Investments Ch 2

Question 1

DEFINITIONS

Market Structure

Asset Classes:

Securities Law:

Answer 1

DEFINITIONS

Market Structure:
A description of market types, market participants,
and market organizations

Asset Classes:
Groupings of investments that are exposed to similar
risks and are subject to similar laws and regulations

Securities Law:
Federal laws that govern securities markets and
securities treading

Answer 2

PRIMARY MARKET FOR TREASURY SECURITIES
* Issued in an auction
* Competitive bids are placed by a group of investment bankers.
* Non-competitive bids are placed by any other investor.
* The yield on a specific issue is set by the lowest competitive bid.
* Individual investors can purchase Treasury securities through
Treasury Direc

Answer 3

PRIMARY MARKET FOR TREASURY SECURITIES

• Issued in an auction
• Competitive bids are placed by a group of investment bankers.
• Non-competitive bids are placed by any other investor.
• The yield on a specific issue is set by the lowest competitive bid.
• Individual investors can purchase Treasury securities through
  Treasury Direct.

Answer 4

PRIMARY MARKET FOR STOCK AND BOND ISSUANCE

• Businesses and municipal governments raise capital in the primary
  market.
• Investment banking firms act as intermediaries
• The underwriting agreement between the issuer and the investment banking firm is either:
• Best efforts
• Firm commitments

Answer 5

SECONDARY MARKET

• Exists for the subsequent purchase and sales of securities that were
  issued in the primary market
• The trading volume activity reported daily on the DJIA or S&P500 are
  from secondary market transactions.
• Provides an opportunity for investors to trade securities
• Provides marketability for securities obtained in the primary market

Question 6

MARKET PARTICIPANTs

The two primary stakeholders in equity markets are the issuing firms
and their investors.

Other participants include:

Answer 6

MARKET PARTICIPANTS

The two primary stakeholders in equity markets are the issuing firms
and their investors.

Other participants include:

• Broker-Dealers
• Securities Exchanges
• Individual Advisers
• Financial Institutions
• Self-Regulatory Organizations
• Transfer Agents

Answer 7

BROKER-DEALERS

• Individuals or firms that buy and sell securities, either for their
  clients or for themselves.
• Broker-dealers perform multiple functions in equity markets,
  including providing and publishing investment advice, supplying
  liquidity in the market, and helping firms raise capital.
• Broker-dealers are regulated by the Securities and Exchange
  Commission and are required to register with FINRA.

Answer 8

SECURITIES EXCHANGES

SECURITIES EXCHANGES
* Secondary markets exist through the functions of securities
exchanges

Organized Exchanges
* Now engaged in mostly electronic trading, they continue to keep the physical locations
* Example: NYSE

Over-The-Counter Markets
* Created to trade securities that were not listed on an exchange
* OTC markets use decentralized trading that consists of broker-
dealers publishing their bid and offer prices
* Example: NASDAQ exchange

Answer 9

INVESTMENT ADVISERS

Investment Advisers
* Individuals or firms that give investment advice to their clients

Financial Institutions
* Perform underwriting services in the primary market and aid firms
and governments in their efforts to raise capital

Answer 10

SELF-REGULATORY ORGANIZATIONS

• Private non-governmental organizations that have limited authority
  to enforce ethical and fair standards among businesses operating in
  the financial services industry.
• Goals of self-regulation are to:
  –protect investors
  –promote trust among all market participants
  –improve the efficiency in the flow of capital and information
  Example: Financial Industry Regulatory Authority (FINRA)

Answer 11

FINRA

Self-regulatory responsibilities are:
– Writing and enforcing rules governing the activities of all registered
broker-dealer firms and registered brokers in the U.S.
–Examining firms for compliance with those rules
–Fostering market transparency
–Educating investors

Answer 12

TRANSFER AGENTS

• Track the ownership of the securities
• Payers of cash distributions to security holders (dividends, coupon
  payments)
• Exchange shares during mergers and acquisitions
• Handle stock splits and stock dividends
• Mail proxy and annual reports

Answer 13

ASSET CLASSES

• Groups of securities with similar liquidity, marketability, and risk
  levels
• The long-term returns of investors are largely influenced by the
  choice of asset class.
• Some of the key asset classes include:
  –Cash and Money Market Securities
  –Fixed-Income Securities
  –Equities

