FIN MKTSINSTINTL F
FIN MKTSINSTINTL F FIN 3244
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This 59 page Class Notes was uploaded by Jeanne Daugherty on Thursday September 17, 2015. The Class Notes belongs to FIN 3244 at Florida State University taught by Debra Peterson in Fall 2015. Since its upload, it has received 50 views. For similar materials see Financial Markets, Institutions, and International Finance Systems in Finance at Florida State University.
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FIN3244 EXAM 3 PROFESSOR DEBRA PETERSON CHAPTER 3 ONLINE INFORMATION AND INVESTING STOCKBROKERSAn agent that charges a fee or commission for executingbuy and sell orders submitted by an investor or The firm that acts as an agent for a customer charging the customer a commission for its services 0 They are licenced by the SEC and the Exchangesex NYSE 0 Visual Presented in Class ofa transaction using a stockbroker u way u FACILITATORS 7 EXECUTE TRADES 7 RETAIN SECURITIES IN STREET NAMETHEY HOLD THE SECURITIES FOR YOU 7 RESEARCH amp ADVICE 7 ACCOUNT STATEMENTSMONTH LY STATEMENTS FOR TAX PURPOSES RECORDS 7 MONEY MARKET INVESTMENT OF IDLE CASH GROWS INTEREST ON CASH NOT CURRENTLY TIED UP CHURNING CHURNING IS A TERM GIVEN TO EXCESSIVE TRADING THE TRADING IS A WAY TO GENERATE COMMISSIONS FOR THE BROKER AND HIS FIRM ASYOU MAY IMAGINE TRADING AN ACCOUNT ON AVERY FREQUEST BASIS MAKES IT ALMOST IMPOSSIBLE FOR ANY INVESTMENT TO SHOW A PROFIT AND AS SUCH THE FEES AND CHARGES WILL QUICKLY REDUCE AN ACCOUNT TO ALMOST ZERO Further Stockbrokers help investors buy and sell securities Besides this major role fullservice stockbrokers provide clients with several other bene ts For example most brokerage firms offer their clients a wide variety of information Many of them have research staffs that periodically review published economic market industry or company behavior forecasts and make recommendations to their clients as to which securities they should buy or sell Every month they mail investors a record of transactions for that month with a total ending balance Some brokerage firms also make arrangements to transfer funds from the sale of securities directly to an investor s savings account where the funds can earn interest Many brokers have reference libraries that clients can use to research securities They can provide uptotheminute stock price quotations Many brokerage rms will also hold certificates for safekeeping to protect against loss The major role of a stockbroker is to execute a client s transactions at the best possible price While it is not necessary to know your stockbroker personally he or she should understand your investment goals This should avoid potential con icts You should also make sure that the broker does not charge you too much for the services provided and that you are not paying for services that you do not need Book TYPES OF BROKERAGE FIRMS Typically brokers charge xed commissions in return for facilitating the purchase or sale of securities Negotiated commissions are also available to investors who maintain large accounts with the broker The commissions usually vary depending on the services the broker provides to the investor The major difference between a fullservice and discount brokeris the fullservice broker provides investment advice Because investing through a discount or deepdiscount broker can save from 30 to 80 percent of the commission the investor must weigh the benefit of advice against the higher commission Online brokers are typically deep discount brokers through whom investors can execute trades electronically online These brokers charge very low commissions but offer little or no individualized research information or investment advice Full service brokers provide personalized timely research and information Basic discounters provide low costs and fast trades Premium discount brokers are in between these extremes Full Service is the most expensive because it renders the most information Premium Discount brokers provide some information but give free range to the user to invest as they please Example I invest with Scottrade now I have two options when making a trade I can do it online with my own knowledge and information for a 7 trade or I can call them talk to a broker and incur the cost of the information along with the trade for a 25 trade Online If the 7 trade was the only option You have to work with your own info and don t need to bother a broker and cost him time so it is cheaper INVESTING TIPS GIVEN ON PPT Not Everything online is true Double Check Tickers and Transactions for accuracy Studies show the more frequently you trade the less often you beat the market too slow to realize losses too quick to realize gains people trade on emotions difficulty interpreting data higher transaction costs DON T TRY TO TIME THE MARKET Day trading is the opposite of a buyandhold strategy since true day traders do not even own stocks overnight The method is highly risky since it often involves margin and short transactions that may result in total loss In addition day traders have high expenses for brokerage commissions training and computer equipment There are several important factors you should consider before trading securities First know how to place and confirm your order before you begin trading Second verify the stock symbol of the security you wish to buy Third use limit orders Fourth don t ignore the online reminders that ask you to check and recheck Fifth don t get carried away Sixth open accounts with two brokers Lastly doublecheck orders for accuracy Many investors set aside an amount of their capital that is designated for purely speculative purposes and not required for daytoday survival In this way they are not jeopardizing themselves or their loved ones if they suffer heavy losses BOOK Yautube Explanation on Day Trading The Securities Investor Protection Corporation SP1 C a nonpro t membership corporation was authorized to protect customer accounts against the consequences of financial failure of the brokerage rm Mediation is an informal voluntary approach in which you and the broker agree to a third party who facilitates negotiations between the two of you to resolve disputes If mediation is not pursued or it fails you may choose arbitration a formal process whereby you and your broker present the two sides of the argument before a panel of third party individualsbook ORDERTYPES MARKET ORDER Least complicatedMost common Tells broker to immediately buy sell regardless of price place order NOW Advantage 7 Certain order execution 7 Speed Fastest Order Execution Disadvantage 7 Price uncertainty 7 Risk in Very fast markets Price can vary significanly from that expected 0 A market order is an order to buy or sell a security at the best price available at the time the order is placed It is the quickest way to make securities transactionsbook ck at or below or to sell stock at or above a speci ed yr Limit order to buy you set a maximum purchase price 7 Tell broker toBuy only if price is 5 limit price or below Limit order to sell you set minimum sell price 7 Tells broker to Sell only if price is 2 limit price or better Limit Order Process PPT Order entered into specialist sdealer s book 7 Executed at limit price or betterafter all orders with higher precedence execute 7 PrecedenceAll market orders because they are executed at the moments market price Limit orders with higher buy prices Limit orders with lower sell prices Same price orders execute chronologically Advantage price certainty Disadvantages no execution certainty Can miss the market Market orders vs Limit Orders Video STOP STOPLOSS ORDERS A stoploss order is an order to buy or sell the stock when its market price reaches or drops below a specified level It is used primarily by investors who wish to protect themselves from a rapid decline in the price of the stock The stoploss order gives them the opportunity to sell the stock when the price declines to the stop price thereby reducing their potential losses It becomes a market order and may in fact be executed at a lower price than the price at which the order was initiatedbook Suspended order is Activated if specified price is reached Becomes a market order Stop order to sell Exits long position if activated Advantage execution certainty if activated Disadvantage uncertain price Main use Limit Losses if market moves against you Youtube Stoplass Video Explanation ORDER TIME LIMITS Market orders trade made at order so there is no time limit Limit or Stop orders Fill or Kill fill order or cancel Day Order order is good for the day Good ti canceledGTC order is good until you take the action of cancellationcould cause accidental losses IN DEXES Stock indexes Grouping of stocks Measure changes in the value of the group over time 7 Excludes transaction costs 7 Excludes dividend payments Indexes let investors quickly 7 Gaugegeneral market conditions Compare individual stock returns to those of larger more diversified portfolios 7 Therefore they are Benchmarks Helps to forecast market behavior cycles amp trends Further Stock market averages anal indexes are used to measure the general behavior of securities markets Averages re ect the arithmetic average price behavior of a certain group of stocks at a given point in time whereas indexes measure the current price behavior of the group relative to a base value set at an earlier point in timeAverages and indexes provide a convenient way of capturing the general mood of themarket When the averages or indexes re ect an upward trend in prices a bull market is saidto exist Likewise when these measures exhibit a downward trend a bear market existsbook 0 Dow Jones Industrial Average ADH 30 securities 7 Chosen for a of total market value 0 Broad public ownership 0 Hi h uali NASDAQ 100ANDX Non nancial stocks 0 SampP 500AGSPC broader than DJI Wilshire 5000 ADWC all NYSE AlVIEX amp actively traded otc stocks Market capitalization explanation Small Cap Indexes The de nition of small cap can vary among brokerages but generally it is a company with a market capitalization of between 300 million and 2 billion Medium Cap Indexes of over 1 billion but below 5 billion International Indexes To give you a better Idea of our used indexes book info The four Dow Jones Averages include the Dow Jones Industrial Average thirty widelyheld stocks issued by large rms the Dow Jones Transportation Average twenty transportation stocks the Dow Jones Utility Average fifteen public utility stocks and the Dow Jones US Total Market Index includes all of the above The six Standard and Poor s SampP Indexes include the SampP 400 Industrial Index 400 industrial rms the Transportation Index twenty transportation companies the Utilities Index forty public utility stocks the Financials Index forty nancial stocks the Composite Index includes the ve hundred stocks in the SampP indexes mentioned above the MidCap Index four hundred mediumsized companies the SmallCapindex made up of six hundred smallsized companies and the fteen hundred SuperComp index which includes all stocks in the Composite lVIidCap and SmallCap indexes Nearly all these indexes can be found in nancial newspapers such as The Wall Street Journal Barron s Investor s Business Daily and local newspapers in major metropolitan areas The New York Stock Exchange Index includes the 2100 stocks listed on the New York Stock Exchange It is calculated in a manner similar to the SampP Indexes This index re ects the value of the stocks listed on the NYSE relative to a base of 5000 set on December 31 2002 TheArnerican Stock Exchange Index re ects the price of shares on the American Stock Exchange relative to a base of 550 set on December 29 1995 The Nasdaq StockMarket Indexes re ect the behavior of the Nasdaq stock market The most popular the Nasdaq Composite Index is calculated using more than 4000 domestic common stocks traded on the Nasdaq system The index is based on a value of 100 set on February 5 1971 Another popular Nasdaq index is the Nasdaq 100 which includes one hundred of the largest domestic and intemational non nancial companies that are listed on the Nasdaq The Value Line CompositeAverage includes the approximately 1700 stocks in the Value Line Investment Survey and traded on a broad cross section of exchanges as well as in the overthecounter market The base of 100 re ects the June 30 1961 average of the stocksYou will use valueline a lot in FIN4244 Bond yields capture the behavior of market interest rates and represent a type of summary measure of the return an investor would receive on a bond if it were held to maturity Barron s quotes the yields on the Dow I ones bond average of ten highgrade corporate bonds and ten mediumgrade corporate bonds a ratio of the highgrade yield to the mediumgrade yield is calculated and known as the confidence index The Dow Jones Corporate Bond I nalex quoted in The Wall Street Journal and Barron s is the mathematical average of the closing prices of thirtytwo industrial thirtytwo nancial and thirtytwo utilitytelecom bonds 0 Different indexes reference different time periods 7 Makes comparing index numbers meaningless except for 1 General directional moves 2 Performance benchmarks Compare your return to that of an Appropriate index over the same time period It s NOT just the size of your return but did you beat the appropriate index benchmark Why Critical thinking Questions on ppt 0 Of the three major indexes NYSE DIIA Nasdaq which would you use to benchmark the performance of a tech stock I think the best choice of the 3 would be the NASDAQ because Tech stocks are non nanancial stocks however this is not necessarily the best choice you could make in the whole market because there are indexes available that are more speci c to Tech than the NASDAQ CHAPTER 4 RETURN AND RISKS CONCEPT OF RETURN 0 Return 7 The level of pro t reward for investing Book Risk is the chance that the actual return from an investment may differ from what is expected The standard deviation is the statistic used to measure risk The risk return traaleo is the relationship between the expected returns from an investment and the risk associated with them The required returns from an investment increase as risk increases to provide an incentive for him or her to take higher risks ie in order to accept higher risks the investors have to be compensated with higher returns Youtube Stock Returns RETURN COMPONENTS 7 Current income cash received as a result of owning an investment Ex Dividends coupon payments interest 7 Capital gains or losses the difference the selling price and the purchase price of an investment Bought 10 stocks at 100 yesterday1000 Sold 10 stocks at 110 today 1100 the difference between the two is your realized capital gains 100 7 Total Return current income capital gain or loss of an investment over a speci ed period of time Ex 100dividend payments 100coupon payments 100capital gains total return 300 Book info The return on investment is the expected pro t that motivates people to invest It includes both current income and or capital gains or losses Without a positive expected return there is no bene t to investing and individuals have