FIN 301 Exam 3 Study Guide Topics Covered on Exam 3 o Chapter 8 Financial Intermediation o Chapter 12 Risk Return and CAPM o Chapter 13 Efficient Capital Markets o Chapter 14 Bonds o Chapter 15 Stocks o Chapter 16 Management of Risk CHAPTER 8 FINANCIAL INTERMEDIATION o Hedge Funds Is a private partnership that uses advanced investment strategies to generate high returns for wealthy investors institutions Approximately 6000 hedge funds Very unregulated because they cater to large sophisticated investors Minimum investment into a HF is millions of dollars 2 20 Fee Structure Investors must commit their money into a HF for at least a year 2 charged on assets under management 20 charged on performance These fees are higher than that of mutual funds which are usually around 1 Absolute Return Strategy generates a return regardless of the market return HF are taxed as capital gains 15 If a hedge fund suffers losses managers don t get paid their performance fees until those losses are recovered later Act was passed after the Great Depression in order to re establish trust and credibility on Wall St It forced the separation of commercial and investment banking activities 1999 Financial Services Modernization Act eliminated separation of banks securities firms and insurance companies and allowed financial institutions to compete with foreign banks o Glass Steagall Act o Two Sides of Wall St Sell Side Buy Side Consists of investment banks and commercial banks They create markets and sell financial products Consists of commercial banks mutual funds money managers insurance companies hedge funds and financial entities They buy hold and trade financial products o Investment Companies Asset Managers and Mutual Pension Funds How do they make money Manage various securities and assets to make returns for corporations individuals etc Asset managers rely on client asset balances for revenue o Revenue is directly linked to market valuations so a major fall in asset prices leads to a decline in revenue generation Broken into three categories Equity fixed income money market mutual funds Equity products have higher margins but they suffer in a down market when the money moves out of riskier more profitable products Money market funds invest in short term debt How are they organized instruments Alternative Asset Management Hedge funds many of these firms are private and lightly regulated o Referred to ass the shadow Wall St Real Estate and private equity funds generally offer high risk high reward opportunities for affluent investors o Insurance Companies How do they make money Collect fees for providing insurance Earn returns on their own investment portfolios Changes in profit margins are primarily affected by morbidity mortality and investment yields Revenues Premiums investment income Expenses Claims administrations o Commercial Banks Interest Revenue Interest Expense Net Interest Income Net Interest Income Banks collect consumer deposits borrow money as short term interest rates and lend at longer term rates o Upward sloping yield curve Commercial banks take deposits and make loans Heavily regulated by the government but enjoy access to the Federal Reserve s discount window Other Revenue Generating Divisions Wealth management investment banking equities fixed income rates domestic banking etc o Financial Crisis and Financial Institutions Aggressive lending and investing put the entire financial system at risk Bail out by federal government and federal reserve Financial Institutions Role in the Financial Crisis Excessive risk taking incentives were oriented toward taking more risks Lack of risk management poor internal controls Lack of regulation poor government policies implemented Compensation these schemes rewarded more risk taking Securitization and the lack of financial transparency investors in securitized securities didn t know exactly what they were buying Ownership Structure o Current Issues for Financial Institutions Regulations developing for Dodd Frank Act Regulatory dialect Banks vs Non banks Global competition o Definitions CAPM E Ri Rf Beta Rm Rf Beta Risk Market Risk Premium Rm Rf CHAPTER 12 RISK RETURN AND THE CAPITAL ASSET PRICING MODEL Average market return Average T Bill return Alpha Observed Return of an Asset Expected Return of an Asset Systematic Risk Market related Measured by Beta Can NOT be diversified away Unsystematic Risk Firm specific risk Can be diversified away o Risk Return The higher the risk the higher your potential returns Risk is measured by price or return volatility T Bills tend to have lower returns between 2 4 while stocks are higher with 6 10 o Rate of Return Cash payment Change in price Price paid o Simple Averages of Percentages If there is a negative percentage return then the calculation of a simple average is biased upwards Simple average returns can hide poor performance o Asset Diversification IMPORTANT in order to reduce risk Means you spread your money amongst different investments Goal to invest in a group of assets to provide you with the best possible returns at a given level of risk Diversification reduces unsystematic risk firm specific risk Total risk in the stock market systematic unsystematic Correlation Coefficients 1 0 correlation coefficient between 2 stocks means that when one of those stocks is up by 10 then the other one will also increase by 10 1 0 correlation coefficient means that when one of the stocks is up 5 the other stock is down 5 Highly correlated assets offer less risk reduction from diversification than do assets that are less correlated o Capital Asset Pricing Model Estimates the rate of return an investor should expect on a risky asset an asset Purpose is to determine the discount rate to use when valuing CAPM E Ri Rf Beta Rm Rf CAPM Expected return of a risky asset Return on the risk free asset Beta Average market return Average T Bill return o Standard Deviation of Return The greater the SD means greater risk and more fluctuation o Beta Is the measure of market related systematic risk of an asset Lower Beta means less volatility Determines an investment s risk premium A stock with a Beta of 2 will usually double market movements A stock with a beta of 0 5 will have movements equal to the up or down market up or down o Alpha Measures performance positive Alpha is good Alpha Observed Return of an Asset Expected Return of an Asset Looking at the Risk Return line on a graph an Alpha plotted above this line is positive