FIN3140 Final Exam Study Guide Investments Basic Financial Rules o Risk and Return Investing is about future expectations No one knows the future without certainty Liquidity The degree to which an asset or security can be bought or sold in the market without affecting the asset s price Liquidity is characterized by a high level of trading activity Assets that can be easily bought or sold are known as liquid assets Default risk Interest rate risk o Time the chance a firm won t be able to meet its legal obligations The chance that interest rates will move against you As a characteristic of the investment vehicle maturity Maturity the period of time for which a financial instrument remains outstanding Maturity refers to a finite time period at the end of which the financial instrument will cease to exist and the principal is repaid with interest The term is most commonly used in the context of fixed income investments such as bonds and deposits Investment Horizon length of time before investment money is needed by the investor Investing o Equity Securities Ownership Returns Stocks Capital Gains Dividends o Debt Securities Lending Money CD s Treasuries Bonds Returns Capital Gains Interest o Capital Gains difference between selling price and purchase price o Transaction Costs costs incurred in buying or selling All costs reduce returns Investments o Generally stock prices move in the same direction Up together Down together o Debt Security prices move in the same direction o Bond prices and bond yields always move in opposite directions o In the specific Investments Move in whatever direction they do Move up and down in various amounts Debt Securities o Interest rates depend on Size amount of investment Cost of money at the time of investment market rate Maturity length of investment Default risk of investment o Certificate of Deposit CD CD specific money amount for specified time Fixed Rate CD s constant rate over securities life Variable Rate CD s changes with interest rate in economy Tips 1 Don t allow automatic roll overs 2 Compare Rates APYs o They can vary a lot Bond Types o Corporate Bonds Face price amount that firm issuer borrows Amount to be repaid at maturity Tradable can be publicly traded between investors o US Saving s Bonds Can t be traded o A bonds face price is NOT always its purchase price o US Treasuries Very liquid o Corporate Bonds Not so liquid Money Market Deposit Accounts o Money Markets trade in short term securities Mature in less than a year High liquidity Lower risk Pay variable interest rates Minimum balance usually required Opportunity cost Penalty if balance falls below minimum amount May have limited check writing o Depository Accounts Usually FDIC insured o MMMF mutual funds MMDA depository accounts ARE DIFFERENT Indexes o An index a group of specified securities Typically diversified around some characteristic More data points make measures more meaningful o Indexes help investors Gauge general market conditions Compare their returns to an index benchmark Are you doing as well as an appropriate index Attempt to forecast future behavior No one will be perfect at this o Index Examples CPI Consumer Price Index measures inflation Bond indexes Well known stock indexes DOW DIJA 30 huge US firms all sectors S P 500 500 largest leading firms in leading industries o Comparing numeric values is meaningless Must compare percentage returns o Often used to benchmark an individual s investment performance You MUST measure over the same time period If the index loses money you re going to expect to lose money o Performance is NOT only about returns also about risk Higher risk higher returns but greater uncertainty of getting them Returns and Debt Securities o Interest Payments Cost of borrowed money o Assuming no default held to maturity Know exact returns for fixed interest debt securities o U S Treasuries Very low default risk Low returns Very high liquidity Low returns o Corporate Bonds Higher risk bong must offer high interest returns Liquidity is lower than U S bonds If sold before maturity there may be uncertain returns capital gains o U S Savings Bonds Not marketable Illiquid Common Stocks Debt Holders vs Shareholders o Debt Holders are entitled to A return for lending their money It s cost plus interest o A return of the money they lent The principal Borrower is legally required to pay back principal and interest If not it can result in default and bankruptcy o Shareholders stock equity in firm Have residual ownership Share in firms profits after all debt obligations are paid Investment Returns o Debt Holders get paid before Shareholders o How much can shareholders lose Their whole investment o Capital Gain Selling Price Purchase Price Stocks when sold Bonds if sold before maturity date Otherwise none o Current Income Dividends Stock Interest Debt General Market Conditions o Strong Impact on Security Movements o Bull Markets Investor Optimism Occur during economic expansions o Bear Markets Investor Pessimism Occur during economic slow downs Market Value and Stock Prices o Market Value of Stock Share A share of a firm s profits paid to its owners Firm s Board of Directors o Decides if and how much to pay individuals What the market thinks Who What s the market Firm s market value of stocks x share price Determined by supply and demand o Expectations of future earnings Change with 1 New Information 2 Investor Psychology o Inherent Risky Investment The future is unknown o Stock Prices can change frequently and rapidly Common Stocks o Listed firms trade on exchanges Such as NYSE and NASDAQ o Even more firms are unlisted Penny Stocks These are typically VERY small firms Limited number of shares illiquid Prices Easily Manipulated o Low trading volume illiquid o Low Share Price often less than 5 per share sometimes pennies VERY risky Stockbrokers o Salespeople who work for brokerage houses Find counter party to trade o Profit from commissions fees Whenever stocks trade Doesn t matter if you make money Be wary of recommendations o Online Brokers are usually the cheapest o Stock information is plentiful o Remember if it looks too good to be true it probably is Financial Similarities o Get information o Know why and what you re buying Your goals determine WHEN money s needed WHAT you can invest in And RISK you can take Opportunity Costs vs Potential Losses o Decide when to sell Monitor situation for firm and economy changes Stay in market position or change Exit