Slide 50)

Interest Rate Fundamentals (Slide 51)

Present Value (Slide52)

Future Value (Slide 53)

The Present Value of an Annuity (Slide 54)

The Future Value of an Annuity (Slide 55)

Determining a Car Payment (Slide 56)

Determining a Mortgage Payment (Slide 57)

Computing Present and Future Values (Slide 58)

Stocks, Bonds, and Mutual Fund (Slide 59)

index continued
Stocks (Slide 60)

Investment Bankers (Slide 61)

Individual Investors (Slide 62)

Portfolio and Investment Management (Slide 63)

Bonds (Slide 64)

Bond Value (Slide 65)

Mutual Funds (Slide 66)

Classification of Mutual Funds (Slide 67)

Insurance Services and Hedging Strategies (Slides 68-69)

Risk and Insurance (Slide 70)

Types of Insurance (Slide 71)

Types of Insurance - Homeowners (Slides 71-75)

Types of Insurance - Automobile (Slides 76-77)

Types of Insurance - Property Liability Insurance (Slides 78-79)

Types of Insurance - Health and Disability Insurance (Slides 80-83)

Types of Insurance - Disability Insurance (Slides 84)

Types of Insurance - Life Insurance (Slides 85-87)

Making a Claim (Slide 88)

Investment Decisions (Slide 89)

Keys to Choosing an Investment (Slide 90)

Investing through Ownership (Slide 91)

Purchasing Short- or Long-Term Investments (Slide 92)

Understanding the Relationship between Personal Finance and Investments (Slide 93)

Using the IEM to make Rational Investment Decisions (Slide 94)

Background on the FOMC (Slides 95-96)

FOMC Policy Decisions (Slide 97)

Fed Policy Contract Description (Slide 98)

Assignment One (Slide 99)

Assignment Two (Slide 100)

Trading and Tracking Stocks on the IEM (Slide 101)

Trading on the IEM (Slide 102)

Tracking Shares on the IEM (Slide103)

Buying and Selling Limit Orders on the IEM (Slide 104)

Accessing Contracts on the IEM (Slide 105)

Predicting Future Trades Based on Historical Trends (Slide 106)

Charting Trends (Slide 107)

Assignment Three (Slide 108)

Computer Industry Returns Contract Description (Slide 109)

Understanding the Relationship Between Risk and Return (Slide 110)

Risk and Return (Slide 111)

Determining Your Own Investment (Slides 112-114)

Strategies for Portfolio Management (Slides 115-117)

Making the Right Decision (Slide 118)

Index (Slides 119-120)

Internet Resources (Slide 121)

Works Consulted (Slide 122)

Index (continued)
internet resources
Internet Resources
  • This interactive Web-site provides product analysis for financial services, banking, lending, insurance, and employee benefits.
  • This web-site is sponsored by the Federal Reserve Bank of Chicago and includes a budget worksheet, the keys to managing money wisely, financial game planning, ways to make your money work harder, and the steps to making smart credit decisions.
  • This document provides the press releases of the Board of Governors of the Federal Reserve System between 1996 and the present.
  • The mortgage calculator provides a computer-based, interactive way to determine mortgage eligibility, monthly payments, discount points, refinancing, and tax implications.
  • Provides a series of interactive calculators, including an auto loan and leasing calculator, loans and savings calculators, financial calculators, mortgage calculators, insurance calculators, college education calculators, and tax calculators.
  • Provides the tools that one needs to make educated investment and credit decisions. Provides in-depth opinions and analyses on global equities, fixed-income credit ratings, risk management, and market developments.
  • Provides daily updates on stocks, bonds, and mutual fund activity, stock quotes, news and charting of stocks, the day in review, market indexes, and data and analysis on financial markets.
works consulted
Works Consulted
  • Garman, E. Thomas and Raymond E. Forgue. 2000. Personal Finance, Houghton Mifflin. Sixth Edition. 577 p.
  • Gitman, Lawrence J. and Jeff Madura. 2001. Introduction to Finance. Addison Wesley Longman. 755 p.
  • Hubbard, R. Glenn. 2002. Money, the Financial System, and the Economy. Addison Wesley. Fourth Edition. 771 p.
  • Kapoor, Jack R., Dlabay, Les R. and Robert J. Hughes. 2001. Personal Finance. McGraw-Hill Irwin. Sixth Edition. 678 p.
  • FOMC Alert. 2000. “Putting in the Fix?” Vol. 4(2), March 21, 2000. pp. 1-5.
  • Freddie Mac. 2001. “Just the Facts: A Media Resource Guide to Housing, Community and Freddie Mac.” Federal National Mortgage Association Public Relations.
  • Matthews, John O. 1994. Struggle and Survival on Wall Street: The Economics of Competition among Securities Firms. (New York: Oxford University Press). 251 p.
  • Organization of the Federal Reserve System. Board of Governors of the Federal Reserve System, Washington, D.C. 20551.
  • Radcliffe, Robert C. 1990. Investment: Concepts·Analysis·Strategy. Scott, Foresman/Little, Brown Higher Education. Third Edition. 999 p.
  • Dr. Joyce Berg, Dr. Thomas Rietz, and Ms. Jeanine Alcocer, University of Iowa, Henry B. Tippee College of Business.