no reason to save and invest Since net demanders are willing to pay net savers a positive return for their funds the opportunity to earn a positive return exists Return on investment can come from either current income or capital gains or both Current income most commonly is periodic payments such as interest received on bonds dividends on stock or rent received from real estate To be considered income these payments must be received in cash or be readily convertible to cash Capital gain refers to the change in the market value of the investment The amount by which the proceeds from the sale of an investment exceed the original purchase is called a capital gain If it is sold for less than the original purchase price a capital loss is realized The use of percentage returns is generally preferred to dollar returns to allow investors to directly compare different sizes and types of investments WHY IS RETURN IMPORTANT Lets you compare the return you expect or receive with the return you require 0 What is your required return Depends on investment costs amp on the level of risk you re willing to take Historical Performance 7 Provides a basis for future expectations 7 Does not guarantee future performance 0 Expected Return 7 What you think an investment will earn in the future 7 Determines what you ll pay for an investment or if you ll make the investment at all Book info Although future returns are not guaranteed by past performance historical data often gives the investor a meaningful basis on which to form future expectations Past return data such as average returns or trends seen in certain time periods can be used along with the investor s insights about future prospects of the investment Together the historical data and future prospects help the investor to formulate an expected return on the investment FACTORS IN RETURN 0 Internal Forces 7 Investment type 7 Risks associated with a speci c investment 0 External Forces risks facing all investments although to varying degrees 7 Political environment are there going to be laws passed that will affect my investment 7 Business environment is there a competeing firm that will lower the pro ts of my company therefore lowering my returns 7 Economic environment is consumer spending down How will that affect my stock in Sears 7 In ation is a rise in the general level of prices of goods and services in an economy over a period of time When the general price level rises each unit of currency buys fewer goods and services Consequently inflation also reflects an erosion in the purchasing power of money a loss of real value in the internal medium of exchange and unit ofaccount in the economy A chief measure of price inflation is the inflation rate the annualized percentage change in a general price index normally the Consumer Price Index over time 7 Deflation is a decrease in the general price level of goods and services Deflation occurs when the inflation rate falls below 0 a negative inflation rate Book info The level of expected returns depends on many intemal characteristics of the investment and the external forces on the investment Internal characteristics include the type of investment the quality of management the method by which the investment is financed and the customer base of the issuer External forces include war shortages price controls Federal Reserve actions and political events among others External forces unlike interna characteristics cannot be controlled by the issuer of the investment Investment vehicles are affected differently by these forces7the expected return of one investment may increase while the expected return of another may decrease in response to external forces History tells us that stock market returns have averaged well above the interest rates payable on savings accounts at banks In recent years especially during the latter part of the 1990s the returns were well above the stock market averages for the earlier part of the century Unfortunately investors often assume that history will repeat itself Hence they buy shares of rms that have experienced increased share prices If the investor is looking for shortterrn gains over a year or two the probabilities are mixed depending on what time periods are cited The best advice given these statistics is for an investor to hold for the long term in order to ride out the market s twists and turns TIME VALUE OF MONEY A dollar is worth more today th tion can deflation occur 7 r w Dli H mm mam FV amount money grows to if compounded over a predetermined time and interest rate How much will 100 be worth what is its future value FV in 5 years if it earns a 9 interest rate that compounds annually Answer 100 1095 15386 You should be indifferent between I Receiving 100 today that you can invest at a 9 interest rate compounded annually and 0 Receiving 15386 five yea rs from now Present amp Future Value Since FV PV1 r I 1001095 15386 PV FT 100 1386 1 739 1 09 r rate of return 8100 15386 1quot discount rate The more frequently money compounds the more interest it earns or the more interest you pay 8 P rd f I owepomt SI es rom ecture The Time Value of Money F V 1r 7 As discmmt rates r T39 present values I V or FVPVIr 7 As interest rates 1quot i future values i The key to valuing a security today is to 1 Correctly determine its expected future cash flows 2 lhcn discount that amount to its value today l V To correctly price securities today you must use the ITCCI 139 value 1311606553131 0 9 RISK AND DIVERSIFICATION Diversification multiple investments that tend to move independently of one another For example if you invest across industries and an event happens that causes stocks in one of the industries to fall your losses will be much less than if you had concentrated your investments into one stock or industry Returns tend to average out over the long runSo you should expect an average return taking risk over time but diversification reduces risk without reducing average returns over time It smoothes out the highs and the lows ofa portfolio Diversification related videos and CRITICAL THINKING QUESTIONS 1 If 100 of your money goes into the best performing stock you will always outperform a diversified portfolio over the same time frame A True unforeseen events may effect that stock more than others which would make you underperform since you would have no protection from diversification 2 On any given day you can be certain of a diversified portfolio s return A True but you should be able to be somewhat certain of its long term return CHAPTER 4 PART 2 RETURN AND RISKS RATES OF RETU RN Rates of Return Rates of return are usually measured as percentages Ending Amt 7 Beginning Amt Beginning Amt Rate of return The required rate of retum fully compensates an investor for all sources of risk Real rate Expected in ation Risk premium of retum remiux 0 investment 539 39 1 R required 1 11 l P REQUIRED RATE OF RETURN RRR Investors use the RRR to decide where to put their money They compare the return of an investment to all other available options taking the riskfree rate of return in ation and liquidity into consideration in their calculation For investors using the dividend discount model to pick stocks the RRR affects the maximum price they are Willing to pay for a stock The RRR is also used in calculations of net present value in discounted cash ow analysis Corporations use the RRR to decide if they should pursue a new project or business expansion in corporate nance the RRR is equal to the weighted average cost of capital WACC Required rate of returnExplained You might require a return of 9 per year to consider a stock investment worthwhile assuming that you can easily sell the stock and inflation is 3 per year Your reasoning is that if you don39t receive a 9 return which is really a 6 return after inflation then you39d be better off putting your money in a CD that earns a riskfree 3 per year really 0 after inflation You aren39t willing to take on the additional risk of investing in stocks which can be volatile and whose returns are not guaranteed unless you can earn a 6 premium over the riskfree CD The RRR will be different for every individual and every company depending on their risk tolerance investment goals and other unique factors investopedia Book info The required rate of return equals the real rate of return plus the expected inflation premium together the riskfree rate and the risk premium ri RF IP Alternatively it equals the riskfree rate of return plus the risk premium REAL RATE OF RETURN Real Rate of Return rate of return in a perfect world a world without risk No such place The theoretical rate of return of an investment with zero risk The riskfree rate represents the interest an investor would expect from an absolutely riskfree investment over a specified period of time 7 Imagine an investment with the least amount of risk 7 The 3 month TBillis most often used proxy for the riskfree rate 7 Risk Free Rate Rf Real Rate of Return Expected inflation Premium Book info The riskfree rate of return equals the real rate of return plus the expected in ation premium RF r IP It is the return on a riskless security as measured by the 90day TBill EXPECTED INFLATION RISK PREMIUM Expected Inflation Premium ip proxy change CPI What is the CPI A measure that examines the weighted average of prices of a basket of consumer goods and services such as transportation food and medical careThe CPI is calculated by taking price changes for each item in the predetermined basket of goods and averaging them the goods are weighted according to their importance Changes in CPI are used to assess price changes associated with the cost of living Sometimes referred to as quotheadline inflationquot CPI is one of the most frequently used statistics for identifying periods of inflation or deflation This is because large rises in CPI during a short period of time typically denote periods of inflation and large drops in CPI during a short period of time usually mark periods of deflation So if the basket s items as an average change 3 then that would be our Expected inflation rate quot you probably wont need to know that but for a full grasp you should return Required rate riskfree rate risk premium Book info The expected in ation premium represents the expected average future rate of in ation It is the compensation that investors demand for future expected in ation that is the decline in the purchasing power of the dollar 39 quot Videohttp 39 quot ideoplaywhatis39 39 39 1f RMVree THE RISK PREMIUM rp Risk Premium return that fully compensates for specific security s risk The return in excess of the riskfree rate of return that an investment is expected to yield An asset39s risk premium is a form of compensation for investors who tolerate the extra risk compared to that of a riskfree asset in a given investment Further Think of a risk premium as a form of hazard pay for your investments Just as employees who work relatively dangerous jobs receive hazard pay as compensation for the risks they undertake risky investments must provide an investor with the potential for larger returns to warrant the risks of the investment For example highquality corporate bonds issued by established corporations earning large profits have very little Lsk of default Therefore such bonds will pay a lower interest rate or yield than bonds issued by less established companies with uncertain profitability and relatively higher default risk The Expected Return must be gt 0 if you expect a return greater than simple value preservation How large a risk premium is depends on 1 Security type and characteristics 2 Specific firm characteristics f investors make different assumptions about a security s risk level they ll require different rates of return Book info The risk premium varies for different security issues and represents the additional return required to compensate an investor for the risk characteristics of the issue and the issuer It is the return on a risk security e g stocks bonds minus the riskfree rate of return which is the rate on a 90day TBill HOLDING PERIOD RETURN HPR Holding Period the time period over which the return on an investment is measured Realized Return the actual return received over a given time period Current income is typically viewed as realized return Paper Return return that would be received if the investment were sold It is only achieved on paper because the asset is still held Book infoThe holding period is simply the period of time over which the investor wishes to measure the return on an investment In comparing alternative investment vehicles it is essential to use equallength holding periods so that the two vehicles being compared are judged under identical conditions This adds objectivity to the comparison Most interest rates are quoted on an annual basis so it is generally convenient to use a oneyear holding period The holding period return HPR is the total return earned from holding an investment for a speci ed period of time To calculate HPR all that is needed is the beginning and endofperiod investment values along with the value of current income received by the investor Because HPR doesn t account for the time value of money the holding period is usually one year or less Holding Period Return The total return earned over a speci ed holding period Current income Capital gain loss during period during period Holding period returns I Beglnnlng investment value Current income earned dividends stock earned interest debt Capital gain 1055 Ending Beginning during penod 1nvestn1ent value 1nvest1nent value AdvantagesEasy to calculate Easy to understand Considers current income and asset growth Gives highest return for dollar invested investments can be compared DisadvantagesTypicaly not sufficiently accurate if HP gt 1 year Doesn t consider time value of money YIELD INTERNAL RATE OF RETURN IRR ill 7 r r An annualized effective compounded rate of return Compounded rates of return include the impact of interest earned on interest They can be compared to other investments across various periods When an investment s return is discounted by its IRR it has a present value PV equal to zero lnvestopedia The discount rate often used in capital budgeting that makes the net present value of all cash flows from a particular project equal to zero Generally speaking the higher a project39s internal rate of return the more desirable it is to undertake the project As such IRR can be used to rank several prospective projects a firm is considering Assuming all other factors are equal among the various projects the project with the highest IRR would probably be considered the best and undertaken first You can think of IRR as the rate of growth a project is expected to generate While the actual rate of return that a given project ends up generating will often differ from its estimated IRR rate a project with a substantially higher IRR value than other available options would still provide a much better chance of strong growth IRRs can also be compared against prevailing rates of return in the securities market If a firm can39t find any projects with IRRs greater than the returns that can be generated in