Answer 14

CASH AND MONEY MARKET SECURITIES

• liquid and marketable
• short-term with maturities of one-year or less
• not subject to many risks

Answer 15

TREASURY BILLS

• Short-term debt obligations of the U.S. government
• 4, 8, 13, 26, and 52-week Treasury bills (T-bills) in denominations of
  $100 are auctioned regularly.
• T-bills are sold at a discount with prices quoted as a percentage of
  the face value.
  Example: A bill sold at 99.125 translates into $99,125 for $100,000
  in par value. At maturity, T-bills pay the face amount. Thus, the
  investor would make $875 from this investment.

Answer 16

COMMERCIAL PAPER

• Firms often issue short-term, unsecured promissory notes called
  commercial paper
• Typically issued in denominations of $100,000 or more
• Maturities are 270 days or less (avoids SEC registration) and are
  often backed by lines of credit from banks
• Maturities are often 45 to 90 days in length
• Commercial paper yields are higher than T-bill yields of similar
  terms (slightly higher default risk and less liquid)

Answer 17

CERTIFICATES OF DEPOSIT (CDs)

• Negotiable CDs (Jumbo CDs) - deposits of $100,000 or more
  placed with banks at a specific stated rate of interest
• Traditional CDs can have much smaller denominations, as low as
  $500, and are sold by many banks. These are non- negotiable and
  do not trade on the open market

Question 18

Repurchase Agreements

Bankers’ Acceptance

Answer 18

REPURCHASE AGREEMENTS

Repurchase Agreements

• Securities dealers use repurchase agreements (repos) to finance large inventories of marketable securities from one to a few days.
• The issuer or seller agrees to repurchase the underlying security at a specific price and specific date. The repurchase price is higher than the selling price.

Bankers’ Acceptance

• Essentially act as a line of credit issued from a bank.
• The bank acts as an intermediary between a U.S. company and a
  foreign company. Companies that are too small to issue commercial
  paper use bankers’ acceptances to fund short-term debt needs.
• These securities usually have slightly higher interest rates than
  commercial paper

Answer 19

SHORT-TERM MUNICIPALS

• States, counties, parishes, cities, towns, and boroughs are
  politically incorporated bodies that have the authority to issue
  bonds.
• These municipalities issue debt instruments ranging in term from 30 days to 30 years. The shorter-term maturities are considered
  money market instruments.

Answer 20

FIXED-INCOME SECURITIES

Bonds
* Represent a form of debt
* An investor of bonds lends funds to the issuer of the bond in exchange for:
–a promise to a stream of periodic interest payments, and
–a repayment of the loaned principal at maturity

Interest (Coupon) Payments
* Generally paid semi-annually
* Coupon payments are based on a percentage of the face value, or par value, of the bond, which is typically $1,000
* Can vary widely and can be as low as zero in the case of zero-coupon bonds

Answer 21

U.S. GOVERNMENT LONG TERM SECURITIES

• Treasury notes are issued with maturities of two, three, five, and ten
  years.
• Treasury bonds are sold with maturities of twenty or thirty years.
• Treasury notes and bonds are coupon securities that pay interest
  on a semi-annual basis.
• Treasury securities are default risk-free

Answer 22

TREASURY INFLATION PROTECTED SECURITIES (TIPS)

• Inflation-indexed Notes and Bonds
• Issued with terms of five, ten, and thirty years
• Minimum purchase is $100 (through Treasury Direct)
• The principal is adjusted for inflation, coupon rate is fixed
• TIPs provide protection from interest rate risk and purchasing power risk
  __________________________________________________________________
  TIPS: EXAMPLE

An institutional investor purchases $500,000 worth of five-year TIPS.
The coupon rate on the note is 4.4%. The semi-annual coupon
payment is $500,000 × (0.044 ÷ 2) = $11,000.

