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89 Cards in this Set

  • Front
  • Back
Investment
Commitment of current resources in the expectation of deriving greater resources in the future.
Real Assets
Assets used to produce goods or services
Financial Assets
Claims on Real Assets or the Income generated by them.
Fixed-Income Securities
Pay a specified cash flow over a specific period.
Money Market
fixed-income securities that are
short term, highly marketable, and generally of very low risk
Money Market Securities Examples
U.S. Treasury bills or bank certificates of deposit (CDs).
fixedincome
capital market
long-term securities such as Treasury bonds, as well as bonds
issued by federal agencies, state and local municipalities, and corporations. These bonds range
from very safe in terms of default risk (for example, Treasury securities) to relatively risky (for
example, high yield or “junk” bonds)
Equity (or Common Stock)
Represents an ownership share in
a corporation.
Not promised particular payment.
receive any dividends the firm may pay and have prorated ownership in the real assets of the firm
- firm successful, value increases
- performance tied directly to success of firm and its real assets
Derivative Securities
Securities providing payoffs that depend on the values of other assets (such as bond or stock prices).
- named b/c values derived from prices of other assets
- inclued options and futures contracts
Derivatives' Primary Use
Hedge risks or transfer them to other parties.
Financial Assets' Role in Economy
- Consumption Timing
- Allocation of Risk
- Separation of Ownership and Management
Consumption Timing
financial markets allow individuals to separate decisions concerning current consumption from constraints that otherwise would be imposed by current earnings.
Allocation of Risk
capital markets allow the risk that is inherent to all investments to be borne by the investors most willing to bear that risk. (purchasing stocks v. bonds)
- allocation of risk also benefits the firms that need to raise capital to finance their investments.
Separation of Ownership and Management
financial assets and the ability to buy and sell those assets in the financial markets
allow for easy separation of ownership and management.
agency problem
Conflicts of interest between managers and stockholders.
Mitigated by:
- Compensation tied to success of firm (stock options, e.g.)
- BoD can force out management teams which underperform
- Outsiders (security analysts, large institutional investors) monitor firms and put pressure on management
- Threat of takeover by shareholders
Portfolio
Investor's collection of investment assets.
- Investment Assets categorized into broad asset classes, such as stocks, bonds, real estate, commodities, and so on.
- Two decisions made in construction portfolio
1. Asset Allocation
2. Security Selection
Asset Allocation
Allocation of an investment portfolio across broad asset classes.
Security Selection
Choice of which particular securities to hold within each asset class.
"Top-Down" Portfolio Construction
Starts with Asset Allocation, then decision of the particular securities to be held in each asset class.
Security Analysis
The valuation of particular securities that might be included in the portfolio.
"Bottom-Up" Portfolio Management
portfolio is constructed from the securities that seem attractively priced without as much concern for the resultant asset allocation.
focus the portfolio on the assets that seem to offer the most attractive investment opportunities.
Risk-Return Trade-Off
Assets with higher
expected returns have
greater risk.
If you want higher expected returns, you will have to pay a price in terms of accepting higher investment risk.
“expected” return
not the return investors believe they necessarily will earn, or even their most likely return.
It is the result of averaging across all possible outcomes, recognizing that some outcomes are more likely than others.
It is the average rate of return across possible economic scenarios.
Diversification
many assets are held in the portfolio so that the exposure to any particular asset is limited.
Efficient Markets
as new information about a security becomes available, the price of the security quickly
adjusts so that at any time, the security price equals the market consensus estimate of the value of the security.
Passive Management
Buying and holding a diversified portfolio without attempting to identify mis-priced securities.
- No "Security Analysis"
Active Management
Attempting to identify mispriced securities or to forecast broad market trends.
The Players in Financial Markets
1. Firms
2. Households
3. Government
Firms
- Net Borrowers
- Raise capital now to pay for investments in plant/equipment
- income generated by those real assets provides the returns to investors who purchase the securities issued by the firm
Households
- Net Savers (typically)
- Purchase securities issued by firms that need to raise funds.
Governments
- Can be borrowers or lenders depending on relationship between tax revenue and gov't expenditures
- Issuance of Treasury bills, notes, and bonds is the major way that the government borrows funds from the public
Financial Intermediaries
Institutions that “connect” borrowers and lenders by accepting funds from lenders and loaning funds to borrowers.
- stand between the security issuer (the firm) and the ultimate owner of the security (the individual investor).
Types of Intermediaries
financial intermediaries include banks, investment companies, insurance companies, and credit unions. Financial intermediaries issue their own securities to raise funds to purchase the securities of other corporations.
primary social function of intermediaries
channel household savings to the business sector.
Investment Companies
Firms managing funds for investors.
