Lecture 2 Flashcards
What is the most important actor in the financial market?
Consumer. The consumer is the most important actor in any market economy as they buy and consume products, and use surplus income to purchase financial securities.
Define Limited Liability Partnership (LLP).
An LLP is a partnership where partners limit their fractions of concern/business, and each partner’s liability is limited to what they have invested.
It encourages investment by facing a maximum loss of 100% of what they’ve invested.
What is a corporation in financial markets?
A corporation is a legal entity with limited liability, often organized when broader ownership is desired.
It can enter contracts, and its officers are selected by a board of directors. Corporations can be publicly traded or privately held.
What is a crown corporation?
In Canada, a crown corporation is government-owned but may be set up to offer a service beyond maximizing profitability (e.g., Canada Post). It can sometimes go public, as in the case of Atomic Energy Canada Limited.
Explain the role of banks in financial markets.
Banks operate in capital markets and might grow into investment banks (IB).
They handle a variety of financial services, including managing funds through investment firms.
What are regulators, and give an example.
Regulators ensure the fairness and integrity of the financial markets.
An example includes the Ontario Securities Commission (OSC) and the Securities Exchange Commission (SEC) which oversee market operations.
What is the NPV method used for in finance?
The NPV (Net Present Value) method is used for valuing various investments or projects by discounting their expected cash flows to present value.
Define assets in the context of finance.
Assets are resources owned by a business or individual that are expected to bring future economic benefits.
Historically, assets included physical items like gold, silver, and IOUs, but now they largely consist of contractual assets like stocks and bonds.
What are stocks?
Stocks are financial securities that represent a share of ownership in a company.
They offer the holder a portion of the company’s profits and are typically bought and sold on stock exchanges.
What are bonds?
Bonds are financial instruments that represent a loan made by an investor to a borrower (typically corporate or governmental).
They bind the issuer to pay back the principal along with interest at a predetermined schedule.
What does it mean when an asset is described as “transferable” and “immaterial”?
Assets that are transferable and immaterial can be freely bought and sold without physical exchange, often existing mainly as entries in electronic records or legal documents, rather than as physical items.
Give examples of ancient and modern forms of assets.
Ancient assets included gold, silver coins, and IOUs, while modern assets include stocks and bonds, which are often purely contractual and stored electronically.
What happens to profits retained by a company?
Profits retained by a company are channeled into Retained Earnings on the balance sheet, which increases the value of the firm and thus the share price.
What is a dividend in the context of stock investments?
A dividend is a distribution of a portion of a company’s earnings to its shareholders as decided by the board of directors.
Explain the difference between common shares and preferred shares.
Common shares typically confer one vote per share and might receive dividends variably.
Preferred shares often provide no or limited voting rights but offer more stable dividends and higher priority during bankruptcy liquidation.
What is a treasury share?
Treasury shares are stock that a company has bought back from shareholders.
They do not affect the company’s value like slicing a pizza into fewer slices, each representing the same total pizza.
What is an IPO?
An IPO (Initial Public Offering) is when a company first offers its shares to the public, facilitated by a syndicate of financial intermediaries.
What happens when a company goes insolvent?
If a company becomes insolvent and files for bankruptcy, it must settle all liabilities before shareholders can receive any residual value, making shareholders lower priority compared to debt holders.
What is the Discounted Cash Flow (DCF) method?
The DCF method is a valuation technique used to estimate the value of an investment based on its expected future cash flows, adjusted for the time value of money.
What does the growing perpetuity formula in stock valuation look like?
The growing perpetuity formula for valuing a stock is given by: PV = D1 / (r - g), where D1 is the dividend expected next period, r is the required rate of return, and g is the growth rate of dividends.
Calculate the price of a stock expected to pay a $5 dividend next year that grows at 3% annually with an 11% required return.
Using the formula PV = D1 / (r - g),
substitute D1 = $5, r = 0.11, and g = 0.03:
PV = $5 / (0.11 - 0.03) = $62.50 (Note: slight discrepancy due to rounding in the original calculation).
What is the Discounted Dividend Model (DDM)?
