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fin4504

fin4504

Description

School: Florida State University
Department: Business
Course: Investments
Professor: Doug smith
Term: Winter 2016
Tags: Investments
Cost: 50
Name: FIN4504 -- Investments -- Exam 1 Review
Description: EXTENSIVE outline from the book and slides on the material Dr. Smith wrote on the board to focus on for the test. I heard that if you go into a lot of detail with each point that you'll be fine on the test, so I tried to be as in-depth as possible. Good luck!
Uploaded: 01/26/2016
14 Pages 7 Views 6 Unlocks
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Mr. Benny Douglas (Rating: )

You're awesome! I'll be using your notes for sure moving forward :D



FIN4504 – Investments – Ch. 1-5


Generate net income to the economy,



Exam 1 Study Guide 

19 MC questions, 3 “open space” questions, bring a #2 pencil, calculator is ok

1 Financial Assets

Real assets -- the land, buildings, equipment and knowledge that can be used to  produce goods and services

∙ Generate net income to the economy

Financial assets -- stocks and bonds

∙ Securities that are no more than sheets of paper, or more likely, computer  entries

∙ Don't directly contribute to the productive capacity of the economy ∙ The means by which individuals in well-developed economies hold their  claims on real assets

∙ Claims to the income generated by real assets

∙ Claims on income from the government

∙ Define the allocation of income or wealth among investors

∙ Individuals choose between consuming their wealth today or investing in the  future

∙ If they choose to invest, they may place their wealth in financial assets by purchasing various securities


What is a commercial paper?



∙ When investors buy these securities from companies, the firms  use the money raised to pay for real assets

∙ Investors' returns on securities come from the income produced  by the real assets that were financed by the issuance of those  

securities

∙ Distinction between real and financial assets:

∙ View balance sheet (Table 1.1)

∙ Household wealth includes financial assets such as bank  accounts, corporate stock or bonds

∙ These securities are financial assets of households, but are  liabilities of the issuers of the securities  

∙ "your asset is the issuers liability"

∙ When you aggregate overall balance sheets, the claims cancel  out

∙ Only real assets are left and are the net wealth of the  economy

∙ The success or failures of the financial assets we choose to purchase  ultimately depend on the performance of the underlying real assets ∙ Types of Financial Assets 


Starts as an order to bank by a bank's customer to pay a sum of money at a future date, typically within six months Like a postdated check.



We also discuss several other topics like miles chen ucla

∙ Debt (fixed-income) securities -- promise either a fixed stream of  income or a stream of income that is determined according to a specified  formula

∙ Money market -- refers to fixed-income securities that are short  term, highly marketable, and generally of very low risk

∙ Capital market -- includes long-term securities such as Treasury  bonds, as well as bonds issued by federal agencies, state and local  municipalities and corporations

∙ These bonds range from very safe (Treasury securities) to  relatively risky (high-yield or "junk" bonds)

FIN4504 – Investments – Ch. 1-5

∙ Designed with extremely diverse provisions regarding  payments provided to the investor and protection against the  

bankruptcy of the issuer

∙ Equity -- represents an ownership share in a corporation ∙ Equity holders are not promised any particular payment ∙ Receive any dividends the firm may pay We also discuss several other topics like What are the chemical properties of oxygen and carbon dioxide that require gases to be transported?

∙ Prorated ownership in the real assets of the firm

∙ If the firm is successful, the value of the equity will increase ∙ If not, the value will decrease

∙ The performance of equity investments is tied directly to the  success of the firm and its real assets

∙ Equity investments tend to be riskier than investments in debt  securities

∙ Derivative securities (options and futures contracts) -- provide payoffs  that are determined by the prices of other assets such as bond or stock  prices

∙ Named this because their values derive from the prices of other  assets

∙ Investors and corporations regularly encounter other financial markets as well ∙ Firms engaged in international trade regularly transfer money back and forth between dollars and other currencies We also discuss several other topics like organic chemistry exam 3

∙ > than trillions of dollars are traded each day in the market for  foreign exchange

∙ Investors might also invest directly in some real assets

∙ You can buy or sell corn, wheat, natural gas, gold, silver, etc. ∙ Commodity and derivative markets allow firms to adjust their exposure to  various business risks

∙ Wherever there is uncertainty, investors may be interested in trading,  either to speculate or to lay off their risks, and a market may arise to meet that demand

1 Asset Allocation Process

∙ Investors make two types of decisions in constructing their portfolios: ∙ The asset allocation decision

∙ The choice among the broad asset classes (stocks, bonds, real estate, commodities, etc.)

