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38 Cards in this Set

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Financial markets

Financial markets provide liquidity by establishing a security pricing mechanism.

Prices risky enterprises higher than non-risky enterprises. Securities trade in financial markets. Determine the cost of capital. Matches investors with providers of capital.

Primary demand for capital in the U.S. is mortgages.

Types of financial markets

Money market: market in which short term securities or investments (mature in 1yr or less) are traded.

Capital market: determines the cost of long-term financing. Does not identify assets needed to support the cost of capital.

Financial markets can be further divided into primary and secondary markets.

Primary markets

Where new securities are sold. When a company issues debt or borrows money it issues bond in the primary market. When a company issues new stock to raise capital that's also done in the primary market.

Types include: direct search (participants find their own trading partners), broker (participants find trading partners through the use of agents), dealer (participants trade with dealers who hold themselves out as buyers and sellers, assumes price risk when securities are sold through a firm commitment underwriting), auction (participants compete against other investors through and intermediary)

Secondary markets

Once a security is out in the primary market it trades among other investors in the secondary market.

Allow for purchase and sell of previously issued securities. Liquidity of the secondary markets means buyers and sellers can resell their securities. Companies often invest their excess cash in the secondary markets.

The largest financial market is the currency market which operates as a dealer market.

To provide liquidity a secondary market must have dept and breadth. Depth: ability to handle significant number of securities without large effect on prices. Breadth: analyzes the number of companies advancing relative to the number declining.


If a company wants to raise money it can borrow money by issuing bonds. Investors or a company can purchase bonds. When a bond is purchased it shows as an asset on financial stmts but when a bond is issued it's shown as a liability in long-term debt.

Know that higher risk means higher return. Which bonds have highest risks and therefore higher return.

Bond par value
The face value (also known as the par value or principal) is the amount of money a holder will get back once a bond matures. A newly issued bond usually sells at the par value. Corporate bonds normally have a par value of $1,000, but this amount can be much greater for government bonds.
Bond coupon rate

A coupon payment on a bond is a periodic interest payment that the bondholder receives during the time between when the bond is issued and when it matures.

Coupons are normally described in terms of the coupon rate, which is calculated by adding the total amount of coupons paid per year and dividing by the bond's face value. For example, if a bond has a face value of $1,000 and a coupon rate of 5%, then it pays total coupons of $50 per year. For the typical bond, this will consist of semi-annual payments of $25 each.

Federal government bonds

Treasury securities are guaranteed by the U.S. government. Generally have lower interest rates due to no risk of default. Offered by the treasury in book entry form. Minimum investment of $100. Not subject to state income tax but interest earned is subject to federal income tax.

Treasury bills (maturity of 1yr or less, issued at discount and mature at par, taxation occurs only at maturity), treasury notes (mature from 1-10yrs, pay interest semi-annually), treasury bonds (mature in 30yrs, pay interest semi-annually), treasury inflation protected securities (coupon rate is fixed percentage of principle, par value of bond adjusted by CPI)

The longer the term of the bond, generally the higher the interest rate it pays. Treasury securities are sold through the auction market.

Federal government bonds pt.2

Government agencies securities: provide slightly higher returns than treasury securities. Issued by government sponsored enterprises. Not guaranteed by federal government. Include FNMA, GNMA, and CMOs.

Corporate bonds

Agreement between corporation and bond holder. Majority are classified as utility bonds, industrial bonds, and bank and finance company bonds. Pay taxable interest. Principal purchasers are corporations, banks, insurance companies, money managers, and pension plan.

State and local bonds

Municipal bonds: issued by state and local governments and have default risk. Typically offer lower interest rates because interest income is tax exempt.

Types: revenue bonds (backed by revenues from a designated project), general obligation bonds (backed by the taxes collected from the government body)

International bonds

Generally pay a higher coupon (interest) rate than domestic bonds due to their additional risks.

Eurobonds: long-term debt that is offered outside insurer's country. Never denominated in issuing country. Typically have maturities of 3-7yrs. Typically pay taxable interest annually. Typically unsecured. Risky so they pay a higher return

Foreign bonds: similar to eurobonds but generally more regulated.

