FIN 401 Exam 1 Definitions, Terms, and Concepts (Nixon)

Asset Types

Real and Financial

Real Asset

tangible (touch); examples include land, buildings, and precious metals

FInancial Assets

stocks or documents that represent a claim on the income and property of the borrower; CDs, bonds, Treasury bills, mortgages, stocks are examples

Fixed Income

debt; most bonds and mortgages; higher-priority claim, no ownership interest, pays specified cash flows at pre-contracted interval until last payment on maturity date

Equity

Stocks; low-priority claim, ownership share in business, indefinite life

Preferred Stock

hybrid; characteristics of debt and equity

Derivatives

value is derived from other asset; options are example

Wealth

bonds, stocks, real assets, and cash-like assets

Allocation

determining how much goes into each area of your wealth (bonds, stocks, real assets, and cash-like assets)

Security selection

selection of specific securities within a particular class

Risk v Return

getting good return for the risk you take

Efficient Markets

if the markets price correctly and quickly

Agency Theory

people making decisions on behalf of other people; principal (shareholder) / agent (manager); can be disconnected from people we hire in the company; company wants to act in the best interest of the shareholders, but that is not always the case

Money Market

short term (

LIBOR (London Interbank Offered Rate)

similar to Fed Fund Rate; rate at which London banks lend to each other

Bond Market

longer-term borrowing; pays interest unlike short-terms; examples include T-notes, T-bonds

TIPS (Treasury Inflation Protected Securities)

set coupon rate, but principal adjusts for inflation

Federal Agency Debt

examples: Government National Mortgage Association, Federal Housing Association

Munis

towns, municipalities; favorable tax treatments, lower interest rate as a result

Corporations

LT debt issued by companies; pay semi-annual coupons and return face value at maturity

LT Debt

mortgage is an example

Stock Market

NASDAQ, NYSE, AMEX are examples in the US

Common Stock

typically get voting rights, potential dividends (not always), possible price appreciation, residual claims (paid last), limited liability

limited liability

the most shareholders can lose in event of the failure of the corporation is their original investment

Preferred stock

hybrid; professionals feel it is more similar to fixed income; paid a constant dividend (typical); paid before common stock; non-voting

ADR (American Depository Receipts)

securities issued by US Bank that represents shares in a foreign country; example is British Petroleum (BP)

Market Indices

Examples are DJIA and S&P500

DJIA (Dow Jones Industrial Average)

30 large companies; price weighted

S&P500 (Standard and Poor's 500)

market value weighted

International Markets

FTSE, DAX, Hang Sung

FTSE

London Stock Exchange

DAX

German stock exchange

Hang Sung

Hong Kong stock exchange

Bond Indices

Merrill Lynch Global Bond Index, Bloomberg Barclays Global Aggregate Index, JP Morgan Emerging Bond Index

Call Option

holder has right to buy stock at a set price

Put Option

holder has right to sell stock at a set price

Futures/Forwards

obligations; agreement to buy or sell at a set price at a set time

Primary Market

new issues sold (could not buy previously); company (issuer) gets the money

Secondary Market

previously issued securities are traded among investors; company (issuer) does not get the money

Investment Bankers (IBs)

raise capital for firms and municipalities; advise clients; specialize in the sale of new securities to the public

Lead Underwriter

The lead investment bank in a syndicate of investment banks and broker-dealers involved in a securities underwriting.

underwriter

purchases securities from the issuing company and resells them

Syndicate

person that helps; everyone at risk, but all can benefit

Firm Commitment

IB actually buys stock from company issuing the stock (less than market value); Issuing firm gets money upfront - no longer at risk; IB at risk, makes profit on the difference of their purchase price and eventual selling price on the market

Best Efforts

IB does not buy stock; attempts to sell at a desired price; IB paid a commission; issuing company at risk

Shelf Registration

securities can be registered up to two years in advance of issuance

Private Placement

sell directly to a small group of wealthy investors; less regulation; less costly than IPO

