Week 1 - Introduction to Investments, Financial Instruments, Recent Trends

Question 1

What is risk?

Answer 1

• we don’t know what is going to happen, but we can describe the likely outcomes with a probability distribution
• total risk, systematic risk, downside risk, tail risk,
• some risks are priced in some are not

Question 2

The investment process

Answer 2

1. Asset allocation
2. Security selection
3. Risk-return trade-off
4. Market efficiency
5. active vs. passive management
   - timing for active management
   - efficient portfolio for passive management

• once the portfolio is established., it is updated and rebalanced by selling existing securities and using the proceeds to buy new securities, by investing additional funds to increase the overall size of the portfolio, or by selling securities to decrease the size of the portfolio

Question 3

Traditional finance

Answer 3

• people are rational
• people hold optimal portfolios (e.g., as described by the mean-variance portfolio theory)
• expected returns on investments are determined only by their risks
• markets are efficient, in the sense that price equal fair values

Question 4

Behavioural finance

Answer 4

• incorporates knowledge about people’s wants, their cognitive errors and emotional shortcuts
• -> people have only limited attention and limited power to process information
• -> people care more than high expected return and low risk (e.g., social responsibility)
• -> people find it difficult to figure out and follow the optimal investment strategy, e.g., weak self control and peer influence
• -> markets are not efficient

Question 5

Investor heterogeneity in practical setting…

Answer 5

• under CAPM, all investors hold the same (market) portfolio
  IN REALITY, investors are different:
• short-term vs. long-term horizon
• sophisticated informed vs. inexperienced uninformed
• investors also have different preferences

Question 6

Three ways too profitable trading

Answer 6

1. Take calculated risk
2. become more informed than others
3. take advantage of naïve investors/noise traders

Question 7

What are real assets?

Answer 7

• the land, buildings, machines, and knowledge that can be used to produce goods and services

Question 8

What are financial assets?

Answer 8

• stocks and bonds; do not contribute to the productive capacity of the economy. Instead, these assets are the means by which individual in well-developed economies hold their claims on real assets
• while real assets generate net income to the economy, financial assets simply define the allocation of income or wealth among investors

Question 9

What are the three broad types of financial assets?

Answer 9

• fixed income
• equity
• derivatives

Question 10

What are fixed income securities?

Answer 10

• promise either a fixed stream of income or a stream of income determined by a specified formula

Question 11

How do you classify financial assets?

Answer 11

• money market

- capital market

Question 12

What is money market?

Answer 12

• refers to debt securities that are short-term, highly marketable, and generally very low risk: i.e. treasury bills, bankers’ acceptances and commercial paper

Question 13

What are fixed-income capital markets?

Answer 13

• includes long-term securities such as government of Canada bonds, as well as bonds issued by federal agencies. provinces, municipalities, and corporations

Question 14

What are derivative securities?

Answer 14

• such as options and futures contracts, provide payoffs that are determined by the price of other assets

Question 15

What is the risk-return trade-off?

Answer 15

• there is a risk-return trade-off in the securities markets, with higher-risk assets priced to offer higher expected returns

Question 16

What are treasury bills?

Answer 16

• the most marketable of all Canadian money-market instruments
• represent the simplest form of borrowing: the government raises money by selling bills to the public. Investors buy the bills at a discount from the stated maturity value. The different is the investors earnings.
• T-bills with initial maturities of 3,6, and 12 months are issued bi-weekly
• sold via auctions; don’t need to be purchase right away
• highly liquid –> easily converted to cash and sold at low transaction costs with not much price risk

Question 17

What are certificates of deposit?

Answer 17

• a time deposit with a charter bank. Time deposits may not be withdrawn on demand. The bank pays interest and principal to the depositor at the end of the fixed term of the deposit
• issued by banks to finance lending activities
• may not be withdrawn on demand
• the bank pays the principal and the interest to the depositor only at the end of the fixed term
• a similar time deposit for smaller amounts is known as a Guaranteed Investment Certificate (GIC)
• although both CDs and GICs are non-transferable in Canada, some bank time deposits are negotiable

Question 18

What is commercial paper?

Answer 18

• Maturity is <270 days; sold at a discount of face value (zero-coupon)
• large well-known companies often issue their own short-term unsecured debt notes rather than borrowing directly from banks
• commercial paper is backed by a bank of credit, which gives the borrower access to cash that can be used (if needed) to pay off the paper at maturity
• mainly held by institutional investor; large denominations
• -> money market and mutual funds hold a majority of CP
• CP attractive because yields are typically higher than other MM –> low risk; CP often issued with a letter of credit form the bank

Question 19

What are federal funds?

Answer 19

• U.S. banks are required to maintain deposits at the Fed
• banks with more than the minimum can end out funds to banks under the minimum requirement
• -> most loans are overnight
• -> interest rate is called the fed funds rate; set by the fed
• major Canadian financial institutions borrow and lend one-day funds among themselves; the Bank of Canada sets a target level for this rate, which is often referred to as the Bank’s Policy Interest Rate. This rate affects other key interest rates in Canada

Question 20

What is the federal funds rate?