- May manage several mutual funds
- Pool and Manage money of many investors
- Arise out of Economies of Scale
Investment Bankers
Firms specializing in the sale of new securities to the
public, typically by underwriting the issue. (Goldman Sachs, Smith Barney, e.g.)
provide a certification role - “seal of approval”—to security issuers
Four Types of Markets
1. Direct Search
2. Brokered
3. Dealer
4. Auction
Direct Search Markets
- Least Organized
- Buyers and Sellers seek each other out directly
- sporadic participation and low-priced and nonstandard goods (buy used fridge, e.g.)
Brokered Markets
- Trading good is active, so profitable to offer search services to buyers/sellers
- Includes Primary Market
- Real Estate Market - economies of scale in searches for homes/buyers make it worthwhile for participants to pay brokers to conduct the searches.
Primary Market
A market in which new issues of securities are offered to the public.
investment bankers who market a firm’s securities to the public act as brokers; they seek investors to purchase securities directly from the issuing corporation.
Dealer Markets
Markets in which traders specializing in particular assets buy and sell for their own accounts
Arise when trading activity in particular type of asset increases
- e.g., Over-the-Counter (OTC) market
Secondary Markets
Already existing securities are bought and sold on the exchanges or in the OTC market.
- Doesn't affect amount of securities outstanding
Auction Market
A market where all traders meet at one place to buy or sell an asset. NYSE
- Most Integrated Market
- Advantage over Dealer - one need not search across dealers for best price
4 Important Trends Changing Investment Environment
1. Globalization
2. Securitization
3. Financial Engineering
4. Information and Computer Networks
Globalization
Tendency toward a worldwide investment environment, and the integration of national capital markets.
Ways to Participate in Foreign Investment Opportunities
1. Purchase foreign securities using American Depository Receipts (ADRs)
2. Purchase foreign securities offered in dollars.
3. Buy Mutual Funds that invest internationally
4. Buy Derivative Securities with payoffs that depend on prices in foreign securities markets
American Depository Receipts
Domestically Traded Securities that represent claims to shares of foreign stock.
- Essentially same as buying US stock (but exchange rate risk)
World Equity Benchmark Shares (WEBs)
- Variation of ADRs
- Allow investors to trade portfolios of foreign stocks in a selected country. Each WEBS security tracks the performance of an index of share returns for a particular country.
Traded just like any other security
Pass-Through Securities
Pools of loans (such as home mortgage loans) sold in one package. Owners of pass-throughs receive all of the principal and interest payments made by the borrowers.
Introduced by the Government National Mortgage Association (GNMA, or Ginnie Mae)
Securitization of Mortgages
Pooling loans into standardized securities backed by those loans, which can then be traded like any other security.
Major Players in Mortgage-Backed Securities Market
Federal National Mortgage Association (FNMA, or
Fannie Mae) and the Federal Home Loan Mortgage Corporation (FHLMC, or Freddie Mac).
- Other loans that have been securitized into pass-through arrangements include car loans, student loans, home equity loans, credit card loans, and debts of firms.
Brady bonds
formed by securitizing bank loans to several countries in shaky fiscal condition. The U.S. banks exchange their loans to developing nations for bonds backed by those loans. - The payments that the borrowing nation would otherwise make to the lending bank are directed instead to the holder of the bond. These bonds are traded in capita markets.
Financial Engineering
The process of creating and designing securities with custom-tailored characteristics.
Creation of new securities by bundling and unbundling
- Creation of new securities either by combining primitive and derivative securities into one composite hybrid or by separating returns on an asset into classes.
Unbundling
breaking up and allocating the cash flows from one security to create several new securities
Bundling
combining more than one security into a composite security.
Money Markets
Include short-term, highly liquid, and relatively low-risk debt instruments
- Sometimes called cash equivalents
-subsector of debt market
Capital Markets
Include longer-term, relatively riskier securities
Four Segments of Capital Markets
1. longer-term debt markets,
2. equity markets,
3. derivative markets for options
4. derivative markets for futures.
Treasury Bills (T-Bills)
Most marketable of all money market instruments; simplest form of borrowing; highly liquid
- low transaction cost; minimum purchase $10k
- Gov't raises money by selling to public
- Investors buy bills at discount from stated maturity value
- At maturity, investor receives pmt. equal to face value of the bill
- Diff. between purchase price and ultimate maturity value = investors earnings
- can purchase directly at auction or in secondary market
Competitive Bid
order for a given quantity of bills at specific offered price
- order fulfilled only if the bid is high enough relative to other bids to be accepted. If high enough to be accepted, the bidder gets the order at the bid price.
- Dangers: may bid too high or bid to low and shut down auction
Noncompetitive Bid
A noncompetitive bid is an unconditional offer to purchase bills at the average price of the successful competitive bids.
