Assets

Question 1

What is a fixed income/debt security?

Answer 1

Promise either a fixed stream of income or a stream of income determined by a specific formula

Eg a corporate bond

Question 2

What does common stock/equity represent?

Answer 2

An ownership share in the corporation

Equity holders are not promised a particular payment

Question 3

What is the performance of equity directly tied to?

Answer 3

The the success of the firm and their real assets

• why they tend to be riskier investments

Question 4

What are derivative securities?

Answer 4

Provide payoffs that are determined by the prices of other assets such as bonds or stock prices

Question 5

Examples of derivative securities

Answer 5

Options and future contracts

Question 6

What is the one of the primary uses of derivatives?

Answer 6

To hedge risks or transfer them to other parties

Question 7

What is the informational role of financial markets?

Answer 7

Stock prices reflect investors’ collective assessment of a firms’ current performance and their future prospects

Question 8

What happens when a market is more optimistic about a firm?

Answer 8

Share prices rises

This higher price makes it easier for firms to raise capital and encourage investment

Question 9

Consumption timing

Answer 9

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

Question 10

Allocation of risk

Answer 10

Capital markets allow the risk that is inherent to all incestments to be borne by thise who are willing to bear that risk

Question 11

Benefits of separation of ownership and management

Answer 11

Structure of board of directors etc gives the firm stability

Question 12

Do the firms managers always pursue strategies that maximise the value of the shares?

Answer 12

No

They may avoid risky projects etc to protect their own jobs

= potential conflict of interest

Question 13

What are potential conflicts of interest also known as?

Answer 13

Agency problems

Because managers who are hired as the agents of shareholders may pursue their pwn interests instead

Question 14

What are some mechanisms to avoid agency problems?

Answer 14

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

Question 15

Why do markets have to be transparent ?

Answer 15

So investors can make informed decisions

Question 16

What is an investor’s portfolio?

Answer 16

Their collection of investments

Question 17

Examples of broad assets

Answer 17

Stocks
Bonds
Real estate
Commodities

Question 18

What is the asset allocation decision?

Answer 18

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

Question 19

What is the security selection decision?

Answer 19

The choice of which particulat securities to hold within each asset class

Question 20

What is top down portfolio construction?

Answer 20

Stars with asset allocation

Then turns to the decision of which of the particular securities should be held in each class

Question 21

What is security analysis?

Answer 21

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

Question 22

What is bottom up portfolio construction?

Answer 22

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

Question 23

Are financial markets highly competitive?

Answer 23

Yes

Question 24

What are “free lunches”?

Answer 24

Securitities that are so underpriced they represent obvious bargains

Question 25

Implication of the “free lunches” concept

Answer 25

1) risk return trade off

2) efficient markets

Question 26

Risk return trade off

Answer 26

Should exist in the securities market

Higher risk assets should offer higher expected returns thatn lower risk assets

Question 27

What does diversification mean?

Answer 27

That manay aseets are held in the portfolio so that the exposure to any particular asset is limited

Question 28

What is the efficient market hypothesis?

Answer 28

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

Question 29

What happens to price in relation to the efficient market hypothesis?

Answer 29

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

Question 30

What is passive management?

Answer 30

Calls for holding highly diversified portfolios without spending effort or other resources attempting to improve investment performance through security analysis

Question 31

What is active management?

Answer 31

The attempt to inprove investment performance by either identifying mispriced securities or by timing the performance of broad asset classes

Question 32

Who are the 3 major olayers in the financial markets?

Answer 32

1) firms - net demanders of capital
2) households - typically net suppliers of capital
3) governments- can be borrowers or lenders