Tax rates

Tax equivalent yield is the pretax yield that a taxable bond needs to posses for its yield to be equal to that of a tax free municipal bond.

TEY = tax free yield / (1 - tax rate)

Tax rate for municipal vs. corporate bonds can be calculated using the following equation:

Tax rate = 1 - (municipal bond rate / corporate bond rate)

Indenture agreement

Bonds are created by indenture agreements which is essentially a contract. Includes principal and maturity date. States coupon rate - interest rate paid (coupon is based on face value of bond.)

Lists rights and duties of seller and buyer. Buyers are creditors and have rights above shareholders. Buyers do not share in company profits.

Buyer is the lender and issuer is the borrower.

Optional bond features

Bonds may have some additional features:

Convertible bonds: can be converted to common stock at a fixed price in the future. Profit potential is generally higher because value is supported by bond and stock. Less market risk than stock.

Callable bonds: can be paid off by issuer before stated maturity date. May have higher interest rates initially. Issuers are likely to call the bond if market interest rates decrease significantly while the bond is outstanding.

Guaranteed bonds: guaranteed by an entity other than the issuer (parent company.)

Optional bond features pt.2

Serial bond: portions of principal mature on different dates.

Participating bonds: tie interest to the issuers financial results.

Floating-rate bonds: adjusted interest rates periodically.

Sinking fund: money is set aside each year to repay principal. Existence of a sinking fund reduces the risk of default and would therefore be expected to increase the value of the bond.

Zero-coupon bonds

A debt security that doesn't pay interest (a coupon) but is traded at a deep discount, rendering profit at maturity when the bond is redeemed for its full face value.

Have precisely identifiable maturity values. The return is simply the difference between the maturity value of the bond and the purchase price of the bond.

Bond collateral

Secured bonds are backed by collateral.

Debentures are unsecured bonds (highest credit risk to the bondholder.) No collateral backing the bond.

Property-casualty insurers typically purchase:

Asset-backed securities: auto loans, credit cards, student loans. E.g. credit card company has receivables that they sell to an insurance company. When card holder pays their bill the insurance company gets the money. Have shorter maturities than mortgage backed.

Mortgage-back securities: 15-30yr mortgages. Same as asset backed except backed with mortgages.

If company goes under the investors get paid in this order: secured bond holders, unsecured bond holders, preferred stock holders then common stock holders.

Yield to maturity

Represents a bonds total return if held to maturity. Most accurate representation of bond's interest rate. Can change over time. Also called discount rate. YTM is determined by the market and is based on risk and return factors.

Yield to maturity is influenced by

Real rate of return: rate required by bondholders to purchase the bond.

Inflation premium: offsets decrease in purchasing power associated with inflation.

Risk premium: compensates holder for credit risk (risk of default), liquidity risk (treasury securities are most liquid), maturity premium (higher for L-T bonds)

Bond valuation

The term structure of a bond represents the effect of the length of time to maturity on the bond's price. Aside from general credit conditions, the risk of default is the most significant factor that influences the coupon rate.

Although bonds are subject to default (credit) risk, the primary risk of long-term bond portfolio is interest rate risk. As market interest rates increase, the value of bonds decrease. The value of long-term bonds is more sensitive to interest rate movements than short-term bonds.

Bond pricing

When a bond matures face value, amortized cost and market value are equal.

Factors affecting bond prices (volatility) (effect bond while its still outstanding): The shorter the bond's term to maturity, the lesser the percentage change in the bond's price for a given change in interest rate. The lower the bond's yield to maturity, the greater the percentage change in the bond's price for a given change in interest rate. Interest rates have an inverse (not direct) relationship with bond prices. The higher the bond's coupon rate, the lesser the percentage change in its price for a given change in interest rate.


Represents ownership in a company. Stock investments are the second largest investment for property-casualty insurers, bond are number one.

Common stock

Typically provides voting rights in company. Dividends are variable and not required. Lowest priority regarding dividends and liquidation rights. Most trades occur in secondary market.

Preferred stock

An alternate class of stock that may be issued by a company.