The DDM is a method used to estimate the value of a stock by discounting expected dividends to their present value.
It assumes dividends will grow at a constant rate indefinitely.
How to calculate the value of growth opportunities for a stock?
The value of growth opportunities can be calculated as the difference between the stock price including growth and the price as a constant perpetuity.
For example, if the stock price with growth is $64.31 and without growth is $45.46, the value of growth opportunities is $64.31 - $45.46 = $18.85.
What happens to the stock price in a zero growth scenario according to DDM?
In a zero growth scenario, where g = 0%, the stock price can be calculated as PV = D0 / r. If D0 = $5 and r = 0.11, then PV = $5 / 0.11 = $45.45.
What is a bond in finance?
A bond is a type of debt or liability where the issuer owes the holders a debt and is obliged to pay interest (the coupon) and/or to repay the principal at a later date, termed maturity.
What are the characteristics of bonds?
Bonds typically involve
regular coupon payments,
a fixed interest rate,
a defined term of loan (maturity),
and the repayment of face value at maturity.
They may be zero-coupon, meaning they do not pay periodic interest.
How is the price of a coupon-paying bond calculated?
The price of a coupon-paying bond can be calculated using the formula:
PV = C[1 - (1 + r)^-N]/r + FV/(1 + r)^N, where C is the annual coupon payment, r is the discount rate, N is the number of years to maturity, and FV is the face value of the bond.
What does it mean if a bond is trading at a discount?
A bond is trading at a discount when its market price is lower than its face value.
This typically happens when the bond’s coupon rate is lower than the current market interest rates.
What does it mean if a bond is trading at a premium?
A bond is trading at a premium when its market price is higher than its face value.
This occurs when the bond’s coupon rate is higher than the current market interest rates.
How do interest rate changes affect bond prices?
Bond prices are inversely related to interest rates.
If interest rates decrease, bond prices increase, and vice versa.
This is because the present value of the bond’s future cash flows becomes more valuable as rates fall.
What is the relationship between a bond’s coupon rate and its trading condition at par?
A bond trades at par (face value) when its coupon rate equals the market discount rate.
Explain how a bond price is recalculated when interest rates change using an example.
For a bond with an original price of $859.53, a coupon of $50, and a yield drop from 7% to 4%, the new price would be calculated as the sum of the discounted future cash flows using the new yield, resulting in a higher bond price of $1074.35.
What are GICs (Guaranteed Investment Certificates)?
GICs are fixed income securities issued by sovereigns (governments) that guarantee the return of the principal and a fixed interest rate.
They are considered low-risk and are primarily used for capital preservation.
What are U.S. Treasury Bills (T-bills)?
U.S. Treasury Bills, or T-bills, are short-term government securities that mature in less than a year.
They are issued at a discount from the face value and do not pay interest before maturity.
What is the significance of the yield on Treasuries and GICs?
The yield on Treasuries and GICs is generally low because they are backed by governments and considered very low risk.
Their price is high relative to the payments they promise, emphasizing safety over high returns.
Explain the 100-age rule used in personal finance.
The 100-age rule suggests that individuals should subtract their age from 100 to determine the percentage of their portfolio that should be allocated to stocks, with the remainder in bonds. This rule aims to balance risk and security through life stages.
What is a junk bond?
Junk bonds are bonds rated as below investment grade.
They offer higher yields due to higher risks associated, including the increased likelihood of default.
How can bonds be riskier than stocks?
Bonds typically considered safe can become risky, especially if issued at an extreme discount (deeply discounted junk bonds, for instance).
These bonds may have high yields that are reflective of high risks, potentially making them as risky or riskier than stocks.
What are Bankers’ Acceptances (BAs)?
Bankers’ Acceptances are short-term financial instruments issued by a company but guaranteed by a bank for future payment.
They are often sold at a discount and traded in secondary markets, implying a small positive interest rate.
What is Commercial Paper?
Commercial Paper refers to unsecured, short-term debt issued by corporations to finance their operations.
It is similar to a credit card for the company, sold at a discount to face value, and typically carries a higher risk and therefore a higher return than BAs.
Explain Municipal Bonds.
