Series 65 wk 4 Flashcards
What is economics?
The study of shortages: supply vs. demand
What does a country’s gross domestic product (GDP) measure? What things does GDP include (4)?
The overall health of a nation’s economy.
Defined as the value of all goods and services produced in a country including consumption, investments, government spending and exports minus imports during a given year.
What are the 4 stages of the business cycle?
- Expansion
- Peak
- Contraction
- Trough
What is expansion?
During an expansionary phase, an economy will see an increase in overall business activity and output.
Corporate sales, manufacturing output, wages, and savings will all increase while the economy is expanding or growing.
What is an economic expansion characterized by (5)?
- Increasing GDP
- Rising consumer demand
- Rising stock market
- Rising production
- Rising real estate prices
What is the peak of the business cycle?
As the economy tops out, the GDP reaches its maximum output for this cycle as wages, manufacturing and savings all peak.
What is contraction?
GDP falls, along with productivity, wages, and savings. Unemployment begins to rise, the stock market begins to fall, and corporate profits decline as inventories rise.
What is a trough?
The economy bottoms out in the trough as GDP hits its lowest level for the cycle. As GDP bottoms out, unemployment reaches its highest level, wages bottom out, and savings bottom out.
The economy is now poised to enter a new expansionary phase and start the cycle all over again.
How is a recession defined?
Defined as a period of declining GDP, which last at least six months or two quarters.
Recessions may vary in degree of severity and in duration.
Extended recessions may last up to 18 months and may be accompanied by steep downturns in economic output.
In the most severe recessions, what do falling prices erode? (3)
Businesses’ pricing power, margins and profits erode as deflation takes hold.
What are recessions generally triggered by?
An overall decrease in spending by businesses and consumers. If this happens, demand falls.
Businesses and consumers will often reduce spending as a cautionary measure in response to an economic event or shock, such as a financial crisis or a busting of a bubble in an inflated asset class.
What is a depression?
Characterized by a decline in GDP, which lasts at least 18 months or 6 consecutive quarters. GDP often falls 10% or more during a depression.
A depression is the most severe type of recession and is accompanied by extremely high levels of unemployment and frozen credit markets.
Steep fall in demand is more likely to lead to deflation during a depression.
What are the economic indicators to determine where we are in business cycle?
- Leading indicators
- Coincident indicators
- Lagging indicators
What are leading indicators? What do they include (9)?
Business conditions that change prior to a change in the overall economy (can be used as gauge for the future direction of the economy).
Leading indicators include:
1. Building permits
2. Stock market prices
3. Money supply (M2)
4. New orders for consumer goods
5. Average weekly initial claims in unemployment
6. Changes in raw material prices
7. Changes in consumer or business borrowing
8. Average work week for manufacturing
9. Changes in inventories of durable goods
What are coincident indicators? What do they include (7)?
Coincident indicators are changes in the economy that cause an immediate change in the activity level of coincident indicators. As the business cycle changes, the level of activity in coincident indicators can confirm where the economy is. Coincident indicators include: 1. GDP 2. Industrial production 3. Personal income 4. Employment 5. Average number of house worked 6. Manufacturing and trade sales 7. Nonagricultural employment
What are lagging indicators? What do these include (6)?
Lagging indicators will only change after the state of the economy has changed direction (can be used to confirm new direction of economy). Lagging indicators include: 1. Average duration of unemployment 2. Corporate profits 3. Labor costs 4. Consumer debt levels 5. Commercial and industrial loans 6. Business loans
What are the schools of economic thought (3)?
- Classical economics
- Keynesian economics
- The monetarists
What is classical economics? What is it also known as?
Also called supply side economics
Classical economic theory believes that lower taxes, and less government regulation will stimulate growth and increase demand through higher employment. Less regulation of business creates lower barriers to entry for employers and allows employers to produce goods at lower prices and to create more jobs.
As a result of the lower prices, lower taxes, and higher employment, aggregate demand in the economy will increase, positively impacting the nation’s GDP
What is Keynesian economics?
The Keynesian economic model believes that a mixed economy based on private and public sector efforts will produce desired economic conditions.
Keynesians believe that the decisions made in the private sector can lead to supply and demand imbalances and that an active policy response from the public sector in the form of government spending (fiscal policy) and adjustments to the money supply (monetary policy) is required.
