week 1 test Flashcards
What are the differences between equity and fixed-income securities?
Equity is a lower priority claim and represents an ownership share in a corporation, whereas debt has a higher priority claim but does not have an ownership interest. Debt also pays a specified cash flow over a specific period and the claim will eventually expire. Equity has an indefinite life.
What is the difference between asset allocation and security selection?
Asset allocation is the allocation of an investment portfolio across broad asset classes. Security selection is the choice of specific securities within each asset class.
What are agency problems? What are some approaches to solving them?
Agency problems are conflicts of interest between managers and shareholders. They are addressed through the corporate governance process via audits, compensation structures and board elections.
What are the differences between real and financial assets?
Real assets are assets used to produce goods and services. Financial assets are claims on real assets or the income generated by them.
How does investment banking differ from commercial banking?
Investment bankers are firms specialising in the sale of new securities to the public, typically by underwriting the issue. Commercial banking processes the financial transactions of businesses such as cheques, wire transfers and savings account management.
For each transaction below, identify the real and/or financial assets that trade hands.
Are any financial assets created or destroyed in the transaction?
CSR Ltd takes out a bank loan to finance the construction of a new factory.
CSR Ltd pays off its loan.
CSR Ltd uses $10 million in cash on hand to purchase the additional inventory of spare auto parts.
The factory is a real asset that is created. The loan is a financial asset that is created by the transaction.
When the loan is repaid, the financial asset is destroyed but the real asset continues to exist.
Cash is a financial asset that is traded in exchange for a real asset, inventory.
Discuss the advantages and disadvantages of the following forms of managerial compensation in terms of mitigating agency problems:
shares in the firm that must be held for 5 years
A salary paid in the form of shares in the firm means the manager earns the most when shareholder wealth is maximised. When the shares must be held for five years, the manager has less of an incentive to manipulate the share price. This structure is most likely to align the interests of managers with the interests of the shareholders. If share compensation is used too much, the manager might view it as overly risky since the manager’s career is already linked to the firm. This undiversified exposure would be exacerbated with a large share position in the firm.
Discuss the advantages and disadvantages of the following forms of managerial compensation in terms of mitigating agency problems:
a fixed salary
A fixed salary means compensation is (at least in the short run) independent of the firm’s success. This salary structure does not tie the manager’s immediate compensation to the success of the firm. The manager might, however, view this as the safest compensation structure with the most value.
a salary linked to the firm’s profits.
When executive salaries are linked to firm profits, the firm creates incentives for managers to contribute to the firm’s success. The success of the firm is linked to the compensation of the manager. This may lead to earnings manipulation, but that is what audits and external analysts will look out for.
Give an example of two financial intermediaries and explain how they act as a bridge between small investors and large capital markets or corporations.
Investment managers pool and manage money for individual investors. This provides small investors with access to capital markets that would be out of their reach ordinarily.
Investment banks sell securities to the public, in effect providing a link between large corporations and small investors.
_______ portfolio construction starts with asset allocation.
Top-down
An intermediary that pools and manages funds for many investors is called _______.
an investment company
Individuals may find it more advantageous to purchase claims from a financial intermediary rather than directly purchasing claims in capital markets because:
- Intermediaries are better diversified than most individuals.
- Intermediaries can exploit economies of scale in investing that individual investors cannot.
In securities markets, there should be a risk-return trade-off with higher-risk assets having _______ expected returns than lower-risk assets.
higher
