TOPIC 1 - INVESTMENT DECISIONS & UNCERTAINTY

Question 1

Real asset

Answer 1

used to produce goods and services (buildings, machines, IP, land)

Question 2

financial assets

Answer 2

claims to the income generated by real assets/claims on income from gov (stocks, bonds)

Question 3

do financial assets directly contribute to economy’s productive capacity?

Answer 3

No –> not fundamental sources of value

Question 4

financial assets = sum of

Answer 4

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

Question 5

types of financial assets

Answer 5

1) fixed income/debt securities
2) equity
3) derivative securities

Question 6

2 steps in portfolio investment

Answer 6

1) asset allocation (choice among broad asset classes)

2) security selection (choice of securities within each asset class)

Question 7

approaches to security analysis

Answer 7

1) top down (determine asset allocation then securities)

2) bottom up (choose attractively priced securities w less concern for asset class)

Question 8

risk-return tradeoff

Answer 8

higher-risk assets are priced to offer higher expected returns than lower-risk assets

Question 9

efficient market hypothesis

Answer 9

prices of securities reflect available information (if true, then there’d be no under or over priced securities)

Question 10

passive management

Answer 10

• highly diversified portfolio

- no attempt to improve performance by searching for mis-priced securities

Question 11

active management

Answer 11

focus on improving performance by finding mis-priced securities or by timing the performance of broad asset classes

Question 12

what does active management profit from

Answer 12

movements in markets/fluctuations on economic activity experienced in countries around the world

Question 13

what’s the closest thing we can find to the risk free rate?

Answer 13

short-term LIBOR and Treasury bill rates

Question 14

TED Spread (Treasury euro dollar)

Answer 14

= dif. btw short-term LIBOR and Treasury bill rates

Question 15

what does TED S[read reflect?

Answer 15

default risk in banking system (both rates in period up to GFC were higher due to higher default risk)

Question 16

LIBOR =

Answer 16

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)

Question 17

T Bills are secured by what

Answer 17

reserves

Question 18

Money market

Answer 18

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.

Question 19

Investments that can be made in money markets

Answer 19

1) Treasury bills
2) Certificates of Deposit
3) Commercial Paper
4) Bankers’ acceptance
5) Eurodollars
6) Repurchase agreements
7) Federal funds
8) Brokers’ calls

Question 20

Treasury bills

Answer 20

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

Question 21

certificates of deposit

Answer 21

• bank pays interest & principal to depositor only at maturity
• time deposit can’t be withdrawn on demand

Question 22

commercial paper

Answer 22

short-term unsecured debt notes, often issued by largem, well known firms and banked by bank line of credit

Question 23

commercial paper makes larger firms kind of like

Answer 23

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

Question 24

eurodollars

Answer 24

dollar denominated deposits at foreign banks/branches of US banks

Question 25

repurchase agreements

Answer 25

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.

Question 26

federal funds

Answer 26

funds in a bank’s reserve acc at Fed reserve bank

Question 27

broker’s calls

Answer 27

investors can buy stocks on margin and brokers in turn may borrow the funds from a bank

Question 28

Bond market (fixed income allocation) is comprised of

Answer 28

longer term borrowing/debt instruments than those that trade in the money market

Question 29

what gets traded in the bond market

Answer 29

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

Question 30

Derivative Markets - what’s traded

Answer 30

1) options (call and put - a right to do something, not obligation)
2) futures contracts

Question 31

derivative asset =

Answer 31

claim whose value directly depends value of an underlying asset

Question 32

call option

Answer 32

holder has R to purchase asset for specified price (exercise price) on/before specified expiration date

Question 33

put option

Answer 33

holder has R to sell an asset for a specified exercise price on/before specified expiration date

Question 34

futures contract (an obligation to do something)

Answer 34

calls for delivery of an asset/cash value at specified delivery/maturity date for agreed price (futures price) to be paid at contract maturity

Question 35

long position - futures contract

Answer 35

is held by trader who commits to PURCHASING the asset on the delivery date

Question 36

short position - futures contract

Answer 36

held by trader committing to DELIVER asset at contract maturity

Question 37

real assets create ….., whereas financial assets

Answer 37

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

Question 38

financial assets can be categorised as:

Answer 38

1) fixed income
2) equity
3) derivative instruments

Question 39

top down portfolio construction techniques start with

Answer 39

financial asset allocation decision, then progress to more specific security selection decisions

Question 40

competition in financial markets leads to a

Answer 40

risk-return trade-off whereby securities offering higher E(r) also impose greater risk on investors.

Question 41

what does presence of risk resulting from risk-return tradeoff imply?

Answer 41

actual returns can differ from expected returns at the beginning of the investment period.

Question 42

what does competition among security analysts also promote?

Answer 42

financial markets that are nearly informationally efficient - pricing reflects all available info re the security’s value

Question 43

in nearly efficient markets, like in instances of competition among security analysis in financial markets are passive or active investment strategies superior?

Answer 43

passive

Question 44

Financial intermediaries pool

Answer 44

investor funds and invest them (demand for services bc small investors can’t efficiently gather info, diversify & monitor portfolios)

Question 45

what do financial intermediaries do?

Answer 45

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)

Question 46

investment banking brings ….. to corporate fund-raising

Answer 46

efficiency

Question 47

why does investment banking bring efficiency to corporate fund raising?

Answer 47

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

Question 48

Financial crisis of 2008 showed what

Answer 48

importance of systematic risk!

Question 49

how to limit systematic risk (first way)

Answer 49

(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;

Question 50

how to limit systematic risk (second way)

Answer 50

(2) frequent settlement of gains or losses to prevent losses from accumulating beyond an institution’s ability to bear them

Question 51

how to limit systematic risk (third way)

Answer 51

(3) incentives to discourage excessive risk taking and accurate and unbiased analysis by those charged with evaluating security risk

Question 52

when a firm starts up and raises working cap it has a low or high ratio of real assets to total assets

Answer 52

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.

Question 53

do you pay the ask or bid price if you’re purchasing a bond?

Answer 53

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

Question 54

Coupon payments occur

Answer 54

semi annually

Question 55

when talking about treasury bonds we talk in what denomination

Answer 55

$1000s

Question 56

If a coupon rate is 3.00 what are the semi annual payments?

Answer 56

= $1000 * 3% = $30 annual payment = $15 semi annual payment

Question 57

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

Answer 57

2%

Question 58

dividend annual income =

Answer 58

no shares x dividend value

Question 59

tulip mania reading conclusion:

Answer 59

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.

Question 60

treasury note vs bill vs bond

Answer 60

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.