∙ The security selection decision Don't forget about the age old question of bridget james sfsu

∙ The choice of which particular securities to hold within  each asset class

∙ "Top-down" portfolio construction starts with asset allocation ∙ Security analysis -- the valuation of particular securities that might be  included in the portfolio

∙ Both bonds and stocks must be evaluated for investment  attractiveness

∙ "Bottom-up" strategy -- the portfolio is constructed from the securities  that seem attractively priced without as much concern for the resultant  asset allocation

∙ Can result in unintended bets on one or another sector of the  economy

FIN4504 – Investments – Ch. 1-5

∙ Focuses the portfolio on the assets that seem to offer the most  attractive investment opportunities

∙ The asset allocation decision is the primary determinant of a portfolio's return

∙ Primary use is to hedge risks or transfer them to other parties ∙ Can also be used to take highly speculative positions

∙ Every so often, one of these positions blows up

∙ Results in well-publicized losses of hundreds of millions of  dollars

∙ Though these losses attract a lot of attention, they don't negate  the potential of these securities as risk management tools

1 Securitization

∙ The landscape in housing finance began to change in the 1970s ∙ Fannie Mae -- FNMA, Federal National Mortgage Association ∙ Freddie Mac -- FHLMC, Federal Home Loan Mortgage Corporation

∙ Fannie Mae and Freddie Mac began buying large quantities of  mortgage loans from originators and bundling them into pools that could  be traded like any other financial asset We also discuss several other topics like comm 151
Don't forget about the age old question of california state university northridge psychology

∙ The pools were soon dubbed "mortgage-backed securities"  ∙ The process was called securitization

∙ The loan originator, the savings and loan, might make a  $100,000 loan to a homeowner

∙ The homeowner repays the principal and interest on the loan  over 30 years

∙ The originator would sell the mortgage to Freddie Mac or Fannie  Mae and recover the cost of the loan

∙ The originator could continue to service the loan (e.g. collect  monthly payments from the homeowner) for a small servicing fee ∙ The loan payments net of that fee would be passed along  to the agency

∙ In turn, Freddie or Fannie would pool the loans into mortgage backed securities and sell the securities to investors such as pension  funds or mutual funds

∙ the agency would typically guarantee the credit or  

default risk of the loans included in each pool

∙ It would retain a guarantee fee before passing along the  rest of the cash flow to the ultimate investor

∙ Because the mortgage cash flows were passed along from the homeowner to the lender and to the investor, the mortgage backed securities were also called pass-throughs

∙ New product -- securitization by private firms of nonconforming  "subprime" loans with higher default risk

∙ Important difference between these and government-agency  pass-throughs was that the investor in the private-label pool would  bear the risk that the homeowners might default on their loans ∙ Originating mortgage brokers had little incentive to  

perform due diligence on the loan as long as the loans could be  sold to an investor

FIN4504 – Investments – Ch. 1-5

∙ These investors had no direct contact with the  

borrowers

∙ Could not perform detailed underwriting  

concerning loan quality

∙ Relied on borrowers' credit scores

∙ Steadily came to replace conventional  

underwriting

∙ Trend of low-documentation to no-documentation loans entailing little verification of borrower's ability to carry a loan soon emerged ∙ Other subprime underwriting standards also deteriorated ∙ When housing prices began falling, these highly leveraged loans  were quickly underwater

∙ Underwater --- the house was worth less than the loan  balance

∙ Many homeowners decided to walk ware or  

abandon their homes, and their loans

∙ Adjustable rate mortgages (ARMs) also grew in popularity ∙ Became the standard in subprime market

∙ Loans offered borrowers low initial or "teaser" interest  rates, but these rates eventually would reset to current market  interest yields