Municipal bonds are issued by local government entities like cities to fund public infrastructure projects. They often enjoy tax-favored status, meaning the income they generate is tax-exempt or reduced, encouraging investment in these bonds.
What is a unique requirement for Quebec cities regarding municipal bonds?
Quebec cities must issue debt through the provincial government, which has specific policy implications and effects on the municipal financing landscape.
How to calculate the implied effective annual rate of return on a discounted commercial paper?
The formula used is PV = FV / (1 + r)^n.
Rearranging to find r when you know the present value (PV), future value (FV), and the term (n), allows you to calculate the annualized rate of return.
Calculate the implied effective annual rate of return for a commercial paper with a face value of $3 million, sold for $2.7 million, maturing in 4 months.
Using the formula r = [(FV / PV)^(1/n) - 1], where FV = 3, PV = 2.7, n = 1/3 (4 months as a fraction of a year),
r = [(3/2.7)^(3) - 1] = 37.17%.
What is a mutual fund?
A mutual fund is an investment vehicle composed of a pool of funds collected from many investors to invest in securities like stocks, bonds, money market instruments, and other assets.
Mutual funds are managed by professional money managers, who allocate the fund’s assets and attempt to produce capital gains or income for the fund’s investors.
What is the purpose of diversification in mutual funds?
Diversification in mutual funds helps to keep risk (standard deviation) low while maintaining returns by spreading investments across various assets, which can individually have higher costs and risks if purchased alone.
How are mutual funds managed?
Mutual funds are generally managed by finance professionals who are paid fees based on the assets under management (AUM) and potentially performance fees. This encourages fund managers to maximize returns.
What is the Management Expense Ratio (MER)?
The MER represents the total percentage of a fund’s assets that are used for administrative, management, advertising, and all other expenses. A typical MER might be around 2% of AUM annually.
Difference between open and closed mutual funds.
Open mutual funds allow investors to buy or sell their units at any time based on the fund’s current net asset value (NAV).
Closed mutual funds do not allow investors to enter or exit the fund after the initial offering, restricting their ability to sell shares back to the fund.
What is Net Asset Value (NAV)?
NAV is the total value of all the securities held by a mutual fund minus its liabilities, divided by the number of units outstanding. It represents the per-unit value of the fund.
How do market discounts or premiums affect mutual funds?
In well-managed mutual funds, if the market prices fall below the NAV (a discount) or rise above it (a premium), this can indicate that the fund is either undervalued or overvalued relative to its asset base.
This might prompt discussions regarding the efficiency of the fund’s management.
What is an Exchange Traded Fund (ETF)?
An ETF is a type of investment fund and exchange-traded product, i.e., they are traded on stock exchanges. ETFs hold assets such as stocks, commodities, or bonds and generally operate with an arbitrage mechanism designed to keep it trading close to its net asset value, though deviations can occasionally occur.
What is the difference between active and passive management in ETFs?
Active ETFs are managed by portfolio managers who actively select stocks, aiming to outperform the market. In contrast, passive ETFs track a specific index or benchmark, allocating funds according to a preset formula without frequent trading, focusing on stability and lower costs.
Why might a low-cost ETF provide the highest net return?
A low-cost ETF can provide the highest net return even with lower gross returns because the lower expense ratio significantly reduces the amount deducted from returns, thereby maximizing investor profit.
What has been a significant trend in capital movement regarding mutual funds and ETFs?
Over the past few decades, there has been a significant shift of capital from actively managed mutual funds to largely passive ETFs, due to the potential for passive funds to provide better returns compared to the least competent active managers.
How has the variety of ETFs changed in recent years?
The variety of ETFs has exploded, with new offerings now including those that are leveraged, those with low diversification, and those that focus on specific investment styles or sectors, deviating from traditional passive strategies.
Give an example of a popular ETF and what it tracks.
A popular example of an ETF is the SPDR S&P Depository Receipt, commonly known as SPDR S&P 500 ETF. It tracks the S&P 500 index, which comprises 500 of the largest companies listed on stock exchanges in the United States.
What is a hedge fund?
