Chapter 1 Introduction Flashcards
Difference between equity and fixed income securities
Fixed income securities have a fixed cash inflow, while equity doesn’t. Also, equity has the ownership of the issuing company while a security doesn’t.
Difference between primary asset and a derivative asset.
A primary asset is an asset that the owner has claim on, while a derivative asset has a payoff depending on a primary asset, but the owner does not have claim over the asset.
Difference between asset allocation and security selection
Asset allocation: the allocation of an investment portfolio across a wide range of assets.
Security selection: the selection of a security within a class of assets.
What are agency problems and how to solve them
Agency problems happen when the management and owner’s interest don’t align. It can be solved through performance-based compensation plans or penalty for poor performance in stock price.
Difference between real and financial assets.
Real assets: Tangible or intangible assets used to produce goods or services.
Financial assets: A claim to the real assets and the income generated
How does investment banking differ from commercial banking
Commercial banks can profit from providing services and also taking risks.
Investment banks can only profit from providing services.
What reforms to the financial system might reduce its exposure to systemic risk.
The Dodd-Frank Wall Street Reform and Consumer Protection Act proposed several mechanisms to mitigate systemic risk.
The act attempts to limit the risky activities in which the banks can engage and calls for stricter rules for bank capital, liquidity, and risk management practices.
The act seeks to unify and clarify the lines of regulatory authority and responsibility in government agencies and to address the incentive issue by forcing employee compensation to reflect longer-term performance.
It also mandates increased transparency, especially in derivatives markets
Why do financial assets show up as a component of household wealth, but not of national wealth? Why do financial assets still matter for the material well-being of an economy?
Because the financial assets represent a claim of a real assets, which is already a component of national wealth. This avoids double counting.
The financial assets are important since they drive the efficient use of real assets and help us allocate resources, specifically in terms of risk return trade-offs.
Advantages and disadvantages of “fixed salary” to solve agency problems.
A fixed salary will drive the manager to seek stability and sustainability of the firm but does not motivate the manager to act in the best interest of the firm.
Advantages and disadvantages of “Stock in the firm that must be held for 5 years” to solve agency problems.
When the stock must be held for five years, the manager has less of an incentive to manipulate the stock price, but motive the manager to act in the firm’s best interest. However, if stock compensation is used too much, the manager might view it as overly risky since the manager’s career is already linked to the firm.
Advantages and disadvantages of “A salary linked to the firm’s profits” to solve agency problems.
This creates incentives for managers to contribute to the firm’s success. However, this may also lead to earnings manipulation or accounting fraud.
Why don’t individual investors in the firm have the same incentive as large institutional investors or creditors to keep an eye on management.
Even if an individual investor has the expertise and capability to monitor and improve the managers’ performance, the payoffs would not be worth the effort, since his ownership in a large corporation is so small compared to that of institutional investors.
In contrast, a bank that has a multimillion-dollar loan outstanding to the firm has a big stake in making sure the firm can repay the loan. It is clearly worthwhile for the bank to spend considerable resources to monitor the firm.
Wall Street firms have traditionally compensated their traders with a share of the trading profits they generated. How might this practice have affected traders’ willingness to assume risk? What agency problem can this practice can engender?
Since the traders benefited from profits but did not get penalized by losses, they were encouraged to take extraordinary risks. Since traders sell to other traders, there also exists a moral hazard since other traders might facilitate the misdeed. In the end, this represents an agency problem.
Why would you expect securitization to take place only in highly developed capital markets?
Securitization requires access to many potential investors. To attract these investors, the capital market needs:
- Strong business laws; low probability of confiscatory taxation/regulation;
- A well-developed investment banking industry;
- A well-developed system of brokerage and financial transactions;
- Well-developed media, particularly financial reporting.
What would you expect to be the relationship between securitization and the role of financial intermediaries in the economy?
The default risk of loans and mortgages shift from the financial intermediaries to the investors, and since the intermediates no longer bear the default risk, their role and motivation in assessing and monitoring the quality of the borrowers is mitigated.
