MIDTERM Flashcards
SDGs
sustainable development goals
Main problems of SDGs
- extreme poverty/inequality
- sustainability and climate change
- underrepresented populations and discrimination
What do financial markets do?
facilitate the flow of capital from people who HAVE money/excess capital/savings to companies and other institutions who NEED capital
intermediary
a person who helps move money from one side of the financial market to the other
- take the money that asset owners have and put it into productive investments
Why are intermediaries needed?
It would be impossible to sort through and match the needs of millions of institutions, people, and opportunities without them (financial markets are too vast and complex)
Sources/Suppliers of Capital
HNIs, households, asset owners, pension funds, insurance companies, sovereign wealth funds
Users/Demanders of Capital
Governments, companies, startups and entrepreneurs, SPVs, agencies
Which is RISKIER/LESS STABLE: stocks or bonds?
Stocks
Which SHOULD generate higher returns: stocks or bonds?
Stocks
What is the “Golden Rule” of finance?
Higher risks generate higher returns
Most LIQUID asset
Cash
Most ILLIQUID asset
Real estate
3 major types of risks
- Volatility
- Liquidity
- Drawdown/max loss
Volatility
stability/security of returns
ex: stocks are very volatile and risky (higher returns), while bonds are less volatile and more secure (lower returns)
Liquidity
how easily an asset can be converted to cash
- safe if can be sold at any time to gain back money
Drawdown/max loss
The greatest amount of money one can lose from an investment (worst case scenario)
Financial instruments
tradable assets or contracts representing a financial value such as stocks, bonds, and derivatives
Asset classes
categories of assets/investments that exhibit similar risk and return characteristics
Major asset classes
equities (stocks), fixed income (bonds), real estate, private debt, cash, alternative investments, commodities, currencies/cash equivalents
dimensions of financial markets
money vs. capital markets
primary vs. secondary markets
money markets
markets where debt securities with maturities of ONE YEAR OR LESS that generate safe, liquid, low returns are sold (SHORT-TERM)
ex: Treasury bills, CDs, Federal Funds
capital markets
markets where securities with maturities of ONE YEAR OR MORE with a variety of risk-return profiles are sold (must bigger than money market)
primary markets
market where NEW securities are created for the first time
- IPOs (initial public offerings)
- investors buy securities DIRECTLY from the issuer
secondary markets
market where investors buy and sell securities that have ALREADY been issued
- Stock Market (NYSE and Nasdaq)
- investors buy and sell securities from EACH OTHER
Major player in the money markets
BANKS
Regulators of banks
Federal Reserve, OCC, FDIC
Major players in capital markets
Investment banks, asset management firms, brokers/dealers (intermediaries)
Global reserve currency
U.S. dollar
Pension funds
Pools of contributions from workers and employers invested for financing retirement benefits
Types of pension funds
defined contribution and defined benefit
endowments and foundations
funds a certain institution has to reinvest and use to run itself (typically through philanthropic donations)
- returns from investments pay for part of the operations, as well as specific causes and projects
Insurance companies
financial institutions that provide life and property/casualty insurance to individuals and corporations and invest “excess” premiums
Types of insurance
life, health, property, travel, auto… etc.
Sovereign wealth funds
funds where low pop. countries that have made a profit from natural resources
Purpose of sovereign wealth funds
supports long-term economic resilience and preserves multi-generational wealth
How much bigger are markets than GDP?
4-5 times
- US market: $120 trillion
US GDP: $27-30 trillion
Two major instruments of capital
Debt and equity
Debt
A bond or loan that promises to repay a fixed amount in a given amount of time + interest
- CONTRACTUAL
Equity
the value of an asset or ownership after subtracting debts and liabilities
ex: stocks
Which is issued more (debt or equity) and why?
Debt because it matures and needs to be reissued while equity is perpetual
Sides within financial markets
Buy Side and Sell Side
Buy Side
Entities that manage portfolios, usually in the form of commingled funds, as fiduciaries for asset owners
- the asset management industry!!
Clients of the buy side
asset owners
products of the buy side
commingled funds
Commingled funds
Funds in which each is its own legal entity and a variety of investors can come in and invest in
- same rules and targets for each
diversification
process of reducing risk and generating consistent returns by investing in various asset classes with different risk and return profiles
Examples of diversification
cautious vs. aggressive
safe vs. risky
low contribution vs. high contribution
asset correlation
a measure of how different investments/assets move in relation to one another
positive correlation
assets that move up and down TOGETHER
- investing in positively correlated assets INCREASES RISK
negative correlation
assets that move in DIFFERENT directions
- investing in negatively correlated assets REDUCES RISK
How do asset owners make allocation decisions?
