BUSFIN 4221 Investments Midterm 1

investment

commitment of current resources in the expectation of deriving greater resources in the future

real assets

Used to produce goods and services: Property, plants and equipment, human capital, etc.

financial assets

claims on real assets or the income generated by them

• ex) stocks or bonds

Informational Role of Financial Markets?

• to direct capital to firms with the greatest perceived potential

asset allocation

The choice among broad array of asset classes

• single most important determinant of portfolio performance

security selection

choice of specific securities within each asset class

financial intermediaries

bring together suppliers of capital (investors) and demanders of capital (corps and government)

• provide SCALE and EFFICIENCY

active investing

refers to a portfolio management strategy where managers make investments with the goal of outperforming markets

passive investing

buying the benchmark index

buy side

comprise the investing institutions such as mutual funds, pension funds... they buy securities- SALOPEK

sell side

serve as intermediaries between issuers of securities and the investing public, analysts who perform stock research and make ratings (investment bankers)

money market

short term, less than one year, very liquid, very low risk , sub sector of the bond market

treasury bills

issued by fed govt., very liquid and zero default risk

CD

issued by banks, low risk, treated as bank deposits

• can not be withdrawn on demand

Commercial Paper

issued by large credit worth companies, very infrequently used

Bankers’ Acceptances

• purchaser authorizes a bank to pay seller for good at a later date 

• bank has to later accept draft

Eurodollars

• dollar denominated deposits held outside the U.S.

Repos and Reverse Repos

• short term sales with an agreement to repurchase securities at higher price 

current fed funds rate

4.25-4.5%

treasury note

1-10 years risk free

treasury bond

10-30 years risk free

municipal bond

a bond issued by a state or local government to provide funding for a specified purpose

revenue bond

a bond that is repaid from the income generated by the project it is designed to finance

general obligation bond

A bond backed by the full faith, credit, and unlimited taxing power of the government that issued it.

• lower risk

tax equivalent yield

yield / (1 - tax rate)

Federal Agency Debt

issued by government agencies to finance their operations

corporate bonds

issued by private company, have specific collateral for backing

common stock

Represents ownership in a publicly held company which entitles owners to dividends, voting rights on matters affecting the company, last to get paid, limited liability

preferred stock

equity ownership with fixed income like characteristics, higher preference over common stock, no voting power

depository receipts (ADR)

certificates traded in US markets that represent ownership in shares of a foreign company

Duties of the Fed

Lender of last resort, monetary policy (raise/lower interest rates)

Dual mandate of the Fed

full employment and price stability

reserve requirement

the percentage of deposits that banking institutions must hold in reserve

open market operations

the purchase and sale of U.S. government bonds by the Fed

hawkish

member who is more concerned with inflation than growth

dovish

member who is more concerned with growth than inflation

derivative

A security that derives its value from the value or return of another asset or security

primary market

the market in which new securities are originally sold to investors

secondary market

the market in which previously issued securities are traded among investors

ipo

the first sale of stock by a private company to the public

direct listing

a company going public that doesn't raise money by offering new shares for sale, they make existing shares immediately avaliable

SPAC

• special purpose acquisition corp

• blank check company

• reverse merger- something is already public and a private company mergers with it

Difference between IPO vs direct listing vs SPAC

• IPOS have an underwrite and direct listings do not (so no fees)

• direct listings have restrictions on how much capital can be raised

• SPACS are faster / not limited for capital

Direct Search Markets

• buyers and sellers locate one another on their own

• ebay

Brokered Markets

• third party assistance in locating buyer or seller 

• real estate

Dealer Markets

• third party acts as intermediate buyer/seller 

• bond markets

Auction markets

• brokers and dealers trade in one location

• stock market

market order

execute immediately at best price

Price contingent order

buy/sell at specified price or better

Limit order

specifies price at which investor will buy/sell

bid ask spread

the difference between the bid price and the asked price

ask price

price at which dealer will sell security, or what you will pay when you buy

• lowest price seller will accept

bid price

the price a dealer is willing to pay, or what you get when you sell

• highest price buyer is willing to pay

Commission trading cost

• fee paid to broker for executing transaction

Bid ask spread cost

• cost of trading with dealer

buying on margin

borrow money from a broker to purchase stock

initial margin

the minimum margin that must be supplied on a securities purchase

maintenance margin

the minimum margin that must be present at all times in a margin account

margin call

notification from broker that you must put up additional funds or have position liquidated

short selling

the sales of a security that is not owned by the seller, benefit from a decline in share price

• 100% potential profit and UNLIMITED loss

A company is in risk of a short squeeze if? 