A hedge fund is a high-powered investment vehicle similar to a mutual fund but aimed at accredited investors. It employs more complex and riskier strategies including the use of leverage and derivatives to achieve higher returns.
What are the primary characteristics of hedge funds?
Hedge funds are characterized by high fees, high risk, and high reward strategies. They are accessible only to accredited investors, typically requiring significant initial investments (often above $2M).
What is the typical fee structure for hedge funds?
Hedge funds often employ a “2 and 20” fee structure, charging 2% of assets under management (AUM) and 20% of any profits earned.
Why do investors choose hedge funds despite high fees?
Investors tolerate high fees because some hedge fund managers are exceptionally talented or lucky, managing to deliver high net returns even after accounting for the fees.
How have hedge funds historically served their investors?
Historically, since the 1940s, hedge funds focused on hedging risks for high net worth individuals.
Over time, they have evolved to incorporate more diversified and high-risk strategies to potentially increase returns.
How do hedge funds compare to ETFs?
Unlike ETFs, which are typically low-cost and passive, hedge funds are expensive, actively managed, and aim for higher returns through higher-risk investment strategies.
What is a REIT (Real Estate Investment Trust)?
A REIT is an investment vehicle that allows individuals to invest in large-scale, income-producing real estate.
It operates like a mutual fund for real estate, where investors can earn a share of the income produced through real estate investment without having to buy, manage, or finance any properties themselves.
What types of properties do REITs typically invest in?
REITs may invest in a variety of real estate properties, including commercial real estate like malls, office towers, and distribution centers, as well as residential properties such as old age homes or condominiums.
How do investors in REITs earn returns?
Investors in REITs receive disbursements of rental income and may also gain from capital returns when properties within the REIT portfolio are sold.
What is the tax advantage of investing in REITs?
REITs often have a tax-favored status because part of the payments to investors are classified as capital gains, which are taxed at a lower rate than regular income.
What are derivatives in finance?
Derivatives are financial instruments whose value is derived from the value of one or more underlying entities such as assets, indexes, or conditions.
They can lead to significant profits or losses and are used for various purposes including risk management, speculation, and price discovery.
What are the two types of derivatives based on exercise conditions?
Derivatives can be categorized as either those requiring a choice to exercise, like options, or those that are unconditional, like futures.
What is the underlying in a derivative?
The underlying in a derivative is the asset, index, or other economic variables that determine the value of the derivative.
It can be virtually anything that is contractually agreed upon by the parties involved in the derivative.
Give examples of items that could be considered derivatives.
Beyond traditional financial derivatives like options and futures, other examples include car or house insurance, lay-away plans that are transferable, stock options, rights of first refusal, and even bets on events like sports where the outcome is uncertain.
How are derivatives used in finance?
Derivatives are used for hedging risk, speculating on future price movements, leveraging investments, and facilitating price discovery. They are complex instruments that require a good understanding of the underlying assets and market conditions.
What is the Sharpe Ratio?
The Sharpe Ratio is a measure of risk-adjusted performance of an investment, calculated by subtracting the risk-free rate from the return of the investment and then dividing the result by the investment’s standard deviation.
Formula: SR = (R_i - R_f) / σ_i
How do you interpret the Sharpe Ratio?
A higher Sharpe Ratio indicates a more attractive risk-adjusted return. It shows how much excess return you are receiving for the extra volatility endured for holding a riskier asset.
What are the key components needed to calculate the Sharpe Ratio?
The key components are
the average return of the investment (R_i),
the risk-free rate (R_f),
and the standard deviation of the investment’s excess returns (σ_i).
What does a higher standard deviation imply about an investment’s risk?
A higher standard deviation indicates more volatility and, thus, higher risk. It shows greater variation in the investment’s return over time.
How does the risk-free rate affect the calculation of the Sharpe Ratio?
The risk-free rate (R_f) serves as a baseline for comparing the performance of the risky asset.
By subtracting it from the return of the investment (R_i), the Sharpe Ratio focuses on the additional return earned over what could be earned in a risk-free investment.
What is the significance of where you hold your financial assets?
Where you hold your assets, such as in different types of accounts, can significantly affect aspects like security, tax implications, and growth potential of those assets.
