Module 1 - Shares & Stock Markets

Question 1

What is an investment?

Answer 1

Current commitment of money or other resources to obtain future benefits. e.g. stocks, house, education.

Question 2

What are real assets?

Answer 2

Assets that determine the productive capacity and net income of the economy. e.g. land, buildings, machines, knowledge used to produce goods and services.

Question 3

What are financial assets?

Answer 3

Claims on real assets. e.g. equity, bonds, derivatives.

Question 4

What is a portfolio?

Answer 4

A collection of assets.

Question 5

What is money?

Answer 5

Anything that is generally accepted in payment for goods or services or in the repayment of debts.

Question 6

Describe 3 traits of money.

Answer 6

Medium of exchange: standardised, widely accepted, divisible, easy to carry, durable.

Unit of account: used to measure value.

Store of value: used to save purchasing power and is liquid.

Question 7

What are financial markets?

Answer 7

Market that bring together those who have excess funds and those who have a shortage of funds.

Question 8

Who are the players in a financial market.

Answer 8

Lenders: those with surplus funds, household (individuals) and some institutions that act on their behalf.

Borrowers, government, firms, individuals, (also foreigners).

Question 9

What are the direct and devolved responsibilities of governments?

Answer 9

Direct: fiscal policy/taxation; national debt management.

Devolved: monetary policy; cash/liquidity management; regulation/

Question 10

What are the 5 roles of financial markets?

Answer 10

Reduction in transaction costs;

Information role (capital flows to companies with best prospects);

Consumption timing (use securities to store wealth & transfer consumption tom the future);

Allocation of risk (investors can select securities consistent with their tastes for risk);

Separation of ownership and management (with stability comes agency problems).

Question 11

What are 5 issues in financial markets?

Answer 11

Corporate governance & corporate ethics;

Accounting scandals (Enron, Rite Aid, HealthSouth);

Auditors (watchdogs of the firms);

Analyst scandals (Arthur Andersen);

Sarbanes-Oxley Act (tighten the rules of corporate governance).

Question 12

What are financial intermediaries?

Answer 12

Entities that bring those with countervailing needs together (lenders and borrowers). They pool and invest funds e.g. investment companies, banks, insurance companies, credit unions.

Question 13

What is asset transformation?

Answer 13

The process of creating a new asset (loan) from liabilities (deposits) with different characteristics by converting small denomination, immediately available and relatively risk free bank deposits into loans–new relatively risky, large denomination asset–that are repaid following a set schedule.

Question 14

Describe money markets.

Answer 14

Short term, low risk, highly liquid debt securities e.g. T-bills.

Question 15

Describe capital markets.

Answer 15

Long term, debt markets e.g. government bonds, commercial paper. Equity markets, e.g. shares.
Derivative markets for future and options.

Question 16

Describe primary markets.

Answer 16

Used for the issue of new stocks, bonds or other securities to the public (IPO).

Question 17

Describe secondary markets.

Answer 17

Where these securities (from primary markets) are subsequently traded markets, e.g. LSE, NYSE, NASDAQ.

Question 18

Describe 4 characteristics of secondary markets.

Answer 18

Broad (wide variety of different types of investors);

Deep (small adjustment of price from previous trade);

Liquid (ease and speed with which a position can be taken, or unwound);

Efficient.

Question 19

Describe the 4 internal participants of secondary markets.

Answer 19

Brokers: agents, take orders from investors, submit them to the market trading mechanisms and charge commissions;

Dealers: principal traders, post bid-ask quotes by choice;

Market-makers: principal traders, obliged to trade in securities in which they are registered;

Broker-dealers: can act both as agents & principals (dual-capacity trading).

Question 20

Describe 2 parts of the investment process.

Answer 20

Asset allocation: choice among broad asset classes;

Security selection: choice of which securities to hold within asset class. security analysis to value securities & determine investment attractiveness.

Question 21

Name 3 types of financial assets.

Answer 21

Fixed income or debt;

Common stock or equity;

Derivative securities.

Question 22

Describe fixed income.

Answer 22

Payments fixed or determined by a formula.
Money market debt: short term, highly marketable, usually low credit risk.
Capital market debt: long term bonds, can be safe or risky.

Question 23

Describe common stock.

Answer 23

Equity or ownership in a corporation. Payments to stockholders not fixed, but depend on the success of the firm.

Question 24

Describe derivatives.

Answer 24

Value derives from prices of other securities, e.g. stocks and bonds. Used to transfer risk.

Question 25

Describe 4 types of markets.

Answer 25

Direct search (buyers & sellers seek each other)

Brokered markets (brokers search out buyers & sellers)

Dealer markets (dealers have inventories of assets from which they buy and sell)

Auction markets (traders converge at one place to trade).

Question 26

Describe ‘bid’.

Answer 26

The price to buy the securities by a participant.

Question 27

Describe ‘ask’.

Answer 27

The price asked for by the participant to sell the security.

Question 28

Describe ‘touch’

Answer 28

The difference between bid and ask spread.

Question 29

What determines the bid-ask spread?

Answer 29

Information asymmetry, volatility of the asset, liquidity of the asset, competition, exchange restrictions.

Question 30

What are call (batch) markets?

Answer 30

Auction markets where buyers & sellers submit their orders in some manner & a process begins to match them (open outcry, written order entry).

Question 31

What are continuous markets?

Answer 31

Non-batch markets where a transaction is allowed whenever two parties agree to trade (dealer or quote-driven markets, order-driven markets).

Question 32

What happens in a quote driven system?

Answer 32

There are quotes, called exposure orders, & traders accepting a quote with a hit order.

Question 33

What happens in an order-driven market?

Answer 33

The type of order that a trader submits depends on the pursued strategy. The main order types used by investors are:
At best (UK)/market (US) order;
Limit order.

Question 34

Why is post-trade anonymity important?

Answer 34

Because otherwise trading strategies can be revealed by small trades.

Question 35

Why is transparency important?

Answer 35

Because the credit risk is borne by the trading parties; i.e. they need to know with whom they are trading.