FIN 310 1st Edition Exam 1 Study Guide I The Investment Environment Real vs Financial Assets Real Assets assets to produce goods or service Financial Assets claims on real assets of the income generated by them Consumption Timing Storing wealth in financial assets making changes during high and low periods By doing this consumption can be shifted over the course of a person s life and this allocates consumption to time periods that provide greatest satisfaction Allocation of Risk selecting investments with the wanted or appropriate amount of risk the market allows risk that is inherent to all investments to be borne by the investors most willing to take on the risk Top down vs Bottom Up Portfolio Formation Bottom Up Constructing a portfolio from attractively priced securities without regard for asset allocation Top down Allocating assets based of careful planning of diversification Financial Intermediaries Institutions that connect borrowers and lenders by accepting funds from lenders and loaning funds to borrowers Financial Intermediaries have evolved to bring together the suppliers of capital with the demands of capital The intermediaries include banks investment companies insurance companies and credit unions Four types of Markets Direct Search the least organized market buyers and sellers have to seek out each other an example of this would be Craigslist Brokered Markets next level of organized market In this market traders find it profitable to offer services to buyers and sellers an example is Real Estate Dealer Markets when trading activity in a particular type of asset increases dealers market arise Dealers specialize in particular assets purchase these assets for their own accounts and later sell them to profit Most bonds trade in over the counter dealer markets Auction Market A market where all traders meet at one place to buy and sell an asset an example is the NYSE II Asset Class and Financial Instruments Asset Classes Equities Common stocks preferred stocks Bonds Treasury Bonds and notes Federal Agency debt Municipal bonds Corporate bonds Mortgage backed securities Derivative Markets Options Futures and forwards Swaps Corporate Bond vs Tax Free Municipal Bond Corporate Bond Long term debt issued by private corporations typically paying semiannual coupons and returning the face value of the bond at maturity Municipal Bond Tax exempt bonds issues by state and local governments When choosing between a taxable or tax exempt bond needs to compare aftertax returns on each bond Indices Price weighted average An average computed by adding the prices of the stocks and dividing by a divisor To calculate this you take the difference in the initial value and the final value of the index and the divide that number by the initial value Market value weighted Index return equals the weighted average of returns of each component security with weights proportional to outstanding market value Calculated by find the total value of the 500 firms in the index and the total of those firms on the day previous the percentage increase represents the increase in the index Equally weighted Index An index of computed from a simple average of returns To reset a portfolio to equal weights you would need to rebalance by selling some of one stock and purchasing more of the other III How Securities are Traded How firms issue securities Primary Market Market for new issues of securities Secondary Market Market for already existing securities Firms need to raise new capital to help pay for their many investment projects they issue securities to raise this capital Once the securities are traded investors might trade among themselves Underwriters and Underpricing Pecking Order Theory postulates that the cost of financing increases with asymmetric information Financing comes from three sources internal funds debt and new equity Companies prioritize their sources of financing first preferring internal financing and then debt lastly raising equity as a last resort Hence internal financing is used first when that is depleted then debt is issued and when it is no longer sensible to issue any more debt equity is issued NYSE vs NASDAQ New York Stock Exchange publishes a market value weighted composite index of all NYSE listed stocks in addition to sub indexes for industrial utility transportation and financial stocks NASDAQ The computer linked price quotation and trade execution system National Association of Securities Dealers publishes an index of more than 3 000 firms trades on the Nasdaq market NYSE is an organized exchange while NASDAQ is an electronic market Specialists Market makers with functions of a broker and a dealer Buy orders Sell order raise the price or sell out of their own inventory to meet demand Buy orders Sell order lower the price or purchase for their own inventory Market Vs Limit Orders Market Market orders are buy or sell orders that are to be executed immediately at current market prices Bid price price at which a dealer or other trader is willing to purchase a security Ask price The price at which a dealer of other trader will sell a security Bid ask spread the difference between the bid and asked prices Limit Order An order specifying a price at which an investor is willing to buy or sell Trading Costs Explicit Cost commission that must be paid to brokers Implicit Cost the dealer s bid ask spread or investor may be forced to make for trading in quantities greater than associated with the posted bid or asked prices Trading on Margin short selling Margin Describes securities purchased with money borrowed in part from a broker the margin in the new worth of the investor s account Purchasing stocks on margin means the investor borrows part of the purchase price of the stock from a broker Short Selling Allows investors to profit from a decline in a security s price An investor borrows a share of stock from a broker and sells it later the short seller has to buy a share of the same stock to replace the one that was borrowed Insider Trading Using information that is not available to the public to make investment decisions illegally IV Investment Companies Investment companies Financial intermediaries that invest the funds of individual investors in securities or other assets Net Asset Value Assets minus liabilities expressed on a per share basis Net Asset Value Market Value of assets minus liabilities Shares outstanding Two Main types of Investment Companies Investment trusts fixed or