chapter 1 3fb3

Question 1

Real Assets

Answer 1

Have productive capacity
Examples: Land, building machines, intellectual property

Question 2

Financial Assets

Answer 2

Claims on real assets
Do not contribute directly to productive capacity
Examples: stocks, bonds

Question 3

Real Assets & Financial Assets: fixed-income securities

Answer 3

Promises a fixed stream of income e.g. corporate bond

Question 4

Real Assets & Financial Assets: Equity

Answer 4

Represents ownership in a corporation e.g. common stock

Question 5

Real Assets & Financial Assets: Derivatives

Answer 5

Provide payoff determined by price of underlying assets e.g. stock, exchange rates, interest rates

Question 6

Other Types of Investments: Currency

Answer 6

One of the largest financial markets
USD 2 trillion traded each day in London alone

Question 7

Other Types of Investments:Commodity and derivative markets

Answer 7

Allows firms to adjust their exposure to various business risks
E.g. corn, wheat, natural gas, crude futures, corn futures

Question 8

Financial Markets and the Economy: informational role

Answer 8

Stock prices largely reflect market participants collective judgement

Question 9

Financial Markets and the economy: Consumption timing

Answer 9

Allows individuals to separate decisions concerning current consumption from constraints imposed by current earnings

Question 10

Financial Markets and the economy: Allocation of risk

Answer 10

Allow risk inherent in all investors to be borne by investors based on their risk preferences

Question 11

separation of ownership and management is called

Answer 11

agency problems

Question 12

mechanism to mitigate agency problems include

Answer 12

Tie managers’ income to success of firm
Oversight from Board of Directors
Monitoring by large investors and security analysts
Takeover threat for poor performers

Question 13

Accounting Scandals 1:

Answer 13

WorldCom: Engaged in massive accounting fraud by improperly capitalizing expenses to inflate profits, leading to a bankruptcy filing in 2002.

Question 14

Accounting Scandals 2:

Answer 14

Enron: Collapsed in 2001 due to fraudulent accounting practices, hiding debts through special purpose entities. This scandal led to the dissolution of its auditing firm, Arthur Andersen.

Question 15

Accounting Scandals 3:

Answer 15

Nortel Networks: Involved in accounting manipulations to inflate revenue, which contributed to the Canadian telecommunications giant’s collapse.

Question 16

Accounting Scandals 4:

Answer 16

Parmalat: The Italian dairy company was involved in a €14 billion accounting scandal in 2003, where fake assets were used to hide its insolvency.

Question 17

Auditors are meant to

Answer 17

serve as independent third parties to ensure that companies’ financial statements are accurate and comply with regulatory standards.

Question 18

Analyst Scandals
During the early 2000

Answer 18

many financial analysts were criticized for biased stock recommendations that misled investors. These analysts were often influenced by their firms’ investment banking relationships, resulting in a lack of independence in their reports.

Question 19

Sarbanes-Oxley Act (SOX) of 2002
The Sarbanes-Oxley Act (SOX) was enacted in response to major corporate and accounting scandals, particularly those involving Enron and WorldCom.

Answer 19

Establishes stricter standards for public company boards, management, and public accounting firms.
Introduces the Public Company Accounting Oversight Board (PCAOB) to oversee auditors.
Requires CEOs and CFOs to personally certify the accuracy of financial statements.
Imposes severe penalties for fraudulent financial activity.
Enhances internal controls to prevent fraud.
Objective: To improve corporate governance and restore investor confidence by increasing transparency and accountability.

Question 20

What is a portfolio?

Answer 20

A portfolio is a collection of investment assets, such as stocks, bonds, real estate, or cash, held to achieve financial goals while managing risk.

Question 21

What is asset allocation?

Answer 21

Asset allocation is the process of dividing investments among broad asset classes (e.g., stocks, bonds, real estate) to balance risk and return.

Question 21

What is security selection?

Answer 21

Security selection involves choosing specific securities, like individual stocks or bonds, within each chosen asset class to optimize the portfolio.

Question 22

What is security analysis?

Answer 22

Security analysis involves evaluating and valuing specific securities to decide if they should be included in a portfolio.