- determine how much they can afford to risk, what returns they need, what asset classes they want to invest in, and the requirements and parameters
- select the right asset manager for each strategy/asset class
What do asset managers do?
asset managers have a FIDUCIARY DUTY to maximize returns according to asset class and returns promised to client
- must have best interest and are responsible for delivering highest returns possible
How are asset managers chosen?
Based on TRACK RECORD and PERFORMANCE
- Their reputation depends entirely on past results and how good they are at generating consistently high returns
Risk and Return Spectrum
what we THINK risk and return will be
- forecasts are never fully accurate, otherwise everyone would put all their money is risky investments to get high returns
What ACTUALLY decides risk and return?
market perception, news, panic, human behavior
Sharpe Ratio
Returns per unit of risk
What is the Sharpe Ratio used for?
to measure/evaluate performance of an asset manager
What can influence model analysis and portfolio accuracy?
Events that influence the ENTIRE economy
ex: COVID
Why do only 10-20 asset managers become dominant in each strategy? And why is it difficult for newcomers to be very successful?
Because SUCCESS BREEDS SUCCESS
- winner takes most
- virtuous cycle that is difficult to change
- hard for new imprints to break in because they need scale and are competing with already successful experts
How private are investment returns?
NOT AT ALL –> completely transparent, repeatable, and scalable
- proven teams and processes that work
Front-running
When an asset manager buys ahead of their client/investor for their company or own self-interest
- violates fiduciary duty and not legally allowed to do this
How many funds do asset management companies (AMC) manage?
From a few to hundreds
open-ended funds/traditional
funds that anyone can buy or sell in at any time
ex: mutual funds, long only managers
close-ended funds/alternative
funds that are only open at specific times and to specific investors
ex: private capital firms, HEDGE FUNDS
What type of client do close-ended funds want?
qualified, sophisticated investors
HNIs
high net worth individuals
mutual funds
funds that pool money from retail investors to buy public securities like stocks or bonds
- investors purchase directly based on NAV (net asset value) that is calculated and released at the end of each day
PASSIVE mutual funds
investments WITHOUT discretionary choices by managers that grow FASTER than active funds because active managers aren’t able to actually outperform the market consistently
- CHEAPER
ACTIVE mutual funds
investments that involve discretionary action from managers that promise to outperform the market and generate alpha
- HIGHER FEES
- not very reliable and not always worth the extra money because difficult to ensure consistently
What does it mean to “create alpha”?
to outperform the market
How can active managers outperform (create alpha)?
- better stock picking (hit rate)
- better trading (timing)
- persistence and consistency
(what you pick, when you pick it, and how often you are able to actually succeed - cannot just be a one time thing or due to pure chance)
Efficient Market Theory
States that it is IMPOSSIBLE to consistently outperform the markets and that active funds are a waste of time and money
- over the long run, wasting time to pick specific stocks and trying to time the market right is inefficient and highly unlikely
- best way to generate consistent returns and be efficient is through PASSIVE funds
hedge funds
a type of investment pool that solicits funds from HNIs and institutional investors that offers a more customized risk and return profile for HIGHER fees
- need to be a QUALIFIED investor to invest
Do hedge funds work?
NO!!
- on average, they make LESS money than the risk free rate
- usually do not workout for the INVESTOR and instead only profitable for the MANAGER (who benefits either way)
- NOT WORTH the high fees
- LOTTERY TICKET –> past performance does NOT guarantee future results (inconsistent)
“2+20”
Typical fee structure for the hedge fund industry
- 2% management fee
- 20% performance fee
ETFs (exchange-traded funds)
similar to mutual funds but are instead traded like stocks throughout the day
- price fluctuates like individual stocks
What is the attraction of ETFs?
lower fees, great liquidity, easy to transact, tax-efficient
What are the main growth areas in the financial markets?
- ETFs
- high AuM, low fees
- alternative funds
- low AuM, higher fees
- favors EXTREMES
- low AuM, higher fees
BlackRock
largest asset manager in the world ($10 trillion AuM)
- manages PUBLIC funds like ETFs that anyone can invest in
Blackstone
largest management firm for ALTERNATIVE managers
- way more profitable (higher fees) and growth area
Which is growing faster, BlackRock of Blackstone, and why?
