Investment Theory - Note 2

What is the money market?

A market for short-term, highly liquid, relatively low-risk debt instruments.

What type of securities trade in the money market?

Short-term debt instruments.

What are three key features of money market securities?

Short maturity, high liquidity, and relatively low risk.

What is a Treasury bill (T-bill)?

A short-term debt security issued by the U.S. government.

How do Treasury bills typically generate returns?

They are sold at a discount and repaid at face value.

What is a Certificate of Deposit (CD)?

A bank deposit instrument with specified maturity and interest terms.

What is commercial paper?

Short-term, usually unsecured debt issued by corporations.

Who issues commercial paper?

Corporations seeking short-term financing.

What is a banker's acceptance?

A payment obligation guaranteed by a bank.

What is a Eurodollar deposit?

A U.S. dollar-denominated deposit held outside the United States.

Does Eurodollar mean a deposit in euros?

No. It refers to U.S. dollar deposits held outside the U.S.

What is a repurchase agreement (repo)?

A short-term financing transaction backed by securities.

How does a repo work?

A security is sold with an agreement to repurchase it later.

What is the capital market?

A market for longer-term debt and equity securities.

What are the two main capital market segments?

The bond market and the equity market.

What are Treasury notes and bonds?

Debt securities issued by the U.S. government.

What are inflation-protected Treasury bonds?

Treasury securities whose principal adjusts for inflation.

What is federal agency debt?

Debt issued by federal agencies or government-sponsored entities.

What is a municipal bond?

A debt security issued by a state or local government.

What is a corporate bond?

A debt security issued by a company.

What is a mortgage-backed security (MBS)?

A security backed by cash flows from a pool of mortgages.

What is the basic difference between bonds and stocks?

Bonds represent debt claims; stocks represent ownership claims.

What is common stock?

A security representing an ownership share in a corporation.

What rights do common shareholders typically have?

Voting rights and a residual claim on company assets and income.

What are dividends?

Distributions of company earnings to shareholders.

Are common stock dividends guaranteed?

No. Companies may reduce, suspend, or omit dividends.

What is a residual claim?

The claim on value remaining after higher-priority claims are paid.

Who has lower priority: common shareholders or bondholders?

Common shareholders.

What does limited liability mean for shareholders?

They normally cannot lose more than their investment.

What is the maximum loss on a fully paid stock purchase?

The amount originally invested.

What is preferred stock?

Equity with features resembling both common stock and debt.

Who has dividend priority: preferred or common shareholders?

Preferred shareholders.

Why does preferred stock resemble debt?

It often pays a specified dividend.

Are preferred stock dividends tax-deductible to the issuing firm?

No. Neither preferred nor common dividends are tax-deductible.

What is a depository receipt?

A certificate representing ownership of shares in another market.

What is an American Depository Receipt (ADR)?

A U.S.-traded certificate representing shares in a foreign company.

What is a market index?

A measure tracking the performance of a selected group of securities.

What are market indexes used for?

Tracking market returns and benchmarking investment managers.

What is a benchmark index?

A reference index used to evaluate portfolio performance.

Why must an index be representative?

It should reflect the market segment it aims to measure.

What is the difference between broad and narrow indexes?

Broad indexes cover many securities; narrow indexes cover fewer.

What is a price-weighted index?

An index where higher-priced stocks have greater influence.

Which major index is price-weighted?

The Dow Jones Industrial Average (DJIA).

What is a market-value-weighted index?

An index weighted by each company's market capitalization.

How is market capitalization calculated?

Stock price multiplied by shares outstanding.

Which indexes in Note 02 use market-value weighting?

The S&P 500 and NASDAQ indexes.

Which stock has more influence in a price-weighted index?

The stock with the higher share price.

Which stock has more influence in a value-weighted index?

The company with the larger market capitalization.

Why can two stock indexes show different returns?

They may differ in constituents and weighting methods.

What is a derivative security?

A contract whose payoff depends on an underlying asset or market condition.

What is an underlying asset?

The asset or reference variable determining a derivative's value.

What is an option?

A contract giving its buyer a right, not an obligation, to trade.

What is a call option?

An option giving its buyer the right to buy an asset.

What is a put option?

An option giving its buyer the right to sell an asset.

What is the strike price?

The price at which an option holder may exercise the right.

What is an option premium?

The price paid by the buyer to acquire an option.

What is an option's expiration date?

The date after which its exercise right ends.

What is a long call position?

Buying a call: the right to buy the underlying asset.

What is a long put position?

Buying a put: the right to sell the underlying asset.

What is a short call position?

Selling a call: assuming an obligation to sell if exercised.

What is a short put position?

Selling a put: assuming an obligation to buy if exercised.

What is the maximum loss for a long option buyer?

The premium paid, excluding transaction costs.

What does an option writer receive initially?

The option premium, in exchange for assuming an obligation.

Which long option benefits from a rising stock price?

A long call, when the price rises sufficiently.

Which long option benefits from a falling stock price?

A long put, when the price falls sufficiently.

What is a futures contract?

An agreement to buy or sell an asset at a set future date and price.

What is the main difference between options and futures?

Options give buyers rights; futures impose contractual obligations.

What is hedging?

Using a financial position to reduce an existing risk exposure.

What is speculation?

Taking financial risk in pursuit of profit from anticipated price moves.