Week 1 - Introduction to Investments, Financial Instruments, Recent Trends Flashcards
1
Q
What is risk?
A
- 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
2
Q
The investment process
A
- Asset allocation
- Security selection
- Risk-return trade-off
- Market efficiency
- 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
3
Q
Traditional finance
A
- 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
4
Q
Behavioural finance
A
- 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
5
Q
Investor heterogeneity in practical setting…
A
- 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
6
Q
Three ways too profitable trading
A
- Take calculated risk
- become more informed than others
- take advantage of naïve investors/noise traders
7
Q
What are real assets?
A
- the land, buildings, machines, and knowledge that can be used to produce goods and services
8
Q
What are financial assets?
A
- 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
9
Q
What are the three broad types of financial assets?
A
- fixed income
- equity
- derivatives
10
Q
What are fixed income securities?
A
- promise either a fixed stream of income or a stream of income determined by a specified formula
11
Q
How do you classify financial assets?
A
- money market
- capital market
12
Q
What is money market?
A
- refers to debt securities that are short-term, highly marketable, and generally very low risk: i.e. treasury bills, bankers’ acceptances and commercial paper
13
Q
What are fixed-income capital markets?
A
- includes long-term securities such as government of Canada bonds, as well as bonds issued by federal agencies. provinces, municipalities, and corporations
14
Q
What are derivative securities?
A
- such as options and futures contracts, provide payoffs that are determined by the price of other assets
15
Q
What is the risk-return trade-off?
A
- there is a risk-return trade-off in the securities markets, with higher-risk assets priced to offer higher expected returns
16
Q
What are treasury bills?
A
- 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
17
Q
What are certificates of deposit?
A
- 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
18
Q
What is commercial paper?
A
- 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
19
Q
What are federal funds?
A
- 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
20
Q
What is the federal funds rate?
A
- the rate of interest on very short-term loans among financial institutions
21
Q
What is the LIBOR market?
A
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
22
Q
Yields on MM Instruments
A
- 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
23
Q
What are treasury notes and bonds?
A
- 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
24
Q
What are corporate bonds?
A
- 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
25
What are municipal bonds?
- 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
26
What are TIPS?
- 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
27
What is common stock?
- 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
28
What is preferred stock?
- 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
29
Price weighted average index?
- the DIJA is a price-weighted average
30
Value weighted index?
- 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
31
What is globalization?
- a tendency towards a worldwide investment environment
32
What is financialization of the economy?
- e.g. hundreds of billions of dollars have flooded into commodities futures, commodities index funds, ETFs and mutual funds over the past two decades
33
What is securitization?
- pooling loans into standardized securities os they can be traded like other securities
34
Financial engineering
- creating new securities from bundling and unbundling the cash flows of other securities
35
Computer technology trend
- has lead to a decrease in the costs of trading and an increase in the availability of information
- Quant strategies, statistical arbitrageurs
36
Artificial Intelligence and Fintech
- hedge funds that employ AI
37
What is rob advisor?
- a hands-off approach to investing and a combination of a human and computer algorithm
38
Responsible/impact investing
- 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
39
What is mortgage securitization?
- 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