Six months later the CPI increases by 2.1%. The principal is adjusted.
The new principal can be computed as:

$500,000 × 1.021 = $510,500

The higher principal base causes the coupon payments to increase as
well. The adjusted semi-annual coupon payment is now:

$510,500 × (0.044 ÷ 2) = $11,231

Answer 23

MUNICIPAL BONDS

• Municipalities (states, counties, parishes, cities, and towns) issue
  bonds for operations or to finance public projects.
• The interest from municipal bonds is not subject to federal income
  tax (in some cases, not subject to state income tax).
• The yields on municipals are generally lower than that of U.S.
  Treasuries due to this tax treatment.
• The two common types of municipal bonds are general obligation
  bonds and revenue bonds.

Answer 24

GENERAL OBLIGATION and REVENUE BONDS

• The two common types of municipal bonds:
• General Obligation Bonds
  – Full faith and credit
  – Paid by taxes
• Revenue Bonds
  –Specific projects
  –Paid with revenue from project

Answer 25

CORPORATE BONDS

• Corporations raise funds by issuing both equity and debt
  obligations.
• The benefits of using debt instead of equity include:
  –no dilution of equity ownership
  –interest expense deduction
  –obtaining a lower cost of capital
• 5 broad categories
  1. Bank and finance companies
  2. Industrials
  3. Public utilities
  4. Transportation
  5. Internationals

Answer 26

ASSET BACKED SECURITIES

Mortgage-Backed Securities (MBS) and Collateralized Mortgage
Obligations

• MBS are ownership claims on a pool of mortgages.
• Investors purchases mortgages from the originating lender, pool
  mortgages together, and sell interests in the pool to other investors.
• This process of transforming mortgages into securities is called
  securitization.
• MBSs tend to have low credit risk as they are supported by the
  underlying mortgages and the mortgage payments.

Answer 27

MORTGAGE-BACKED SECURITIES

• “Pass-through” securities - monthly mortgage payments are passed
  through to the MBS investors
• Each investor will receive a pro-rata share of principal and interest each month.
• Like other fixed-income obligations, MBS are subject to interest rate risk (due to interest rate fluctuations).
• MBSs are subject to prepayment risk.
• The majority of the mortgage-backed securities have been issued by:
  – Federal National Mortgage Association (FNMA or “Fannie Mae”)
  – Government National Mortgage Association (GNMA or “Ginnie Mae”)
  – Federal Home Loan Mortgage Corporation (FHLMC or “Freddie Mac”)

Answer 28

COLLATERALIZED MORTGAGE OBLIGATIONS (CMOs)

• Like the MBS, a CMO is backed by mortgages.
• Unlike the MBS, the cash flows associated with a pool of mortgages
  are divided into repayment periods called tranches.

Answer 29

RATING AGENCIES

• Bond rating agencies analyze the financial information of
  companies to determine a credit rating for the various debt issues.
• The two largest and most popular rating agencies are:
• Moody’s and Standard & Poor’s

Answer 30

BOND RATINGS

Answer 31

EQUITY: COMMON STOCK

• Represents an ownership interest in a firm
• Shareholders may receive dividends and capital gains from their
  ownership positions.

A firm that generates positive net income can:
–Distribute the earnings to shareholders in the form of dividends or
by repurchasing some of its outstanding shares.
– Reinvest the earnings back into the company in the form of new
projects or improvements to existing product lines

Answer 32

RISKS OF EQUITY SECURITIES

• Equity securities are exposed to:
• Systematic risk (market)
  –Variability in stock return due to changes in economic factors
  – It cannot be diversified away
  – It is measured by B (beta)
• Unsystematic risks (company)
  –Risks that are unique to individual firms, industries, or countries
  –Can be virtually eliminated through diversification

Answer 33

TYPES OF EQUITY SECURITIES: DEFENSIVE

• Stocks that are relatively unaffected by general fluctuations in the
  economy
• MAY provide products and services that are necessary for everyday
  life, such as food, health care and household products
• Demand for these products is inelastic
• Tend to have steady (although slow) growth:
  –Popular during economic recessions
  – Lose popularity during economic booms

Answer 34

TYPES OF EQUITY SECURITIES: CYCLICAL

• Tend to prosper during expanding economic times, do poorly during contracting business cycles
• Highly correlated with the overall stock market
• Typically have higher betas
• Usually have large investments in plant and equipment and,
  therefore, have high fixed costs
• Examples: automobiles, cement, paper, airlines, railroads,
  machinery, and steel

