The asset management industry and banking

Question 1

what do pooled investment vehicles do

Answer 1

aggregate funds from numberous investors and invest the money as one large portfolio

• pooled funds allow investors to have access to professional fund managers and allow investors to benefit from economies of scale

Question 2

what are mutual funds

Answer 2

investment vehicles that pool money from many investors to invest in a diversified portfolio of stocks, bonds or other securities

• funds managed by professional fund managers who make investment decisions on behalf of the investors
• often have relatively low minimum investment requirements, suitable for both individual and institutional investors
• most are open-ended = can issue and redeem shares at any time

Question 3

what are open-ended and closed-end funds

Answer 3

open-ended: can issue and redeem shares at any time

closed-end: when created typically issue all the shares it will issue, with such shares thereafter being traceable among investors
- typically listed on a stock exchange while open-ended ones are not

Question 4

what are exchange traded funds

Answer 4

and open-ended fund that holds many securities
- traded on an exchange
- its price changes throughout the trading day as underlying shares are bought and sold on the market

Question 5

what is the difference between mutual and exchange traded funds

Answer 5

1. ETFs are traded on an exchange but mutual funds are not
2. mutual funds trade only once per day after the market closes unlike ETFs
3. ETFs tend to be more cost-effective and more liquid than mutual funds

Question 6

what are hedge funds

Answer 6

private investment pools, open to wealthy or institutional investors

• largely unregulated: permit hedge funds manager to
  1. borrow
  2. sell short
  3. use complex investment strategies
  4. complex incentive schemes for managers
  == these are practices are not normally available to mutual funds trade only and allow hedge funds to implement risky strategies
• can make returns both when markets are rising and falling

Question 7

what are the main strategies of hedge funds

Answer 7

1. macro funds:
   - look for investment opportunities in bonds, shares and currencies in response to expected global macroeconomic events
2. directional funds:
   - exploit expected movements in financial assets where they perceive the pricing is not correct or inconsistent
3. event-driven funds
   - concerned with corporate events
   - forecast price movements and trade on their expectations
4. relative value funds
   - trade on perceived inconsistencies in the prices of securities

Question 8

what are banks

Answer 8

the most important category of financial institution in the financial system

• perform
  1. payment services
  2. risk managment
  3. information processing and monitoring of loans
  4. asset transformation - size, maturity and risk

Question 9

what is intermediation

Answer 9

main activity of banks
- encompasses information processing and monitoring of loans and asset transformation

• involves issuing deposit claims (to accept short term deposits) and holding loan claims (lending out longer-term loans to borrowers)

Question 10

what causes liquidity risk

Answer 10

banks engage in liquid transformation
- liabilities are liquid (can withdraw with no/little notice period)
- loans are not liquid (hard to convert to cash at short notice)

banks hold liquid assets to meet liquidity demands
(this is in the form of cash and other liquid assets)
- if many depositors with to withdraw deposits at the same time, the bank will not be able to generate the cash to pay them

Question 11

what are the 3 main elements to the regulation of banks to mitigate systemic risk

Answer 11

1. banks need to hold sufficient liquidity on their balance sheet in order to have more cash available to meet liquidity needs
2. banks need to hold more capital as this can protect a bank from failure
3. banks need to have deposit insurance in place (usually arranged by the regulator) - this pays out depositors in the event of bank failure —- reducing incentive of depositors to join a run

Question 12

what are money market funds

Answer 12

alternative to banks for depositors
- provide access to liquid deposit type claims (often with higher interest rates than banks)
but
- not regulated by a banking type regulator = no deposit insurance type scheme
- vulnerable to runs

Question 13

what is the difference between directional and relative value funds

Answer 13

directional:
- have market exposure
- their funds are directly tied to whether the market or asset prices go up or down
- if the market goes in the expected direction = profit

relative value funds
- market neutral = don’t take strong directional view on the overall market
- they look for relative mispricing btween securities
- aims to reduce market risk by balancing long and short positions in correlated securities