Investment in Equities - Midterm 1

What are real assets?

Assets used to produce goods and services, such as buildings, machinery, and patents.

What are financial assets?

Claims to income generated by real assets.

What determines an economy's productive capacity?

Real assets.

What determines how an economy's wealth is distributed?

Financial assets.

What are the three main types of financial assets?

Stocks, fixed-income securities, and derivatives.

What are stocks?

Ownership shares in a company.

What are fixed-income securities?

Debt instruments promising a specified income stream, such as bonds and T-bills.

Why are fixed-income securities generally safer than stocks?

Debt holders have priority; stockholders are residual claimants.

What are derivatives?

Securities whose values depend on underlying assets; examples include futures and options.

What is the primary role of financial markets?

Capital allocation: directing funds from savers toward productive investments.

What are the two major causes of inefficient capital allocation?

Information asymmetry and agency problems.

What is information asymmetry?

When one party has more or better information than another.

What is an agency problem?

A conflict of interest between managers and shareholders.

What three mechanisms help mitigate capital allocation problems?

Disclosure rules, aligned compensation, and takeover threats.

What is asset allocation?

Deciding which asset classes to invest in, such as stocks or bonds.

What is security selection?

Choosing specific securities within each asset class.

What is top-down portfolio construction?

Asset allocation first, followed by security selection.

What is bottom-up portfolio construction?

Security selection first, followed by overall asset allocation.

What is an Initial Public Offering (IPO)?

When a private company issues shares to the public for the first time.

What is a Seasoned Equity Offering (SEO)?

When an already publicly traded company issues additional shares to raise capital.

What is a direct listing?

When existing shareholders sell their shares directly to the public without a traditional underwritten IPO.

What is the main difference between a traditional direct listing and an IPO?

In a traditional direct listing, existing shareholders sell shares without the company raising new capital; an IPO issues new shares.

What is a Special Purpose Acquisition Company (SPAC)?

A blank-check company that raises money through an IPO to acquire or merge with another company.

How long does a SPAC typically have to find an acquisition target according to the lecture?

Two years.

What is a market order?

An order executed immediately at the best available market price. Prioritizes execution over price certainty.

What is a limit order?

An order executed only at a specified price or better. Prioritizes price certainty but may not be filled.

What is a stop-loss order?

An order that becomes a market order when a specified trigger price is reached, helping limit losses or protect gains.

What is a stop-limit order?

An order that becomes a limit order when the stop price is triggered, providing price control but risking nonexecution.

What is a trailing stop order?

A stop order that automatically adjusts its trigger by a fixed dollar amount or percentage as the price moves favorably.

If a stock is $100 with a $5 trailing sell stop, what is the initial trigger price?

$95.

If the stock rises from $100 to $110 with a $5 trailing sell stop, what is the new trigger?

$105. The trigger does not decrease if the stock price subsequently falls.

What is the bid price?

The highest price a buyer is currently willing to pay for a security.

What is the ask price?

The lowest price a seller is currently willing to accept for a security.

At which price does a market buy order typically execute?

The ask price.

At which price does a market sell order typically execute?

The bid price.

What is the bid-ask spread?

The ask price minus the bid price. A smaller spread indicates a tighter market.

What is buying on margin?

Borrowing money from a broker to purchase securities, allowing investors to increase their exposure.

What is the initial margin?

The percentage of a security's purchase price that the investor must contribute using their own funds.

What is the maintenance margin?

The minimum equity percentage an investor must maintain in a margin account to avoid a margin call.

What is short selling?

Borrowing shares, selling them, and later repurchasing them to return to the lender, aiming to profit from a price decline.

What is the main difference between buying on margin and short selling?

Buying on margin uses borrowed money to purchase securities and generally profits from rising prices; short selling uses borrowed shares and profits from falling prices.

What is a demand shock?

An event that increases or decreases the demand for goods and services.

What is a positive demand shock?

An event that increases overall demand for goods and services.

What are examples of positive demand shocks?

Lower interest rates, increased money supply, increased government spending, and increased foreign demand for exports.

What is a negative demand shock?

An event that decreases overall demand for goods and services.

What are examples of negative demand shocks?

Higher interest rates, decreased money supply, reduced government spending, and decreased foreign export demand.

What is a supply shock?

An event that affects an economy's production capacity or production costs.

What is a negative supply shock?

An event that reduces production capacity or increases production costs.

What are examples of negative supply shocks?

Rising energy prices, natural disasters destroying crops, lower workforce education levels, and higher required wages.

What is a positive supply shock?

An event that increases production capacity or lowers production costs.

What are examples of positive supply shocks?

Falling energy prices, improved worker education, and lower production costs.

What is the business cycle?

The recurring pattern of economic expansion, recession, and recovery.

What is a peak in the business cycle?

The point where an economic expansion ends and a contraction begins.

What is a trough in the business cycle?

The bottom of a recession, when the economy begins to recover.