• if a stock starts to rise rapidly the trend will continue because investors will want out

• 1. short interest = # of shares short/ # of shares outstanding

open end fund

A type of mutual fund that does not have restrictions on the amount of shares the fund will issue

• shares outstanding: changes when new shares are sold or old shares are redeemed

close end fund

organized as a publicly traded investment company by the SEC, share price may trade at discount or premium to NAV

• shares outstanding: no change unless new stock offered

ETF

active vehicle, offshoots of a mutual fund that allows investors to trade index portfolios

- trade continuously throughout the day

- lower costs

- can short

- very liquid

hedge fund

A private investment pool, open to wealthy or institutional investors, that is exempt from SEC regulation and can therefore pursue more speculative policies than mutual funds.

venture capital

source of capital for start up companies that cannot fund on own

private equity

Invests in companies not traded on stock exchange

(PS-PB+CF)/PB

holding period return equation

geometric average

measures compound rate of growth of a portfolio

• no break in time periods

• FAVORED to compare returns of investment managers

arithmetic average

the sum of returns in each period divided by the number of periods

• NOT continuous time periods

investment risk

The chance that an investment's actual return will be different than expected.

standard deviation

used to quantify uncertainty (higher = more risk)

Value at Risk (VaR)

measure of downside risk

excess return

actual rate of return in excess of risk free rate

risk premium

an expected return in excess of that on risk-free securities

historical market risk premium

4-7%

sharpe ratio

a ratio of return vs. risk

(Rp - Rf) / Std Dev (p)

What does the sharpe ratio tell you?

• how much excess return did you get per unit of risk

• Greater than 1: more return 

• less than 1: not being compensated enough

systematic risk

a risk that influences a large number of assets

• impacts economy as a whole

unsystematic risk

a risk that affects at most a small number of assets, firm risk

efficient diversification

highest return for given level of risk

correlation

how two securities move with each other

+1, positive, and 0 correlation, -1

• +1 means theres no reduction in risk

• positive means risk reduced but not eliminated

• zero correlation means risk reduced but not eliminated 

• -1 means COMPLETE reduction of risk

The risk of the portfolio is directly affected by_____?

• correlation between assets

Efficient Frontier of risky assets

• graph representing set of portfolios that maximizes expected return at each level of portfolio risk

undervalued

EROR > RROR

technical analysis

research on recurrent and predictable stock price patterns and on proxies for buy or sell pressure in the market

fundamental analysis

attempting to measure the intrinsic value of a company relative to its current price

quantitative analysis

the application of mathematical and statistical principles to markets and individual stocks

Efficient Market Hypothesis

the hypothesis that prices of securities fully reflect available information about securities

random walk theory

A market analysis theory that the Past movement or direction of the price of a stock or market cannot be used to predict its future movement or direction.

weak form

Stock prices already reflect all information contained in history of trading

• technical analysis would add no value

semi strong form

stock prices reflect all publicly available information (not just that in past prices)

• fundamental analysis adds no value

strong form

Stock prices reflect public and private info. Not even access to inside info can produce superior results

• passive strategy

behavioral finance vs traditional

• behavioral is the application of psychology to make financial decisions

• traditional ignores how real people make decisions

loss aversion

The strong tendency to regard losses as considerably more important than gains of comparable magnitude—and, with this, a tendency to take steps (including risky steps) to avoid possible loss.

• higher number means risk aversion (avoiding)

• lower number means risk seeking

• @ 1 you are impacted by gain and loss the same

framing

the way an issue is posed; how an issue is framed can significantly affect decisions and judgments.

anchoring

the tendency, in making judgments, to rely on the first piece of information encountered or information that comes most quickly to mind

confirmation bias

• the tendency to accept evidence that confirms our beliefs and reject evidence that contradicts them 

overconfidence effect

• occurs when people’s subjective confidence in their own ability is greater than their actual performance