Book4 Flashcards
Main functions of financial system
- allocate capital to it’s most efficient use
- determine the returns (r) that equate the total supply of savings with the total demand for borrowing.
- allow entities to save and borrow money, raise equity capital, manage risks, trade assets currently and in future
**Financial system allows the transfer of assets and risks from one entity to another as well as across time.
Private securities
not traded in public markets
Bond vs note vs commercial paper
long term
intermediate term
and short term deb securities issued by firms.
- government debt: bills
- bank debt: certificate of deposit
Pooled investment vehicles
mutual funds, hedge funds, depositories, asset backed securities
Financial intermediaries
stand between buyers and sellers and facilitate the exchange of assets, capital and risk.
- brokers, dealers and exchanges
- securitizers
- depository institutions: like banks
- Insurance companies
- arbitrageurs: provide liquidity to the market where they buy the asset.
- clearinghouses and custodians
Brokers, dealers and exchanges
- brokers
- block brokers: they conceal their clients intention of a block trade so that the market does not move against them
- investment banks
- exchanges
- Alternative trading systems (ATS): like exchanges but have no regulatory function
- dealers
* some dealers act as broker-dealer but these functions have conflicts of interest, broker should seek the best price for client but a dealer makes money from higher prices and spreads.
Insurance companies risks
- moral hazard: the insured may take more risks once he is protected against losses.
- adverse selection: those most likely to experience losses are the predominant buyers of insurance.
- fraud: the insured purposely causes damage.
Payments in lieu
all dividends or interest that the lender of a short sale would have received from the security, it should be paid to the lender.
Leverage ratio of a margin investment
value of the asset / value of the equity position
*value of the equity position (part of the whole bought assets financed by the investor not the margin loan) is at least equal to “initial margin requirement” that is set by the broker.
Call money rate
interest rate paid on a margin loan
Margin call price
=P0(1- initial margin (%)) / (1- maintenance margin)
- it’s correct because the maintenance margin applies to the price at the day.
- in a short sale an increase in the price can decrease the margin percentage below maintenance margin percentage and generate a margin call.
Good on close orders
Good on open orders
*validity instructions
- should only be filled at the end of the trading day
- should only be filled at the opening of the trading day
Book building
gathering indications of interest in buying a new issue from different investors by an investment bank.
*when the number of shares covered by indications of interest are greater than the number of shares to be offered, the offering price may be adjusted upward.
Investment bank conflict of interest in underwritten issues
as issuer agents they should sell higher but to be able to sell the underwritten amount they want to sell cheaper.
Brokered markets
brokers find the counterparty to execute a trade. good for times that the the trader has a security that is unique and illiquid, like blocks of stock.
Well functioning financial system
has complete markets, operationally efficient (low trading costs) and informationally efficient (prices reflect all the information)
- complete market:
1. investors can can save for future at fair rates of return
2. creditworthy borrowers can obtain funds.
3. hedgers can manage their risks
4. traders can obtain the currencies, commodities and other assets they need.
ROE when buying on margin
the commission on the purchase should be added to initial margin required and go to the denominator.
sale commissions go in the calculations of return in nominator
Price index vs return index
an index return can be calculated using a price index or a return index, a price index uses only the prices of the constituent securities in the return calculation —> price return
return index includes both prices and income from the constituent securities–> a rate of return calculated based on a return index is called a total return.
Equal weighted index
a portfolio that includes equal dollar amounts of constituent securities.
return of this index is equal to the arithmetic average return of the index stocks
- it’s simple
- the matching portfolio should be rebalanced periodically to adjust for price changes–> high transaction costs that reduce returns
Float adjusted market capitalization weighted index
constructed like a market capitalization weighted index but the weights are based on the proportionate value of each firm’s shares that are available to the investors (market float of the company)
Cap weighted index issues
- biased toward firms with higher market caps
- the relative impact of a stock on index return increases as its price rises and decreases as it falls–> stocks that are overvalued are given more weight and stocks that are undervalued are given low weights.
Fundamental weighted index
uses weights based on firms fundamentals such as earnings dividends, …
- good: no cap or price base
- bad: value bias, tilted towards the performance of firms with high earnings yield.
Rebalancing
adjusting the weights of securities in a portfolio to their target weights after price changes have affected the weights.
*no need for price and cap weighted indices because they get adjusted to their weighs by a change in price, but important for equal weighted indexes.