∙ Many borrowers had maxed out their borrowing  

capacity at the teaser rate

∙ As soon as the loan rate was reset, their monthly  payments would soar

∙ Starting in 2004, the ability of refinancing to save a loan began  to diminish

∙ Higher interest rates put payment pressure on  

homeowners who had taken out adjustable rate mortgages

∙ Housing prices peaked in 2006, so homeowners' ability to  refinance a loan using built-up equity in the house declined

∙ Housing default rates began to surge in 2007

∙ So did losses on mortgage-backed securities  

2 Money Market Instruments

∙ Treasury bills

∙ Interest type -- discount

∙ Most marketable of all money market instruments

∙ T-bills represent the simplest form of borrowing

∙ The government raises money by selling bills to the public ∙ Investors buy the bills at a discount from the stated  

maturity

∙ At the bill's maturity, the holder receives from the  

government a payment equal to the face value of the bill

∙ The difference between the purchase price and the  

ultimate maturity value represents the investor's earnings

∙ Issued with initial maturities of 4, 13, 26, or 52 weeks

∙ Individuals can purchase T-bills directly from the Treasury or on  the secondary market from a government securities dealer

FIN4504 – Investments – Ch. 1-5

∙ T-bills are highly liquid

∙ Sell in minimum denominations of only $100

∙ Denominations of $10,000 are more common

∙ Income earned on T-bills is taxable at the federal level, but  exempt from all state and local taxes

∙ Asked price -- the price you would have to pay to buy a T-bill  from a securities dealer

∙ Bid price -- the slightly lower price you would receive if you  wanted to sell a bid to a dealer

∙ Bid-asked spread -- the difference in these prices, which is the  dealers source of profit

∙ Bank-discount method -- the bill's discount from maturity is  annualized based on a 360-day year and then reported as a  

percentage of its face value

∙ The higher the bid yield, the lower the bid price

∙ Has a long tradition but is flawed for 2 reasons:

1. Assumes a year has only 360 days

2. Computes the yield as a fraction of face value  

rather than of the price the investor paid to acquire  

the bill

∙ Issued by: Federal Government

∙ Denomination: $100, commonly $10,000

∙ Maturity: 4, 13, 26, or 52 weeks

∙ Liquidity: Highly liquid

∙ Default Risk: None  

∙ Interest Type: Discount

∙ Taxation: Federal taxes owed, exempt from state and local taxes ∙ Certificates of deposit

∙ Interest type -- BEY

∙ A time deposit with a bank

∙ May not be withdrawn on demand

∙ The bank pays interest and principal to the depositor only at the  end of the fixed term of the CD

∙ Issued in denominations > $100,000 and are usually negotiable ∙ They can be sold to another investor if the owner needs to cash in the certificate before its maturity date

∙ Short-term CDs are highly marketable

∙ The market thins out for maturities of three months or  

more

∙ Treated as bank deposits by the Federal Deposit Insurance  

Corporation

∙ Insured for up to $250,000 in the event of bank  

insolvency

∙ Issued by: Depository Institutions

∙ Denomination: Any, $100,000 or more are marketable

∙ Maturity: Varies, typically 14 day minimum

∙ Liquidity: 3 months or less are liquid if marketable

∙ Default Risk: First $100,000 ($250,000) is insured

∙ Interest Type: Add on

FIN4504 – Investments – Ch. 1-5

∙ Taxation: Interest income is fully taxable

∙ Commercial paper

∙ Interest type -- discount

∙ Large, well-known companies often issue their own short-term  unsecured debt notes directly to the public rather than  

borrowing from banks

∙ Sometimes CP is backed by a bank line of credit

∙ Gives the borrower access to cash that can be used if  

needed to pay off the paper at maturity

∙ Maturities range up to 270 days

∙ Longer maturities require registration with the SEC and  

are almost never issued

∙ Most commonly issued with maturities less than one or  

two months

∙ Issued in denominations of multiples of $100,000

∙ Small investors can invest in commercial paper only  

indirectly

∙ Through money market mutual funds

∙ Considered a fairly safe asset

∙ Trades in secondary markets

∙ Quite liquid

∙ Most issues are rated by at least one agency

∙ The yield on CP depends on its time to maturity and credit rating ∙ Asset-backed commercial paper -- short-term CP used to raise  funds for the institution to invest in other assets, most  

notoriously, subprime mortgages

∙ These assets in turn were used as collateral for the CP

∙ Issued by: Large creditworthy corporations and financial institutions ∙ Denomination: Minimum $100,000