What is an Account in the context of financial investments?
An account is a place where you store financial securities such as stocks, bonds, or mutual fund units. It acts like a safe or treasure cave where your financial assets are held and managed.
Why is tax protection important for investment accounts?
Some accounts offer mechanisms to mitigate or defer taxes on gains from investments, allowing the capital to grow from a larger base and potentially reduce the total taxes paid over time.
How do the characteristics of investment accounts vary?
Investment accounts can vary in terms of accessibility, tax benefits, and protection they provide to the assets. The specifics of these accounts can change regularly and sometimes drastically due to new laws or regulations.
What is a Registered Retirement Savings Plan (RRSP)?
An RRSP is a type of Canadian account where you can place various investments like stocks, bonds, and ETFs.
Contributions to an RRSP can reduce your taxable income, providing tax benefits both at the time of contribution and during retirement.
How do contributions to an RRSP affect your taxable income?
Contributions to an RRSP reduce your taxable income for the year the contribution is made. This reduction can potentially lower the contributor’s tax bracket, resulting in significant tax savings.
What happens when you withdraw from an RRSP?
Withdrawals from an RRSP are added back to your income, increasing it. This means the withdrawn amount is taxable, potentially smoothing taxable income if done during retirement when your income may be lower.
How does the progressive tax system interact with RRSP contributions and withdrawals?
The progressive tax system in Canada means that income is taxed in increasing brackets.
Contributions to an RRSP can reduce taxable income during higher earning years, deferring taxes to years where you may fall into a lower tax bracket, such as during retirement.
What are the marginal tax brackets for federal and Quebec taxes as provided?
Back:
The marginal tax brackets range from 26.53% for income up to $49,275, to 53.31% for income over $235,675.
What is a Registered Retirement Income Fund (RRIF)?
A RRIF is a retirement fund that you must convert your RRSP into by the age of 71. It allows for continued investment growth but requires minimum annual withdrawals, which are taxable.
When must you convert your RRSP into a RRIF?
You must convert your RRSP into a RRIF by the year you turn 71. Alternatively, you can choose to take a lump sum payout instead.
Can you make contributions to a RRIF?
No, you cannot make contributions to a RRIF. Instead, you are required to make minimum annual withdrawals.
How do RRIF withdrawal rates vary?
RRIF withdrawal rates vary by age, starting at a minimum of 4% at age 65 and increasing to 20% by age 95.
This ensures a gradual expenditure of the retirement funds over time.
What is the purpose of mandatory RRIF withdrawals?
The mandatory withdrawals from a RRIF ensure that retirees use and pay taxes on their retirement income throughout their later years, preventing tax avoidance strategies using estates and ensuring the government receives taxes on the income earned.
What is a Registered Education Savings Plan (RESP)?
An RESP is a savings account in Canada that allows contributions to be made for a beneficiary’s education.
Contributions are not tax-deductible, but investment growth and withdrawals used for educational purposes are tax-free.
Who can contribute to an RESP?
Grandparents, parents, and guardians can contribute to an RESP, making it a family-supported plan to invest in a child’s future education.
What is the primary benefit of investing in an RESP?
The primary benefit of an RESP is the ability to grow investments tax-free until withdrawal, which must be used for the beneficiary’s educational expenses.
This can significantly offset the cost of higher education.
What is a Registered Disability Savings Plan (RDSP)?
An RDSP is a Canadian savings plan designed to provide long-term financial security for individuals with disabilities. Contributions are not tax-deductible, but the plan offers income-tested grants and the growth is tax-deferred.
How does the RDSP benefit contributors and beneficiaries?
Contributors can reduce their taxable income through contributions, depending on their income level.
Beneficiaries benefit from the grants and bonds provided by the government, which supplement the contributions made to the RDSP.
What makes RDSP unique compared to other savings plans?
Unlike RRSPs and RESPs, the RDSP includes income-tested grants where the government matches contributions, making it particularly beneficial for families with limited incomes to support individuals with disabilities.
What is a Tax-Free Savings Account (TFSA)?
