FoF - Unit 1 Flashcards
The Axioms about investors
- investors prefer more to less
- investors are risk averse
- money paid in the future is worth less than same amount paid today (“time value of money”, opprotunity cost)
Axioms about the market
- financial markets are highly competitive
- no arbitrage condition (“no free lunch”)
Axiom 4: What is the riskless arbitrage you could undertake in financial markets?
having a diverse profile
real assets
assets used to produce goods and services
EX: land, patents, human capital
financial assets
claims to the returns generated by real assets. They allocate the proceeds from a real activity according to pre-determined rules
EX: cash, derivatives, bonds, stocks (2 main)
Derivatives
(contingent claims) on other financial assets (pay a premium). Options, futures, swaps, swaptions.
bonds
paied interest, then face value on maturity date. If company brankupt paid first bc creditors.
Use of Financial Instruments
- Allocation of capital
- Allocation of risk (diversification/hedging)
- Consumption Smoothing (saving-borrowing)
- meeting place for investors with different needs
hedging
a risk management strategy employed to offset losses in investments by taking an opposite position in a related asset (insurance)
Fixed Income Securities (Bonds)
fixed promised cash-flows: coupon/interest payments and principal payments (aka face value)
Ex: treasuries, municipal, and corporate bonds.
Valuation of Bonds
time value of money (TVM) adjustment, credit risk adjustment
Types of treasury bonds:
Treasury bills (less than 1-year maturity)
Treasury notes (1-10 year maturity)
Treasury bonds (10-30 year maturity)
Which bond pays the highest interest rate? A 10-year T-bond or 1-year T-note?
Bond with higher maturity have higher yield, because it has more time. Value of duration. If more risk for a longer time then higher yield.
Municipal Bonds:
Issued by state and local governments.
-Exempt from Federal Income taxes
-Exempt from issuing State local tax (how they attract investors)
Types of Municipal Bonds:
General obligation bonds: backed by the “full faith of credit” of the issuer (taxing power)
Revenue bonds (riskier): Issued to finance specific projects (airports, hospitals, etc.)
A (general obligation) muni bond pays 4% interest. A Treasury bond pays 5% interest. Which bond would you rather buy if your marginal tax rate on interest income is 20%?
Municipal bond
Treasury bond
Indifferent
Treasury bond
What if your marginal rate is higher than 20% and they are equally safe?
Municipal bond
Treasury bond
Indifferent
Municipal bond
Corporate Bonds (risker)
Fixed payments, but subject to default and prepayment risk.
Different “seniority” classes:
Senior, Junior/subordinated.
Types of Corporate Bonds:
Short term: Commercial paper
Long term: Corporate bonds.
Equity
is the residual claim and has control rights on/over the firm
Stock investment is risky because cash flows (dividends) are uncertain. Also risk from changes in liquidity.
Maturity is indefinite, cash flows can occur far away.
Equity Valuation
TVM adjustment + risk adjustment.
Two main classes of equities:
Common stock: voting rights (“junior”) - may have some coupon/fixed income
Preferred stock: non-voting (“senior”)
Derivatives
securities whose cash flows depend on other assets
Derivatives can be written on equity, credit default, interest rates, commodities, exchange rates, etc.
Derivative Valuation
TVM + option adjustment
Call (Put) option
right, but not the obligation, to buy (sell) the underlying asset. At a specified price (strike price)
On a specified date (maturity)
Long Futures
an obligation to buy the underlying asset:
At a specified price,On a specified date.
Two kinds: commodities or financial
Securitization
the process in which certain types of assets are pooled so that they can be repackaged into interest-bearing securities.
Tranches are pieces of a pooled collection of securities, usually debt instruments, that are split up by risk or other characteristics in order to be marketable to different investors
Tranches
Tranches are pieces of a pooled collection of securities, usually debt instruments, that are split up by risk or other characteristics in order to be marketable to different investors
Mutual Funds
financial intermediaries that pool funds from small investors and invest in a diversified portfolio of stocks and/or bonds
WHAT DETERMINES THE PRICE OF A SECURITY?
Equilibrium price is when demand = supply
Supply up if more stocks issued and then drops when people buy stocks
Demand up and down on news
How are new securities sold (“floated”)?
Government securities: typically auctioned
Corporate securities (stocks and bonds), federal agency debt, municipal bonds, mortgage-backed securities: typically underwritten by investment banks
Underwriters
a syndicate of investment banks.
- Firm commitment:
- Best effort:
- Road show and Book-building:
Registration through Securities and Exchange Commission (SEC) (Red Herring Prospectus and Form S-1).
Firm Commitment
Investment banks buys all the securities and takes the risk that it won’t be able to sell all the securities.
Best Effort
investment bank doesn’t purchase the securities but just helps the firm to place as many shares as possible with the public.
Road show and Book-building:
Goal is to trace out an aggregate demand curve. Based on the status of the book, underwriters determine the price and quantity at which they will offer the security to the public.
SECONDARY MARKETS:
Brokers help investors trade without taking positions themselves (no inventory)
Brokers guarantee counterparties that:
- An investor can pay for a security she is buying
- An investor can deliver the security she is selling
Two types of margin requirement:
initial margin: represents the minimum amount an investor must put up to purchase a stock
Maintenance margin: represents the minimum amount required to be maintained in the margin account to maintain an open position
In the US, regulations govern the margin requirement. (Long Position)
the Federal Reserve Regulation T initial margin requirement is 50% and the maintenance margin requirement is 25%
In the US, regulations govern the margin requirement. (Short Position)
the initial margin requirement is 150% and maintenance margin is 130%
Short sales
Selling shares of a firm not owned by borrowing security, and later replacing it (cover it).
A profit is made is the short position is covered at a price lower than the one at which it was established (Bearish investment or as a hedge)
Short Sale Requirements
Short sale proceeds must remain with the broker
The investor is also required to deposit collateral (to post margin) as a guarantee against default. The margin requirement is 50%
Short selling is subject to an uptick rule
Risk in Short Sale:
Over the long term equity markets have a tendency to rise
The standard lending practice is that the securities must be returned on demand. This can lead to a short squeeze
Crowded Short: When a large number of investors short the same security they create a “crowded short.” A rise in the security’s price may induce a number of them to cover their shorts at the same time.
A broker-dealer needs to explicitly obtain the right to borrow securities from one customer before lending them to another.
Most brokerage firms require a stock to be trading above a given price level to be margined, typically $5 to $7 per share. Low-cost shares are almost impossible to borrow.
