Exam on Thursday 2 pencil 25 MC Exam One Chapters 1 5 Real assets The material wealth of a society is ultimately determined by the productive capacity of its economy that is the goods and services it members can create This capacity is a function of the real assets of the economy the land buildings equipment and knowledge that can be used to produce goods and services In contrast to such real assets are financial assets such as stocks and bonds Such securities are no more than sheets of paper or more likely computer entries and do not directly contribute to the productive capacity of the economy Instead these assets are the means by which individuals in well developed economies hold their claims on assets Real assets assets used to produce goods and services o Examples patents college education customer goodwill Financial assets claims on real assets or the income generated by them some financial security such as bonds and portfolios o Examples A 5 bill Lease obligation While real assets generate net income to the economy financial assets simply define the allocation of income or wealth among investors Asset allocation An investor s portfolio is simply his collection of investment assets Investors make two types of decisions in constructing their portfolio o Asset allocation allocation of an investment portfolio across broad asset classes Stocks bonds real estate commodities etc o Security selection choice of specific securities within each asset class Top down portfolio construction starts with asset allocation before turning to the decision of particular securities to be held in each class Starting from securities without much concern for asset allocation is called bottom up o Security analysis analysis of the value of securities Aspects of to derivatives Derivative asset a security with a payoff that depends on the prices of other securities Derivative securities Securities providing payoffs that depend on the values of other assets such as bonds or stock prices Derivative A security whose price is dependent upon or derived from one or more underlying assets The derivative itself is merely a contract between two or more parties Its value is determined by fluctuations in the underlying asset The most common underlying assets include stocks bonds commodities currencies interest rates and market indexes Most derivatives are characterized by high leverage Exam on Thursday 2 pencil 25 MC o Futures contracts forward contracts options and swaps are the most common types of derivatives Derivatives are contracts and can be used as an underlying asset There are even derivatives based on weather data such as the amount of rain or the number of sunny days in a particular region o Derivatives are generally used as an instrument to hedge risk but can also be used for speculative purposes For example a European investor purchasing shares of an American company off of an American exchange using U S dollars to do so would be exposed to exchange rate risk while holding that stock To hedge this risk the investor could purchase currency futures to lock in a specified exchange rate for the future stock sale and currency conversion back into Euros Mortgages Interest Rates Real estate trusts REITS is similar to a closed end fund REITs invest in real estate or loans secured by real estate Besides issuing shares they raise capital by borrowing from banks and issuing bonds or mortgages Most are highly leveraged with a 70 debt ratio o Two typical types Equity trusts invest in real estate directly and mortgage trusts invest primarily in mortgage and construction loans o REITs are generally established by banks insurance companies or mortgage companies which then serve as investment managers earn a fee Mortgage backed security either an ownership claim in a pool of mortgages or an obligation that is secured by such a pool o A type of asset backed security that is secured by a mortgage or collection of mortgages These securities must also be grouped in one of the top two ratings as determined by an accredited credit rating agency and usually pay periodic payments that are similar to coupon payments Furthermore the mortgage must have originated from a regulated and authorized financial institution Also known as a mortgage related security or a mortgage pass through o When you invest in a mortgage backed security you are essentially lending money to a home buyer or business An MBS is a way for a smaller regional bank to lend mortgages to its customers without having to worry about whether the customers have the assets to cover the loan Instead the bank acts as a middleman between the home buyer and the investment markets This type of security is also commonly used to redirect the interest and principal payments from the pool of mortgages to shareholders These payments can be further broken down into different classes of securities depending on the riskiness of different mortgages as they are classified under the MBS Exam on Thursday 2 pencil 25 MC Conforming mortgages loans that have to satisfy certain underwriting guidelines before they could be purchased by Fannie Mai or Freddie Mac o The term conforming is most often used when speaking specifically about a mortgage amount however the terms conforming and conventional are frequently used interchangeably Mortgages that exceed the conforming loan limit are classified as non conforming or jumbo mortgages o OFHEO which sets the conforming loan limit on an annual basis has regulatory oversight to ensure that Fannie Mae and Freddie Mac fulfill their charters and missions of promoting homeownership for lower income and middle class Americans OFHEO uses the October to October percentage increase decrease in average housing prices in the Monthly Interest Rate Survey of the Federal Housing Finance Board FHFB to adjust the conforming loan limits for the subsequent year Subprime mortgages Riskier loans made to financially weaker borrowers As a result of the borrower s lowered credit rating a conventional mortgage is not offered because the lender views the borrower as having a larger than average risk of defaulting on the loan Lending institutions often charge interest on subprime mortgages at a rate that is higher than a conventional mortgage in order to compensate themselves for carrying more risk o Borrowers with credit ratings below 600 often will be stuck with subprime mortgages and the higher interest rates that go with those mortgages Making late bill