Blackstone because despite having less AuM, alternative fees are higher are more profitable and have a greater market value
US Sustainable Investment
Based on emissions/affluence, US SHOULD be contributing $30 trillion towards sustainable development, but is only contributing about $8 trillion
- not even 1/3 contribution despite possessing nearly half of the world’s assets (responsibility)
John Bogle/Vanguard
PASSIVE is the way to go
- designed to benefit INVESTORS and NOT just the MANAGERS
- believed active cannot work because as markets get more efficient (technology, algorithms), it becomes incredibly difficult to get an information advantage (someone will have already figured it out) –> hard to become successful as an active manager
- average fee 0.06%! (about 10% of what active funds charge)
- now the SECOND LARGEST FUND MANAGER IN THE WORLD (after BlackRock)
Venture capital firms
provide financing for startup companies
- specialize by sector and stage of financing of startup
- create venture capital funds for which they seek investors
Why is the equity market highly regulated?
To protect investors against fraudulent practices
Who regulates the equity market?
The SEC (Securities and Exchange Commission)
Major exchange on which listed stocks are traded
The NYSE (New York Stock Exchange)
Stock specialists
- conduct activities as to maintain a FAIR and ORDERLY market characterized by price continuity and reasonable depth
- required to conduct the auction process
Nasdaq Stock Market
national securities exchange registered with the SEC
- listing requirement for a stock to be traded on it
What exactly is Nasdaq?
a telecommunications network that links thousands of geographically dispersed market-making participants
- many traded are “internalized” –> a broker-dealer firms acts as a market maker in executing on a principal basis the trade of one of its companies
What is a market-maker?
an individual or firm that buys and sells securities to ensure that markets are liquid, efficient, and orderly
- aka designated brokers
bid-ask spread
bid –> the highest price an investor is willing to pay for a share
ask –> the lowest price a seller is willing to sell a share for
broker-dealer firm
a financial institution that buys and sells securities for its own account or for the benefit of its clients
- can act as a broker or dealer –> highly regulated
broker: intermediary between buyer and seller, usually charges a commission
dealer: broker dealer buys and sells securities for their OWN account
Objectives of federal regulation of securities markets
- protect investors
- ensure smooth functioning of market
- reduce systemic risk
insider trading
ILLEGAL trading in breach of fiduciary duty or other relationship of trust and confidence while in possession of NONPUBLIC knowledge about the security –> unfair information advantage
Equity research analysts
the CENTER of the financial markets (involved in BOTH buy side and sell side)
- speak to companies that NEED capital, the buy side that POOLS the capital of the households, and the sell side that INTERMEDIATES the markets for stocks and companies
- compensation based on RANKING SYSTEM
The problems at the heart of the capital markets
ASYMMETRIC INFORMATION
-principal-agent problem
Why is this a problem?
separation of ownership and control creates problem of corporate governance
- SUSPICION/LACK OF TRUST and questioning of intentions
- investors are trusting people that know more than them must have faith that they are being truthful and doing exactly what they should be doing in their best interest
- complex communication game
- INVESTORS CONCERN ABOUT MANAGERS
BUY SIDE TAKEAWAYS
There is a market for risk and return and a lot of credible established benchmarks
- size and scale MATTER
- “it takes 5 years to build a 5 year track record”
- track records don’t lie, money is drawn to returns
- SUCCESS BREEDS SUCCESS
SELL SIDE
CONNECTIVE TISSUE between companies looking to RAISE capital and ASSET MANAGERS (buy side)
- entities involved in the origination, placement, and trading of securities
- help companies RAISE capital
- INVESTMENT BANKS, TRADING FIRMS, market-makers
- originate debt and equity securities
JOB: to generate transactions and trading volume
- VOLUME DRIVEN: more short-term and fast-paced
2 general functions of investment banks
- for DEMANDERS of capital (corporations, government…), investment banks assist in OBTAINING those funds
- for SUPPLIERS of capital (investors/asset owners), investment banks act as BROKERS OR DEALERS in the buying and selling of securities
*** sell side is the CONNECTIVE TISSUE
Types of investment banks
- bank-affiliated investment banks
- independent investment banks
- independent of a large financial service holding company
- full-service investment banks
- engage in MANY investment banking activities
- boutique investment banks
- specialize in one or a few activities
- HIGHLY LEVERAGED COMPANIES
- specialize in one or a few activities
Traditional process (in U.S.) for issuing new securities
- advising the issues on the terms and timing of offering
- buying the securities from the issuer
- distributing the issue to the public (IPO)
Initial Public Offering (IPO)
A common stock offering issued by companies that had NOT previously issued common stock to the public
- PRIMARY MARKET!!