Answer 20

• the rate of interest on very short-term loans among financial institutions

Question 21

What is the LIBOR market?

Answer 21

the LIBOR is the rate at which large banks in London are willing to lend money among themselves. This rate, which is quoted on U.S. dollar-denominated loans, has become the premier short-term interest rate quoted in the European money market

Question 22

Yields on MM Instruments

Answer 22

• the securities of the money market do promise yields greater than those on default-free T-bills, at least in part because of greater relative riskiness
• in addition, many investors require more liquidity; thus they will accept lower yields on securities such as T-bills that can be quickly and cheaply sold

Question 23

What are treasury notes and bonds?

Answer 23

• treasury notes and bonds are used to finance government spending
• -> t-notes: maturity 1-10 years
• -> t-bonds: >10 years
• pay semi-annual coupons and face value at maturity

Question 24

What are corporate bonds?

Answer 24

• firms use corporate bonds to borrow (raise) money directly from the public
• typically pay semi-annual coupons over their lives and return the face value to the bondholder at maturity
• riskier than t-bonds
• rated by agencies

Question 25

What are municipal bonds?

Answer 25

• debt securities issued by a city, or country to finance local capital expenditures such as the construction of bridges, highways, airports etc.
  two types:
  –> General Obligation Bonds: principal and interest are secured by the full faith and credit of the issuer and usually supported by either the issuer’s unlimited or limited taxing power.
  –> Revenue bonds: principal and interest secured by revenues derived from tolls, charges or rents
• Canadian municipal bonds offer investors an attractive risk-return profile because they typically offer higher yields than other types of Canadian government and provincial bonds, with low risk of default. However, they are fully taxable which limits their popularity

Question 26

What are TIPS?

Answer 26

• issued by U.S. Treasury. Interest income and growth in principal are exempt from state/local income taxes, but subject to federal
• the principal of a TIPS increases with inflation and decreases with deflation
• TIPS pay interest twice a year, at a fixed rate. The rate is applied to the adjusted principal; so like the principal, interest payments rise with inflation and fall with deflation
• UPSIDE: in periods of rising inflation, RRBs will provide there PP protection
• DOWNSIDE: inflation-protected bonds lose their advantage over conventional bonds when inflation moves below expectations

Question 27

What is common stock?

Answer 27

• an ownership share in a public company
• each share entitles its owners to one vote on any matter of corporate governance that are put to a vote at the corporation’s annual meeting, as well as to share in the financial benefits of ownership
• share of earnings and shareholders have voting rights
• limited liability: the most a shareholder can lose in the event the corporation fails is their original investment

Question 28

What is preferred stock?

Answer 28

• hybrid between stocks/bonds
• like a bond because:
• -> a promised fixed dividend stream
• -> no voting rights
• like a common stock because:
• -> failure to pay dividends doesn’t trigger bankruptcy
• -> dividends before common shareholders

Question 29

Price weighted average index?

Answer 29

• the DIJA is a price-weighted average

Question 30

Value weighted index?

Answer 30

• the TSX is value weighted; computed by calculating the total make value of the stocks in the index and the total market value of those stocks in the previous day of trading

Question 31

What is globalization?

Answer 31

• a tendency towards a worldwide investment environment

Question 32

What is financialization of the economy?

Answer 32

• e.g. hundreds of billions of dollars have flooded into commodities futures, commodities index funds, ETFs and mutual funds over the past two decades

Question 33

What is securitization?

Answer 33

• pooling loans into standardized securities os they can be traded like other securities

Question 34

Financial engineering

Answer 34

• creating new securities from bundling and unbundling the cash flows of other securities

Question 35

Computer technology trend

Answer 35

• has lead to a decrease in the costs of trading and an increase in the availability of information
• Quant strategies, statistical arbitrageurs

Question 36

Artificial Intelligence and Fintech

Answer 36

• hedge funds that employ AI

Question 37

What is rob advisor?

Answer 37

• a hands-off approach to investing and a combination of a human and computer algorithm

Question 38

Responsible/impact investing

Answer 38

• pay special attention to sustainability and societal impact of an investment in a company or business
• ESG is becoming an integral part of the investment process for investors across the world
• “There is growing consensus that integrating material ESG factors correlates to long-term financial returns and can help generate alpha)
• when companies pursue a stakeholder-centric approach to value creation by incorporating ESG into their long-term investment strategy, they’re able to attract the best talent, build loyal customer bases, prosper through strong corporate governance oversight, mitigate risk, and drive profitable growth by investing in sustainable innovation

Question 39

What is mortgage securitization?

Answer 39

• before 1970, mortgages originated in local banks…
• -> long distance lending was rare because of the costs of collecting information
• -> a potential homeowner’s ability to get a loan depended on local credit conditions
• In 1970, government agencies introduced securitization
• -> individual home securities are aggregated into relative homogenous pools
• today over 70% of mortgages are securitized
• mortgage securitization has benefited potential borrowers and investors
• -> potential homeowners are no longer constrained by the local credit conditions
• -> investors have more choice