IPO (initial public offering)

sell to public at large; SEC regulation; cost =~ 7%

Market Order

execute immediately at current price

Ask

what investor buys at

Bid

what investor sells at

Spread

the difference between the bid and ask prices

Price-contingent order

set price at which you buy or sell

Limit Buy

buy when the price falls below X

Stop Buy

buy when the price rises above X

Stop Loss

Sell when the price falls below X

Limit Sell

Sell when the price rises above X

Margin buying

investor borrows some of the money when buying securities (at least 50% must initially be cash)

Why borrow?

expand upside, but also expands downside

maintenence margin

how far the stock can decrease in value before a margin call; broker is at risk, so they will issue a margin call if price drops below this

short sales

investor borrows shares to sell from dealer, but must later repurchase shares to replace them; benefits when the price decreases; must post margin with broker to cover potential losses

Unit investment trust

portfolio is fixed for life

managed investment trust

portfolio not fixed for life (can add and subtract securities)

open-ended

can create more shares

closed-ended

finite number of shares

NAV (Net Asset Value)

value of a share should equal this; market value of assets minus liabilities all over shares outstanding

REIT

Real Estate Investment Trust

hedge fund

private investors (wealthy) pool funds for investment, SEC has less regulatory power; require higher fees and provide less transparency to investors; offer greater expected returns given supposed "expertise"

mutual funds

an open ended investment company (example is Vanguard); includes equity, bonds, international, index (S&P500), state; can be bought and sold at the end of the trading day (not continuous); gives investors the chance to easily diversify, cheap, tax benefits

Costs of mutual funds

1) operating expenses

2) front-end load: upfront sales charge

3) back-end load: pay fees when you sell

4) 12b-1 charges: advertising, commissions

ETF (exchange traded fund)

similar to mutual funds, except that they can be bought and sold like stock throughout the trading day (continuous); most tax effective; lower transaction costs; trading fees; pay bid ask spread

passive investment

not attempting to buy or sell mispriced securities; evidence suggests that on average, passive funds outperform the active managed funds

active management

investors attempt to buy or sell mispriced securities

Effective Annual Rate (EAR)

sets everything to n=1 (annual) basis; standardized measure

Value at Risk (VaR)

loss suffered given an extreme adverse price change; 5% of the time, you would be expected to be more than 1.64485 Std Dev below the mean; 5% of the time, I'll do worse than this

always

Returns are [] calculated as a weighted average

not

Standard deviation is [] calculated as a weighted average; almost always less than weighted average

lending section of CAL

section on CAL between 100% in RF portfolio and 100% in the risky portfolio

borrowing section of CAL

section on CAL greater than 100% in the risky portfolio. At this stage, you are borrowing money

Where does each investor end up on the CAL?

depends on the risk tolerance

How many CAL's are there

infinite

Capital Market Line (CML)

market portfolio; if our portfolio (P) is a proxy to the entire market, P is the market portfolio (M); This CAL is the CML

Market/Systematic/Nondiversifiable Risk

risk that you can't eliminate; economy wide; not all securities have an equal amount

Firm Specific/Non-systematic/Diversifiable Risk

Specific to the company; can be offset by diversification

What if I change the weights of A and B in a portfolio?

Recalculate the portfolio expected return and standard deviation for each possible weight of A and B

Efficient Set

Area on the curve between the tip of the football (minimum variance portfolio point) and above; greater return with more risk

Minimum Variance Portfolio

the least amount of risk with no risk free assets

As the correlation coefficient approached -1

the more and more diversification exists within the portfolio; weird zig zag lines on the graph

As the correlation coefficient gets closer to +1

the portfolio gets less and less diversified; straight line connected going up

As the correlation coefficient is between -1 and +1

ideal diversified portfolio; curve on the graph

How to get benefits from diversification

correlation coefficient being below +1.0

When adding a risky asset to a portfolio of many risky assets, which property of the asset is more important, its standard deviation or its covariance with the other assets? Explain.

the covariance with the other assets is more important. diversification is accomplished via correlation with other assets. Covariance helps determine that number