Answer 35

TYPES OF EQUITY SECURITIES: BLUE-CHIP

• Highly regarded quality companies
• Tend to be quality investments with both steady dividend streams
  and relatively consistent capital appreciation
• Usually maintain ability to pay dividends in years the company has
  losses
• Examples: Proctor & Gamble, Home Depot, ExxonMobil

Answer 36

TYPES OF EQUITY SECURITIES: GROWTH

• Issued by companies that have sales, earnings, and market share
  growing at higher rates than the average company or the general
  economy
• Most of the earnings generated by these companies are reinvested
  in the company to support future growth

Answer 37

TYPES OF EQUITY SECURITIES: INCOME

• May be attractive because they make large divided payments
  relative to other companies
• Often are firms in the mature phase of the industry life cycle
• Tend to have a high dividend payout ratio
• Generally, appreciate moderately, but may continue to be profitable
  and grow over time
• Example: Utility companies

Answer 38

TYPES OF EQUITY SECURITIES: INTEREST SENSITIVE

The performance of some companies is significantly affected by
changes in interest rates.

• Rising interest rates increase the cost of debt. Companies that have
  significant debt have increasing interest expense.
• Interest rates may affect the demand for a firm’s products.
• Example: the housing industry. There is greater demand for
  housing when interest rates are low because it is less expensive
  for consumers to purchase homes. When interest rates increase,
  the cost of purchasing homes goes up, causing the demand to
  decline

Answer 39

TYPES OF EQUITY SECURITIES: VALUE

• Stocks trading at prices that are low based on their historical
  earnings and current asset value
• Tend to have low price-to-earnings ratios
• May be currently out of favor in the market

Answer 40

SECURITIES LAWS AND REGULATIONS

The goal of regulatory oversight is to promote:

• Transparency
• Integrity
• Accuracy in financial reporting and decision making
  1929 Stock Market Crash:
• Significant government influence over capital markets began in
  earnest after the market crash in 1929.
• Dow Jones Industrial Average lost $30 billion (which is equivalent to
  approximately $400 billion today)

Answer 41

MAJOR SECURITIES LAWS

Answer 42

SECURITIES ACT OF 1933

• Requires investors receive financial and significant information on
  securities being offered to the public
• Prohibits misinformation or fraud in sale of securities

Answer 43

SECURITIES ACT OF 1934

• The Act created the Securities and Exchange Commission
• The formal goal of the SEC: “to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation”
• Ensure the markets work and is efficient and fair to all participants

Answer 44

INVESTMENT ADVISERS ACT OF 1940 (1 OF 2)

• Supports investor protection
• Definition of Investment Adviser has three elements:

1. Providing advice to others or issuing reports or analysis regarding
   securities
2. Is engaged in the business of giving advice
3. Advice is given for compensation

“For compensation, is engaged in the business of, providing advice
to others or issuing reports or analyses regarding securities.”

Answer 45

INVESTMENT ADVISERS ACT OF 1940 (2 OF 2)

Brochure Rule

• Written disclosure document
• Must be delivered prior to or at the time of entering into an advisory
  contract.
• Includes information about the adviser’s business, conflicts of
  interest, disciplinary history, and other information

Answer 46

EXCLUSIONS FROM DEFINITION OF REGISTERED INVESTMENT ADVISER

• Banks and bank holding companies
• Lawyers, accountants, engineers, and teachers (incidental advice)
• Brokers and dealers (incidental advice)
• Publishers
• Government security advisers
• Other (Credit ratings agencies, family offices, government and
  political subdivisions , non-U.S. advisers)

Answer 47

SUITABILITY STANDARD VS. FIDUCIARY DUTY

• Suitability: Investment must be suitable based on client risk tolerance, time horizon, and objectives.
• Fiduciary: Must place the interest of the client ahead of the adviser’s own interest, disclose conflicts of interest, act in the best interest of the client.
• Registered Investment Advisers (RIAs) have a fiduciary duty to clients, on an ongoing basis.
• SEC Regulation Best Interest (BI) –
  requires that broker-dealers (and their representatives):“act in the best interest of the retail customer at the time the recommendation is made, without placing the financial or other interest of the broker-dealer ahead of the interest of the retail
  customer.”

Answer 48

INDEPENDENT ORGANIZATIONS (1 OF 2)

Independent Organizations:
* Organizations whose goal is to promote integrity within the financial
services industry. These organizations require their members to act
professionally and ethically.

