TOPIC 1 - INVESTMENT DECISIONS & UNCERTAINTY Flashcards
Real asset
used to produce goods and services (buildings, machines, IP, land)
financial assets
claims to the income generated by real assets/claims on income from gov (stocks, bonds)
do financial assets directly contribute to economy’s productive capacity?
No –> not fundamental sources of value
financial assets = sum of
all of the claims conceptually on the real assets (ie the dif sectors like manufacturing/wholesale) to the extent that the claims are distributed through financial assets can ultimately only be the total value of the real assets
types of financial assets
1) fixed income/debt securities
2) equity
3) derivative securities
2 steps in portfolio investment
1) asset allocation (choice among broad asset classes)
2) security selection (choice of securities within each asset class)
approaches to security analysis
1) top down (determine asset allocation then securities)
2) bottom up (choose attractively priced securities w less concern for asset class)
risk-return tradeoff
higher-risk assets are priced to offer higher expected returns than lower-risk assets
efficient market hypothesis
prices of securities reflect available information (if true, then there’d be no under or over priced securities)
passive management
- highly diversified portfolio
- no attempt to improve performance by searching for mis-priced securities
active management
focus on improving performance by finding mis-priced securities or by timing the performance of broad asset classes
what does active management profit from
movements in markets/fluctuations on economic activity experienced in countries around the world
what’s the closest thing we can find to the risk free rate?
short-term LIBOR and Treasury bill rates
TED Spread (Treasury euro dollar)
= dif. btw short-term LIBOR and Treasury bill rates
what does TED S[read reflect?
default risk in banking system (both rates in period up to GFC were higher due to higher default risk)
LIBOR =
interbank lending spread
–> the average interest rate that banks charge each other for short-term, unsecured loans
(the volume weighted av of all possible funding costs for associated banks & dealers in London)
T Bills are secured by what
reserves
Money market
trading in very short-term debt investments. At the wholesale level, it involves large-volume trades between institutions and traders.
very liquid and considered extraordinarily safe. Because they are extremely conservative, money market securities offer significantly lower return than most other securities.
Investments that can be made in money markets
1) Treasury bills
2) Certificates of Deposit
3) Commercial Paper
4) Bankers’ acceptance
5) Eurodollars
6) Repurchase agreements
7) Federal funds
8) Brokers’ calls
Treasury bills
gov raises $ by selling bills to public
- ask price = price u pay to buy Tbill from securities dealer
- bid price = slightly lower price you would receive if you wanted to sell a bill to a dealer
- bid-ask spread is the dif in these prices, the dealer’s source of profit
certificates of deposit
- bank pays interest & principal to depositor only at maturity
- time deposit can’t be withdrawn on demand
commercial paper
short-term unsecured debt notes, often issued by largem, well known firms and banked by bank line of credit
commercial paper makes larger firms kind of like
banks.
Smaller firms turn to banks for financing but larger firms in the markets can issue commercial paper to raise short term working cap for their firm
eurodollars
dollar denominated deposits at foreign banks/branches of US banks
repurchase agreements
short-term (overnight usually) security sales with an agreement to repurchase them at a slightly higher price
The one selling the repo is effectively borrowing and the other party is lending, since the lender is credited the implicit interest in the difference in prices from initiation to repurchase.
federal funds
funds in a bank’s reserve acc at Fed reserve bank
broker’s calls
investors can buy stocks on margin and brokers in turn may borrow the funds from a bank
Bond market (fixed income allocation) is comprised of
longer term borrowing/debt instruments than those that trade in the money market
what gets traded in the bond market
1) treasury ntoes and bonds
2) corporate bonds
3) municipal bonds (issued by local govs)
4) mortgage securities
5) federal agency debt - bonds issued by those federal gov sponsored enterprises
Derivative Markets - what’s traded
1) options (call and put - a right to do something, not obligation)
2) futures contracts
derivative asset =
claim whose value directly depends value of an underlying asset
call option
holder has R to purchase asset for specified price (exercise price) on/before specified expiration date
put option
holder has R to sell an asset for a specified exercise price on/before specified expiration date
futures contract (an obligation to do something)
calls for delivery of an asset/cash value at specified delivery/maturity date for agreed price (futures price) to be paid at contract maturity
long position - futures contract
is held by trader who commits to PURCHASING the asset on the delivery date
short position - futures contract
held by trader committing to DELIVER asset at contract maturity
real assets create ….., whereas financial assets
wealth
Financial assets represent claims to parts or all of that wealth. Financial assets determine how the ownership of real assets is distributed among investors
financial assets can be categorised as:
1) fixed income
2) equity
3) derivative instruments
top down portfolio construction techniques start with
financial asset allocation decision, then progress to more specific security selection decisions
competition in financial markets leads to a
risk-return trade-off whereby securities offering higher E(r) also impose greater risk on investors.
what does presence of risk resulting from risk-return tradeoff imply?
actual returns can differ from expected returns at the beginning of the investment period.
what does competition among security analysts also promote?
financial markets that are nearly informationally efficient - pricing reflects all available info re the security’s value
in nearly efficient markets, like in instances of competition among security analysis in financial markets are passive or active investment strategies superior?
passive
Financial intermediaries pool
investor funds and invest them (demand for services bc small investors can’t efficiently gather info, diversify & monitor portfolios)
what do financial intermediaries do?
sells its own securities to small investors, then invests the funds raised and uses proceeds to pay back the small investors and profits from the dif (the spread)
investment banking brings ….. to corporate fund-raising
efficiency
why does investment banking bring efficiency to corporate fund raising?
IBankers get expertise in pricing new issues and marketing them to new investors.
By end of 2008, all major stand alone IBs had been absorbed into commercial banks or had reorganised themselves into bank holding companies. In Europe, where universal banking had never been prohibited, large banks had long maintained both commercial and investment banking divisions
Financial crisis of 2008 showed what
importance of systematic risk!
how to limit systematic risk (first way)
(1) by transparency that allows traders and investors to assess the risk of their counterparties’ capital requirements to prevent trading participants from being brought down by potential losses;
how to limit systematic risk (second way)
(2) frequent settlement of gains or losses to prevent losses from accumulating beyond an institution’s ability to bear them
how to limit systematic risk (third way)
(3) incentives to discourage excessive risk taking and accurate and unbiased analysis by those charged with evaluating security risk
when a firm starts up and raises working cap it has a low or high ratio of real assets to total assets
low ratio. When a firm is in full production it has high ratio of real assets to total assets and then when the project ‘shuts down’ and the firm sells it off for cash, the financial assets once again replace real assets.
do you pay the ask or bid price if you’re purchasing a bond?
the ask price. It’s found as $1000 * the figure in the table,
eg, if it’s 101.9297 you would have to pay the ask price of: 101.9297% of par value of $1,000 = $1,019.297
Coupon payments occur
semi annually
when talking about treasury bonds we talk in what denomination
$1000s
If a coupon rate is 3.00 what are the semi annual payments?
= $1000 * 3% = $30 annual payment = $15 semi annual payment
Yield to maturity (required return, ask yield), an investor buying a security today with a YTM of 2% & holding it until it matures earns an annual return of
2%
dividend annual income =
no shares x dividend value
tulip mania reading conclusion:
EMH is a “working hypothesis”: Investors are primarily rational and typically price securities in a rational fashion, but outbreaks of crowd behavior, typified by “extraordinary popular delusions and madness,” are a possibility.
treasury note vs bill vs bond
Treasury bills = maturities of a year or less.
Treasury notes = maturities from 2-10 years.
Treasury bonds = long-term investments that have maturities of 10 to 30 years from their issue date.
