Personal Financial Management

Semester 2 2007 – 2008Gareth Myles g.d.myles@ex.ac.ukPaul Collier p.a.collier@ex.ac.uk

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