Personal Financial Management

1. Personal Financial Management Sample Exam 2006 – 2007 Prof. Gareth Myles g.d.myles@ex.ac.uk

2. 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.

3. 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. • Points: a. current position (debt?) b. expected employment (degree?) c. personal situation (marital status?) d. interests. Make assumptions, then construct the plan. Set objectives, and be realistic. • Any assumption will be allowed but a degree of realism will be rewarded.

4. Degree of Detail • The categories of expenditure do not need to be excessively precise • Marks will be gained by focus on the financial aspects - use of financial instruments - understanding of appropriate interest rates - comprehension of risks

5. Sketch

6. 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.)

7. Question2

8. Points • An answer should talk about return and risk in general terms, then should provide formal definitions. More risk described, then defined. Must say what we mean by risk and how we measure it. • Provide an explanation in terms of compensation for risk. • This should involve defining beta and noting how it is employed.

9. Calculations • The expected return of the portfolio is r = (300/1000)8 + (200/1000)5 + (500/1000)2 = 4.4 • The beta of the portfolio is bp = (300/1000)1.10 + (200/1000)0.95 + (500/1000)0.75 = 0.895 • Variance is s2 = bp2 sm2 = 0.895225 = 20.025

10. 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?

11. Points The first part of the answer should provide a discussion of repayment and interest-only mortgages (plus variations). The second part involves calculation. The final part should discuss the trade-off between cost and risk.

12. Calculation • For £100,000 repayment mortgage over 25 years at 5%

13. 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 £123.13 Total cost is £416.67 + £123.13 = £539.80

14. 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?

15. Points This answer must define what an APR is, what it is trying to do, and 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.

16. 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%

17. Calculation • The APR on the second loan solves • So the APR is 8.89% • This loan has a lower APR

18. 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?

19. 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.

20. 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

23. 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?

24. 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

25. Points The first part cannot be answered without first outlining the theory of insurance. The basic feature is the sharing of risks. 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.

26. 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.

27. 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.

28. 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.

29. 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

30. 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. • This is equal to £7629 invested at 60. • Needs a description of pensions. • Advice must be that compound interest makes early investment preferable.