FINANCIAL INVESTMENTS TEST 1 STUDY GUIDE 19 multiple choice questions 3 math show calculation and solution 1 Financial assets Ch 1 Financial assets claims on real assets or claims on asset income o These 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 o These assets are the means by which individuals hold their claims on real assets o All financial assets owner of the claim are offset by a financial liability issuer of the claim When we aggregate over all balance sheets only real assets remain 3 Major classes of financial assets o 1 Fixed income or Debt Securities pay a specified cash flow over a specific period Promise either a fixed stream of income or a stream of income that is determined according to a specific formula o 2 Equity an ownership share in a corporation Equity holders are not promised any particular payment If the firm is successful the value of the equity will increase and vice versa o 3 Derivative Securities securities providing payoffs that depend on the values of other assets Derivative securities such as options and futures contracts provide payoffs that are determined by the prices of other assets such as bond or stock prices 2 Asset allocation process Ch 1 Ch 4 and Ch 5 Allocation of an investment portfolio across board asset classes Choosing the percentage of funds in asset classes The asset allocation decision is the primary determinant of a portfolio s return Active management takes part in asset allocation along with finding undervalued securities and timing the market o Passive management does not The most basic form of asset allocation envisions the portfolio as dichotomized into risky and versus risk free investments Part of the asset allocation process is weighing sectors based on manager forecasts riskier Stocks 60 Bonds 30 Alternative Assets 6 Money market Securities 4 o REFER TO Slide 54 Ch 5 Slide 55 Ch 5 3 Securitization Ch 1 Loans of a given type such as mortgages are placed into a pool and new securities are issued that use the loan payments as collateral The securities are marketable and are purchased by many institutions The end result is more investment opportunities for purchasers and spreading loan credit risk among more institutions Securitization has grown rapidly due to Changes in financial institutions and regulation permitting its growth particularly lower capital requirements on securitized loans Improvement in information capabilities Credit enhancement provided by pool issuers has improved marketability 4 Money market instruments Ch 2 Money markets include short term highly liquid and relatively low risk debt instruments Different types of money market instruments issued by the federal government highly liquid no default Treasury bills Certificates of deposit risk is fully taxable unsecured rated its bank to pay the seller for the goods at a date in the future Bankers acceptances Commercial paper issued by corporations and financial institutions Originates when a purchaser of goods authorizes issued by depository institutions interest income o When the purchaser s bank accepts the draft it becomes a contingent liability of the bank and becomes a marketable security Eurodollars dollar denominated time deposits held outside the U S o Pay a higher interest rate than U S deposits Repos and reserves agreement to repurchase the securities at a set higher price short term sales of securities arranged with an o A RP is a collateralized loan many are overnight although RPs may have a one month maturity o A Reverse Repo is lending money and obtaining security title as collateral Broker s calls investors who buy stock on margin borrow money from their brokers to purchase stock The borrowing rate is the call money rate o The loan may be called in by the broker depository institutions must maintain deposits with the Federal funds Federal Reserve Bank o Federal funds represents trading in reserves held on deposit at the Federal Reserve LIBOR London Interbank Offer Rate London and elsewhere lend each other o Base rate for many loans and derivatives rate at which large banks in Yields on money market instruments are not always directly comparable o REFER TO Slide 67 Ch 2 5 Calculate taxable tax free yields Ch 2 rTax Exempt rTaxable 1 Tax Rate o REFER TO o TRY Slide 28 30 Ch 2 Problem 1 Ch 2 slides Problem 3 Ch 2 slides 6 Price dollar weighted Ch 2 Price Ch 5 DWR Price Weighted method cash and stock dividends proportionately assumes you buy 1 share of each stock and invest o DJIA o Add up the prices of the stock and divide by a given divisor Higher priced shares get more weight REFER TO Example 2 2 in Text pg 41 Dollar weighted return procedure DWR find the discount rate that makes the NPV of the cash flows equal zero find the IRR for the cash flows o Tips on calculating DWR This measure of return considers both changes in investment and security performance Initial investment is an outflow Ending value is an inflow Additional investment is an outflow Security sales are an inflow o OR use CF function on financial calculator REFER TO TRY Slide 16 Ch 5 Concept check 5 1 pg 113 in book 7 Residual claims Ch 2 Residual Claim means stockholders are the last in line of all those who have a claim on the assets and income of the corporation Lowest priority in case of bankruptcy First debtholders then preferred then common Common stock In the event of bankruptcy what will stockholders receive o In a liquidation of the firm s assets the shareholders have claim to what is left after paying all other claimants such as taxes employees suppliers bondholders etc o Management can either pay this residual as cash dividends to shareholders or reinvest in the business 8 Common hedging strategies Ch 4 Hedge funds similar to mutual finds but not registered and regulated by the SEC o Available to institutional and high net worth investors Can pursue investment strategies that are not allowed for mutual funds o Heavy use of derivatives o Short sales o Leverage Hedge funds are designed to invest in a wide range of investments with various funds focusing on derivatives distressed firms currency speculation convertible bonds emerging markets etc May jump from one asset class to another as perceived investment opportunities shift 9 Types of securities underwritten by investment banks Ch 3 In a typical underwriting arrangement the investment bankers purchase the securities