the financial markets it may simply choose to invest its retained earnings into the market AdvantagesAppropriate for use with HPs greater than 1 yearConsiders the time value of money compounding interest Tells you if you should put money in an investment lfthe investment s yied B the required return the investment is acceptable Disadva ntagesCompex calculation Book info The yield or IRR is the annual rate of return earned by a longterm investment It is also de ned as the discount rate that produces a present value of benefits received equal to the present value of costs investments Unlike the HPR it takes into account the time value of money and can be used to calculate the return on investments held for over one year The HPR is inappropriate for investments held for more than one year INTEREST ON INTEREST Using yield IRR to measure return assumes that all income earned over the investment horizon is reinvested at the same rate as the original investment Reinvestment Rate is the rate of return earned on interest or other income received from an investment A fully compounded rate of return The required rate of return assumes that interest is earned on interest Investopedia The interest that is earned upon the reinvestment of interest payments lnterestoninterest is primarily used in the context of coupon paying bonds where all coupon payments are assumed to be reinvested at some interest rate and held until the bond matures or when the bond is sold quotExample the interest rate used to calculate interestoninterest can be the bond39s yield at the time the coupon payment is made Book info The critical assumption underlying the use of yield as a return measure is an ability to earn a return equal to the calculated yield on all income received from the investment during the holding period Ifyou earn 10 percent on all income received from an investment during the holding period your yield on the investment will be 10 percent On the other hand if you earn 0 percent on the income received your rate of return on the investment would actually be less than 10 percent If the interestoninterest earned from the investment is less than its calculated yield the investment s return will fall below the yield Clearly when using yield as a measure of investment return the validity of this assumption must be recognized and evaluated Ifthe interestoninterest assumption does not hold use of the calculated yield could lead to poor investment decisions SOURCES OF RISK RiskReturn Tradeoff is the relationship between risk and return in which investments with more risk should provide higher returns and vice versa Real estate and other F s E tangible re 3 Deposit Mutual Iryestments 3 accounts 5 and Preferred unds op ons Q g certificates Smc Common stock Q of deposit x w Convertible Bonds securities Riskfree U S ate39 RF government securities 0 Risk Risk is the chance that the actual return from an investment may differ from what is expected Business riskis concerned with the degree of uncertainty associated with an investment s earnings and the investment s ability to pay investors interest dividends and other returns owed them Business risk is usually related to the firm s line of business The possibility that a company will have lower than anticipated profits or that it will experience a loss rather than a profit Business risk is influenced by numerous factors including sales volume perunit price input costs competition overall economic climate and government regulations Financial riskis the risk associated with the mix of debt and equity capital structure used to finance the firm The greater the firm s debts and interest obligations the greater its financial risk A company with a higher business risk should choose a capital structure that has a lower debt ratio to ensure that it can meet its financial obligations at all times Both business and financial risk can lead to default Purchasing Power Riskarises because of uncertain in ation rates and pricelevel changes in the future When prices rise each dollar invested has less valueiit can buy less and vice versa 0 the chance that changing price levels in ation or de ation will adversely affect investment returns Interest Rate Risk is the chance that changes in interest rates will adversely affect a security s value remember bonds and interest rates have an inverse relationship The risk associated with changes in the prices of fixedincome securitiesresulting from changing market interest rates As the market interest rates change theprices of these securities change in the opposite direction thereby changing the level ofreturn that an investor can expect to obtain from them Another important aspect o nterest rate risk involves the ability to reinvest income received at the initial rate ofreturn in order to earn the fully compounded rate of return 0 Liquidity Risk is the risk of being unable to sell an 39 39 quot and at a 39 39 price is the risk of not being able to liquidate an 39 39 quot and ata 39 39 price In general investment vehicles traded in markets with small demandand supply characteristics tend to be less liquid than those traded in broad markets Tax Risk is the chance that Congress will make unfavorable changes to the tax laws resulting in lower aftertax returns or lower investment market values Market Risk is the risk of lower investment returns resulting from market factors independent of the given investment is the risk of changes in investment returns caused by factors independent of the given investment vehicle It results from factors such as political economic and social events or changes in investor tastes and preferences 0 Event Risk comes from an unexpected event that has a signi cant and immediate effect on theunderlying value of an investment is the risk that comes from a largely or totally unexpected event that has a signi cant and usually immediate effect on the underlying value of an investment The effect of this risk seems to be isolated in most cases affecting only certain companies and properties ACCEPTABLE RISK LEVELS DEPENDS UPON THE INDIVIDUAL INVESTOR Riskindifferent describes an investor who doesn t require an increased return as compensation for greater risk Riskaverse describes an investor who requires greater return in exchange for taking greater risk Riskseeking describes an investor who will accept a lower return in exchange for greater risk This tradeoff is negative such investors enjoy risk and are therefore willing to accept lower returns for increasing levels of risk Book info In general most investors are risk averse They require increased returns from an investment as its risk increases The risk preference of an investor is an important determinant of hisher investment decisions Riskaverse investors may not make speculative investments while risktaking investors may Thus an investment that is considered unsatisfactory by a riskaverse investor may be deemed satisfactory by a risktaking investor INVESTMENT PROCESS FOR CONCEPTUAL PURPOSES Book The investment process can be summarized in four steps 1 Estimate the expected returnover a given holding period using historical data or projected return data or both The time value of these returns must be considered for longterm investments 2 Assess the riskof the investment returns through the subjective judgmental evaluation of historical returns and by using beta for securities 3 Evaluate the riskreturn behaviorof each alternative investment The expected return must be quotreasonablequot given the level of risk possessed by the investment Only investments offering the highest expected return for a given level of risk are considered reasonable 4 Select the vehicleswith the highest return for the level of risk the investor is willing to take These fit the definition of a good investment CHAPTER 5 INVESTING IN COMMON STOCK THE APPEAL OF COMMON STOCK Residual Owners Stockholders Owners are entitled to dividend income and Prorateddistributed share of the firm s earnings but only once all other obligations are met For instance if the firm doesn t have enough money this quarter to give you a dividend it just won t declare one and there s nothing you can do about it except sell the stock if you desire Stocks are also a good tool to meet individuals needs and preferences such as if an one investor really desires income through dividends they will focus on dividend growth of stocks when choosing their investments but if they desire capital gains through increased value over time they will focus on EPS growth when choosing their stocks Stock Returns include price behavior and dividend income Book A common stock is an equity investment that represents ownership in a corporate form of business Each share represents a fractional ownership interest in the firm The key attribute of this investment security is that it enables investors to participate in the profits of the firm As residual owners of the company common stockholders are entitled to dividend income and a prorated share of the firm s earnings after all other obligations of thefirm have beenmet They have no guarantee they will ever receive any return on their investment One important investment attribute of common stocks is that they enable investors to participate in the profits of the firm and as such they can offer attractive return opportunities Another attribute is the versatility of the security it can be used to meet just about any type of investment objective In addition as investment vehicles go common stocks are fairly simple and straightforward so they re easy to understand though that certainly doesn t mean they re easy to value They are easy to buy and sell and the transactions costs are modest Moreover price and market information is widely disseminated in the news and financial media THE TECHNICALITIES OF A BEAR MARKET CORRECTION AND ROUTINE DECLINE Routine decline is a drop of 5 or more in one of the major markets NASDAQ dropped 6 that s ok its just a routine decline Correction a drop of 10 or mort in one of the major market indexes The DowNasdaqand SampPSOO dropped 11 there must have been a correction Bear Market a drop of 20 or more in one of the major market indexes The Dow is down 20 fishdicks we must be in a bear market Bull bear and sideways market video STOCK OWN ERSH l P ADVANTAGES Potentially higher returns than other investments Stocks have averaged nearly double the returns of highgrade corporate bonds over the last 50 years Inflation hedge is an investment with intrinsic value such as oil natural gas gold farmland and to a lesser degree commercial real estate Typically most hard assets are an excellent inflation hedgen general commoditieshard assets are negatively correlated to both stocks and bonds In other words when stocks and bonds decline commodities tend to appreciate Easy to 7 Buy amp sell moderate transaction costs liquidity 7 Obtain information price amp market Unit coststockshm usually within a people s reach Book info The major advantage of common stock ownership is the returns it offers Because stockholders are entitled to participate in the prosperity of a rm there is almost no limit to a stock s capital gains potential In addition many stocks provide regular current income in the form of annual dividends7and for most incomeproducing stocks those dividends tend to grow over time adding even more to the stockholder s return Common stocks are also highly liquid and easily transferable their transaction costs are relatively low market information is readily available and unit price is nominal STOCK OWNERSHIP DISADVANTAGES Stocks are subject to many different kinds of risk 7 See Chapter 4quotSources of Risk Hard to evaluate stock value predict performance relative to other stocks amp time price swings volatility Low current income levels amp higher uncertainty of receiving it compared with most fixedincome investments Book infozThe risky nature of common stocks is the mostsigni cant disadvantage of common stock ownership As residual owners of the firm noretum is guaranteed Furthermore prices are subject to wide swings making valuationdifficult Finally the sacri ce in current income is a disadvantage relative to otherinvestments like bonds for instance that pay higher and more certain returns The principal risks to stockholders include business and financial risk purchasing power risk and of course market risk Business risk is related to the kind of business the company is in and deals with both sales volatility and the amount of variability in the film s earnings Financial risk is associated with the mix of debt and equity financing The more debt nancial leverage the rm uses the greater the likelihood that it will default on its principal and interest paymentsiwhich in turn will have a negative impact on the stock Purchasing power risk refers to the possibility of price increases and the corresponding decline in the value of the dollars invested in common stock Market risk is caused by factors independent of the rm that affect the return on the rm s common stock Such things as economic uctuations threat of war and political factors affect market risk and therefore can have a bearing on the market price of a stock The market itself has an impact on the price performance of a stockiwhich of course is what beta is all about ie a stock s beta is a measure of the extent to which the stock reacts to the market METHODS OF lSSUlNG NEW STOCK IPO Initial Public Offering first offering of a firm s stock to the investing public Rights Offering existing shareholders are given the chance to buy shares of a new stock issue in proportion to their present ownership position Stock SpinOff a firm creates a new separate firm from a subsidiary or division It distributes stock of the new firm to its shareholders Book Stock spinoffs involve conversion of one of firm s subsidiaries to a stand alone company by distribution of stock in that new company to existing shareholders For eg PepsiCo spun off its restaurant operations Pizza Hut KFC and Taco Bell into a new company called Tricon Global Restaurants now called Yum Brands Investors have shares in both the old and the new firm allowing them to keep those divisions they want to hold and selling the other Stock Split a firm increases the number of common shares outstanding by exchanging a specified number of new shares for each of its old outstanding shares A stock split occurs when a fum announces its intention to increase the number of shares of stock outstanding by exchanging a speci ed number of new shares for each outstanding share of stock Book Most stock splits are executed with a view to lowering the price of the stock and enhancing its trading appeal If the stock split is not accompanied by an increase in the level of dividends stock prices will fall to account for the split Thus a 100 stock will fall to 50 after a 2 for 1 split If the company had changed its dividend rategsay by increasing dividendsithe stock price will rise after adjusting for the split In the above case the stock price will end up above 25 per share depending on the size of the dividend increase Thus other things being equal a change increase in the dividend rate will have a