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