Question 23

What is the “top-down” approach in security analysis?

Answer 23

The top-down approach starts with asset allocation, then identifies specific securities to include within each asset class based on overall portfolio strategy.

Question 24

What is the "bottom-up" approach in security analysis?

Answer 24

The bottom-up approach focuses on finding attractively priced securities based on their individual merits, with less emphasis on asset allocation.

Question 25

Why are financial markets highly competitive?

Answer 25

financial markets are highly competitive because investors continuously seek opportunities, making it difficult to consistently outperform the market without taking on additional risk.

Question 26

What is the risk-return trade-off?

Answer 26

The risk-return trade-off means higher-risk investments typically offer higher expected returns, while lower-risk investments come with lower expected returns. Risk and expected return are positively correlated.

Question 27

What does "there is no free lunch" mean in finance?

Answer 27

It means you cannot achieve high returns without taking on higher risks—every investment comes with some level of risk.

Question 27

What does the Efficient Markets Hypothesis (EMH) state?

Answer 27

The EMH states that the prices of securities fully reflect all available information, making it difficult to consistently outperform the market.

Question 28

How do prices behave in efficient markets?

Answer 28

Prices quickly adjust to all relevant information, leaving little to no room for under-priced or over-priced securities.

Question 29

If markets are efficient, why invest in them?

Answer 29

Even in efficient markets, investing is essential to participate in overall market growth, diversify risks, and achieve financial goals aligned with the risk-return trade-off.

Question 30

What is passive management?

Answer 30

Passive management involves holding a highly diversified portfolio without trying to find undervalued securities or time the market, focusing on long-term returns.

Question 31

What is active management?

Answer 31

Active management seeks to outperform the market by finding mispriced securities and timing the performance of broad asset classes.

Question 32

What is the key difference between passive and active management?

Answer 32

A: Passive management aims for market-level returns with minimal effort, while active management tries to outperform the market through research and market timing.

Question 33

Q: How do firms participate in financial markets?

Answer 33

A: Firms are net demanders of capital, raising funds by borrowing to invest in equipment and other projects needed for growth.

Question 34

Q: How do households contribute to financial markets?

Answer 34

A: Households are net savers and suppliers of capital, purchasing securities (e.g., stocks and bonds) issued by firms to fund their operations.

Question 35

Q: How do governments interact with financial markets?

Answer 35

A: Governments can act as both borrowers (when expenditures exceed tax revenues) and savers (when tax revenues exceed expenditures).

Question 36

Q: What are financial intermediaries, and what is their role?

Answer 36

A: Financial intermediaries, such as investment companies, banks, insurance companies, and credit unions, bring suppliers (savers) and demanders (borrowers) of capital together to facilitate efficient financial transactions.

Question 37

What do investment bankers do?

Answer 37

A: Investment bankers advise companies on the sale of new securities to the public, helping them raise capital and navigate the regulatory process.

Question 38

What is venture capital (VC)?

Answer 38

A: Venture capital is money invested in new, high-potential firms that are not yet publicly traded, often supporting startups or early-stage companies.

Question 39

Q: What is fintech?

Answer 39

A: Fintech refers to the application of technology in financial markets, transforming traditional financial services and reshaping the financial landscape.

Question 39

Q: What is private equity?

Answer 39

A: Private equity involves investments in companies whose shares are not publicly traded on a stock market, often aiming to restructure or grow the business for future profitability.

Question 40

Q: What is peer-to-peer lending, and how does it work?

Answer 40

A: Peer-to-peer (P2P) lending uses technology to directly connect lenders and borrowers, bypassing traditional financial intermediaries (financial disintermediation).

Question 41

Q: What are cryptocurrencies?

Answer 41

A: Cryptocurrencies, like Bitcoin and Ethereum, are digital currencies that allow payments without using traditional channels like credit cards, debit cards, or cheques.

Question 42

Q: What is blockchain technology, and why is it significant?

Answer 42

A: Blockchain technology supports faster, more secure, and anonymous financial transactions, providing a decentralized system for verifying and recording data

Question 43

Q: How did the Fed respond to the 2000–2002 tech bubble, and what was the result?

