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Personal Financial Management
Semester 2 2007 – 2008Gareth Myles [email protected] Collier [email protected]
Question 1
How can a financial plan assist the management of personal finances? Illustrate your answer by constructing a financial plan for someone in mid-career aiming for early retirement.
Points
The discussion of the value of financial planning should describe what financial planning is, and then its value
Need to emphasise objectives, constraints and attitudes
Make assumptions a. current position (debt?) b. employment expectations (promotion?) c. personal situation (marital status?) d. interests.
Construct the plan
Degree of Detail
Any assumptions will be allowed but a degree of realism will be rewarded
The categories of expenditure do not need to be excessively precise
Marks will be gained by focus on the financial aspects of the plan Use of financial instruments Taxation Understanding of appropriate interest rates Comprehension of risks
Sketch
46 47 48 49 50 51 52 53 54 55Income Income Income Income Income Income Income Income Income Income
Exp. Exp Exp Exp Exp Exp Exp Exp Exp Exp
Pension plan
Pension plan
Pension plan
Pension plan
Pension plan
Pension plan
Pension plan
Pension plan
Pension plan
Pension plan
Saving Saving Saving Saving Saving Saving Saving Saving Saving Saving
Pension saving
Pension saving
Pension saving
Pension saving
Pension saving
Pension saving
Pension saving
Pension saving
Pension saving
Pension saving
Other saving
Other saving
Other saving
Other saving
Other saving
Other saving
Other saving
Other saving
Other saving
Other saving
Total Total Total Total Total Total Total Total Total Total
Question 2
Define expected return and the risk for a financial asset. Why do assets with a higher expected return also have higher risk? Explain how the beta of a stock can be used as a measure of its risk. If the variance of the market return is 25, find the expected return and variance of the portfolio described in the table. (You can ignore the idiosyncratic errors.)
Question 2
Expected Return Holding (£) Beta
Asset A 8 300 1.10
Asset B 5 200 0.95
Asset C 2 500 0.75
Points
(i) An answer should talk about return and risk in general terms, then should provide formal definitions
(ii) More risk described, then defined. Must say what we mean by risk and how we measure it
(iii) Provide an explanation in terms of compensation for risk
(iv) This should involve defining beta and noting how it is employed
Calculations
The expected return of the portfolio isr = (300/1000)8 + (200/1000)5
+ (500/1000)2 = 4.4
The beta of the portfolio is
p = (300/1000)1.10 + (200/1000)0.95 + (500/1000)0.75
= 0.895 Variance is
2 = p2 m2 = 0.895225 = 20.025
Question 3
Define the two major classes of mortgage. If the interest rate is 5% and the return on investments 7% (both assumed constant), which form of mortgage is cheaper if £100000 is borrowed over 25 years? Which would you actually choose, and why?
Points
The first part of the answer should provide a discussion of the two mortgage types Repayment Interest-only mortgages Plus variations of these
The second part involves calculation The final part should discuss the trade-off
between cost and risk in the choice of mortgage
Calculation
For £100,000 repayment mortgage over 25 years at 5%
27.591£05.112
05.1000,10024
0
25
t
t
tx
Calculation
The summation in the denominator can cause problems
2251.3071524.3925261.2785963.2653298.252695.2
406619.292018.2182875.2078928.2979932.1885649.1
79856.1710339.1628895.1551328.1477455.14071.1
340096.1276282.1215506.1157625.11025.105.11
)05.1()05.1()05.1()05.1()05.1()05.1(
)05.1()05.1()05.1()05.1()05.1()05.1(
)05.1()05.1()05.1()05.1()05.1()05.1(
)05.1()05.1()05.1()05.1()05.1()05.1()05.1()05.1(
242322212019
181716151413
121110987
654321024
0
t
t
Calculation
For the interest-only mortgage For a £100,000 loan at 5%, interest is £5000 per
annum, so monthly payment is £416.67 Payments are made into an investment policy
Assume investment return of 7% then annual payment solves
So monthly payment is £123.13Total cost is £416.67 + £123.13 = £539.80
000,10007.125
1
t
tx
Question 4
Define an APR and describe the general formula used for its calculation. If you borrow £2000 which is repaid with four payments of £550 made 3 months, 6 months, 18 months and 24 months after the initial borrowing, what is the APR? How does the APR on this loan contrast to making two repayments of £1100 after 9 months and 18 months? Do these calculations show that the APR is a useful concept?
