Midterm Flashcards
Personal finance is
the application of principals of finance to the decisions of an individual or family
Economics
provides structure for decision making in many important areas.
Accounting
provides financial data in various forms.
Psychology
tries to explain irrational behaviour of financial market participants
Statistics+Econometrics
tries to quantify risks as well as calculate the probability of the negative events occurring
Commercial Bank
accepts both demand (checking) and time (savings) deposits. Makes loans directly to borrowers or through the financial markets.
Savings Bank
holds savings, deposit accounts. Makes residential real estate loans to individuals.
Credit Union
Deals primarily in transfer of funds between consumers. Membership is generally based on some common bond, such as working for a given employer.
Major Financial Institutions
Commercial Bank
Savings Bank
Credit Union
Mutual Fund
Pension Fund
Insurance Company
Venture Capital Funds
Brokerage Company
Investment Banks
Governmental entities
Mutual Fund
pools funds of savers and makes them available to business and government demanders. Creates a diversified and professionally managed portfolio of securities to achieve a specified investment objective.
Investment Banks
Underwriting (=raising capital)
Mergers and Acquisitions
Sale of securities = brokerage services
Proprietary trading
Research and Consulting
Governmental entities:
Treasury
Central Bank
Depositorium
Financial Markets
- Is a place where buyers and sellers meet and they exchange financial securities/instruments
- Participants in the financial market range over the public, private and government institutions.
Financial Markets classify by:
Nature of claims (equity vs. debt)
Issuer involvement (primary vs. secondary)
Maturity (money vs. capital)
Complexity (simple or derivative)
Time of delivery (spot vs. forward)
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.
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Nature of claims: Equity markets involve buying ownership (stocks) in companies, while debt markets involve lending money to entities (bonds) in exchange for interest payments.
Issuer involvement: In primary markets, securities are directly issued by companies to investors, while in secondary markets, securities are bought and sold among investors.
Maturity: Money markets deal with short-term debt securities (less than one year), while capital markets deal with long-term securities (over one year).
Complexity: Financial instruments in simple markets are straightforward, like stocks and bonds, while in derivative markets, contracts derive their value from underlying assets.
Time of delivery: In spot markets, transactions involve immediate delivery of assets, while in forward markets, delivery occurs at a specified future date.
Structure and Functions of the Financial Markets
Money markets
Capital markets
Money markets
Securities in this market include commercial paper sold by corporations to finance their daily operations or certificates of deposit with maturities of less than 12 months sold by banks.
Capital markets
- Long-term markets
- Securities include common stock, preferred stock and corporate and government bonds.
- Primary – where securities are issued for the very first time.
- Secondary – traded in between the market participants.
Personal financial planning
is the process of managing your money to achieve personal economic satisfaction.
The Financial Planning Process
Step 1: Determine your current financial situation.
Step 2: Develop financial goals.
Step 3: Identify alternative courses of action.
Step 4: Evaluate alternatives.
Step 5: Create and implement a financial action plan.
Step 6: Reevaluate and revise your plan.
Step 1: Determine your current financial situation.
Prepare a list of current asset and debt balances and amounts spent for various items
Step 2: Develop financial goals.
Analyze your financial values and attitudes towards money.
Step 3: Identify alternative courses of action.
Continue as you are, expand or change the current situation, or take a new course of action.
Step 4: Evaluate alternatives.
Take into consideration your life situation, personal values and current economic situation.
Opportunity cost is what you give up by making a choice.
The cost, referred to as the trade-off of a decision, can be measured in money or time
Consider lost opportunities that will result from your decisions.
Evaluate the risks faced
Interest Rate Risk
Changing interest rates affect your costs when you borrow and your benefits when you invest
Inflation Risk
Rising prices cause lost buying power
Liquidity risk
Some investments may be more difficult to convert to cash or sell without significant loss in value
Product Risk
Products or services flawed or not meet your expectations
Retailers may not honour their obligations
Risk of Death
Premature death can cause financial hardship to family members left behind
Risk of Income Lost
Your income could stop as a result of job loss or because you fall ill or are hurt in an accident
Health Risk
Poor health may increase your medical costs, may reduce your working capacity or life expectancy
Asset and Liability Risk
Assets may be stolen or damaged
Others may sue you for negligence or for damages caused by your accidents
Step 5: Create and implement a financial action plan.
Choose ways to achieve your goals
May require assistance from others
Step 6: Reevaluate and revise your plan
Your plan should be reviewed regularly based on your life circumstances
Financial goals are influenced by
Personal values and attitudes towards money
Time frame in which you want to achieve your goals.
Type of financial need that drives your goals.
Your life situation
Factors that influence your financial goals:
Timing of goals.
Goals for different financial needs.
Life Situation takes into consideration personal factors
Social Changes
Other events that influence your life situation include
Timing of goals
Short-term, intermediate and long-term goals.