Answer 43

A: The Federal Reserve aggressively reduced interest rates, which led to a mild and brief recession known as the "Great Moderation," characterized by economic stability.

Question 44

Q: What impact did reduced interest rates have on the housing market?

Answer 44

A: Dramatically reduced interest rates contributed to a historic housing market boom, fueled by the seemingly stable economy and increased borrowing.

Question 45

Q: How did risk tolerance change during this period?

Answer 45

A: There was a greater tolerance for risk, exemplified by the rise of securitized mortgages, as investors sought higher returns in a low-interest-rate environment.

Question 46

Q: What was the "old way" of housing finance?

Answer 46

A: Mortgage loans were issued by banks or credit unions and held as major assets in their portfolios, with liabilities primarily consisting of depositors' funds. This was known as the "originate to hold" approach.

Question 47

What is securitization in housing finance?

Answer 47

Securitization involves pooling mortgage loans and converting them into securities that can be traded like stocks or bonds, providing greater liquidity to lenders.

Question 48

Q: How does the "new way" of housing finance differ from the old?

Answer 48

A: The "originate to distribute" approach replaces the "originate to hold" model, where lenders issue loans intending to sell them to investors through securitization.

Question 49

Q: Why was credit risk underestimated before the crisis?

Answer 49

A: Credit risk was underestimated due to poor credit underwriting, misestimated default probabilities for a different borrower pool, and insufficient risk reduction from geographic diversification.

Question 50

Q: What were the issues with rating agencies and financial products?

Answer 50

A: Rating agencies faced conflicts of interest (agency problems), and the complexity of financial-engineered products like CDOs made risks harder to assess accurately.

Question 51

Q: How did systemic risk contribute to the crisis?

Answer 51

A: The crisis led to systemic risk, where problems in one market caused spillover effects into others. Additionally, the crisis was not limited to the U.S., affecting global markets.

Question 52

Q: What is the Dodd-Frank Act, and when was it passed?

Answer 52

A: The Dodd-Frank Wall Street Reform and Consumer Protection Act, passed in 2010, aimed to prevent future financial crises by introducing reforms to mitigate systemic risk. Some provisions were partially rolled back in 2018.

Question 53

Q: Why was the financial crisis less severe in Canada?

Answer 53

A: Canada’s financial system was more resilient due to the stability provided by universal banks, which benefit from stable funding through bank deposits.

Question 54

Q: What mechanisms did the Dodd-Frank Act introduce to reduce financial risk?

Answer 54

A: It enforced stricter rules for bank capital, liquidity, and risk management, limited risky activities for banks, and increased transparency in derivatives markets.

Question 55

: What role did conservative mortgage lending practices play in Canada’s resilience?

Answer 55

A: Conservative mortgage lending, such as limited sub-prime mortgage lending and mandatory default insurance for mortgages with less than 20% equity, helped prevent widespread defaults.

Question 55

: What role does the Office of Credit Ratings play under the Dodd-Frank Act?

Answer 55

A: The Office of Credit Ratings, created within the SEC, oversees credit rating agencies to ensure accountability and prevent conflicts of interest.

Question 56

Q: What is mandatory default insurance in Canada’s mortgage system?

Answer 56

A: In Canada, mortgages with less than 20% equity require mandatory default insurance, which protects lenders against borrower default, contributing to a more stable housing market.

Question 57

Q: How did the COVID-19 pandemic impact real GDP in 2020?

Answer 57

A: In the second quarter of 2020, real GDP plummeted by 38.5%, reflecting the severe economic contraction caused by the pandemic.

Question 58

Q: What happened to the stock market during the early stages of the pandemic?

Answer 58

A: In March 2020, both the S&P 500 and S&P/TSX indices declined by approximately 33%, marking a significant market drop during the crisis.

Question 58

Q: How did the stock market recover after the initial downturn?

Answer 58

the stock market rebounded quickly due to the swift implementation of aggressive monetary policies and fiscal stimulus measures aimed at supporting economic growth.