Secondary Common Stock Offering
A common stock offering that had been ALREADY issued in the past by the corporation
- SECONDARY MARKET!!
Privatization
When investment bankers assist in offering securities of government-owned companies to PRIVATE investors
“prop” trading
when the trader positions the capital of the investment banking firm to take advantage of a specific anticipated movement of prices or a spread between two prices
The Volcker Rule
- prohibition/limitation of prop trading
- prohibition of acquiring or retaining an ownership interest in or sponsoring a hedge fund or private equity fund
asset-backed securities
securities backed by a pool of loans or receivables
merchant banking
when an investment banking firm commits its own funds by taking either an equity interest or a creditor position in companies
What is the risk free rate?
the theoretical rate of return on an investment that has NO RISK OF LOSS
- US Treasury bonds!!
Primary types of private equity
buyout funds
growth funds
How can a market be considered operationally efficient?
if it offers investors REASONABLY PRICED services related to buying and selling
Who is fighting against ESG commitments and why?
Right-side conservatives/red states who associate ESG with being “woke” and “liberal”
- it doesn’t align with their political beliefs
- ignorant!
- businesses must do what is RIGHT because there are causes worth fighting for
Who did BlackRock specifically receive criticism and public scrutiny from and why?
- Red states like Texas and West Virginia whose economies depend on the fossil fuel industry
- Republican lawmakers pulled $1 billion worth of investments out of BlackRock
- Climate activists who believe BlackRock is lagging behind on Larry Fink’s leadership and NOT DOING ENOUGh to back up its promises
Larry Fink
CEO and Founder of BlackRock
- Writes annual letters to various stakeholders that have great influence on financial markets (since BlackRock is #1)
- committed to ESG!
sustainable finance
any form of financial service integrating ESG criteria into the business or investment decisions for the lasting benefit of both clients and society at large
Ex: sustainable funds, impact investing, green (and blue) bonds, carbon credits, microfinance
- development of whole financial system in a more sustainable way
Why would a modern company invest in sustainability?
- reputation/brand visibility
- many face backlash/public scrutiny if they don’t
- to keep up with trends and competitors
- considered “embarrassing” not to and facing pressure
- loss of clients/business
- younger generations are DEMANDING ESG consideration, and companies who don’t do so risk alienating an entire generation of clients and talent
- it is the right thing to do and they actually believe in it
Why are sustainable practices NECESSARY for companies like fisheries?
- overfishing depletes available fish stocks
- less business/profit!!
- must allow fish stocks to recover to MAXIMIZE economic yield
- sustainability is worth long term returns
- more revenue generated when there are more fish to sell (must keep population high enough)
SRI Funds
Socially responsible investing funds
Investing using various filters: “positive” vs. “negative” screens
positive –> carefully select BEST investments for portfolio
- “cream of the crop”, top 10%
negative –> filter out WORST-PERFORMING companies or investments from portfolio
microfinance
small, short-term investments to small businesses and entrepreneurs that lack access to banking and related services
Importance/benefits of microfinance
Considered to be BEST way to pull people out of poverty
- supports local economies and provides both access to working capital and opportunities to pay back loans)
Controversies of microfinance
HIGH INTEREST RATES
- must be high to attract investors because perceived as RISKY investments, but makes it difficult for small businesses to pay back and generate a profit
SOLIDARITY GROUPS
- groups of ~12 women that are responsible for paying back each other’s loans if anything happens
- joint and several liability (reduces risk for investor)
Debt-for-nature swaps
a mutually beneficial transaction between a conservation organization and developing countries whereby resources are mobilized for conservation while the debt burden of that country is reduced
- buying a country’s debt in exchange for promise of conservation in that country
- clever use of financial mechanisms to achieve environmental aid and create protected areas
A TRANSACTIONAL Approach to Nature Conservation
Using finance, law, and market mechanisms to maximize sustainable benefits
- ultimately relied on philanthropic donations and concessionary capital
- now seeing transactional to MARKET
conservation easements
protect land for future generations while allowing owners to retain property rights to live on/use their land at the same time
- bundle of rights
- organization like the Nature Conservancy buy the individual right of development and conserve the land forever at a FRACTION of the cost
- reliant on LAW to achieve sustainability
emissions trading
a market-based approach to reduce pollution by setting limits on emissions and trading allowances that authorize emissions
- cap and trade!!