- Treasury ranks bids by offering price and accepts bids in order of descending price until the entire issue is absorbed by the competitive plus noncompetitive bids
Certificates of Deposit (CDs)
A bank time deposit
- may not be withdrawn on demand.
- bank pays interest and principal to the depositor only at the end of the fixed term of CD
Commercial Paper (CP)
Short-term unsecured debt issued by large corporations
- maturity ranges up to 270 days
Bankers' Acceptances
An order to a bank by a customer to pay a sum of money at a future date (typ. w/in 6 mo.)
- very safe assets
- like T-bills, sold at discount from face value of the payment order
Eurodollars
Dollar-denominated deposits at foreign banks or foreign branches of American banks.
- need not be European banks
Repurchase Agreements (Repos)
Short-term sales of government securities with an agreement to repurchase the securities at a higher price.
- increase in the price is the overnight interest.
- securities serve as collateral for the loan
Brokers' Calls
Individuals who buy stocks on margin borrow part of the funds to pay for the stocks from their broker.
- usually 1% higher than short-term T-bills
Federal Funds
Funds in the accounts of commercial banks at the Federal Reserve Bank.
In the Federal funds market, banks with excess funds lend to those with a shortage.
London Interbank Offer Rate (LIBOR) Market
Lending rate among banks in the London market.
THE BOND MARKET
Longer-term borrowing or debt instruments than those that
trade in the money market. This market includes: Treasury notes and bonds, corporate bonds, municipal bonds, mortgage securities, and federal agency debt.
fixed-income capital market
instruments in bond market
- called this b/c most of them promise either a fixed stream of income or stream of income that is determined according to a specified formula
Treasury Notes or Bonds
Debt obligations of the federal
government with original maturities of one year or more.
T-note maturities range up to 10 years
T-bonds are issued with maturities ranging from 10 to 30 years.
- both issued in increments of 1k+
Coupon Payments
T-Bonds and T-Notes make Semiannual interest payments
Major distinction between T-Bonds and T-Notes
T-bonds may be callable during a given period, usually the last five years of the bond’s life. The call provision gives the Treasury the right to repurchase the bond at par value. While callable T-bonds still are outstanding, the Treasury no longer issues callable bonds.
Yield to Maturity
a measure of the annualized rate of return to an investor who buys the bond and holds it until maturity. It is calculated by determining the semiannual yield and then doubling it, rather than compounding it for two half-year periods.
Federal Agency Debt
government agencies issue their own securities to finance their activities.
International Bonds
Eurobond is a bond denominated in a currency other than that of the country in which it is issued.
Municipal Bonds (Munis)
Tax-exempt bonds issued by state and local governments.
Municipal Bonds - 2 Types
General Obligation - backed by "full faith and credit" (taxing power) of the issuer
Revenue Bonds - Issued to finance specific projects, backed by revenue generated by project or by municipal agency operating project
- Riskier; usually issued by airports, hospitals, and turnpike or port authorities
Municipal Bonds - Key Feature
Their tax-exempt status. Because investors pay neither
federal nor state taxes on the interest proceeds, they are willing to accept lower yields on these securities.
equivalent taxable yield
rate a taxable bond would need to offer in order to match the after-tax yield on the tax-free municipal
An investor choosing between taxable and tax-exempt bonds needs to compare after-tax returns on each bond.
t = investor’s federal plus local marginal tax rate
r = total before-tax rate of return available on taxable bonds
r(1 - t) =  r[municipal]
- equals after tax rate available on those securities
- If value exceeds rate on munis (r[m]), then investor should hold taxable bonds
r = r[municipal]/(1-t)
cutoff tax bracket
tax bracket at which investors are indifferent between taxable and tax-exempt bonds.
t = 1 - (r[mat]/r)
Corporate bonds
means by which private firms borrow money directly from the public.
- structured like Treasury issues
Long-term debt issued by private corporations typically paying semiannual coupons and returning the face value of the bond at maturity.
- Default risk high v. T-bonds
Current Yield on a Bond
Annual coupon income per dollar invested in a bond
Current Yield = Annual Coupon Income / Price

*ignores the difference between the price of a bond and its eventual value at maturity
mortgage-backed security
either an ownership claim in a pool of mortgages or an obligation that is secured by such a pool. These claims represent securitization of mortgage loans.
Pass-Throughs
mortgage-backed securities called this b/c Mortgage lenders originate loans and then sell packages of these loans in the secondary
market. Specifically, they sell their claim to the cash inflows from the mortgages as those
loans are paid off. The mortgage originator continues to service the loan, collecting principal and interest payments, and passes these payments along to the purchaser of the mortgage.
Turnover
The ratio of the trading activity of a portfolio to the assets of the portfolio.
Exchange-traded Funds (ETFs)
Offshoots of mutual funds that allow investors to trade index portfolios.