What is monetary economics?
Believe that the supply of money in the economy can influence the direction of the economy and prices as a whole.
During times of low demand and high unemployment the economy can be stimulated by increasing the money supply. As more money enters the system interest rates fall increasing demand. As more money enters the system the value of the currency tends to decline and during times of expansionary monetary policy inflation may increase.
What two tools does the government have that it can use to try to influence the direction of the economy?
Monetary policy - controlled by Federal Reserve Board - determines the nation’s money supply
Fiscal Policy - controlled by the president and Congress - determines government spending and taxation.
How does the Federal Reserve Board try to steer the economy? What actions can it take (6)?
Tries to adjust the level of money supply and interest rates.
The Fed may:
1. Change the reserve requirement for member banks
2. Change the discount rate charged to member banks
3. Set target rates for federal fund loans
4. Buy and sell US government securities through open-market operations
5. Change the amount of money in circulation
6. Use moral suasion
What are interest rates? What are the 4 types?
“the cost of money”; Overall interest rates are determined by the supply and demand for money, along with any price movement in the cost of goods and services, known as inflation.
The key interest rates which all other rates depend:
1. Discount rate
2. Federal funds rate
3. Broker call loan rate
4. Prime rate
What is the discount rate? What is bank free to do?
The interest rate that the Federal Reserve Bank charges on loans to member banks. A bank may borrow money directly from the Federal Reserve by going to the discount window, and the bank will be charged the discount rate.
Bank is free to lend out this money at a higher rate and earn a profit, or it may use these funds to meet a reserve requirement shortfall. Although a bank may borrow money directly from the Federal Reserve, this is discouraged, and the discount rate has become largely symbolic.
What is the federal funds rate? What is this an indicator of?
Rate that member banks charge each other for overnight loans. The federal funds rate is widely watched as an indicator for the direction of short-term interest rates?
What is the broker call loan rate?
The broker call loan rate is the interest rate that banks charge on loans to broker dealers to finance their customers’ margin purchases.
Many broker dealers will extend credit to their customers to purchase securities on margin.
The broker dealers will obtain the money to lend to their customers from the bank, and the loan is callable or payable on demand by the broker dealer.
What is prime rate?
The rate that banks charge their largest and most credit-worthy corporate customers on loans.
Prime rate has lost a lot of its significance in recent years because mortgage lenders are now basing their rates on other rates, such as 10-year Treasury note. The prime rate is, however, very important for consumer spending, because most credit card interest rates are based on prime plus a margin.
What is Reserve requirement? How does increasing or decreasing the reserve requirement affect the economy?
The reserve requirement is a percentage that the member banks must keep of their depositors’ assets in an account with the Federal Reserve. (intended to ensure that all banks maintain a certain level of liquidity)
If Fed wanted to stimulate economy, it might reduce the reserve requirement for the banks which would allow the banks to lend more (by making more money available to borrowers, interest rates will fall and demand will increase)
If Fed wanted to slow down the economy, it might increase the reserve requirement (make less money available to borrowers, interest rates would rise as a result and the demand for goods and services would slow down.)
Why would the Federal Reserve Board change the discount rate?
In an effort to guide the economy.
Discount rate is the rate that the Fed charges member banks on loans.
If Fed wants to stimulate the economy, it would reduce the discount rate (as discount rate falls, all other interest rates fall with it, making cost of money lower).
If Fed wanted to slow the economy down, it would increase the discount rate. As the discount rate increases, all other rates go up with it, raising the cost of borrowing.
What is the Federal Open Market Committee (FOMC)?
The Fed’s most flexible tool.
The FOMC through open-market operations will buy and sell US government securities in the secondary market in order to control the money supply.
If Fed wants to stimulate the economy and reduce rates, it will buy government securities, which sends money into the banking system now available to lend. This will reduce interest rates and borrowing demand should increase to stimulate the economy.
If Fed wants to slow down the economy, it will sell US government securities, which causes money to flow from the banks into the Fed thus reducing money supply. Less money available to be loaned out will increase interest rates and slow down borrowing and demand.
Economists gauge the money supply using 3 measures, what are they?
M1, M2, M3
What does M1 include (2)?
M1 is the largest and most liquid measure of the nation’s money supply, it includes:
- Cash
- Demand deposits (Checking accounts)
What is M2? What does it include (4)?
