FINANCE STUDY GUIDE TEST 1 Chapter 1 The Financial System Financial Markets Direct channels for buying and selling financial securities Direct 2 party system Financial Intermediaries Indirect interaction commercial banks for deposits investment bank no deposits mutual funds etc Players 1 Government Federal State and Local a If government size shrinks local services will be stopped Businesses 2 3 Households small retail investors Purpose 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 businesses Benchmarking the standard by which we compare something such as housing appraisal Services of a financial system Risk the chance that investment returns will be other than expected High risk high returns 1 Risk sharing help to spread or transfer risk between parties o Mutual funds share risk 2 Liquidity 1 the speed and ease which an asset can be converted to cash 2 at a reasonable value o 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 bills Main government regulators 1 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 currency 2 Securities and exchange commission SEC regulates the financial markets 3 Federal Deposit Insurance Corporation FDIC insures deposits in commercial banks Assets 1 Asset anything of value 2 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 stock a 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 bonds Liabilities when we make loans that are originally assets but fail and turn into liabilities Chapter 2 Interest Rates and Rates of Return Investment Returns From Bonds Income is made by interest and you get capital gains loss From 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 sold o Paper unrealized gains asset is held Total Returns current income capital gains loss Returns How 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 return Required 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 Short term is least risk because they can print money 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 inflation Real rate of return risk free rate expected inflation Expected inflation is real world proxy Real rate of return measures increases buying the investment provides Required return on investment real rate of return expected inflation risk premium for investment j is the only variable that directly impacts an investment Averages and risk An investment is more risky if it deviates from the average We can use the Standard Deviation to measure risk Level of returns Factors 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 countries 3 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 term Holding period returns Holding period time period over which an investment return is measured measures the total return Current Income Capital Gains HP return Current Income Capital gains Either bond interest or stock dividends Both realized and unrealized To compare investments use HP s of equal length adjusted annually 1 2 And use returns instead of dollar returns Holding Period Return HPR HPR Current Income during period Capital gains loss Beginninginvestment value return End value start value intitialinvestment HP 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 tomorrow Compounding the time value of money Compounding the process of earning interest on money p P principle i interest rate n of compound intervals Compounding semi annually and quarterly have different formulas Ex A 30 year bond makes 60 interest payments every year for 30 years the 60 you make in year one is worth more than year 30 Present and future value Most financial transactions involve future payments Interest rates i link the financial present and future Future Value FV the value of money received at a specified time in the future rates of return move forward in time while discount rates move
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