Chapter 1 - Investments: Background and Issues

Question 1

Define Active Management

Answer 1

Attempting to identify mispriced securities or to forecast broad market trends,.

Question 2

Define Agency Problems

Answer 2

Conflicts of interest between managers and stockholders.

Question 3

Define Asset Allocation

Answer 3

Allocation of an investment portfolio across broad asset classes

Question 4

Define Derivative Securities

Answer 4

Securities providing payoffs that depend on the value of other assets

Question 5

Define Equity

Answer 5

An ownership share in a corporation.

Question 6

Define Financial Assets

Answer 6

Claims on real assets or the income generated by them.

Question 7

Define Financial Intermediaries

Answer 7

Institutions that “connect” borrowers and lenders by accepting funds from lenders and loaning funds to borrowers.

Question 8

Define Fixed-Income (Debt) Securities

Answer 8

Pay a specified cash flow over a specific period.

Question 9

Define Investment

Answer 9

Commitment of current resources in the expectation of deriving greater resources in the future.

Question 10

Define Investment Bankers

Answer 10

Firms specializing in the sale of new securities to the public, typically by underwriting the issue.

Question 11

Define Investment Companies

Answer 11

Firms managing funds for investors. An investment company may manage several mutual funds.

Question 12

Define Passive Management

Answer 12

Buying and holding a diversified portfolio without attempting to identify mispriced securities.

Question 13

Define Primary Market

Answer 13

A market in which new issues of securities are offered to the public.

Question 14

Define Private Equity

Answer 14

Investments in companies that are not trades on a stock exchange.

Question 15

Define Real Assets

Answer 15

Assets used to produce goods and services.

Question 16

Define Risk-Return Trade-Off

Answer 16

Assets with higher expected returns entail greater risk.

Question 17

Define Secondary Market

Answer 17

Previously issued securities are traded among investors.

Question 18

Define Securitization

Answer 18

Pooling loans into standardized securities backed by those loans, which can then be trades life any other security.

Question 19

Define Security Analysis

Answer 19

Analysis of the value of securities.

Question 20

Define Security Selection

Answer 20

Choice of a specific security with each asset class.

Question 21

Define Systematic Risk

Answer 21

Risk of breakdown in the financial system, particularly dude to the spillover effects from one market into others.

Question 22

Define Venture Capital

Answer 22

Money invested to finance a new firm.

Question 23

What are the three broad types of financial assets?

Answer 23

Debt
Equity
Derivatives

Question 24

What are two common markets on which commodities are traded?

Answer 24

New York Mercantile Exchange

Chicago Board of Trade

Question 25

What mechanisms have evolved to address agency problems? 4

Answer 25

• Compensation plans that tie the income of managers to the success of a firm.
• Board of directors forcing out management teams that are under-performing.
• Security analysts and large institutional investors such as pension funds monitor firms closely and make the life of poor performers at the least uncomfortable.
• Bad performers are subject to the threat of takeovers. Unhappy shareholders in principle can elect a different board.

Question 26

What is proxy contest?

Answer 26

Launched by shareholders that allows for the shareholders to vote to allow a firm to be taken over, presumably by someone more capable than the current management.

Question 27

What is needed for markets to operate efficiently?

Answer 27

For investors to be acting on accurate information. To this end the markets need to be transparent for investors to make informed decisions.

Question 28

What two decisions does an investor have to make when constructing their portfolios?

Answer 28

Asset Allocation decision - choosing among broad asset classes
Security Selection decision - The choice of which particular securities to hold within each asset class.

Question 29

Which portfolio construction method starts with asset allocation?

Answer 29

The “Top-Down” method.

Question 30

What portfolio construction method starts with finding attractively priced securities?

Answer 30

The “Bottom-Up” method. There is less concern for the resultant asset allocation.

Question 31

What does diversification mean and what does it do?

Answer 31

When many assets are held in the portfolio.

It limits the exposure to any particular asset and the risk.

Question 32

What are two implications of the no-free-lunch proposition?

Answer 32

Risk-Return Trade off

Efficient Markets

Question 33

Who are the three major players in the financial markets?

Answer 33

Firms - Net demanders of capital
Households - Suppliers of capital.
Governments - Can be borrowers or lenders depending on if they run a deficit or surplus.

Question 34

What is securitization?

Answer 34

The process of buying large quantities of mortgage loans and bundling them into pools that could be trades like any other financial asset.