Chapter 1: The Financial SystemChapter 2: Interest Rates and Rates of ReturnAverages and riskChapter 10: Risk of InvestmentsChapter 3: Transaction Costs, Asymmetric Information, and the Structure of the Financial SystemFINANCE STUDY GUIDE- TEST 1Chapter 1: The Financial SystemFinancial Markets- Direct channels for buying and selling financial securities.• Direct 2 party systemFinancial Intermediaries- Indirect interaction, commercial banks for deposits, investment bank no deposits, mutual funds etc.Players:1. Government- Federal, State, and Locala. If government size shrinks, local services will be stopped2. Businesses3. Households- small retail investorsPurpose of the financial system: to provide channels for transferring funds between lenders and borrowers.• Savers supply funs, and borrowers demand funds• #1 savers- Households• #1 borrowers- government and businessesBenchmarking- the standard by which we compare something, such as housing appraisalServices of a financial systemRisk: the chance that investment returns will be other than expected.• High risk= high returns1. Risk sharing- help to spread or transfer risk between parties.o Mutual funds share risk2. Liquidity- 1) the speed and ease which an asset can be converted to cash 2) at a reasonable valueo House is not liquid because we would have to sell it under price. Cannot immediately make money on house turnover.3. Information- the collection and communication of facts about borrowers and about expected returns. • Cash is our most liquid asset• Illiquidity is slow process to be converted into cash• Illiquid- I don’t have cash vs. Insolvent- I can’t pay by billsMain government regulators1. The Federal Reserve (The Fed) - central bank of the US, lender of last resort, conducts monetary policy.a. The U.S. Treasury is concerned with fiscal policy. This involves taxing, budgeting and spending. It is the Treasury that actually prints currency2. Securities and exchange commission (SEC)- regulates the financial markets3. Federal Deposit Insurance Corporation (FDIC)- insures deposits in commercial banksAssets1. Asset- anything of value2. Security- financial asset that can be traded in the financial market• Mortgage backed security• Securitized loans are loans that are tradable (can be bought and sold) in financial markets. 3. Equity security- ownership of private or public stocka. Stock, residual ownership, paid as dividends 4. Debt Security- Buyer of debt lends money in form of bond. a. Bonds, lent as principle, K is made in payment as interest (cost of money)A bubble is an unsustainable increase in the price of a class of assets. Many economists believe there was a housing bubble in the U.S. between 2000 and 2005.In 2006 declining housing prices caused mortgage-backed securities to lose value. This caused losses for the investment institutions that owned them.Securitization- process of turning an asset into a security• Mortgage backed securities were put into a bundle with payments staggered• Collateralized debt obligations reduce risk• Fannie Mae and Freddie Mac bought the MBS and sold bondsLiabilities- when we make loans that are originally assets but fail and turn into liabilities.Chapter 2: Interest Rates and Rates of ReturnInvestment ReturnsFrom Bonds: Income is made by interest and you get capital gains/lossFrom Stocks: Income is made by dividends and capital gain/loss• Interest- the cost of money • Dividend- payment that might be made by a firm to its shareholders• Capital gains- increase in market value of an asset, ( The selling price- price paid)o Realized gains: asset must by physically soldo Paper (unrealized) gains- asset is heldTotal Returns- current income +capital gains (loss)ReturnsHow much returns are necessary to attract somebody to an investment?• Enough to compensate for lost opportunities (opportunity cost)• Compensate for inflation (sufficient purchasing power)• Compensation for risk of not getting expected returnRequired return: rate of return that an investor must get to fully compensate a risk.Measuring returns• Least risky investments would be issued by the government b/c they can print money.• Government issues debt vehicles, NOT equity.• Federal government is least risk because they can print money.• Short term debt securities have least risk because less can go wrong in short period.3 month Treasury bill: risk free rate (Rf), meaning no uncertainty of default.• Return on 3 month T Bill will compensate for expected inflationReal rate of return = risk free rate – expected inflation• Expected inflation is real world proxyReal rate of return measures increases buying the investment providesRequired return on investment: real rate of return + expected inflation + risk premium for investment• “j” is the only variable that directly impacts an investmentAverages and risk• An investment is more risky if it deviates from the average• We can use the Standard Deviation to measure risk.Level of returnsFactors that affect risk:1) Internal Characteristics, such as the asset type, management quality, capital structure, firm size.2) External forces- things not under the control of investment vehicles issuer such as interest rates, war, and politics, economics in foreign countries3) Sensitivity to X: the degree of price reaction to changes in X, X can be an external or internal factor.• Equity is riskier than debt • Long term is more risky than short termHolding period returnsHolding period: time period over which an investment return is measured• HP return measures the total return (Current Income + Capital Gains)• Current Income- Either bond interest or stock dividends• Capital gains : Both realized and unrealizedTo compare investments use:1) HP’s of equal length, adjusted annually2) And use % returns instead of dollar returnsHolding Period Return (HPR)HPR= Current Income during period+Capital gains/ lossBeginning investment value% return= End value− start valueintitialinvestmentHP pros and cons: Quick and easy to use but generally not useable for periods greater than one year and doesn’t consider the time value of money.Time value of money: refers to how a dollar received now is worth more than one you receive in the future.• One dollar today is worth more than a dollar received tomorrowCompounding the time value of moneyCompounding- the process of earning interest on money.1.08 ¿51+i¿n=$ 100 ¿p ¿P=
View Full Document
Unlocking...