week 1

Question 1

asset allocation decision

Answer 1

choosing between broad asset classes. This decision is made first in a “top-down” approach

Question 2

When constructing an investment portfolio, investors make two main decisions

Answer 2

asset allocation decision

security allocation decision

Question 3

security selection decision

Answer 3

choosing specific securities to invest in within each broad asset class. Selection is assisted by security analysis to determine value and attractiveness of securities.

Question 4

when you forgo consumption of wealth today, where do you place the wealth?

Answer 4

In real assets

Financial assets

Question 5

what are financial assets

Answer 5

claims to income generated by real assets

Question 6

features of financial assets

Answer 6

• Overcome consumption timing issues that can be associated with real assets;
• Allow investment risk to be shared in a manner that cannot be achieved with real assets; and,
• Allow a separation of ownership and control to occur.
• these features faciliate diversification and liquidity

Question 7

Financial assets are traded in financial markets including:

Answer 7

The money market, which facilitates short-term lending and borrowing;

The capital market, which assists in longer-term lending and borrowing;

The derivative market, which facilitates the transference of risk between market participants; and,

The foreign exchange market, which facilitates international trade.

Question 8

New securities are issued to raise funds for the issuing firm via

Answer 8

a primary market transaction

Question 9

New securities are issued to raise funds for the issuing firm via a primary market transaction. They could be issued by:

Answer 9

Public offering, which may be underwritten in a firm commitment or best-efforts arrangement or may not be underwritten at all; or,

Private placement, which reduces disclosure requirements, but is subject to size limitations.

Question 10

bid price

Answer 10

price the dealer is willing to buy a security;

Question 11

ask price

Answer 11

price at which the dealer is willing to sell the security

Question 12

bid-ask spread

Answer 12

difference between the bid and ask price is the dealer’s profit.

Question 13

Price and Order Types

Investors might want to execute one of two types of order through these mechanisms, namely:

Answer 13

A market order:

A price-contingent order

Question 14

A market order

Answer 14

A buy or sell order that is to be executed straight away at the prevailing market price;

Question 15

price-contingent order

Answer 15

A buy or sell order only to be executed at a specified price. Limit orders awaiting execution are known as the limit order book.

Question 16

The difference between the highest buy and the lowest sell order

Answer 16

he difference between the highest buy and the lowest sell order, or the inside quotes, is called the inside spread

Question 17

secondary markets employ one of 3 trading mechanisms

Answer 17

Dealer, or Over-The-Counter (“OTC”) Markets; Electronic Communication Networks (“ECNs”);

and,
Formal Exchanges.

Question 18

OTC market

Answer 18

Market makers accept market order from customers

Market makers also trade among themselves

Question 19

Electronic communication network

Answer 19

A Computer Network that manages the limit order book and matches buy/sell orders directly without the intervention of a broker

Question 20

On formal exchanges such as the NYSE, trading in each security is

Answer 20

On formal exchanges such as the NYSE, trading in each security is managed by a specialist (now called a “designated market maker”), who acts as broker or dealer that:

Question 21

designated market maker

Answer 21

1. Maintains a fair and orderly market and is obligated to provide price continuity to the market
2. Intervenes through supplying liquidity, i.e. act as a buyer/seller when no other trader can be found for the other side of the transaction.
3. Trades out of his/her own portfolio; and,
4. Earns income from commissions and spreads

Question 22

Difference between ASX and NYSE

Answer 22

1. Trading currently occurs electronically via ASX Trade:
2. Unlike the NYSE, no specialists are involved;
3. Brokers enter client trades (including those submitted online) on ASX Trade; and,
4. Orders are then sent to the market, and seen by all participants, where they are executed based on price and time priority.

Question 23

ASX

once a trade has occurred

Answer 23

Once a trade has occurred, CHESS effects settlement within 3 days by Delivery versus Payment (“DvP”), which involves:

1. Transferring title of the instruments between the seller and buyer; and,
2. Facilitating the movement of funds between the traders’ banks accounts.

