Assets Flashcards
What is a fixed income/debt security?
Promise either a fixed stream of income or a stream of income determined by a specific formula
Eg a corporate bond
What does common stock/equity represent?
An ownership share in the corporation
Equity holders are not promised a particular payment
What is the performance of equity directly tied to?
The the success of the firm and their real assets
- why they tend to be riskier investments
What are derivative securities?
Provide payoffs that are determined by the prices of other assets such as bonds or stock prices
Examples of derivative securities
Options and future contracts
What is the one of the primary uses of derivatives?
To hedge risks or transfer them to other parties
What is the informational role of financial markets?
Stock prices reflect investors’ collective assessment of a firms’ current performance and their future prospects
What happens when a market is more optimistic about a firm?
Share prices rises
This higher price makes it easier for firms to raise capital and encourage investment
Consumption timing
Can “store” wealth in financial assets eg in a high earnings period you invest savings in financial assets and in low you sell them
Financial markets allow individuals to separate decisions concerning current consumption from constraints that would otherwise be imposed by current earnings
Allocation of risk
Capital markets allow the risk that is inherent to all incestments to be borne by thise who are willing to bear that risk
Benefits of separation of ownership and management
Structure of board of directors etc gives the firm stability
Do the firms managers always pursue strategies that maximise the value of the shares?
No
They may avoid risky projects etc to protect their own jobs
= potential conflict of interest
What are potential conflicts of interest also known as?
Agency problems
Because managers who are hired as the agents of shareholders may pursue their pwn interests instead
What are some mechanisms to avoid agency problems?
Compenstation plans tie income of managers to the success of firms (form of stock or stock options so managers dont do well unless stock prices increase)
Boards of directiors can force out management teams that are underperforming
Bad Performers are subject to the threat of takeover
Why do markets have to be transparent ?
So investors can make informed decisions
What is an investor’s portfolio?
Their collection of investments
Examples of broad assets
Stocks
Bonds
Real estate
Commodities
What is the asset allocation decision?
The choice among these broad asset classes
Also includes the decision of how much of somebody’s portfolio to place in safe assets eg bank accounts and risky assets
What is the security selection decision?
The choice of which particulat securities to hold within each asset class
What is top down portfolio construction?
Stars with asset allocation
Then turns to the decision of which of the particular securities should be held in each class
What is security analysis?
Involves the valuation of particular securitities that might be included in in the portfolio
Both bonds and stock must be evaluated for investment attractiveness but it is much harder to do for stock as their performance is usually far more sensitive
What is bottom up portfolio construction?
Constructed from the securities that seem attractively priced without too much concern for the resultant asset allocation
Focuses on the assets which seem to offer the most attractive investment opportunities
Are financial markets highly competitive?
Yes
What are “free lunches”?
Securitities that are so underpriced they represent obvious bargains
Implication of the “free lunches” concept
1) risk return trade off
2) efficient markets
Risk return trade off
Should exist in the securities market
Higher risk assets should offer higher expected returns thatn lower risk assets
What does diversification mean?
That manay aseets are held in the portfolio so that the exposure to any particular asset is limited
What is the efficient market hypothesis?
That financial markets process all available information about securities quickly and efficiently so the security price usually reflects all the information available to investors concerning its value
What happens to price in relation to the efficient market hypothesis?
As new information about a security becomes available its price quickly adjusts so that at any time the security price equals the market consensus estimate of the value of the security
If this is the case there will be under/overpriced securities
What is passive management?
Calls for holding highly diversified portfolios without spending effort or other resources attempting to improve investment performance through security analysis
What is active management?
The attempt to inprove investment performance by either identifying mispriced securities or by timing the performance of broad asset classes
Who are the 3 major olayers in the financial markets?
1) firms - net demanders of capital
2) households - typically net suppliers of capital
3) governments- can be borrowers or lenders