Chartered Financial Analyst Institute Mission Statement:
* “To lead the investment profession globally by promoting the highest standards of ethics, education, and professional excellence for the ultimate benefit of society.”

Global Association of Risk Professionals Mission Statement
* “To be the leading professional association for risk managers, dedicated to the advancement of the risk profession through education, research, and the promotion of best practices globally.”

Answer 49

INDEPENDENT ORGANIZATIONS (2 OF 2)

Chartered Alternative Investment Analyst Association Mission
Statement

• “As the leader in alternative investment education, CAIA Association
  seeks to act as the catalyst for the best and most current
  knowledge and practices in the industry.”
  Certified Financial Planner Board of Standards, Inc. Mission
  Statement
• The mission of Certified Financial Planner Board of Standards, Inc.
  (CFP Board) is to benefit the public by granting the CFP®
  certification and upholding it as the recognized standard of
  excellence for competent and ethical personal financial planning.

Question 50

Which of the following firms is most likely to have a higher than average beta?

Answer 50

high tech stock

Question 51

Wayne owns physical stock certificates that were severely damaged in a recent flood and are unreadable. Which of the following will handle the recovery and replacement of the certificates?

Answer 51

The transfer agent.\

Rationale

Transfer agents perform a variety of general functions. They act as the payers of cash distributions to security holders, exchange shares during mergers and acquisitions, handle stock splits and stock dividends, mail proxy and annual reports, and act as recovering agents to locate lost or damaged certificates.

Question 52

Which of the following transactions is most accurately described as taking place in a secondary market?

The sale of newly issued securities in a biotech firm by an investment bank on a firm commitments basis.

The sale of an engineering firm’s new bond issue by an investment bank on a best efforts basis.

The sale of shares in an electric vehicle company by a director who has owned the shares since the company was founded.

Answer 52

The sale of shares in an electric vehicle company by a director who has owned the shares since the company was founded.

Rationale

As the director owns the shares already and is selling them on, this is an example of a transaction in the secondary market.

In each of the other three choices, a business is raising finance through new issues. These are examples of transactions in the primary market.
The purchase of 2,500,000 of the 140,000,000 million shares issued by a water treatment company in its initial public offering.

Question 53

A business seeking access to capital from investors will sell securities in the:

Answer 53

Primary market.

The primary market for equity and non-treasury fixed-income securities is the means to raise capital for businesses and local governments

Question 54

A firm has $5 billion outstanding in long term bonds. The firm currently has sufficient cash flow to make the scheduled coupon and principal payments but would struggle to make those payments in the future if a substantial weakening of the economy occurs. The most likely rating on these bonds is

Answer 54

BBB.

Rationale

BBB rated bonds are still considered to be investment quality and generally have enough cash flow to make upcoming debt service payments.
The firm, however, is not strong enough to withstand a significant decline in economic output.
In the event of a weakening economy, these bonds will likely be downgraded.

Question 55

A U.S. citizen who invests in foreign securities:

Answer 55

Will not eliminate market risk by purchasing foreign securities.

Rationale

Investment gains will be decreased if the foreign currency weakens in relation to the U.S. dollar.

Investments in foreign securities are subject to country risk, regardless of the number of stocks issued by companies within the same country.

An investor does not need to be a citizen of a country to purchase that country’s government-issued securities.

All securities, including foreign securities are subject to market risk.

Question 56

Which would least likely be classified as an investment adviser by the Securities and Exchange Commission?

A financial analyst who issues a report on the performance of value stocks.

An analyst who recommends a triple A rated bond to a client.

A money manager who makes asset allocation assignments for institutional investors.

A financial firm that acts as a dealer in investment grade bonds.

Answer 56

A financial firm that acts as a dealer in investment grade bonds.
Rationale

Broker dealers are explicitly excluded from being classified as advisers under the legal framework of the Investment Advisers Act. Individuals or firms that issue reports, offer investment advice, including asset allocation decisions, are considered to fit the definition of an investment adviser.