positive impact on the stock s price after adjusting for the stock split Stockholders end up with a different number of shares but the pnce of each share 1s adjusted so that the shareholder s total value in the rm doesn t change Value of stocl39 number of shares X share price Most commonly of shares T but plice l 39 Makes it more attractive to investors EX A rm does a 32 stock split 39Prior to split Value 200 shares X 60 1200 After split Value 300 shares X 40 12000 Reverse split of shares lbut pn39ce T PPT SLIDE You Tube Stock Split Explanation You Tube Reverse Stack Split Explanation TREASURY STOCK Stock shares repurchased by their issuing firm in the secondary market 7 Reduces the number of publicly traded stock sharesbut why Firm considers its shares to be a good investment Firm attempts to raise its stock price if it believes its shares are undervalued by the market Firm attempts to prop up its stock price if it believes its shares are overvalued by the market 7 Treasury stock may be used for mergers acquisitions or employee stock option plans Book info Firms do not quotissuequot treasury stock these are simply shares of common stock that have been issued and subsequently repurchased by the issuing firm This is generally done because the firm views the stock as an attractive investment perhaps the price is unusually low Most treasury stock is later reissued by the firm and used for such purposes as mergers and acquisitions employee stock option plans or for payment of stock dividends Treasury stock is not a form of classified stock Investopedia Treasury stock is often created when shares of a company are initially issued In this case not all shares are issued to the public as some are kept in the companies treasury to be used to create extra cash should it be needed Another reason may be to keep a controlling interest within the treasury to help ward off hostile takeovers Alternatively treasury stock can be created when a company does a share buyback and purchases its shares on the open market This can be advantageous to shareholders because it lowers the number of shares outstanding However not all buybacks are a good thing For example if a company merely buys stock to improve financial ratios such as EPS or PE then the buyback is detrimental to the shareholders and it is done without the shareholders39 best interests in mind CLASSIFIED COMMON STOCK Most common stock gives shareholders one vote per share held amp pays whatever the declared dividend is Different classes of stock however may have different voting rights ampor dividend payments 7 May allow a relatively small group to control a publiclytraded company 7 May differ in dividend payout schedulesamounts If multiple classes check privileges benefits and limits 7 Different classes of stock typically differ in price Book Classification of common stock simply breaks common stock into different classes or groups Each class has different voting rights andor dividend obligations For example class A stock might designate nonvoting shares that receive preferential dividends while class B stock might designate voting shares with lower dividends Some classes pay stock dividends to appeal to individuals interested in capital gains other classes pay higher cash dividends that attract incomeseeking investors Investopedia The specific features of each class are set out in the corporate charter and bylaws Voting privileges are the main reason companies create different classes although liquidation and dividend rights may also be involved COMMON STOCK VALUES Market Value current price of a stock share as determined by the stock market Market Capitalization current value of a firm as determined by the stock market Mkt Cap if of shares outstanding x price5hare Investment Value the maximum amount an investor will pay for a stock what he thinks it s worth 7 Basis for potential returns cap gains amp dividends 7 Risk exposure from holding stock 7 Assess investment value based on assumptions Book The par value ofa stock is its stated or face value and exists primarily for accounting purposes Many stocks are issued with no par value It is a relatively useless number The liquidation value ofa stock is an estimate of the market value of the firm s assets if sold at auction less the liabilities and preferred stock outstanding While this measure of value is vitally important to the highstakes LBO and takeover artists it is very difficult to determine and is generally of little interest to the typical individual investor who tends to view the firm as a going concern Book value is an accounting measure of the amount of stockholder s equity in the firm Book value indicates the amount of stockholder funds used to finance the firm Investment value perhaps the most important measure for a stockholder indicates what value investors place on the stock Investment value is based on the expectations of the risk and return patterns ofa stock the returns come from dividends and capital gains and the risk is based on the exposure to holding the stock DIVIDENDS A partial return of firm profits to stockholders owners The question on the amount of dividends to be paid is decided by the frrm s board ofdirectors The directors evaluate the rm s operating results and nancial conditions todeterrnine whether dividends should be paid and if so in what amount During a Board of Directors meeting a variety of factors are considered in making theinvestment decision These include a The rm s current earnings or profits are considered a vital link in the dividend decision b The Board also looks at the rm s growth prospect Firms with good investment opportunities pay less dividends using the retained earnings instead for newinvestment c The Board also considers the rm s cash position to make sure it has suf cient liquidity to meet a cash dividend of a given size d The Board also ensures that it is meeting all legal and contractual constraints that might be imposed by loans e The Board also makes an effort to meet the dividend expectations of its shareholders failure to meet these expectations can lead to disastrous results in the stock market Although once begun the BoD doesn t like to lower or cut dividends dividend payments are not required DIVIDENDS VS CAPITAL GAINS Book While they don t provide the bang that capital gains do dividends are an important source of return to stockholders Dividend returns are always positive although the dividend yield has been under 25 percent during the past decade Capital gains have ranged from 3832 percent in 1975 to 72757 in 1974 Over the past 50 years dividends have accounted for a little less than 50 of the average annual total return from stocks There s no question that capital gains provide the really big returns though they also lead to wider swings in yeartoyear yields Dividends in contrast provide an element of stability and tend to shore up returns in off years Currently dividends are taxed at 5 percent and 15 percent rates the same as capital gains KEY DATES FOR DIVIDENDS June Declaration date Date of record Exdividend date Payment date ppt slide Book infoThe axdividend date which occurs two business days prior to the date of record determines who is eligible to receive the declared dividend when the stock is sold If the stock is sold on or after the eXdividend date the owner seller receives the dividend if it is sold prior to the eXdividend date the new shareholder buyer receives the dividend Thus if the stock is sold on the eXdividend date the seller receives the dividend7going exdividend means the buyer is not entitled to the dividend since the stock is being sold without the dividend Yautube dividend dates explained DIVIDEND BENEFITS Cash Dividends 7 Provide income more predictable than capital gains 7 Usually paid by firms with greater earnings stability 7 Provide a portion of total returns 7 Currently taxed at same taxedadvantaged rate as longterm capital gains 7 Tend to increase over time Stock Dividends 7 Dividends paid in additional shares of stock 7 Tend to be negatively viewed by shareholders Book info Cash dividends are simply dividend payments made to the stockholder in cash This form of dividend represents something of value A stock dividend is an issue of new shares expressed and distributed as a percentage of each shareholder s existing shares It really has no value since the market responds to stock dividends by adjusting the market price accordingly As an example consider a stock that is trading at 50 per share if the issuing firm declared a 10 percent stock dividend the price of this stock would drop by 91 percent to 4545 SSOll Thus an investor who held 100 shares before the stock dividend would hold 110 shares after but the total market value of these shares would be basically the same 50 x 100 4545 x 110 When a stock dividend is declared by the firm additional shares of the stock are issued to existing shareholders Stock dividends may be used as a substitute for cash dividends but they have no value because the stock prices adjust to the stock dividend accordingly Stock splits occur when the firm gives shareholders new shares in exchange for each share they own The central difference between stock dividends and stock splits is that dividends are additional issues and stock splits are exchanges In a 200 percent stock dividend the investor receives additional shares equaling 200 percent of existing shares ie 100 shares already owned x 200 200 new shares distributed in addition to the original 100 In a 3for1 stock split the investor receives 3 new shares for each existing share 100 x 3 300 shares held after split TYPES OF STOCKS NOT MUTUALLY EXCLUSIVE WHICH MEANS YOU DON39T HAVE TO CHOOSE JUST ONE TYPE 14 a Blue chips are common stocks of very high quality that have a long and proven record of earnings and dividends They offer respectable dividend yields and modest growth potential They are often viewed as longterm investment vehicles have low risks and provide modest but dependable rates of return b Income stocks are issues that have a long and sustained record of higher than average dividends These are ideal for investors who desire high current income with little risk Unlike other types of income securities bonds for instance holders of income stocks can expect the amount of dividends they receive to increase regularly over time One disadvantage with these stocks is their generally low to modest growth potential Dividend Yield Annual Dividends per share Current price per share Further Income stocks generally have limited capital gains potential because they pay out large amounts of their earnings in dividends in essence little of their income is plowed back into the company to nance growth Returns from income stocks come mostly from current income rather than capital gains a distinction favored by many investors This does not mean these stocks are unpro table most in fact are highly pro table with excellent longterm future prospects c Midcap stocks are stocks with capitalization value between 1 billion and 5 billionMidcaps offer investors attractive return opportunitiesithey have the sizzle of smallcapstocks without the high price volatility They also provide characteristics of the big established stocks This midcap range is probably most appropriate for investors willing to tolerate a bit more risk and price volatility than large stocks One type of midcap stock a baby blue chip has all the characteristics of regular blue chip except for size d American Depository Receipts ADRS are negotiable instruments issued by American banks Each ADR represents a speci c number of shares of stock in a specific foreign company They are used as a way to purchase foreign stocks and are traded on US exchanges for example the NYSE or in the OTC markets they trade just like shares of American stocks Beyond the simpli ed trading the investment merits of an ADR are a function of the investment merits of the foreign company that issued the stock as well as the value of the dollar relative to the currency of the foreign company e IPOS are initial public offerings of primarily small relatively new companies As the name suggests these stocks are offered to the public for the rst time IPOs offer a chance to earn phenomenal capital gains At the same time it is very likely that investing in IPO stocks might result in a loss As such these should be considered only by experienced and knowledgeable investors IPOs must be considered to be highly risky investments f Tech stocks are issued by companies in the technology sector Issuing rms produce everything from computers to Internet content They typically are growth stocks or speculative stocks because they pose considerable risk to the investor This sector hashas done extremely well in good times and depreciated signi cantly in bear markets g Growth consistent high rates of earnings growth A growth stock usually does not pay a dividend as the company would prefer to reinvest retained earnings in capital projects Most technology companies are growth stocks Note that a growth company39s stock is not always classified as growth stock In fact a growth company39s stock is often overvalued h Speculative potential for high return but have high risk Speculativestocks often have a high probability of declining in value and a low probability of experiencing aboveaverage gains Investors in these types of stock may be overly optimistic about the probability of earning above average gains or the lure of the above average gains may be enticing enough for them to make a purchase i Cyclical earnings closely related to business activity An example is the automobile market as economic growth slows consumers have less money to spend on new cars Noncyclical stocks would be in industries such as healthcare where the demand for goods and services is constant j Defensive earnings tend to be more stable in a bad economy Defensive stocks remain stable during the various phases of the business cycle During recessions they tend to perform better than the market however during an expansion phase it performs below the market Betas of defensive stocks are less than one To illustrate this phenomenon consider a stock with a beta of 05 If the market is expected to drop 15 and the existing riskfree rate is 3 a defensive stock will only drop 9 05153 On the other hand if the market is expected to increase 15 with a riskfree rate of 3 a defensive stock will only increase 6 05153 The utility industry is an example of defensive stocks because during all phases of the business cycle people need gas and electricity Many active investors will invest in defensive stocks if a market downturn is expected However if the market is expected to prosper active investors will often choose stocks with higher betas in an attempt to maximize return INVESTING IN FOREIGN STOCKS Increasingly global world financially 7 1970 US share of world stock market was 67 7 2008 US share of world stock market is 3S 7 US market remains largest equity market in world 7 Some returns from nonUS markets result from changes in currency exchange rates in addition to price changes amp dividend payments 7 Changes in the currency exchange rate can make the