Includes all measure in M1 plus:
- Money market instruments
- Time deposits of less than $100K
- Negotiable CDs exceeding $100K
- Overnight repurchase agreements
What is M3? What does it include (2)?
Includes all measures in M1 and M2 plus:
- Time deposits greater than $100K
- Repurchase agreements with maturities greater than 1 day
What is disintermediation?
Disintermediation occurs when people take their money out of low yielding accounts offered by financial intermediaries or banks and invest money in higher yielding investments
What is moral suasion?
The Federal Reserve Board often will use moral suasion as a way to influence the economy. By simply implying or expressing their views on the economy, they can slightly influence the economy.
What is fiscal policy? Who is it controlled by? What can fiscal policy change the levels of (3)?
Fiscal policy is controlled by the president and Congress. Fiscal policy determines how they manage the budget and government expenditures to help steer the economy through the business cycle.
Fiscal policy may change the levels of:
1. Federal spending
2. Federal taxation
3. Creation or use of federal budget deficits or surpluses
What can the government influence through fiscal policy (2)?
Spending and taxation
As the government spends more, it will increase aggregate demand and therefore productivity. Also can stimulate economy by reducing taxation. This leaves a larger portion of earnings for the consumers and businesses to spend.
If the government wants to slow down the economy, it may reduce spending to lower the level of aggregate demand or raise taxes to reduce demand by taking money out of the hands of the consumers.
What are 3 indicators for the health of the US economy that the Federal Reserve Board and the government monitor?
- Consumer price index
- Inflation/deflation
- Real GDP
What is consumer price index (CPI)? What does a rising or falling CPI indicate?
The consumer price index is made up of a basket of goods and services that consumers most often use in their daily lives.
The consumer price index is used to measure the rate of change in overall prices.
A CPI that is rising would indicate that prices are going up and that inflation is present; A falling CPI would indicate that prices are falling and deflation is present.
What is inflation/deflation?
Inflation is the persistent increase in prices, while deflation is the persistent decrease in prices.
What is Real GDP?
Real GDP is adjusted for the effects of inflation or deflation over time.
GDP is measured in constant dollars so that the gain or loss of the dollar’s purchasing power will not show as a change in the overall productivity of the economy.
What are 4 things that are bullish for the stock market?
- Falling interest rates
- Increasing money supply
- Increase in government spending
- Falling taxes
What are 4 things that are bearish for the stock market?
- Increasing taxes
- Increasing interest rates
- Falling government spending
- Falling money supply
What does currency value relative to other currencies impact?
Impacts a country’s international trade and the balance of payments.
What is exchange rate?
The amount of another country’s currency that may be received for a country’s domestic currency
What does a weak/strong currency benefit?
Weak currency benefits exporters, while a strong currency benefits importers.
What is London interbank offered rate (LIBOR)?
LIBOR is the most widely used measure of short-term interest rates around the world. The LIBOR rate is the market-driven interest rate charged by and between financial institutions, similar to the fed funds rate in the US.
What is the range of LIBOR loans? How is the rate calculated?
1 day to 1 year
Rate is calculated by British Banker’s Association
What can be analyzed by the shape of the yield curve (2)?
Cost of borrowed funds given various maturities and the general health of the economy
What does a normal, ascending, positive or upward sloping yield curve mean?
The level of interest rates increases ads the term of the maturity increases. Simply put, lenders are going to demand higher interest rates on longer-term loans. The longer the lenders need to wait to be repaid (and money is at risk), the higher the level of compensation (interest) required to make the loan. Higher interest rates also compensate the lenders for the time value of money.
This curve is present during times of economic prosperity and depicts the expectation of increased interest rates in the future.
What does an inverted, negative, or downward slope yield curve mean?
Happens when demand for short-term funds are running much higher than the demand for longer-term loans or in times where the Federal Reserve Board has increased short-term rates to combat an economy that is growing too quickly and threatening long-term price stability.
With an inverted yield curve, interest rates on short term loans far exceed the interest rates on longer-term loans.
These tend to normalize quickly and is often a precursor to a recession.
What is the investment adviser required to do for a client (2)?
- Develop a client profile when opening the client’s account and must update it regularly as the client’s needs change
- Have fiduciary duty to provide only suitable advice to clients.
