FIN 301 Exam 3 Study Guide- Topics Covered on Exam 3:o Chapter 8 Financial Intermediationo Chapter 12 Risk & Return and CAPMo Chapter 13 Efficient Capital Marketso Chapter 14 Bondso Chapter 15 Stockso Chapter 16 Management of Risk- CHAPTER 8 FINANCIAL INTERMEDIATIONo 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 Investors must commit their money into a HF for at least a year 2-20 Fee Structure- 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 themarket 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 latero Glass-Steagall Act 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 bankingactivities 1999: Financial Services Modernization Act eliminated separation of banks, securities firms, and insurance companies and allowed financial institutions to compete with foreign bankso Two Sides of Wall St. Sell Side- Consists of investment banks and commercial banks- They create markets and sell financial products Buy Side- Consists of commercial banks, mutual funds, money managers, insurance companies, hedge funds, and financial entities- They buy, hold, and trade financial productso 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 revenueo Revenue is directly linked to market valuations so a major fall in asset prices leads to a decline inrevenue generation How are they organized?- 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 instruments Alternative Asset Management- Hedge funds – many of these firms are private and lightly regulatedo Referred to ass the shadow Wall St.- Real Estate and private equity funds generally offer highrisk, high reward opportunities for affluent investorso 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, administrationso 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 rateso 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 towardtaking 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 Structureo Current Issues for Financial Institutions Regulations developing for Dodd-Frank Act Regulatory dialect Banks vs. Non-banks Global competition- CHAPTER 12 RISK & RETURN AND THE CAPITAL ASSET PRICING MODELo Definitions CAPM = E(Ri) = Rf + Beta * (Rm - Rf) Beta = Risk Market Risk Premium = (Rm - Rf)- 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 awayo 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 paido 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 performanceo 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 bestpossible 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 correlatedo Capital Asset Pricing Model Estimates the rate of return an investor should expect on a risky asset Purpose is to determine the discount rate to use when valuing an asset CAPM = E(Ri) = Rf + Beta * (Rm - Rf)- CAPM = Expected return of a risky asset = Return on therisk-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