difference between making or losing money on foreign stocks Book Less than 50 percent of the world equity market is in US stocks For the most part the US stock market has been one of the best places to invest over the past twenty ve years However the United States nished rst in only one year during the 198172005 period Thus to achieve greater returns on their portfolio in a given year investors should also consider foreign markets Furthermore the appreciated value of a foreign currency relative to the US dollar would enhance foreign equity returns The US investor can either invest directly in foreign markets or indirectly by buyingAmerican Depository Receipts ADRS All things considered American investors are probably better off with ADRs because they avoid many logistical problems that arise with direct investing ADRs are dollar denomjnated and are about as easy to buytrade as US stocks International investing more complex amp riskier than domestic investing currency and other reasons Must pick the right stocks and market ampalso account for changes in currency exchange rates Stronger US dollar negatively impacts foreign investments Weaker US dollar positively impacts foreign investments Remember direct amp indirect foreign investing and ADRs Yautube an foregin investing INVESTMENT STRATEGIES WITH RISING RISK Buyand Hold gt more AggressiveSpeculative strategiesthe below are disadvantages to the latter strategies Buy and hold explanation 7 Spec Investment vehicles are risky high qualityless risk 9 penny stocksmore risk 7 Emphasis more on capital gains less on current income 7 Investment holding periods shorten in length 7 Frequency of trading increases in and out of positions 7 Market timing increasingly important 7 Equal or higher returns are anticipated over shorter time periods Short positions increasingly used Use of leverage lower margin levels used Higher trading costs experienced with higher trade frequency AGGRESSIVE TRADING STRATEGY A method of portfolio management and asset allocation that attempts to achieve maximum return An aggressive investment strategy attempts to grow an investment at an above average rate compared to its industry or the overall market but usually take on additional risk Because their aim is capital growth aggressive investors place a higher percentage of their assets in equities rather than in safer debt securities As such aggressive investors build portfolios that bear a fairly high amount of risk But before assuming this strategy an investor should evaluate his or risk tolerance making sure it39s high and be sure that he or she has quite a few years before needing the invested funds 39 often have a high probability of declining in value and a low probability of experiencing above average gains Investors in these types of stock may be overly optimistic about the probability of earning above average gains or the lure of the above average gains may be enticing enough for them to make a purchase Penny stocks are an example of a speculative stock Book info on Trading strategies A quality conscious investor would probably do best with a simple and conservative buyandhold strategy With this strategy the investor purchases income quality and blue chip stocks and watches them grow over time On the other hand if an investor is willing to tolerate a lot of risk an aggressive stock management strategy is the most appropriate Here the investor aggressively trades in and out of the various types of quality stocks in an attempt to earn above average return from both dividends and capital gains An individual s investment approach depends upon whether common stock is viewed primarily as a storehouse of value way to accumulate capital or source of income CHAPTER 12 MUTUAL FUNDS PROFESSIONALLY MANAGED PORTFOLIOS MUTUAL FUND AN INVESTMENT COMPANY L Business Is to pool the investmentscash of lots of different people then go out and make expert decisions on securities stocks bonds etc and share returns with the investors who hold shares of the mutual fundby means of capital gains amp dividends of the stocks inside the portfolio when a mutual fund buys stocks you personally don t hold these stocks you hold shares of the mutual fund Product Portfolio of securities that have been put together based on the expert actions of the company You buy a share of the portfolio Investors directly hold shares of the mutual fundnvestors hold the securities owned by the fund so they have No control over specific securities bought or sold No control over timing of security purchases or sales Whenever you buy a mutual fund for the first time you must receive a prospectus from the fund information about the fund required by the SEC Again so what The Funds Decisions directly impact what you pay in taxes later in the chap Book info A mutual fund invests in a diversi ed portfolio of securities and issues shares in the portfolio to individual investors mutual funds represent ownership in a managed porifolio of securities The mutual fund concept therefore revolves around diversi cation Diversification which reduces the overall risk borne by the investor is available through a mutual fund This coupled with the fact that mutual funds have professional management which frees the individual investor from managing his own portfolio makes mutual funds attractive to individuals MUTUAL FUNDS AND TAXES 0 MP pay dividends if stocks in portfolio pay dividends suppose you have a growth mutual fund what stocks would you expect it to be comprised of Growth Stocks 0 Distribution if the fund holds stocks for over a year you pay long term capital gains tax 15 but if it is held below a year you must pay short term capital gains taXyour marginal income tax rate PROCESS OF A MUTUAL FUND STEP BY STEP 1 Cash from many individual investors is invested in a mutual fund I invest 100 dollars 2 The investors receive a proportional amount of shares of the mutual fund to the cash they invested I receive 2 50 shares of the mutual fund 3 The managers of the mutual fund use the invested cash to buy stocks they pick to perform wellthe managers buy 200 shares of IBM 500 shares of Atampt etc 4 If the stocks go up or down or pay dividends this directly affects the price of the mutual fundThe stock prices rise by 10 altogether so now my shares in the mutual fund are worth 55 a pop 0 MP realize capital gainslosses when 7 Portfolio stocks are boughtsold MFs avoid taxes if shareholders pay them all capital gains amp 2 90 of dividends derived from MF activities 7 Dividend distributions 7 Capital gains distributions longl5 or shortterm taXmarginal depends on time length MF held the stock 7 Shareholders are taxed at their marginal tax rate NOT the MF corporate tax rate So think about this critically most of the investors will not be in the top marginal tax bracket which is 35they will be below but the corporate tax rate is 35 The mutual fund is going to pass the tax costs of your investments to you regardless of what the tax costs are so if they direct the taxes to the shareholders the shareholders pay taxes at their income bracket often way below the corporate level and therefore save money considering if the corporation paid 35 tax on everything then transferred the costs to you you would have to pay more in taxes So the corporations directing the taxes directly to the investors actually saves the investors money because they will be incurring the cost of the taxes regardless Worst case scenario you normally pay 35 tax on everything so you would be paying the same amount as if the corporation paid the taxes then charged youbut the vast majority of people are not in the top tax bracket we spent like 20 mins on this in class so I gured I would go HAM on the explanation Book info Maj or risk for mutual funds is market risk systematic risk because a mutual fund is a large diversified portfolio Therefore its fortunes are generally tied to the behavior of the market A second kind of risk arises from management practices If a mutual fund is managed aggressively the probability of a loss in capital may be high This is not to imply that a conservative strategy is the only feasible strategy for a mutual fund Obviously all funds are notsubject to the same amount of risk The more aggressive is the fund management the greater the potential return and the greater the amount of risk Moreover since funds deal in different markets their market risk may not be the same either M UTUAL FUND RETURN SOURCES You don t have control over these sources Dividends and capital gains of stocks in portfolio This you do have control over The capital gains of selling the shares you hold of the mutual fund Book info The three sources of return for a mutual fund are l dividend income 2 capital gains distributions and 3 changes in the net asset value of the fund Each of these components has an effect on the total return of a mutual fund The greater the return from any of these components the greater the total return to the investor For closedend investment companies changes in price premiums or discount are another source of return The premium or discount actually affects the market price or net asset value of the fund and hence investment retum7ie as discount or premium changes it affects the changes in NAV and therefore total return M UTUAL FU N D ADVANTAGES Portfolio diversification reduces risk Professional management expert investors making decisions for you You can buy small amounts Services automatic dividend reinvestmenttakes your dividends and reinvests the money into the fund which gives you more shares of the fundamp withdrawal plans you get the dividends YOU WILL BE TAXED FOR BOTH OPTIONS Book info Mutual funds offer a variety of services to investors These include Savings and automatic reinvestment plans Investors are provided a way to accumulate capital and have returns systematically and automatically reinvested for the long haul at little or no cost Withdrawal plans Investors receive regular payments from the mutual funds and conversion privileges and phone switching When the investment climate changes and or an investor s goals change he or she can quickly and easily switch from one kind of fund to another within the same family using the conversion privilege Some mutual funds mostly money funds are extremely liquid because they offer check writing privileges Most mutual Automatic investment plans allow shareholders to automatically send amounts of money from their paycheck or bank accounts into the fund Automatic reinvestment plans enable mutual fund investors to keep their capital fully employed this is important because that s the way investors earn fully compounded rates of return Normally dividends and capital gains distributions are paid in the form of cash in an automatic reinvestment plan however those dividends and capital gains distributions are used to buy additional shares in the fund Thus the number of shares owned by the investor will grow over time Phone switching is a type of conversion privilege that enables fund owners to simply pick up the phone to move their money from one fund to another such a move of course must be con ned to the same family of funds Investors would use such a service as a way to meet their changing investment goals ie when the investment environmentaloutlook changes investors can move between funds as the situation dictates funds also will design and provide for individual retirement plans Convenience 7 Easy to buy amp sell high liquidity 7 Recordkeeping done by fund 7 Fund prices and info are readily available 7 Offered through many pension plans ATTENTION Book info The major advantage of mutual funds is that they provide diversi cation and fulltime professional management Investors with modest amounts of capital can invest in mutual funds and receive the advantages of these services Also mutual funds may offer several attractive services like monthly withdrawal plans They also handle all the paperwork and record keeping deal in fractional shares and automatically reinvest dividends if the investor so desires MUTUAL FUND DISADVANTAGES Transaction Costs 7 Loads commission fees pays the people to make investment moves for you 7 Annual management fees deducted regardless of fund performance Financial analysts don t live on stock charts the Mutual fund is a company and needs to be able to cover its costs of payroll and expenses regardless of economic conditions Questionable longterm performance 7 Many mutual fundsjust keep up with the SampP 500 index 7 Very hard to consistently beat the market Luck sometimes has a lot to do with the performance the way you can counteract investing in a lucky firm is to check the historical consistency of returns Book infoThere are several disadvantages however For one thing the funds can be quite expensive to acquire if they are load funds or have other types of charges and fees like 12b7l fees In terms of performance over the long run mutual funds on average have not done all that well indeed only a handful have been able to outperform the market with some degree of regularity Their performance in general has corresponded to the performance of the market as a whole Of course indexbased mutual funds should provide the return of that market covered less mutual fundrelated costs More Book info Since a mutual fund is really a large portfolio of securities it behaves very much like the market as a whole or a given segment of the market as bond funds would relate to bond markets When economic conditions are good and the stock market moves up mutual funds do well When the market takes a plunge mutual funds do poorly Some funds such as sector funds may not move with the overall market at all That is one reason these funds are attractive to some investors Past performance is important to the mutual fund selection process7it s an indication of how well the fund and its fund managers have done over time And in this regard it s important to look at past performance over an extended ve to ten year period of time covering both good markets and bad If a fund and its managers have done well in both up markets and down markets that s a pretty good indication of what they re capable of doing in the future Whether they actually will perform up to expectations is another matter and is dependent to a large extent on what the future behavior of the market holds That s why it s so important to try to get a handle on the future direction of the market if you think it s headed up that should bode well for mutual funds Combining these two variables the past performance of the fund with the future expectations of the market is an important method for selecting among funds OPENEND MUTUAL FUND THERE IS NO END TO THE AMOUNT OF SHARES THEY CAN PRODUCE 9095 OF ALL MUTUAL FUNDS ARE THIs TYPE Openend refers to a MF s ability to issue an unlimited number of shares therefore since there is unlimited supply there is no way the MF s price can be dependent on supply and demand The Funds price is determined by the NAV N AV 7 Value of All Securities All Liabilitie s Perms of Common Shares Outstanding furyng dawn whmh Wu d hurt yuu 1 n n n n muses mg chunk ufmunequck y 39 nvesmrs trade dvec y mn the mutua