Question 57

The piece of legislation whose purpose is to reduce the volatility in financial markets is most likely the:

Answer 57

Dodd Frank Act of 2010.
Rationale

Dodd Frank was passed as a direct result of the financial crisis of 2008 and was designed to reduce volatility by providing stability within the financial markets. It was written to prevent another collapse of the large financial institutions that performed so poorly during the 2008 crisis

Question 58

Which of the following is not correct concerning Bankers Acceptances?

bankers Acceptances have similar tax treatment to Jumbo CDs.

Bankers Acceptances are subject to capital gains tax since they are negotiable.

Bankers Acceptances are typically used in connection with foreign commerce.

Bankers Acceptances are typically issued by banks on behalf of smaller companies that have weaker credit on their own

Answer 58

Bankers Acceptances are typically issued by banks on behalf of smaller companies that have weaker credit on their own.
Rationale

Bankers Acceptances, used to facilitate foreign trade, are typically issued by banks on behalf of companies that have strong credit on their own because the bank is unwilling to take on the credit risk of companies without a strong credit rating.
Since Bankers Acceptances are negotiable, they are subject to capital gains tax, like Jumbo CDs.

Question 59

A hedge fund manager pursuing a high-risk portfolio construction strategy is least likely to invest in:

Answer 59

Thirty-year Treasury bond.
Rationale

Hedge fund managers invest in higher risk stocks and bonds (remember that even muni bonds can have high default risk) and certainly can use real estate as a portfolio component. A hedge fund manager is not likely to invest in risk-free Treasury bonds

Question 60

Which would most likely be classified as a primary market transaction?

Answer 60

A MBS purchased from an institution that originates the mortgage loans.

Rationale

Primary market transactions are those in which the financial securities are created, which would include the creation of a MBS by the originating institution. The equity and preferred shares, and the corporate bond are examples of secondary market transactions.

Question 61

A large firm operating in the automobile industry issues a bond to finance a profitable expansion into a foreign country. The most likely benefit of the bond issue is a reduction in:

Answer 61

The weighted average cost of capital.
Rationale

Firms have a choice between issuing debt and equity when financing projects. Key benefits of issuing a bond instead of equity include tax advantages, no dilution of ownership, and a potential for lowering the firm’s cost of capital because the YIELD ON THE BONDS IS LESS than the required return on equity

Question 62

A Canadian apple farmer buys fertilizer from a U.S. based firm located near the Canadian border. The apple farmer receives a guarantee of payment from a Canadian bank and sells the guarantee in the secondary market. The risk of the banker’s acceptance depends most likely on the:

Answer 62

Canadian bank.

A banker’s acceptance involves three parties (at least) and

the risk of default depends primarily on the credit rating of the bank issuing the payment guarantee

Question 63

The correlation coefficient between the return on a share of stock operating in the pharmaceutical industry and the return on a Michelangelo painting is likely to be the closest to:

Answer 63

+0.0.

Rationale

Alternative investments such as artwork is very likely to have no statistical relationship with traditional assets such as a share of stock. The correlation coefficient therefore will be close to zero.

Question 64

An investor buys $100,000 in par value of TIPS with a coupon rate of 8%. Inflation during the first six months is 2.4%. The first semi-annual coupon payment is closest to:

Answer 64

$4,096.

Rationale

Semi-Annual CP = (100,000 × 1.024 × 0.08) ÷ 2 = $4,096

or

$100,000 @ 2.40% = $2,400

102,400 @ 8 % = $8,192 /YR = $4,096 / SEMI ANNUAL

Question 65

Which of the following statements regarding federal law is correct?

The Securities Act of 1933 provides for protection from misrepresentation, deceit, and other fraud in previously issued securities.

The Securities Investor Protection Act of 1970 is designed to protect individual investors from losses as a result of brokerage house failures.

The Investment Advisers Act of 1940 requires that person or firms advising others about securities investment must register with the Securities and Exchange Commission.

The Investment Advisers Act of 1940 assures the investor's safety of investment in companies engaged primarily in investing, reinvesting, and trading in securities.

a I, II and III only.
b I and III only.
c II and IV only.
d II and III only.

Answer 65

The correct answer is D.

Options “II” and “III” are correct statements. Option I is incorrect because the Security Act of 1933 pertains to new securities. Option “IV” is untrue because the Investment Advisers Act of 1940 addresses registration requirements and conduct of advisers, but does not deal with investment safety.