Characteristics of dividends: usually pay a fixed dividend similar to coupon payment of bonds. Dividend paid to preferred stock before commons stock dividend can be paid. Cumulative (past unpaid dividends must be paid before dividend paid on common stock.)

Preferred stock shareholder rights

Usually doesn't have voting rights. Shareholders have liquidation preferences over common shareholders. Claim is subordinate to creditors. Some shares have a redemption value. Convertible (allows conversion to common shares.) Call option (if exists, stock priced like bond.)

Valuation of stock volatility theory

Economic theory suggests that stock prices are a result of supply and demand. Investors may think prices of certain stocks will move up or down due to economy.

Financial theory suggests that stock price is discounted present value of future dividends. Cost of capital may also have an affect. Indicates that the value and price fluctuations of a stock are based on the present value of future cash flows.

Fundamental analysis, technical analysis and the efficient market hypothesis are approaches to pricing stock.

Fundamental analysis

Involves analysis of financial data and macroeconomics to determine stock price. If pricing a stock you would perform analysis of company it self's financial stmts. Requires thourough understanding of the specific company and its method of operation. More inclusive than technical analysis and encompasses quantitative and qualitative factors.

Determines the extent to which the following factors exceed S&P average: expected earnings growth, stability of sales, dividend payout, leverage, institutional ownership of stock. Analyst would be likely to analyze a company's earnings and dividend prospects.

Technical analysis

Technical indicators can be used to determine if an investor should invest in a certain asset class. A little psychology. Attempts to determine patterns in market activity and past prices. Doesn't attempt to measure intrinsic value of stock. Usually more effective when combined with fundamental analysis.

Concentrates on past price and volume relationships of a security of technical market indicators applicable to that security.

Efficient market hypothesis

EMH contends that the market is efficient at pricing securities. The market is difficult to beat, especially for individual investors. Market information is widely available and generated in a random fashion. It may be a waste of time for an individual to attempt to locate undervalued stocks.

Forms: weak (stock prices reflect market info), semi-strong (stock prices reflect all publicly available info), strong (stock prices reflect both private and public info, building and incorporating weak and semi-strong)

Overview of return

There are 2 components of return: income generated by investment (yield) e.g. interest earned on bond or dividend from stock. Also capital gain or loss on the disposition e.g. what you earn when you sell your investment.

Annual rate of return is the sum of yield and capital gain/loss expressed in percentage terms.

Bond return

The annual rate of return from a bond can be expressed in the following formula:

(Interest + capital gain) / beginning price

Capital gain represents the difference between the ending and beginning price of the bond.

Stock return

The annual rate of return from the stock can be expressed in the following formula:

(Dividend + capital gain) / beginning price

Capital gain represents the difference between the ending and beginning price of the stock.

Financial statement valuation

Bonds and stocks can be valued on GAAP financial statements based on: cost (original purchase price, readily available and verifiable), amortized cost (bonds only), fair value (fluctuates over time. According to FASB guidance fair value should equal the assets exit price (what it could be sold for today), for security not actively traded, fair value is estimated based on similar investments.)

Bond rating assigned by SVO will affect the value of the bonds on the insurer's financial stmts. Bond values usually constitute a signifcant portion of the insurer's surplus. Bonds purchased below their stated par value are considered discount bonds, not premium bonds.

Amortized cost

A concept applicable to bonds. Allocates the difference between a bond's purchase price and face value over time. Stabilizes the bond's value on financial stmts.

If a bond is purchased with a coupon less than the YTM, the bond will be purchased a discount. Discount is amortized over time. At maturity book value equals face value.

GAAP reporting

SFAS 115 provides guidance on reporting assets held as investments. Depends on classification of asset. An impairment in financial asset results in a reduction in shareholders equity or surplus.

Realized gains and losses - applies to gain/loss at the time of sale. Reported in income at time of sale.

Statutory reporting

Reporting of bonds on annual statement form: highest-quality bonds (amortized cost. Quality determined by securities valuation office.), lower-quality bonds (lower of amortized cost or fair value), stocks (fair value), unrealized gains/losses (adjustment to capital and surplus account)

Real rate of return equation

Real rate of return = [(1 + nominal rate) / (1 + inflation rate)] - 1