∙ Maturity: Maximum 270 days, usually 1-2 months

∙ Liquidity: 3 months or less are liquid if marketable

∙ Default Risk: Unsecured, Rated, Mostly high quality

∙ Interest Type: Discount

∙ Taxation: Interest income is fully taxable

∙ Asset backed commercial paper is backed by a loan or security ∙ In summer 2007, asset backed CP market collapsed when subprime  collateral values fell

∙ Bankers' acceptances

∙ Interest type -- discount

∙ Starts as an order to bank by a bank's customer to pay a  sum of money at a future date, typically within six months

∙ Like a postdated check

∙ When the bank endorses the order for payment as  

"accepted," it assumes responsibility for ultimate payment to  

the holder of the acceptance

∙ At this point, may be traded in secondary markets

∙ Considered very safe assets

∙ Allow traders to substitute the bank's credit  

standing for their own

FIN4504 – Investments – Ch. 1-5

∙ Used widely in foreign trade where the creditworthiness of one trader is unknown to the trading partner

∙ Acceptances sell at a discount from the face value of the  payment order

∙ Eurodollars

∙ Interest type -- BEY

∙ Dollar-denominated deposits at foreign banks or foreign  branches of American banks

∙ These banks escape regulation

∙ Doesn't have to necessarily be in Europe, that's just the  name

∙ Most are for large sums

∙ Most are time deposits of less than six months' maturity ∙ Eurodollar certificate of deposit -- resembles a domestic  bank CD except it is the liability of a non-US branch of a bank,  typically a London branch

∙ Advantage is that the holder can sell the asset to  realize its cash value before maturity

∙ Eurodollar CDs are considered less liquid and risker  than domestic CDs

∙ Offer higher yields

∙ Repos and Reverses

∙ Interest type -- discount

∙ Dealers in government securities use repos (repurchase  agreements) as a form of short-term, usually overnight,  

borrowing

∙ The dealer sells securities to an investor on an overnight  basis with an agreement to buy back those securities the next  day at a slightly higher price

∙ The increase in price is the overnight interest

∙ The dealer basically takes out a one-day loan from the  investor

∙ The securities serve as collateral for the loan

∙ Term repo -- same thing but the term of the loan can be  30 days or more

∙ Considered very safe in terms of credit risk because the  loans are collateralized by the securities

∙ Reverse repo -- mirror image of a repo; the dealer finds an investor holding government securities and buys them with an  agreement to resell them at a specified higher price on a future  date

∙ (Life lesson from Dougy) Look at all things from the viewpoint of the broker dealer:

∙ If I'm taking in cash, I call that a repurchase agreement ∙ If I'm taking in cash, and giving back collateral, I call that a reverse RP ∙ Broker's Calls

∙ Individuals who buy stocks on margin borrow part of the  funds to pay for the stocks from their broker

FIN4504 – Investments – Ch. 1-5

∙ The broker may borrow the funds from a bank, agreeing to repay the bank immediately (on call) if the bank requests it

∙ The rate paid on such loans is usually about one  

percentage point higher than the rate on short-term T-bills

∙ Federal Funds

∙ Interest type -- BEY

∙ Banks maintain deposits of their own at the Federal  

Reserve Bank, or the Fed

∙ Each bank is required to maintain a minimum balance in a reserve account with the Fed

∙ Balance depends on the total deposits of the bank's customers

∙ Some banks have excess

∙ Some big banks, primarily New York and other  

financial center banks, have a shortage

∙ Banks with excess funds lend to those with a  

shortage

∙ These loans are usually overnight  

transactions

∙ Arranged at a rate of interest called the  

Federal funds rate

∙ Arose primarily as a way for banks to transfer balances to  meet reserve requirements