fund rNusecundzw mammtradesmubmker n Mn v m menu 5e n n We mum Fun 1 a CLOSED END MUTUAL FUND Er uf A czaeedeendmvemene rampanny a fund that uperates mm a xed numE uutsLandmg shares and dues en regularlny ue new shares ufstuck These funds whxch trade m the smek marketimust are listed bum eneaanpnee Tradehkestuckm szgmupufstuckstmdedzsunesmck paybmkermmmwssmn e Bmween mvesturs m the secundzry market sun wnn 2 Med ammunt uf mveslment eepnex Dun tnemczshunhandfnrredemmuns Can nde out bzdums an mvest mareeggnesswew Nm cantmquy uukmg fur new mveslments Pnce determmed by man wavy supp y a demand 7 Share prices usually at discount or premium to NAV Book info The major types of closedend funds include those that specialize in municipal bonds taxable bonds various types of equity securities international securities and regional and singlecountry funds Key differences between closedend CEFs and openend OEFs mutual funds include 1 CEFs trade like stocks while OEFs are traded directly with the fund operators 2 Large traders of CEFs affect the buy or sell price while trading large amounts of OEFstypically do not affect the price ie CEFs are much less liquid than OEFs 3 CEFs do not provide the full range of services provided by OEFs 4 CEFs typically have a relatively constant capitalization Unlike OEFs CEF investors do not continually buy new shares 5 Most importantly although OEFs are traded bought and sold at net asset value CEFs have two values a market value and a net asset value and these are rarely the same EXCHANGETRADED FUNDS ETF An exchangetraded fund ET F is a type of openend investment company that trades as a listed security on one of the stock exchanges An ETF is a basket of securities 7 Most track indices through replication or sampling 7 Since 2008 some are actively managed 7 Characteristics of both open amp closedend funds Trade in the secondary mkt throughout the day but has an unlimited number of shares 7 Result benefits of both open amp closedend funds Share price close to NAV amp priced continuously Can be shortsold and traded on margin Index tracking low cost turnover amp taxes THIS IS WHERE WE STOPPED IN THE LAST CLASS TYPES OF MUTUAL FUNDS There is a wide variety of mutual funds a Aggressive growth funds are highly speculative funds that concentrate on obtaining large capital gains These funds tend to be small and their portfolios consist of speculative common stocks Returns on these funds generally move with the market but in larger increments when the market s up these funds do great but when the market falls they do really poorly b Equityincome funds emphasize current income by investing primarily in high yielding common stocks In addition to highgrade common stocks these funds also invest in convertible securities preferred stocks and even bonds They like securities that provide high current yields but also consider potential price appreciation over the longer haul These funds are generally viewed as a fairly low risk way of investing in stocks c Growthand income funds seek a balanced return made up of both current income and longterm capital gains with the greatest emphasis placed on growth of capital Unlike balanced funds growth and income funds have 80790 percent of their capital in common stocks They tend to invest in growthoriented blue chips for their capital gains and highyield common stocks for their current income due to high dividends d Bond funds come in all shapes and colors from government bond funds to high yield junk corporate bond funds and they all have one thing in common they invest principally or exclusively in some types of xedincome security While current income is the primary objective of these funds capital gains is not ignored altogether Today there s a full range of bond funds ranging from the very conservative to the very risky e Sector funds are mutual funds that concentrate their holdings in one or more industries that make up a target sector For instance a health care sector fund may hold drug companies medical suppliers biotech companies and hospital management companies They are not widely diversi ed and therefore are riskier than diversified funds f Socially responsible funds are mutual funds that actively and directly incorporate ethics and morality into the investment decision These funds will consider only socially responsible companies for inclusion in their portfolios For example these funds generally will not invest in companies that derive revenues from tobacco alcohol or gambling companies that are weapons contractors or that operate nuclear power plants LOAD AND NO LOAD FUNDS SIMPLE Load Fund a mutual fund that charges a commission 7 Usually sold through a broker Frontend charged only once when buy new shares Backend charged when shares are redeemed 7 Rates tend to fall over time until they disappear NoIoad Fund a mutual fund sold without a commission 7 Usually bought directly from the mutual fund 12b1 fees charged annually by some funds 7 Help with distribution amp advertising costs hidden fees REVIEW QUIZZES HIGHLIGHTER AND X NOTES CORRECT CHOICE l The Internet can be used to do which of the following I chart the performance ofa stock or a mutual fund determine how exchange rates affect the rate of return on a foreign investment I screen databases to find securities that meet your criteria IV locate guidelines and suggestions for constructing an investment portfolio a andonly b I III and IV only c II III and IV only 2 The recommendations and analysis provided by a brokerage firm to its clients are called a investment newsletters 3 arm 39le r I V w Izmir1 c Form lOk39s d subscription service reports E Uquot 0quot N 9 Which one of the following statements is correct a An index is an arithmetic average price of a group of securities b The DJIA is based on the largest 50 domestic stocks 7 ll 7 1 IU nr Wl ml hi1 39 Hli39bf iinf jquot lr d The SampP Industrials index is one of the broadest measures of market activity Holding securities in street name means that the securities are actually a issued in the name of the broker who purchased them on behalfof a client t tvll w u H9 Y a slug 39 mm c owned by whomever has possession of the actual stock certificate d owned by the specialists trading on the floor of the NYSE An account whereby an investor pays a broker a flat fee per year to manage his or her portfolio is called a account cash c margin d market order A GTC sell order placed on the NYSE a can only be executed on the expiration date b will only be executed at the specified price c will be executed at the market price on the expiration date if it has not been executed previously Niall t lillquot l5quotllf cv39 7 397 On Tuesday Pete placed a stoploss sell order at a price of 15 when the market price of a stock was at 18 The stock closed at 1790 per share on Tuesday On Wednesday morning the market opened with the stock priced at 1465 a share Which one of the following statements is correct concerning Pete39s order a Pete received 1790 a share b Pete received 15 a share c Pete39s order did not execute c SIPC insurance protects investors from market losses d A limit buy order guarantees that you will purchase the stated number of shares at the stated price 9 Rosita purchased a stock last year at a price of 3846 a share During the year she received quarterly cash dividends of 23 23 25 and 25 per share Today Rosita sold the stock for 3618 per share What is her percentage total return on this investment a 593 b 6 30 d 842 10 Which one of the following statements is correct a Longterm corporate bonds tend to underperform longterm government bonds over an extended period of time b Largecompany stocks tend to outperform smallcompany stocks over the longterm L U ll d Historically the rate of Inflation over the longterm has averaged slightly over 4 11 An annuity due is an stream of payments paid at the of each time period a unequal beginning b equalend d unequal end 12 What is the net present value of the following set of ordinary cash flows at a discount rate of 8 Year 1 20 Year 2 22 Year 3 24 Year 4 25 c 6989 d 8079 13 The required return on an investment is equal to the a riskfree rate plus an expected inflation premium b riskfree rate minus a risk premium d real rate plus a risk premium 14 Sam purchased a stock for 44 a share Today the stock is valued at 51 a share Sam stills owns his shares Sam has a return of 7 a share a real c required d realized U39I 0quot N 00 L0 N O N An investment has an expected rate of return Ruth purchased a stock for 68 a share and sold it eight months later for 72 a share Ruth also received a 1 a share dividend Ruth39s holding period return is a 694 b 1103 d 588 Five years ago ABC stock paid an annual dividend of 136 per share ABC now pays 162 per share in dividends What is the dividend growth rate a 520 b 413 d 298 Which one of the following definitions is correct a Business risk is related to the capital structure ofa firm b Financial risk is the uncertainty related to an investment39s earnings c Purchasing power risk is the risk associated with changing interest rates ll y l of 8 and a standard deviation of 7 What is the coefficient of variation c 150 d 1143 Shares of Alpha Co stock closed at 32 a share today A threefortwo stock split is effective tomorrow What is the anticipated opening price per share all else constant a 4800 b 3200 d 1067 Randolph Enterprises has total assets of 545 million and total liabilities of 400 million There are 230000 shares of common stock outstanding The book value of the preferred stock is 61 million What is the book value per share of common stock a 4218 b 6304 c 5450 The Jennings Company has aftertax earnings of 632 million The company pays out 264 million in preferred dividends and 182 million in common dividends There are 33 million shares of preferred stock outstanding and 232 million shares of common stock outstanding What is the amount of the earnings per share a 70 c 272 d 80 22 Which one of the following statements concerning dividends is correct c DIVIdends are paId on the date of record d If the date of record for a dividend is Friday August 26 then an investor who purchases shares of the stock on August 23 will receive the dividend 23 Dividends which are automatically reinvested are never taxed b c taxed when the shares purchased with the dividend are sold d taxed at the shareholder39s discretion in either in the year received or the year when the shares purchased with the dividend are sold Which of the following statements concerning types of stocks are correct Income stocks generally pay higherthan average dividends Growth stocks generally grow at two to three times the growth rate of the average stock Stocks that have the potential for substantial capital gains due to a special situation are referred to as speculative stocks Stocks that perform well during economic downturns are called cyclical stocks a II III and IV I III and IV only d II III and IV only N Uquot An American investor purchased a British stock at a price of 1698 per share and sold it one year later at a price of 1848 The investor also received a dividend of 250 The exchange rate at the time of the stock purchase was 163 1 When the stock was sold the exchange rate was 183 10 What is the percentage rate of return on this investment in US dollars a 22 2 c 101 d 30 N 0quot Which one of the following statements is correct a Buyandhold is a relatively high risk strategy b lr 39 all m Shortterm trading is a conservative investment strategy stocks at all times I which a re smallcap in size are generally less volatile than largecap stocks generally provide more current income than an equivalent investment in bonds which pay dividends always have positive total rates on return on an annual basis 28 Which one of the following statements concerning mutual funds is correct b Over the long term most mutual funds outperform the overall market c The transfer agent safeguards the securities and other assets of a mutual fund d Fund shares which impose a backend load are called quotAquot shares 29 A fund that has an unlimited number of shares and sells its shares at NAV directly to investors is called UJ UJ UJ UJ 0 Hedge funds an a closedend load fund c closedend noload fund d openend load fund An exchangetraded fund is a type of closedend fund trades as a listed security on a stock exchange is generally an index fund offers less liquidity than a mutual fund a II III and IV only b I and IV only ll si 716 ll ll 5iquot l w d and II only 12bl fees a are a type of backend load b are applied only during the first year c are a type of frontend load w 9 W 39l Ell j r39 a are a type of mutual fund b d A mutual fund that seeks undervalued stocks with low PE multiples is referred to as a fund a balanced equityincome d growth Aclosedend fund a represents the best investment opportunity when purchased as an IPO m ll l 39Lgliaujcmjll on Jr no in L l c is more liquid than an openend fund d is another name for an exchangetraded fund 35 A fund had an NAV of 864 at the beginning of the year and an NAV of 902 at the end of the year During the year the fund distributed 030 in dividends and 103 in capital gains What is the holding period return for the year a 190 c 147 d 154 36 What is the average annual rate of return for a fund with the following values Fund price beginning of year 1 1333 Fund price end of year 2 1268 Annual distribution year 1 089 Annual distribution year 2 221 LINK To SECRET NOTECARD SPOT http quot 39 39 39 flashcardsview2009470 You might need to make an account but its quick and easy DISCLAIMER The cost of this study guide in no way reflects the cost of the intellectual property of the text author investopedia or the lecture When you buy this study guide you are paying for the time it took me to gather all these FREE materials into one area The sources were all heavily relied upon and should be credited greatly Pearson Website htt w sawcom aw itman fundinv 10 60 15413 394584Scw indexhtml nvestopedia http 39 quot mm ax 1fRMVree and various youtube users Study Guide for Test 2 In ationa persistent substantial rise in the general level of prices related to an increase in the volume of money and resulting in the loss of value of currency Investment Vehicles A product into which funds can be placed with the expectation that it will generate positive income andor preserve or increase its value Economic policy Expansionary Seeks to expand money supply to encourage economic growth or combat in ation Contractionary Seeks to slow down the economy usually through raising interest rates and reserve requirements Monetary policy Acts of government that determine size and rate of growth of the money supply Fiscal policy Government spending policies that in uence interest rates to control the economy Federal funds rate The interest rate at which a depository institution lends immediately available funds to another depository institution overnight Structure of the Fed Federal Open Market Committee Give s direction to Fed s open market operations composed of 12 members 1 Chairman of Board of Governors 1 President of Fed Reserve Bank NY 6 Board Governors 4 Presidents of 4 Reserve Banks Committee meets 8X a year