What are cyclical industries?

Industries whose sales and profits are highly sensitive to economic conditions.

What are examples of cyclical industries?

Housing, automobiles, luxury goods, technology, travel, and dining.

When do cyclical industries generally perform best?

During economic recovery and expansion, when consumer spending and business activity increase.

What are defensive industries?

Industries whose sales and profits are less sensitive to changes in the business cycle.

What are examples of defensive industries?

Healthcare, utilities, groceries, and consumer staples.

What is sector rotation?

Shifting portfolio investments toward sectors expected to outperform during different stages of the business cycle.

How should investors rotate between cyclical and defensive industries?

Favor defensive industries entering a recession and cyclical industries during recovery and expansion.

What is an investment company?

A financial intermediary that pools investors' money and invests it in a portfolio of securities.

What is a Unit Investment Trust (UIT)?

An investment fund with a fixed, unmanaged portfolio that generally remains unchanged for the life of the trust.

What is a closed-end fund?

An investment fund whose shares trade on exchanges between investors throughout the trading day.

Can closed-end funds trade above or below their Net Asset Value (NAV)?

Yes. Closed-end funds can trade at a premium or discount to NAV.

What is an open-end mutual fund?

An investment fund that issues and redeems shares directly with investors at NAV.

When are open-end mutual fund transactions executed?

Once per trading day after the market closes, at the calculated NAV.

Can open-end mutual funds trade at a discount or premium to NAV?

No. Investors buy and redeem shares directly with the fund at NAV.

What is an Exchange-Traded Fund (ETF)?

An investment fund that holds a portfolio of securities and trades on an exchange throughout the day.

What is the main difference between ETFs and open-end mutual funds?

ETFs trade intraday on exchanges, while open-end mutual funds transact once daily at NAV.

What is the main difference between closed-end funds and open-end mutual funds?

Closed-end fund shares trade between investors at market prices, while open-end funds issue and redeem shares at NAV.

What is the main difference between UITs and managed investment companies?

UITs hold a fixed, unmanaged portfolio, while managed investment companies can adjust their holdings.

Can ETFs be bought on margin or sold short?

Yes. Unlike traditional mutual funds, ETFs can generally be bought on margin or sold short.

Are most ETFs actively or passively managed?

Most are passively managed and track a market index, although actively managed ETFs also exist.

What are money market funds?

Mutual funds that invest in short-term, highly liquid debt securities.

What securities are considered money market instruments?

Treasury bills, repurchase agreements, commercial paper, and certificates of deposit.

What is a government money market fund?

A fund investing in short-term government securities and repurchase agreements collateralized by government securities.

What is a prime money market fund?

A fund that invests in money market instruments such as government securities, commercial paper, and CDs.

What is an equity fund?

A mutual fund that primarily invests in stocks.

What is the difference between income and growth equity funds?

Income funds focus on dividend-paying stocks, while growth funds focus on stocks with capital appreciation potential.

What is a bond fund?

A mutual fund investing in bonds, such as corporate, Treasury, municipal, or mortgage-backed securities.

What is a sector fund?

A mutual fund that concentrates its investments in one industry or economic sector.

What is a balanced fund?

A mutual fund that invests in both stocks and bonds according to its investment objectives.

What is an index fund?

A fund designed to track a specific market index by holding securities represented in that index.

What is the difference between global and international funds?

Global funds invest in both US and foreign securities, while international funds invest outside the US.

What is the difference between money market instruments and capital market instruments?

Money market instruments are short-term securities; capital market instruments, such as stocks and bonds, are long-term.

What is skewness?

A measure of the asymmetry of a return distribution.

What is the skewness of a normal distribution?

Zero, because a normal distribution is symmetric.

What is a right-skewed distribution?

A distribution with positive skewness and a longer or fatter right tail.

What is a left-skewed distribution?

A distribution with negative skewness and a longer or fatter left tail.

What does positive skewness indicate about investment returns?

Extreme positive returns are more common than extreme negative returns.

What does negative skewness indicate about investment returns?

Extreme negative returns are more common than extreme positive returns.

Why does standard deviation overestimate risk for right-skewed distributions?

It treats large positive returns as risk even though extreme gains are favorable to investors.

Why does standard deviation underestimate risk for left-skewed distributions?

It does not adequately capture the additional downside risk from extreme negative returns.

What are examples of right-skewed investments?

Venture capital investments and buying out-of-the-money options, which can produce rare large gains.

What is an example of a left-skewed investment?

High-yield bonds, which may experience rare but severe losses from defaults.

What is kurtosis?

A measure of the thickness of a distribution's tails and the likelihood of extreme outcomes.

What is the kurtosis of a normal distribution in the lecture?

Zero, using excess kurtosis.

What does high kurtosis indicate?

Fat tails and a greater likelihood of extreme positive or negative outcomes.

What does low kurtosis indicate?

Thinner tails and fewer extreme outcomes relative to a normal distribution.