2 fundamental financial statements
- income statement
- balance sheet
- assets at one moment in time
What is an impact bond?
a financial instrument or contractual agreement that pays a return based on agreed upon social or environmental outcomes
- it is a short-term investment that generates a predictable and quantifiable FUTURE SAVINGS
- Pay-for-performance/success
2 types of impact bonds
social and environmental
social impact bonds (SIBs)
short-term investment that will generate a predictable, positive SOCIAL impact
ex: reducing recidivism by investing in the training of prisoners and equipping them w/ skills
- worth the money/effort because reduces crime and BENEFITS SOCIETY
- investors are paid returns if social impact actually occurs as intended (if recidivism decreases)
environmental impact bonds (EIBs)
short-term investments that will generate a predictable, positive ENVIRONMENTAL impact
Who typically invests in impact bonds?
HNIs/rich people who have lots of money to invest because these bonds generate high returns but are VERY risky
Which strategies play the BIGGEST role in financing critical gaps for sustainability?
Public and private debt, venture capital, real assets
Which are LESS important for financing these gaps?
Public and private EQUITY
3 main sides of investment banks
- Global Markets
- Sales and Trading
- Investment Banking
- New issuances, underwriting activity
- Wealth Management
- open platform
** also includes ASSET MANAGEMENT
Investment Banking Industry (Sell Side)
comprised of firms that help companies and government raise capital by issuing debt securities or equity, and then provides an ORDERLY market for those securities to be traded between investors
- investment banks sit BETWEEN asset managers and companies issuing securities (CONNECTIVE TISSUE!!)
Investment Banking
- primary issuance!
Clients: companies and governments who want to raise capital/take advantage of market opportunities
role: to help companies raise capital and advise them on strategic opportunities
Sales and Banking
- secondary issuance!
Clients: asset managers looking to buy or sell assets
Role: provide market information, make markets, take positions, market research
Wealth Management
- private, exclusive banks
Clients: HNIs and small funds/companies
Role: offer portfolio management services, tax/estate planning, and lending
Organization/Culture of INVESTMENT BANKS: How exactly do they operate?
VERY organized and HIERARCHICAL
- goal: move up ladder
- either get paid, promoted, or get out!
- long hours, very competitive and stressful work environment that is TRANSACTION BASED
- everyone working for end of year bonus
- demanding and monotonous work, constant client expectations
- narrow focus on money, feast or famine mentality
Organization/Culture of SALES AND TRADING
big, open trading floor to SECONDARY market debt or equities
- facilitate transactions and provide orderly liquidity
- not as hierarchical or formal
- loud, fast paced, aggressive –> develop street smarts
- more reasonable hours based on market (but no job security!)
- skills not as useful and less deep learning
- becoming more automated
Regulation of Investment Banks
HIGHLY regulated –> always watched and monitored to make sure market is FAIR and ORDERLY
- no unfair information advantages or illegal trading –> must be careful
Regulated by: SEC, FDIC, CFTC, OCC
If power and relevance has largely SHIFTED to the BUY SIDE, why do people and asset managers still bother with banks?
banks have access to MEETINGS and RESEARCH
- they are responsible for new issuances (IPOs)
- asset management firms must be good customers and maintain good relationship with banks to get allocation/shares
Coupang
When finance WORKED THE WAY IT SHOULD
- global involvement
- fastest growing e-commerce company ever
The Great Recession
Huge market meltdown, houses prices fall, no one can get mortgage or car loan, 17 million jobs lost in the US, billions in savings lost (between states, pension funds, and households)
The Rescue/Response
TARP (Trouble Asset Relief Program)
- stabilized financial system and housing market
- bankers got record bonuses
SELL SIDE TAKEAWAYS
TRANSACTIONAL mindset (goal is to increase volumes, make money in the SHORT-TERM)
- high, necessary regulation
- fun, exciting, fast-paced, lucrative, but NOT AS IMPACTFUL
Why has the buy side become more relevant than the sell side?
buy side has become more important because sell side is too TRANSACTIONAL and SHORT-TERM for meaningful innovation