Centerpiece of Fed policymaking Wide array of economic forecast books Summarizes its views on a public statement of the balance of risks between higher in ation or a weaker economy and a directive issued to the Fed s trading desk Member Banks Banks that are part of the Federal Reserve System Own shares of stock in district banks and receive dividends Have reserve requirements with the Fed and have access to discount lending Board of Governors Administer monetary policy and set discount rate Headquartered in DC 7 members appointed by President and con rmed by Senate Non renewable term of 14 years Terms staggered and one expires every other January Geographical restrictions insure that no one district is overrepresented Administers monetary policy to in uence money supplybase through open market operations reserve requirements and discount lending Holds 7 of 12 seats on the FOMC Sets margin requirements the proportion of the purchase price of securities that an investor must pay in cash rather than buying on credit Federal Reserve District Banks District bank in one of 12 districts to conduct discount lending Private commercial banks in each district that are members of the Federal Reserve System own the district bank Private government joint venture Elect directors to represent banks businesses and the general public 3 Class A Directors Bankers 3 Class B Directors Leaders in industry commerce and agriculture 3 Class C Directors Public interest Chosen by board Duties Manage check clearing Manage currency in circulation Conduct discount lending Perform supervisory and regulatory functions Provide information services Open Market Operations Purchase and sales of securities in financial markets by the Fed Purchases increase the monetary base they put more money in circulation Sales decrease the monetary base investors give money which takes it out of circulation Generally conducts operations in liquid Treasury securities markets effecting the interest rate Purchase of Treasury Securities increases price decreases yield expands money supply Sale of Treasury Securities decreases price increases yield contracts money supply Purchases tend to decrease interest rates and are viewed as expansionary Sales tend to increase interest rates and are viewed as contractual Discountrate Interest rate that an eligible depository institution is charged to borrow shortterm funds directly from a Federal Reserve Bank If Fed increases the discount rate less banks will borrow the volume of discount loans decreases and the money supply decreases If Fed decreases the discount rate more banks borrow the volume of discount loans increases and the money supply increases Discount window Means by which the Fed makes discount loans to banks serving as a channel to meet liquidity needs of banks Discountloans Fed in uences the amount of discount loans by setting the discount rate and terms of loans Lending practices Primary Credit Available to healthy banks Secondary Credit For banks not eligible for primary funds can t be used to fund expansion Seasonal Credit Temporary shortterm loans to satisfy seasonal requirements of smaller depository institutions in areas where agriculture and tourism are important Requiredreserves A certain fraction of deposits in cash or deposits with the Fed that a bank must hold mandated by Fed Board of Governors sets reserve requirements Compliance monitored every 2 weeks beginning on Thr ending on Wed Dodd Frank Act Implements changes that affect the oversight and supervision of financial institutions Provide for a new resolution procedure for large financial companies Create a new agency responsible for implementing and enforcing compliance with consumer financial laws Introduce more stringent regulatory capital requirements Effect signi cant changes inthe regulation of over the counterderivatives Reform the regulation of credit rating agencies Implement changesto corporate govemanceand executive compensation practices Fed Independence Main argument for independence is that monetary policy is too important and technical to be determined by politicians Frequent politician elections increase concern of shortterm benefits with no regard for long term costs Monetary policy tends to be expansionary if left to policymakers leading to in ation Control of the Fed by politicians increases the likelihood of political business cycle uctuations in the money supply Brief history of the Fed Alexander Hamilton organized the rst Bank of the United States Southemers and Westerners distrust led to its demise in 1811 2quotd Bank of the US was founded in 1816 but its charter expired with Andrew Jackson Congress appointed a National Monetary Commission to design a central bank Supported by Woodrow Wilson the Federal Reserve Act of 1913 was enacted Act created a central bank for the US Federal Reserve System Created 4 groups within the system Responsibilities assigned to each group were intended to give the central bank control over the amount of currency outstanding and the volume of discount loans to member banks Current Income Periodic interest payments from money invested in a savings account Capital gains Pro ts that an investor realizes when he she sells a capital asset for a price higher then the original purchase price ShortTerm Selling stock at a higher price then originally paid Marginal tax rates The amount of tax paid on an additional dollar of income Averagetaxrates Describes the ratio at which a business or person is taxed Progressivetaxes A tax that takes a larger percentage of income from highincome families then low income ones Regressivetaxes A tax that takes a larger percentage from lowincome individuals than high income ones Capital gains taxes Tax levied on capital gains incurred by businesses and individuals Business cycle Recurring and uctuating levels of economic activity that an economy experiences over a period of time Recession A signi cant decline in activity across the economy lasting longer than a few months Expansion Phase of business cycle where economy moves from trough to peak business activity surges and GDP expands Peak The highest point between the end of an economic expansion and the start of a contraction Trough Marks the end of a declining business period and marks the beginning of expansion Short term investments and their characteristics Savings instruments with lives of one year or less Carry little to no risk Used to house idle funds and earn small interest Provide liquidity Eam interest in 2 ways Stated rate of interest Disc0unt Basis Security is purchased at a price below its redemption value and the difference is the interest that the investment will return Money markets Highly liquid instruments with short maturities are traded Capital markets Market in which longterm securities such as stocks and bonds are sold Investment vehicles and their maturities Common StockAn equity investment that represents ownership in a company Fixed Income Securities Investment vehicles that offer a fixed period return ie Bonds convertible securities preferred stock mutual funds Derivative Securities Derive value from an underlying security or asset Associated with high levels of risk and higher expected returns Key derivative securities are options and futures Tax Advantaged Investments Vehicles and strategies for legally reducing tax liability Real Estate Entities such as residential homes warehouses apartment buildings etc TangiblesInvestment assets besides real estate that can be seen or touched Primary market Market in which new issues of securities are sold to the public 3 options for marketing securities 1 Public Offering Firm offers securities to public 2 Rights Offering Firms offer new shares to existing shareholders on a pro rata basis 3 Private Placement Firm sells new securities directly to investors without SEC mandates Secondary market Market in which securities are traded after they have been issued Gives securities liquidity Provides mechanism for continuous pricing 3ml Market OTC transactions made in listed securities typically by market makers from NYSE AMEX etc that are not necessarily members of such exchanges Charge lower commissions 4 1 Market Consists of transactions made through a computer network directly between large institutional buyers and sellers Bypass market makers IPOs Main vehicle in the primary market which is the first public sale of a company s stock Process Must obtain approval of current private shareholders Auditors and lawyers must certify all documents to legitimize company Company nds an investment bank willing to underwrite Underwriter is responsible for promoting and facilitating sale of IPOs Companies file registration statement with SEC included is the Prospectus Describes keys aspects of the issue and its management and financial position Investment bankers and executives promote the stock through Road Shows After underwriter sets terms and prices the SEC must approve offering Seasoned offerings New issues offered by companies that are already public Spreads Difference in bid and ask price of a particular asset OTC trading Trading smaller unlisted securities through computerized trading Trade takes place on OTC Bulletin Board and pink sheets Listed securities Security listed on some exchange Security exchanges Forums where buyers and sellers are brought together to execute trades SEC Securities amp Exchange Commission Regulatory body for securities offeringsmarkets All securities for public sale must be registered with and approved by SEC Must con rm adequacy and accuracy of information provided to potential investors Bulletin board stocks Traded in OTC market through an electronic quotation system linking market makers who trade shares of small companies SEC regulated Pink sheets Unregulated market where companies need not le with the SEC Provide almost no liquidity Bull Market Favorable markets associated with rising prices investor optimism economic recovery and government stimulus Bear Market Unfavorable markets associated with falling prices investor pessimism economic downturn and government restraint ECNs electronic computer networks Electronic trading networks that automatically match buy and sell orders that customers place electronically Brokers and Broker markets Broker Markets Two sides to a transaction are brought together and a trade takes place Consists of national and regional securities exchanges Major Broker Markets NYSE AMEX Regional stock exchanges Options amp Futures exchanges Commission Brokers Execute orders for their f1rm s customers Independent Broker Works for himself and handles orders on a fee basis Specialist Stock exchange member specializing in making transactions with one or more stocks Manages auction process Dealersand Dealer markets Dealer Markets Buyer and seller are never brought together directly Consists of Nasdaq and OTC markets Market Makers Dealers in the dealer market that make markets by offering to buy or sell certain securities Bid Price Highest price offered to pay for a security Ask Price Lowest price at which a security is offered for sale ADRs Amelich Depository Receipts Dollar denominated receipts for stocks of foreign companies held in the vaults of banks in the companies home country FlN3244 PROFESSOR DEBRA PETERSON EXAM 2 CHAPTER 19 ORGANIZATION OF CENTRAL BANKS FEDERAL RESERVE BANKS 12 FEDERAL RESERVE DISTRICTS Each has a district bank to conduct discount lending DISTRICTS SPECIFICALLY RELATED To Contain a mixture of economic interests Theoretically the private commercial banks that belong to the Federal Reserve System in each district own the district bank The Federal Reserve Act of 1913 created the US Federal Reserve System the Fed ts three principal components are the Federal Reserve banks the Board of Governors and the Federal Open Market Committee FOMC The Fed s formal activities are conducting open market operations setting reserve requirements and making discount loans The FOMC issues guidelines for open market operations The Board of Governors sets reserve requirements Depository institutions obtain discount loans through district Federal Reserve banks although the Board of Governors essentially determines the discount rate the interest rate charged on discount loans Locations of the Federal Reserve District Banks Philadelphia Board of Governors Richmond J 139 Alaska and Hawaii are part of the San Francisco District 3n 3quot DISTRICT BANK STRUCTURE Each district bank has 9 Members that make up its Board of Directors There are 3 director classifications 3 of each type ClassrA Bankers elected by member banks Class B Industry Commerce and Agriculture elected by member banks ClassC Public interest elected by Fed s Board ofGovernors These 9 directors elect the president of their district bank subject to approval by the Fed s boa rd of Governors MEMBER BANKS All national Banks required to be members of the Fed State Banks can decide originally many didn t join 0 Fed has reserve requirements require banks to keep funds on deposit with the fed with no interest paid on these funds Essentially it is a Tax on these banks Later Law I required all banks to keep reserves on deposit I gave equal access to the discount loan and payment system BOARD OF GOVERNORS Functions 7 Members Administers Monetaw Policy Members are 0f the Appointed by the US board of President and must be Governors ISets Reserve confirmed by the Requirementswithin senate congressional limim 390 en Market Operations Operates the Discount each serve 14 Year Window nonrehewable Duties relating to finanCIal terms regulation Setting Margin Requirements for secutities purchases 1 Discount window Credit facilities in which financial institutions 39go to borrow funds from the Federal Reserve These loans which are priced at the discount rate are often structured as secured loans to alleviate pressure in reserve markets It helps to reduce liquidity problems for banks and assists in assuring the basic stability of financial markets Further The Federal Reserve may lower the discount rate andor make temporary changes to the terms ofthe loans in orderto make the discount window a more attractive source for financial institutions to borrow from in times of financial distress In practice power within the Federal Reserve System is more centralized than is apparent from the official structure The Board of Governors especially its chairman typically dominates monetary policy decisions CHAIRMAN OF THE BOARD OF DIRECTORS Very In uential Chairman 39n selling Appointed by us i lent and on l med by monetary polky and shaping etonomit polity Populaiiled by Alan Greenspan Serves a 4 Year term but at expiration may can be reappointed for an additional 4 years or serve an additional 10 as a member FEDERAL OPEN MARKET COMMITTEE FOMC The branch of the Federal Reserve Board that determines the direction of monetary policy The FOMC is composed of the board of governors which has seven members and five reserve bank presidents The president ofthe Federal Reserve Bank of New York serves continuously while the presidents of the other reserve banks rotate their service of one year terms I Further The FOMC meets eight times per year to