Question 24

Algorithmic trading is

Answer 24

Algorithmic trading is the use of computerised trading rules that are programmed to achieve certain objectives. Examples include:

Iceberging and high frequency trading

Question 25

Iceberging

Answer 25

arge orders are broken down and submitted over time to minimise the price impact (often measured by VWAP)

Question 26

High-frequency trading

Answer 26

computers made decisions based on information submitted to them electronically before humans would be able to analyse and act on it

Question 27

Dark trading:

Answer 27

Allows traders to match orders away from the “lit” market and disclose them within a specified timeframe;

Reduces the price and volatility impact of large trades resulting from short-term differences in the demand and supply of instruments; and,

Is permissible under the rules of markets including the ASX.

Question 28

Recent technological advances mean many smaller traders now

Answer 28

Recent technological advances mean many smaller traders now also trade alongside larger investors in dark pools

Question 29

If dark pools steal too much trade from the lit market

Answer 29

1. displayed orders may not execute;
2. This may make placing orders in the market less attractive and have liquidity and trading cost impacts for everyone; and,
3. Regulators are concerned there is sufficient transparent trading to ensure price discovery along with market depth and liquidity.

Question 30

Short selling is

Answer 30

Short selling is the selling of borrowed shares with the intention of profiting from an expected decline in the share’s price. More specifically, the investor:

• Borrows shares through a dealer;
• Sells the borrowed shares; and,
• Closes the position by purchasing and returning an equivalent number of shares at a later date.

Question 31

Unit investment trusts

Answer 31

Unit investment trusts involve the investment of funds in a fixed-composition (i.e. unmanaged) portfolio.

Question 32

features unit invesment fund

Answer 32

• A trust is formed when the sponsor buys a portfolio of securities and places them in a trust;
• Units in the trust are then sold to investors;
• Investors will receive any income earned on the portfolio as distributed by the funds trustees;
• Investors can sell their units back to the trustee for net asset value (“NAV”); and,
• The trustee will either liquidate a portion of the underlying portfolio to buy units back from these investors, or will sell the units to a new investor for a premium.

Question 33

the portfolios of managed investment companies

Answer 33

are managed in contrast to unit investment trust securities

Question 34

Managed investment companies can be further categorised as

Answer 34

• Open-end funds, more commonly referred to as mutual funds: These funds redeem or issue shares at their NAV, meaning investors can exit by simply selling shares back to the fund; or,
• Closed-end funds: These funds do not redeem or issue shares, meaning investors can only exit by selling their shares to other investors. This is facilitated by these shares trading on organized exchanges.

Question 35

mutual funds

Answer 35

the common name for open-end investment companies, are the dominant type of investment company.

Question 36

Mutual funds

Funds are often classified based on their investment policy, which defines the type of assets they invest in. Common examples include:

Answer 36

Equity funds, which primary invest in stocks;

Bond funds, which invest in fixed income securities; and,

Index funds, which track the performance of a broad market index such as the S&P500.

Question 37

Fees associated with investing in mutual funds include:

Answer 37

Operating expenses, or fees incurred in running the fund. These fees are deducted from the funds assets and, therefore, reduce portfolio value;

Front-end load, or commissions paid to brokers who sell the funds;

Back-end load, or exit fees paid when shares are sold. These are typically a decreasing function of the time money is invested in the fund; and,

Distribution costs, or expenses incurred in marketing funds that are subsequently recovered from investors.

Question 38

All buy and sell orders arriving throughout a given day

mutual funds

Answer 38

are executed at the NAV calculated at the end of the day

Question 39

mutual funds

All buy and sell orders arriving throughout a given day are executed at the NAV calculated at the end of the day!

Answer 39

Some funds accept orders after the market closes for the day (ie after NAV is determined);

If news released after the market closes is positive and, thus, is expected to increase such a fund’s NAV on the next day, late traders can buy into the fund after market close and reverse their position the next day at the adjusted NAV!;

Market timers can take advantage of stale prices in a similar fashion; and,

These practices reduce the returns to other investors!