∙ Today many large banks use Federal funds as one  

component of their total source of funding

∙ Fed funds rate is simply the rate of interest on very  short-term loans among financial institutions

∙ LIBOR (London Interbank Offer Rate)

∙ The rate which large banks in London are willing to lend  money among themselves

∙ Has become the premier short-term interest rate quoted  in the European money market

∙ Serves as a reference rate for a wide range of  

transactions

∙ LIBOR interest rates may be tied to currencies other than  the US dollar

∙ There is a similar rate called the EURIBOR (European  Interbank Offer Rate) which banks in the euro zone are willing to  lend euros among themselves

According to Doug:

∙ You really don’t want anything backed by LIBOR

∙ LIBOR is a bunch of banks deciding the rates

1 Calculate Taxable/Tax-free Yields

Tax-free yields:

∙ Municipal bonds are tax-exempt

∙ Rate is based off of T-bills

Equivalent taxable yield:

R(1-t) = Rm or R = Rm/(1-t)

FIN4504 – Investments – Ch. 1-5

∙ The tax free rate divided by 1-t

∙ Can calculate the tax bracket at which investors are indifferent between  taxable and tax-exempt bonds

T = 1 - (rm/r)

∙ rm/r is the yield ratio

∙ A key determinant of the attractiveness of municipal bonds ∙ The higher the yield ratio, the lower the cutoff tax bracket

1 Price/Dollar weighted Averages

Price-weighted average:

∙ An average computed by adding the prices of the stocks and dividing by a divisor

∙ The return on a portfolio that holds one share of each stock ∙ Assumes you buy 1 share of each stock and invest cash and stock  dividends proportionately

∙ Higher priced shares get more weight

∙ Bad, high price doesn't always mean it's big

Dollar-weighted average:

∙ Computing the portfolio manager's internal rate of return (IRR) ∙ The IRR is the interest rate that sets the present value of the cash flows  realized on the portfolio equal to the initial cost of establishing the  portfolio

∙ Given net cash flow in millions for each quarter:

0 = (NCF at 0) + (NCF at 1)/(1+IRR) + (NCF at 2)/(1+IRR)2 + (NCF at 3)/(1+IRR)3 + …  

Solve for IRR

2 Residual Claims

o One of the two most important characteristics of common stock as an  investment

o Means stockholders are the last in line of all those who have a claim on the assets and income of the corporation

o In liquidation of a firm's assets, the shareholders have claim of what's  left after paying all other claimants

 Shareholders have claim to the part of operating income left  after interest and income taxes have been paid

o Management can either pay this residual as cash dividends to  shareholders or reinvest it in the business to increase the value of the  shares

3 Common Hedging Strategies

Hedge funds -- pool and invest the money of many clients, similar to mutual  funds

∙ Open only to institutional investors such as pension funds, endowment  funds or wealthy individuals

∙ More likely to pursue complex and higher-risk strategies

∙ Typically keep a portion of trading profits as part of their fees ∙ Mutual funds charge a fixed percentage of assets under management

FIN4504 – Investments – Ch. 1-5

1 Types of Securities Underwritten by Investment Banks Investment bankers -- specialize in selling securities to the public and can offer their services at a cost below that of maintaining an in-house security issuance division

∙ Advise an issuing corporation on the prices it can charge for the securities  issued, appropriate interest rates  

∙ Investment banking firms handle the marketing of the security in the primary  market -- where new issues of securities are offered to the public ∙ In this role, the banks are called underwriters

1 Shelf Registration

∙ Innovation in the issuing of securities introduced in 1982 when the SEC  approved Rule 415

∙ Rule 415 -- allows firms to register securities and gradually sell them to the public for two years following the initial registration

∙ Since the securities are already registered, they can be sold on  short notice with little additional paperwork

∙ They can't be sold in small amounts without incurring  

substantial flotation costs

∙ The securities are "on the shelf" ready to be issued, which gave rise to  the term shelf registration

2 Types of Securities Markets

∙ Direct search markets

∙ The least organized market

∙ Buyers and sellers must seek each other out directly

∙ Characterized by sporadic participation and low-priced, nonstandard  goods

∙ Wouldn't pay for most people or firms to specialize in such markets ∙ Brokered markets