set key interest rates such as the discount rate and to decide whether to increase or decrease the money supply which the Fed does by buying and selling government securities For example to tighten the money supply or decrease the amount of money available in the banking system the Fed ses government securities The meetings of the committee which are secret are the subject of much speculation on Wall Street as analysts try to guess whether the Fed will tighten or loosen the money supply thereby causing interest rates to rise or fall Directs the Feds Open Market Members consist of the Operations five district bank 2 Member Federal presidents one of which Open MarkEt is always the New York committee District bank president FOMC The FOMC issues Directives1 to the trading desk at the NY District Bank 1The directive is cast in terms designed to provide guidance to the Manager in the conduct of dayto day open market operations The directive sets forth the Committee39s objectives for longrun growth of certain key monetary and credit aggregates It also sets forth operating guidelines for the degree of ease or restraint to be sought in reserve conditions and expectations with regard to shortterm rates of growth in the monetary aggregates Policy is implemented with emphasis on supplying reserves in a manner consistent with these objectives and with the nation39s broader economic objectives POWER IN THE FED The Federal Reserve s formal Structure defuses power between the B of G board of governors the 12 Federal Reserve Banks and the FOMC The Informal Power of the Fed Lies with the chairman of the board of Governors Member banks Have Little actual influence FIGURES SHOWN IN CLASS and imam byquot insrim 12 Federal imam n1 Gnvemals gunman Banks FEE The nirvadireiwrs are evenly splitameng buslnats banking aha nunlic imar u nackgmmas Thebanks k e re e i 39 Appointed bym vmnidamand confirmed hymn 5mm The key role arms board I to administer monetary policy Holds seven of 12 seats or me FOMC v i minions Hnld viva 93912 liming seats on the FOMC Estublish lie sm Iceser and margin requirements Huviews diwuum raiu m by FREI and tie is obtain miscun loans Manage currency in air by Issuing new FR um and collecting damaged nmss i 3 i MDNETARV POLICY lai InTheorv b In Practice CHAIRMAN OF THE BOARD OF GOVERNORS Member Commercial Banks Own district FRBS MONETARV POLICV monetarv policy Votes on and Supervises V o sets agenda for i sets agenda for r r Board FOMc Federal Reserve Governors Stan Banks Governors vote as Twelve rr39ie39mb39ers39i ssue Five FRB presidents members ofthe FOMC polipy direct 7 hold voting seats on Votes Votes Sets drsount Consults I Federal Advisory Sets within D39rects Council open market llmltsl reserve 0 mmons L I requiramems 4 Consults P m 9 real Puwer HANDLING EXTERNAL PRESSURES The Fed was designed to operate independently of external pressures political Reality the Fed operates in a political arena and is subject to political pressure The President makes appointments to the Board of Governors The Fed was created by Congress Only it can reduce the Fed s power or even eliminate it FED MOTIVATION Public interest View the Fed acts in the interest of the general public Principalagent View the Fed acts to increase its power influence and prestige 7 Implies there may be a political business cycle 7 Evidence of a political business cycle is weak Further The public interest View of Fed motivation argues that the Fed pursues monetary policies and financial regulation in the broad national interest Alternatively the principalagent View stresses that the Fed is more interested in enhancing its own wellbeing as an organization than in the national interest FED INDEPENDENCE Should the Fed be independent Some argue that it should because its longer time horizon relative to those of elected officials enables it to pursue monetary policies in the longterm interest of the nation Critics of central bank independence note that monetary policy is an important part ofthe national policy agenda and hence should be controlled by elected officials Political issue of Fed s independence arises when the public negatively views Fed policy Pro independence Monetary policy too important Politicians focus on shortterm oriented 7 Monetary policy too technical for politicians Con independence Monetary policy too important Only elected officials should make public policy Further The degree of independence from the political process and the general procedures for appointing governors vary for central banks of other industrialized countries Countries having relatively independent central banks generally have lower inflation rates than do countries having less independent central banks CHAPTER 20 MONETARY POLICY TOOLS BUSINESS CYCLE Regular fluctuations in economic activity lSt Phase Expansion growing economy 7 4 employment 4 income 4 output amp 4 interest rates 7 At some point economy activity gets overheated 2quotd Phase Declinecomes after the immediatly peak economy slows amp eventually turns downward 3rd Phase RecessionContraction economy stops growing 7 J employment J income J output J prices amp J interest rates At some point the economy bottoms amp begins to rebound 4th Phase Recoverycomes after the lowest point in the trough economy begins to grow again At some point the recovery becomes an expansion Real GDP Recoverv Boom Contradicn Expanslon Time FISCAL POLICYGovernment spending policies that influence macroeconomic conditions These policies affect tax rates interest rates and government spending in an effort to control the economy CHANGES IN TAXING 81 SPENDING BY THE FEDERAL GOV39T WITH THE INTENT OF EXPANDING OR CONTRACTING THE DEMAND IN THE ECONOMY IN A RECESSION AN EXPANSIONARV FISCAL POLICY INVOLVES LOWERING TAXES 81 INCREASING GOV39T SPENDING 0 IN AN OVERHEATED ECONOMV A CONTRACTIONARV FISCAL POLICY REQUIRES HIGHER TAXES amp REDUCED SPENDING Further effectsUnfortunately the effects ofany fiscal policy are not the same on everyone Depending on the political orientations and goals of the policymakers a tax cut could affect only the middle class which is typically the largest economic group In times of economic decline and rising taxation it is this same group that may have to pay more taxes than the wealthier upper class Similarly when a government decides to adjust its spending its policy may affect only a specific group of people A decision to build a new bridge for example will give work and more income to hundreds of construction workers A decision to spend money on building a new space shuttle on the other hand benefits only a small specialized pool of experts which would not do much to increase aggregate employment levels M ON ETARY POLICYThe actions of a central bank currency board or other regulatory committee that determine the size and rate of growth of the money supply which in turn affects interest rates Monetary policy is maintained through actions such as increasing the interest rate or changing the amount of money banks need to keep in the vault bank reserves Controlled by the Federal Reserve The Fed Changes in interest rates amp money supply to expand or contract demand in the economy In a recession the Fed lowers interest rates amp increases the money supply In an overheated economy the Fed raises interest rates amp decreases the money supply Further In the United States the Federal Reserve is in charge of monetary policy Monetary policy is one of the ways that the US government attempts to control the economy If the money supply grows too fast the rate of inflation will increase if the growth of the money supply is slowed too much then economic growth may also slow In general the US sets inflation targets that are meant to maintain a steady inflation of 2 to 3 OPEN MARKET OPERATIONS The buying and selling of government securities in the open market in order to expand or contract the amount of money in the banking system Purchases inject money into the banking system and stimulate growth while sales of securities do the opposite The Fed buys amp sells securities in financial markets The Federal Open Market Committee FOMC guides open market operations Open market purchases are expansionary increase money supply Open market sales are contractionary reduce money supply The FOMC issues a general directive stating its overall policy objectives Types Of 0 pen Ma rket V Defenswe transactions 0 peratlo S x 7 used to make adjustments to the monetary base offset Dynamic transactions disruptions change monetary policy Performed bythe trading Much more common ght purchases amp sales desk at the Federal Reserve Bank of NY May be expected or unexpected minor or major Trade With private security firms selected by the Fed RepurChase 8 reverse39 repurchase agreements Advantages to Open Market Operations Control Flexibility ease of implementation Open market operations purchases and sales of securities in financial markets are the most widely used of the Fed s principal monetary policy tools The Federal Open Market Committee FOMC issues guidelines for open market operations as general directives Some transactions are dynamic that is designed to implement changes in the monetary base suggested by the FOMC Most transactions are defensive that is designed to offset unintended disturbances in the monetary base Further Open market operations are the principal tools of monetary policy The discount rate and reserve requirements are also used The US Federal Reserve39s goal in using this technique is to adjust the federal m rate the rate at which banks borrow reserves from each other DISCOUNT POLICYThe Fed s discount policy sets the discount rate and the terms of discount lending The Fed fulfills its role as the lender of last resort by providing primaw secondary and seasonal credit ADVANTAGES 7 MOST DIRECT WAv FOR THE FED TO ACT AS THE BANKING SVSTEM S LENDER OF LAST RESORT 7 SIGNALS FED S INTENTIONS DISADVANTAG ES 7 HARDER TO CONTROLTHE IMPACT OF DISCOUNT POLicv ON MONEV SUPPLv THAN OPEN MARKET OPERATIONS 7 MAY HAVE UNINTENDED CONSEQUENCES RESERVE REQUIREMENTSRequirements regarding the amount of fundsthat banks must hold in reserve against deposits made by their customers This money must be in the bank39s vaults or at the closest Federal Reserve bank Banks must hold part of their deposits in cash or as deposits with the Fed Rarely change indicates a major change in monetary policy Every two weeks the Fed monitors compliance with its reserve requirements Debate continues on what the Fed s role should be in setting reserve requirements Set by the Fed39s board of governors reserve requirements are one of the three main tools of monetary polig The other two tools are open market operations and the discount rate covered above CHAPTER 1FUNDAMENTALS OF INVESTING THE INVESTMENT ENVIRONMENT INVESTMENTS AND THE INVESTMENT PROCESS The investment process brings together suppliers and demanders of funds This may occur directly as with property investments More often the investment process is aided by a financial institution such as a bank savings and loan savings bank credit union insurance company or pension fund that channels funds to investments andor a financial market either the money market or the capital market where transactions occur between suppliers and demanders of funds An investment is any asset into which funds can be placed with the expectation of preserving or increasing value and earning a positive rate of return An investment can be a security or a property Individuals invest because an investment has the potential to preserve or increase value and to earn income It is important to stress that this does not imply that an investment will in fact preserve value or earn income Bad investments do exist Return the reward for owning an investment Can be negative Current Income Stock s returns would be in dividendsnever negative and capital gains Debt interest payments coupon Types of Investments Securities represents debt ownership or the right to buy or sell securities Securities are investments commonly evidenced by certificates that represent a legal claim For example a bond represents a legal claim on debt and a stock represents a proportionate ownership in the firm Direct investment investor specifies where fund s are invested With a direct investment an individual acquires a direct claim on a security or property For example an investment in one share of IBM stock directly provides the stockholder a proportionate ownership in IBM Indirect investment investor invests funds with a 3rd party who pools funds with those of other investors The controller manager of the group funds makes the specific investment decisions An indirect investment provides an indirect claim on a security or property For example if you bought one share of Fidelity Growth Fund a mutual fund you are in effect buying a portion of a portfolio of securities owned by the fund Thus you will have a claim on a fraction of an entire portfolio of securities Debt An investment in debt represents funds loaned in exchange for the receipt of interest income and repayment of the loan at a given future date The bond a common debt instrument pays specified interest over a specified time period then repays the face value of the loan EquityAn equity investment provides an investor an ongoing fractional ownership interest in a firm The most common example is an investment in a company s common stock Derivative SecuritiesDerivative securities are securities derived from debt or equity securities and structured to exhibit characteristics different from the underlying securities Low or High Riskrisk refers to the chance that the return from an investment will differ from its expected value The broader the range of possible values dispersion the greater the risk of the investment Lowrisk investments are those considered safe with respect to the return of funds invested and the receipt of a positive rate of return Highrisk investments are those which have more uncertain future values and levels of earnings ShortTerm or LongTermShortterm investments typically mature within one year while longterm investments have longer maturities including common stock which has no maturity at all However long term investments can be used to satisfy shortterm financial goals Domestic or ForeignForeign investments are investments in the debt equity derivative securities of foreign based companies and property in a foreign country Both direct and indirect foreign investments provide investors more attractive returns or lowerrisk investments compared to purely domestic investments They are useful instruments to diversify a pure domestic portfolio SUPPLIERS AND DEMANDERS OF FUNDS I Government The various levels of government federal state and local require more funds for projects and debt repayment than they receive in revenues Thus governments are net demanders of funds Governments also demand funds when the timing of their revenues does not match their expenditures The term net refers to the fact that while governments both supply and demand funds in the investment process on balance they demand more than they supply Federal State and local projects amp operations