Goals for different financial needs.
- Consumable products goals
Food, clothing - Durable product goals
Appliances, cars, sporting equipment
Life Situation takes into consideration personal factors
Age, income, marital status, household size, personal beliefs and employment situation
Influences your spending and savings patterns
Social Changes
Married at later age
More households with two incomes
Single parents
Living longer
Other events that influence your life situation include;
Graduation
Engagement and marriage
Birth or adoption of a child
Career change or move to a new area
Dependant children leaving home
Changes in health
Divorce
Retirement
Death of spouse or other family member
life cycle approach to financial planning
Early years (until the mid-30’s)
Middle years (mid-30’s to mid-50’s)
Middle Years (50’s+)
Retirement Years
Early years (until the mid-30’s)
Focus on creating an emergency fund, saving for down payment on house or condo, purchasing life insurance, start thinking about retirement
Middle years (mid-30’s to mid-50’s)
Focus on building wealth by paying down mortgage and increasing savings and investments
Middle Years (50’s+)
Focus is on providing an adequate retirement fund
Retirement Years
Focus is on the efficient management of previously acquired wealth
Common financial goals and activities include
Obtain appropriate career training
Create an effective financial record keeping system
Develop a regular savings and investment program
Accumulate an appropriate emergency fund
Purchase appropriate types and amounts of insurance coverage
Create and implement a flexible budget
Evaluate and select appropriate investments
Establish and implement a plan for retirement goals
Make a will and develop an estate plan
Developing a Flexible Financial Plan
A financial plan is formalized report
Your financial plan can be created by you, done with assistance from a financial planner, or made using a money management software package.
Develop good financial habits.
Achieving your financial objectives requires A willingness to learn and Appropriate information sources
A financial plan is formalized report that…
Summarizes your current financial situation.
Analyzes your financial needs.
Recommends future financial activities.
Develop good financial habits.
Use a spending plan to stay within your income, allowing you to save and invest for the future.
Have appropriate insurance protection to prevent financial disasters.
Become informed about tax and investment alternatives.
Regular banking:
Fees
Variety of services offered
Support and advice, relationship
Physical proximity, working hours
Partnership with your employer
Fees:
a. cash management fee, deposits, withdrawals
b. transfers including international
c. card management
d. account maintenance fees
e. overdraft fee
authorized vs. unauthorized
suggestions: compare the fees, consider bundle plans
Savings options
- Current Account
- Savings Accounts
- Certificate of deposit
- Money market mutual fund
- Treasury bills
- Short duration bond funds
- Precious metals (in countries with unstable political situation or where such payments are normal)
Savings Accounts
a. Time deposit (fixed interest, duration)
b. Savings deposit (can add amounts before maturity)
c. Regular savings deposit (fixed amount every month)
What to keep an eye for:
- desired level of liquidity - ease of getting out
- government insurance/protection
- transaction fees
Latest innovations/ trends
- “Sweep accounts”
- “Save the change”
- Savings accounts bundles - not such a good idea
- Loyalty programs
Sweep Accounts: Automatically move extra cash from checking to investments for higher returns.
Save the Change: Round up purchases to the nearest dollar, saving the difference.
Savings Accounts Bundles: Combining savings accounts with other products, which may not always be beneficial.
Loyalty Programs: Rewards for using a bank’s products or services regularly.
What determines the interest rates on savings: SUPPLY AND DEMAND that is driven by
Supply side
- . economic conditions
- inflation nominal vs. real
- economic growth
- level of consumption
- situation in the capital markets - alternatives
- foreign inflows, currency
What determines the interest rates on savings: SUPPLY AND DEMAND that is driven by Demand side
- banks’ lending situation - economy
- availability of other sources of capital
Is it possible to have a negative interest rate on savings? Why?
This can occur when central banks implement monetary policies to stimulate economic activity, discourage saving, and encourage spending. Negative interest rates effectively penalize banks for holding excess reserves, incentivizing them to lend money rather than keeping it idle.
Estimation methods
70/7 rule of thumb
Debt burden method
Family need
70/7 rule of thumb =
70% of your salary x 7 years to adjust to financial consequences
Debt burden method =
equal to the total amount of the debt your family has
Family need =
methods where you need to cover:
A) 5 x Annual Income
B) + Special needs (college, disability)
C) + Funeral expenses
D) – Liquid assets (savings)
= net result
Stock life insurance
stockholders
Mutual life insurance
policyholders
Choosing the company
You care about:
Financial stability
Reputation
Supervision/regulator
How many claims were met/complaints
Diversification might (not) be a good idea
Policies – Term Insurance“Gyvybės rizikos draudimas”
This is a temporary insurance for a specified period of time (1,5,10 years)
Basic & less expensive
Renewability option
Multiyear level term
Decreasing term
Return of premium
Conversion option
Renewability option
can renew the policy after expiration, usu. with no or minimal medical exam
Multiyear level term
same premium for the whole duration of your policy
Decreasing term
payout will be less than time passes – good for mortgageholders
Return of premium
you get all of premium back (- admin fee) if you outlive your policy
Conversion option
convert into whole life
Policies – Whole Life “Kaupiamasis gyvybės draudimas”
Longer-term, in return for a premium a sum is paid to the beneficiary upon death, however there is a cash value involved
Cash surrender value – amount the policyholder receives if one gives up the insurance, so it’s like savings+insurance combined together
Limited payment - You pay a premium for a predetermined number of years and you have your policy for the rest of your life.