Points
This answer must define What an APR is What it is trying to do Why this is worthwhile
The formula must be stated and the interpretation of this given
The calculations must then be undertaken The evaluation of whether it is worthwhile
should be related to your example, and to general conclusion
Calculating APRs
The APR formula involves a series of cash flows at different times
Receive £2000 at t = 0, pay £550 at t = 0.25, t = 0.5, t = 1.5, t = 2
How do you solve? By trial and error in the examination
The answer is r = 9.6%
25.15.025.00 1
550
1
550
1
550
1
550
1
2000
rrrrr
Calculation
The APR on the second loan solves
So the APR is 8.89% This loan has a lower APR Discussion should focus on using the APR
Does it help choose between these two loans?
5.175.00 1
1100
1
1100
1
2000
rrr
Question 5
You have accumulated a debt of £1000 on a credit card. If the card charges a rate of interest of 18% per year and allows a minimum payment of 5% of outstanding balance to be made, what would be the debt on card after 2 years of making the minimum payment? Is making the minimum payment a good financial strategy? Can you suggest a better alternative?
Points
The calculation is the same as in the class exercise
This should be set out in detail for each month: balance, interest, repayment
Whether it is a good strategy should be related to the typical rate of interest on the credit card compared to alternative forms of borrowing
This then links into the final part concerning either alternative ways of borrowing or changes to consumption plan to avoid borrowing
Points
You should not underestimate the importance of the discussion
Each question should take 40 minutes – use this time
The better alternatives should reveal financial knowledge
1000 1015 964.25
964.25 978.7138 929.7781
929.7781 943.7247 896.5385
896.5385 909.9866 864.4872
864.4872 877.4546 833.5818
833.5818 846.0856 803.7813
803.7813 815.838 775.0461
775.0461 786.6718 747.3382
747.3382 758.5483 720.6209
720.6209 731.4302 694.8587
694.8587 705.2815 670.0175
670.0175 680.0677 646.0643
Calculation
646.0643 655.7553 622.9675
622.9675 632.3121 600.6965
600.6965 609.7069 579.2216
579.2216 587.9099 558.5144
558.5144 566.8921 538.5475
538.5475 546.6257 519.2944
519.2944 527.0838 500.7296
500.7296 508.2406 482.8286
482.8286 490.071 465.5674
465.5674 472.5509 448.9234
448.9234 455.6573 432.8744
432.8744 439.3675 417.3991
Calculation
Question 6
What is adverse selection? Demonstrate the effect that it can have upon the market for car insurance. Does adverse selection explain the use of the no-claims bonus?
Good Essays
Besides describing the theory of insurance you must also answer the questions
To do this requires understanding the theory It also requires an interpretation of the
question Make sure this interpretation is stated
Points
The first part cannot be answered without first outlining the theory of insurance. The basic feature is the sharing of risk
Any question of this form is an invitation to describe the theory Do this carefully
The second part must provide a clear analysis of the effect of adverse selection
Examples always make for a better answer
Question 7
"Most decisions in Personal Financial Management have a tax dimension". Describe the main features of one tax and use it to illustrate the statement.
Points
The answer must first describe why taxation is important in financial decisions
The basic features of a tax must then be described
For example inheritance tax: rate of tax, what it applies to, exemptions, spouses
Then the implications of this for financial planning must be considered
Question 8 (04-05)
Assume you start investing in a pension scheme at the age of 30. Assume the return on investment is 7%. What is the value at age 65 of £1 invested when 30? Repeat for £1 invested at 40, 50, and 60. How much would you need to invest at 60 to match the value of £1000 invested when 30? From these calculations deduce financial advice for financing a private pension.
Points
Once again begin by going one step further back: what is a pension?
Defined benefits (knowing what will be received) and defined contribution (knowing what must be put in) can then be explained.
The discussion could focus on the different risks under the two systems
Calculation
£1 invested at 30 is worth at 65 £1 invested at 40 is worth at 65 £1 invested at 50 is worth at 65 £1 invested at 60 is worth at 65 £1000 invested at age 30 provides £10680 at
65
68.10£)07.1( 35
43.5£)07.1( 25
76.2£)07.1( 15
40.1£)07.1( 5
Comments
This is equal to £7629 invested at 60 Needs a description of pensions Advice must be that compound interest makes
early investment preferable