What is the Uniform Prudent Investors Act of 1994 (UPIA)?
This sets the basic standards by which all investment professionals acting in a fiduciary capacity must abide.
How does the UPIA update?
Updates the requirements and definitions of prudent standards in light of the application of of modern portfolio theory and the advancement in the understanding of the behavior of capital markets
What are the 5 fundamental changes in the approach to prudent investing for investment professionals acting in a fiduciary capacity?
- The main consideration of a fiduciary is the management and trade off between risk and reward.
- The standard of prudence for each investment will be viewed in relationship to the overall portfolio rather than as a stand alone investment
- The rules regarding diversification have become part of the definition of prudent investing.
- The restrictions from investing in various types of investments have been removed and the trustee may invest in anything that is appropriate in light of the objectives of the trust and in line with other requirements of prudent investing.
- The rules against delegating the duties of the trustee have been removed and the trustee may now delegate investment functions subject to safeguards.
What can’t an investment adviser employ or engage in (13)?
- Churning
- Manipulative and deceptive practices
- Unauthorized trading
- Fraudulent acts
- Blanket recommendations
- Misrepresentations
- Omitting material facts
- Making guarantees
- Selling dividends
- Recommending speculative securities without knowing the customer can afford the risk.
- Short-term trading in mutual funds
- Switching fund families
- Charging fees in excess of fees disclosed in the advisory contract
What is churning?
Many advisers are compensated when the customer makes a transaction based on their recommendation.
Churning is the practice of making transactions are are excessive in size or frequency with the intention to generate higher commissions for the adviser.
What will regulators look for when determining if an account has been churned (3)? What is not an issue when determining if an account has been churned?
- Frequency of transactions
- Size of the transactions
- Amount of commission earned by the representative
Customer profitability is not an issue
What is reverse churning?
Practice of placing inactive accounts or accounts that do not trade frequently into fee-based programs that charge an annual fee based on the assets in the account.
What are examples of manipulative and deceptive devises (5)?
- Capping
- Pegging
- Front running
- Trading ahead
- Painting the tape/matched purchases/matches sales
What is capping?
A manipulative act designed to keep a stock price from rising or to keep the price down.
What is pegging?
A manipulative act designed to keep a stock price up or to keep the price from falling
What is front running?
The entering of an order for the account of an agent or firm, prior to the entering or a large customer’s order. The firm or agent is using the customer’s order to profit on the order they entered for their own account.
What is trading ahead?
The entering of an order for a security, based on the prior knowledge of a soon-to-be-released research report
What is painting the tape?
A manipulative act by two or more parties designed to create false activity in the security without any beneficial change in ownership. The increased activity is used to attract new buyers.
What is unauthorized trading?
An unauthorized transaction is one that is made for the benefit of a customer account at a time when the customer has no knowledge of the trade and the adviser does not have discretionary power over the account.
How is “fraud” defined?
Fraud is defined as any act that is employed to obtain an unfair advantage over another party
What 7 things are included as fraudulent acts?
- False statements
- Deliberate omissions of material facts
- Concealment of material facts
- Manipulative and deceptive practices
- Forgery
- Material omission
- Lying
What are blanket recommendations?
It is inappropriate for an adviser to make blanket recommendations in any security, especially low-priced speculative securities.
No matter what type of investment is involved, a blanket recommendation to a large group of people will always be wrong for some investors. (Sometimes this action could also be deemed to be market manipulation)
When is selling dividends a violation?
Selling dividends is a violation that occurs when an adviser use a pending dividend payment as the sole basis of their recommendation to purchase the stock or mutual fund. (Creating urgency on the part of the investor to purchase stock is prime example of this type of violation)
What can an adviser not knowingly make a misrepresentation regarding (5)?
- Client’s account status
- Representative
- Firm
- Investment
- Fees to be charged
What are the rules with omitting material facts?
A representative may not omit any material fact either good or bad when recommending a security. A material fact is one that an investor would need to know in order to make a well-informed investment decision. The adviser may however omit an immaterial fact.
What are the rules with making guarantees?
No representative, broker dealer or investment adviser may make any guarantees of any kind. A profit may not be guaranteed and a promise of no loss may not be made.
What should an adviser recommending a mutual fund do?
Ensure that the mutual fund’s investment objective meets the customer’s investment objective.
