Investments Ch 1 & 2 Flashcards
Financial assets
Claims to the income generated by real assets; they do not contribute directly to the productive capacity of the economy.
Investment
The current commitment of money or other resources in an expectation of reaping future benefits.
Fixed-income; debt securities
Financial assets that promise either a fixed stream of income or a stream of income determined by a specified formula. Ex: bonds.
Equity
Depends on the context. In accounting and finance, equity represents ownership in any asset after all debts associated with that asset have been repaid. A house with no outstanding debt is considered the owner’s equity because he can readily sell it for cash. Stocks are equity because they represent an ownership shares in a company.
Derivative securities
Contracts that provide payoffs that are determined by the prices of other assets such as bond or stock prices. They’re typically used to hedge risk. Ex: options and futures.
Hedge
Making an investment to reduce the risk of price movements in an asset. An example of a hedge would be if you owned a stock, then sold a futures contract stating that you will sell your stock at a set price, therefore avoiding market fluctuations. Investors use this strategy when they are unsure of what the market will do. A perfect hedge reduces your risk to nothing (except for the cost of the hedge).
Arbitrage
When you simultaneous buy and sell an asset in order to profit from a difference in price. It’s a trade that profits by exploiting price differences of identical or similar financial assets.
Turnover
The ratio of a portfolio’s trading activity to its total shares or assets. A small turnover is desired because it means the investor is paying less in commission to the broker.
Portfolio
An investor’s collection of financial assets such as stocks, bonds, and cash equivalents. Portfolios are held directly by investors and/or managed by financial professionals.
Asset allocation
Choosing among broad asset classes such as stocks vs bonds, or safe assets vs risky assets.
Security selection
Choosing the particular securities to include in the portfolio.
Security analysis
Determining correct value of a security in the marketplace.
Top-down investing
Top-down investing starts with asset allocation before security selection.
Bottom-up investing
Bottom-up investing starts with security selection before asset allocation.
Risk-return trade-off
Investors must take on greater risk if they want higher expected returns.
Efficient market hypothesis (EMH)
The efficient market hypothesis is an investment theory that states it is impossible to “beat the market” because stock market deficiency causes existing share prices to always incorporate and reflect all relevant information.
Passive management
Buying a well-diversified portfolio to represent a broad-based market index without attempting to search out mispriced securities.
Active management
Attempts to achieve portfolio returns more than commensurate with risk, either by forecasting broad market trends or by identifying particular mispriced sectors of a market or securities in a market.
Financial intermediary
An institution such as a bank, mutual fund, investment company, insurance company, or credit union that serves to connect the household and business sectors so households can invest and businesses can finance production.
Mutual fund
An investment vehicle made up of a pool of funds collected from many investors, operated by money managers, who invest the fund’s capital in securities and attempt to produce capital gains and income for the fund’s investors.
Investment company
Firm that manages and invests the pooled capital its investors who in turn share in the profits and losses.
Hedge fund
You can think of hedge funds as mutual funds for the super rich: its investors have to earn a minimum amount of money annually and have a net worth of more than $1 million. They’re similar to mutual funds in that investments are pooled and professionally managed, but differ in that it’s more flexible and uses more advanced strategies such as leveraged, long, short and derivative positions in both domestic and international markets with the goal of maximizing returns. Plus they’re unregulated (unlike mutual funds) because they cater to these sophisticated investors. “Hedging” is actually the practice of attempting to reduce risk, but hedge funds use tons of different strategies and can actually carry more risk than the overall market, so the name is mostly historical.
Investment Bank
Firms specializing large and complex financial transactions. They assist in raising new capital for companies through underwriting, facilitate mergers and acquisitions, and acting as a broker or financial advisor for institutional clients.
Underwriting
Underwriters (investment bankers) purchase securities from the issuing company and resell them.
Primary market
Where new stock and bond issues are sold to investors.
Secondary market
Where already existing securities are bought and sold on the exchanges or in the OTC market.
Venture capital (VC)
Money invested to finance a new, not yet publicly-traded firm; equity investment in young companies.
Over-the-counter market; OTC market
Where securities are traded in some context other than on a formal exchange such as the NYSE, TSX, or AMEX. So trades made over the phone, through email, or through electronic trading platforms. A stock is usually traded over the counter because the company is small, making it unable to meet exchange listing requirements.
Private equity
Investment in a company that is not traded on a stock exchange.
Securitization
Pooling various types of contractual debt, such as residential mortgages, and selling the debt as bonds, pass-through securities, or collateralized mortgage obligation (CMOs), to investors.
2008 Financial Crisis Explained
Markets rely on Standard & Poor’s to objectively rate debt. But the companies that want a favorable debt rating are the same companies that pay Standard & Poor’s.
Banks wrote a ton of bad mortgages to people they knew were going to default, it’s called predatory lending, then hid those bad mortgages inside good mortgages to shine up the books for S&P, which gave them triple-A ratings.
Then they’d bundle the whole thing and sell the debt to Fannie Mae and Freddie Mac, which is owned by - You and me.
And then the banks bet on those loans defaulting. Not that much different from fixing a college basketball game except a ton of people wind up broke and homeless.
Those people can’t buy things anymore, so businesses start going out of business and more people are broke. When you start eliminating consumers, you start eliminating jobs, which eliminates consumers, which eliminates jobs, which eliminates consumers.
2008 financial crisis
The Federal Reserve had responded to the implosion of the dotcom bubble in 2000-2002 by aggressively reducing interest rates. Then by mid-decade the economy seemed healthy again, and the fear of default was low. The combination of dramatically reduced interest rates and an apparently stable economy fed a historic boom in the housing market. Low volatility and growing complacency about risk encouraged greater tolerance of risk, particularly in the markets for securitized mortgages, mortgage derivatives, and credit default swaps.
By fall 2007, housing price declines were widespread, mortgage delinquencies increased, and the stock market entered its own free fall. In September 2008, the giant federal mortgage agencies Fannie Mae and Freddie Mac were put into conservatorship, Merrill Lynch was sold to Bank of America, and Lehman brothers filed for bankruptcy.
Lehman had borrowed considerable funds by issuing commercial paper, so when it faltered, money market mutual funds across the country rushed out of commercial paper essentially shutting down short-term financing markets. The freezing up of credit markets was the end of any dwindling possibility that the financial crisis could be contained to Wall Street.