A TFSA is a Canadian investment account that allows individuals to contribute post-tax income and receive tax-free returns.
Withdrawals from a TFSA are also tax-free, providing flexible and tax-efficient savings opportunities.
How do TFSA contributions and withdrawals affect taxes?
Contributions to a TFSA are made with after-tax dollars and do not provide any tax deductions. However, all gains within the account, including interest, dividends, and capital gains, are tax-free, as are withdrawals.
Are there any restrictions on withdrawals from a TFSA?
While withdrawals from a TFSA are tax-free, there are restrictions on the frequency of withdrawals to avoid it being used for regular income, which could otherwise lead to tax avoidance issues.
How has the maximum annual contribution limit for TFSAs changed over the years?
The maximum annual contribution limit for TFSAs started at $5,000 in 2009 and has varied over the years. It was $5,000 until 2012, increased to $5,500 in 2013, jumped to $10,000 in 2015, then stabilized to $5,500 until 2018, increased to $6,000 from 2019 to 2022, and rose to $6,500 in 2023.
What are the potential economic criticisms of TFSAs?
TFSAs may favor wealth over income by allowing wealthier individuals to benefit more from the tax savings due to their ability to make larger contributions and benefit from compound growth, potentially exacerbating wealth inequality.
What is a pension plan in the context of employment?
A pension plan is an arrangement provided by employers to offer financial benefits to workers after they retire.
The plan’s details, such as contributions and payouts, are often arranged by a plan sponsor, typically the employer.
What are the two main types of pension plans?
The two main types of pension plans are defined benefit plans, where retirees receive a set payment based on salary and years of service, and defined contribution plans, where benefits are based on the contributions made and the investment growth of those contributions.
How do defined benefit and defined contribution plans differ in terms of risk?
In a defined benefit plan, the employer carries the risk of ensuring there are sufficient funds to provide the promised benefits. In a defined contribution plan, the risk shifts to the employee, as benefits depend on investment performance.
What is a defined benefit plan?
A defined benefit plan promises a specific payout at retirement, typically calculated based on factors like length of employment and salary history.
The employer is responsible for managing the plan’s investments and ensuring there is enough money to pay out retirees.
What is a defined contribution plan?
In a defined contribution plan, the employee and/or employer contribute a fixed amount or percentage of the salary into a fund, which is then invested on the employee’s behalf.
The retirement benefit received depends on the fund’s performance, and there is no guaranteed payout.
Why have employers moved away from defined benefit plans in recent decades?
Employers have shifted from defined benefit plans to defined contribution plans mainly due to the financial risk and liability associated with ensuring enough funding for defined benefits, exacerbated by increased life expectancy and the long-term financial commitment required.
What is a 401(k) plan?
A 401(k) plan is a retirement savings plan in the US sponsored by an employer.
It allows employees to save and invest a portion of their paycheck before taxes are taken out. Employers often match a portion of employee contributions.
How does a Roth 401(k) differ from a traditional 401(k)?
Unlike a traditional 401(k) where contributions are made with pre-tax dollars, a Roth 401(k) allows employees to make contributions with after-tax dollars. This means that withdrawals during retirement are tax-free, provided certain conditions are met.
What is an Individual Retirement Account (IRA)?
An IRA is a tax-advantaged retirement savings account in the US that individuals can contribute to independently of their employer.
Contributions may be tax-deductible depending on the type of IRA and the individual’s circumstances.
How is an IRA similar to a Canadian RRSP?
Both an IRA and a Canadian RRSP allow individuals to contribute pre-tax income, which can grow tax-deferred until withdrawals begin, typically during retirement.
What are the penalties for early withdrawal from an IRA compared to an RRSP?
Early withdrawals from both IRAs and RRSPs come with penalties. However, the IRA penalty is a flat 10% plus the income tax due on the amount, which can be more punitive for lower-income individuals compared to the variable rate based on income with an RRSP.
What are the tax benefits of contributing to a Roth 401(k) or Roth IRA?
Contributions to Roth 401(k) and Roth IRA accounts are made with after-tax dollars, but earnings and withdrawals are tax-free, provided they meet specific conditions regarding age and duration of the account.