Variable life insurance policy – cash values fluctuate according to the yields earned by the separate fund managed by the insurer
While minimal death benefit is guaranteed cash value could be reduced by the fluctuations in the market
Universal life – similar to VLI, but is more flexible, you can change premiums, make withdrawals
How does it all work?
LT for the above two - Investicinis gyvybės draudimas
Other types of insurance
Group insurance
Endowment life
Credit life
Endowment life
very similar to limited payment, except that the term is shorter – 10,20 years after maturity, not until death
Credit life
equals to the amount of loans one has
Naming the beneficiary; primary and contingent
Grace period
how many days can you delay payment of the premiums without losing your protection
Nonforfeiture clause
requirement that life insurance policies return surplus cash values (if any) to the policy owner if the policy lapses, or is terminated by the policy owner.
Incontestability clause
a clause that prevents the provider from voiding coverage due to a misstatement by the insured after a specific amount of time has passed.
Suicide clause
suicide risk is frequently not covered in the first several years of the policy
Automatic premium loans
if premium is not paid within grace period, it will be taken out of cash value
Policy loan provision
one can borrow from the cash value
Insurance Riders
A rider to a policy modifies the coverage by adding or excluding conditions or altering benefits
Waiver of premium disability benefit – insurer will pay the premiums for you if you become disabled
Accidental death benefit – “double indemnity” – payout is bigger if death occurs because of the accidents
Guaranteed insurability option – can buy any level of insurance without any proof of health
Cost of living protection - purchase additional insurance to cover the rising cost of living.
Accelerated benefits, also called living benefits, pay to those who are terminally ill before they die
Second-to-die option, also called survivorship, insures two lives
How the money is paid out - settlement?
A) Lump-sum
B) Limited installments (“anuitetas”)
C) Life income
D) Proceeds left with the company – trustee – good for bequest motives
FV
future value
PV
present value
I (or r)
interest rate
N (or n)
number of periods
The universal truth of Finance is
The 1 dollar today is worth more than a 1 dollar in a year’s time
Why?
Opportunity costs
Default risk
Inflation
You deposit $1000 in a bank at 10% for 2 years
Simple interest:
Y1: 1000 x 10% =
Y2: 1000 x 10% =
+ 1000 returned =
You deposit $1000 in a bank at 10% for 2 years
Compound interest:
Y1: 1000 x 10% =
Y2: 1100 x 10% =
+ 1000 returned =
Situation: We have $ 2,000 to invest for three years at 6%
What should we do:
You invest 12,000 today at 9% per year. How much will you have after 15 years?
What is the current value of 100,000 after 10 years if the discount rate is 12%
M –
periodic adjustment factor
What will $400 be worth if you invest it for 15 years at 6% per year compounded each six months?
What’s the PV at 9% of $200 paid at the end of years 1,2,3,4,5 ?
Home Buying Process
Assess Types of Housing Available
Single-family dwelling
Multi-unit dwelling
Condominium
Cooperative housing
Multi-unit dwelling
Duplex, townhomes
Condominium
You own your unit in a building of units
It is not a type of building structure, but rather a form of homeownership
Cooperative housing
Non-profit organization - members own shares and rent a unit in a building with multiple units
Manufactured homes
Fully or partially assembled in a factory, and then moved to the housing site
Prefabricated type has components built in the factory and assembled at the site
Mass production under factory conditions keeps costs lower than site built homes
Mobile homes
A type of manufactured home, often <1,000 sq. ft.
Offer same features as a conventional house
Safety is debated and they tend to depreciate
FIND AND EVALUATE A PROPERTY TO PURCHASE
Selecting a Location
Be aware of zoning laws
Assess the school system if you have children.
Two problems of lending
Adverse selection
Moral hazard
Homeownership steps
Once you decide on the mortgage and get the preliminary approval, get some patience, because it is just the beginning
Buy-Downs
Interest subsidy from a home builder or a real estate developer that reduces the mortgage payments for the first few years
Second mortgage
Home is collateral and interest may be tax deductible. Home equity loans are an example