∙ Markets where trading in a good is active, brokers find it profitable to  offer search services to buyers and sellers

∙ Brokers in particular markets develop specialized knowledge on valuing assets traded in that market

∙ An important brokered investment market is the primary market ∙ Where new issues of securities are offered to the public ∙ Investment bankers who market a firm's securities to the public  act as brokers

∙ They seek investors to purchase securities directly from  the issuing corporation

∙ Dealer markets

∙ Arise when trading activity in a particular type of asset increases ∙ Dealers specialize in various assets, purchase assets of their own  accounts and later sell them for a profit from their inventory

∙ The spreads between dealers' buy (or bid) prices and sell (or ask)  prices are a source of profit

∙ Save traders on search costs because market participants can easily  look up the prices at which they can buy from or sell to dealers

FIN4504 – Investments – Ch. 1-5

∙ A fair amount of market activity is required before dealing in a market  is a attractive source of income

∙ Most bonds trade in over-the-counter dealer markets

∙ Auction markets

∙ Most integrated market

∙ All traders converge at one place to buy or sell an asset

∙ Example: The New York Stock Exchange (NYSE)

∙ Advantage over dealer markets is that one doesn't need to search  across dealers to find the best price for a good

∙ If all participants converge, they can arrive at mutually agreeable  prices and save the bid-ask spread

∙ Both over-the-counter dealer markets and stock exchanges are  secondary markets

3 Bid/Offer (Ask)

Dealer markets -- markets in which traders specialize in a particular asset Bid (buy) price -- price at which the dealer or other trader is willing to purchase a security

Offer (ask/sell) price -- price at which the dealer or other trader will sell a  security

Bid-ask spread -- difference between the bid and ask price; a source of profit

4 Common Aspects of Short Sales

Short sale -- the sale of shares not owned by the investor but borrowed through a broker and later purchased to replace the loan

∙ Investor borrows a share of stock from a broker and sells it ∙ The short-seller must later purchase a share of the same stock in order to  replace the share that was borrowed

∙ Called covering the short position

∙ Short-seller anticipates the stock price will fall, so that share can be  purchased later at a lower price than it initially sold for

∙ Short-sellers must not only replace the shares but also pay the lender of the  security any dividends paid during the short sale

∙ Shares loaned out for a short sale are provided by the short-seller's brokerage firm

∙ The owner of the shares doesn't have to know that the shares have  been lent to the short-seller

∙ If the owner wants to sell the shares, the brokerage firm will simply borrow  shares from another investor

∙ Short sale may have an indefinite term

∙ If the brokerage firm can't locate new shares to replace the ones sold, the  short-seller will need to repay the loan immediately by purchasing shares in the market and turning them over to the brokerage house to close out the loan

∙ Exchange rules require that proceeds from a short sale must be kept on  account with the broker

∙ Short-seller cannot invest these funds to generate income ∙ Short-sellers are required to post margin (cash or collateral) with the  broker to cover losses should the stock price rise during the short sale

5 Investment Organizations

FIN4504 – Investments – Ch. 1-5

Investment companies -- financial intermediaries that collect funds from  individual investors and invest those funds in a potentially wide range of  securities or other assets

∙ Perform several important functions for their investors:

1. Record keeping and administration

2. Diversification and divisibility

3. Professional management

4. Lower transaction costs

∙ Unit investment trusts -- money pooled from many investors that is invested in  a portfolio fixed for the life of the fund

1. Little active management because once established, the portfolio  composition is fixed

∙ These trusts are referred to as unmanaged

∙ Tend to invest in relatively uniform types of assets

∙ Ex. One trust may invest in municipal bonds, another in  corporate bonds

2. To form:

∙ Sponsor (brokerage firm) buys portfolio of securities -->  deposited to trust

∙ Sells public shares (units) in trust called redeemable trust  certificate

∙ All income/payments of principal from the port are paid out by  fund's trustee's (bank/trust company) to the shareholders

o Managed investment companies

1 Open-end fund -- a fund that issues or redeems its shares at net asset  value

2 Closed-end fund -- shares may not be redeemed, but instead are traded at prices that can differ from net asset value

o Other investment organizations:

1 Comingled funds -- partnerships of investors that pool funds  ∙ Management firm that organized the partnership, a bank or  insurance company, manages the funds for a fee

∙ Typical partners -- trust or retirement accounts that have  portfolios much larger than those of most individual investors but are  still too small to warrant managing on a separate basis

∙ Similar in form to open-end mutual funds  

∙ Instead of shares, the fund offers units which are bought an sold  at NAV

2 Real Estate Investment Trusts (REITs)

∙ Similar to a closed-end fund

∙ Invest in real estate or loans secured by real estate

∙ Besides issuing shares, they raise capital by borrowing from  banks and issuing bonds or mortgages

∙ Most are highly leveraged

∙ Typical debt ratio of 70%

∙ 2 principal kinds of REITs:

∙ Equity trusts -- invest in real estate directly

∙ Mortgage trusts -- invest primarily in mortgage and  

construction loans

FIN4504 – Investments – Ch. 1-5

∙ Generally established by banks, insurance companies, or mortgage  companies

∙ Serve as investment managers to earn a fee

2 Hedge funds -- a private investment pool, open to wealthy or institutional  investors, this is exempt from SEC regulation and can therefore pursue  more speculative policies than mutual funds

∙ Like mutual funds, hedge funds are vehicles that allow private  investors to pool assets to be invested by a fund manager

∙ Unlike mutual funds, hedge funds are commonly structured as private partnerships

∙ Not subject to many SEC regulations

∙ Require investors to agree to initial "lock-ups"

∙ Periods as long as several years in which investments  cannot be withdrawn

∙ Allow hedge funds to invest in illiquid assets without  

worrying about meeting demands for redemption of funds

∙ Managers can pursue other investment strategies that aren't open to  mutual funds

∙ Ex. Heavy use of derivatives, short sales, and leverage

6 Calculate NAV

Net asset value (NAV) -- the value of each share

∙ Investors buy shares investment companies and ownership is proportional to  the number of shares purchased

∙ Assets - liabilities on a per-share basis

Net asset value = (Market value of assets - Liabilities)/Shares outstanding

7 Types of Mutual Funds Charges

12b-1 charges -- annual fees charged by mutual fund to pay for maturity and  distribution costs

o Named after SEC rule that permits use of these plans

o Funds may use annual 12b-1 charges instead of, or in addition to, front end loads to generate the fees with which to pay brokers

o 12b-1 charges must be added to operating expenses to obtain the true  annual expense ratio of the fund

Front-end charge -- commission/sales charge paid when you purchase the shares Back-end charge -- redemption/exit fee incurred when you sell your share Operating expenses -- incurred by mutual fund in operating the portfolio, including  administrative expenses/advisory fees paid to investors

8 Aspects of ETF

Exchange-traded funds (ETF) -- offshoots of mutual funds that allow investors to  trade index portfolios

∙ Can be traded throughout the day (not just at the end)

∙ Includes diamonds

∙ Lowers taxes

∙ Can be sold short or purchased on margin

∙ Lower cost since no marketing cash

∙ Merely sold, not paid out

FIN4504 – Investments – Ch. 1-5

∙ Arbitrage helps ensure ETF doesn't stray away from NAV

∙ Must pay brokerage commission

∙ Large growth in popularity

9 Calculate Holding Period Return

Holding Period Return (HPR) -- rate of return over given investment period HPR = (Ending price - Beg. Price + Cash dividend)/(Beg. Price)

10 Calculate Real/Nominal Return

Nominal return -- return that doesn't account for inflation

Real return -- return that does account for inflation

∙ Use The Fisher Effect:

(1 + R) = (1 + r)(1 + i)

R = nominal rate

r = the real rate

i = inflation rate

11 Calculate Total Return

(couldn't find this in the book so I Googled it)

Return on Investment (ROI)

ROI = (Gain from investment - cost of investment)/Cost of investment

12 Calculate Geometric Return

G( R ) = [((1+r1) x (1+r2) x … (1+rn))1/N] – 1

13 Calculate Expected Return

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