FIN4504 -- Investments -- Exam 1 Review
FIN4504 -- Investments -- Exam 1 Review FIN4504
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This 14 page Study Guide was uploaded by Gabrielle Isgar on Tuesday January 26, 2016. The Study Guide belongs to FIN4504 at Florida State University taught by Dr. Doug Smith in Winter 2016. Since its upload, it has received 466 views. For similar materials see Investments in Business at Florida State University.
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FIN4504 – Investments – Ch. 1-5 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 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 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 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 > 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 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 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) = R mr R = R /m1-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 - (m /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 3 + (NCF at 3)/(1+IRR) + … 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+r 1 x (1+r 2 x … (1+r )n ] – 1 13 Calculate Expected Return
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