Investments Ch 2 Flashcards
DEFINITIONS
Market Structure
Asset Classes:
Securities Law:
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
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
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.
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
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
MARKET PARTICIPANTs
The two primary stakeholders in equity markets are the issuing firms
and their investors.
Other participants include:
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
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.
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
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
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)
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
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
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
CASH AND MONEY MARKET SECURITIES
- liquid and marketable
- short-term with maturities of one-year or less
- not subject to many risks
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.
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)
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
Repurchase Agreements
Bankers’ Acceptance
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
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.
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
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
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
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.
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
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
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.
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”)
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.
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
BOND RATINGS
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
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
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
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
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
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
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
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
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
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)
MAJOR SECURITIES LAWS
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
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
INVESTMENT ADVISERS ACT OF 1940 (1 OF 2)
- Supports investor protection
- Definition of Investment Adviser has three elements:
- Providing advice to others or issuing reports or analysis regarding
securities - Is engaged in the business of giving advice
- Advice is given for compensation
“For compensation, is engaged in the business of, providing advice
to others or issuing reports or analyses regarding securities.”
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
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)
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.”
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.”
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.
Which of the following firms is most likely to have a higher than average beta?
high tech stock
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?
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.
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.
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.
A business seeking access to capital from investors will sell securities in the:
Primary market.
The primary market for equity and non-treasury fixed-income securities is the means to raise capital for businesses and local governments
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
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.
A U.S. citizen who invests in foreign securities:
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.
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.
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.
The piece of legislation whose purpose is to reduce the volatility in financial markets is most likely the:
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
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
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.
A hedge fund manager pursuing a high-risk portfolio construction strategy is least likely to invest in:
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
Which would most likely be classified as a primary market transaction?
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.
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:
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
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:
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
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:
+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.
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:
$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
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.
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.
