tamug econ 311 final exam

benefits of mutual funds

• liquidity intermediation

• demnomination intermediation

• divversification

• cost advantages

• managerial expertise

liquidity intermediation

• investors can convert their investments into cash quickly and at a low cost

• allow investors to buy and redeem at any time and in any amount

demnomination intermediation

• allows small investors access to securities they would be unable to purchase without the mutual fund

• by pooling money, the mutual fund can purchase these securities on behalf of investors

diversification

• risk can be lowered by holding a portfolio of diversified securities rather than a limited number

• mutual funds provide a low cost way to diversify into foreign stocks

cost advantages

• institutional investors negotiate much lower transaction fees than are available to individual investors

• buying securities through a mutual fund, investors can share these lower fees

managerial expertise

• investors can rely on professional money managers to select stocks

ownership of mutual funds

• 82% of mutual funds are owned by households

• accounts for 22% of the US retirement market

• 45% of households own mutual funds

• median investor is middle class, 49 years old, married, employed, possess 200,000 in assets

open ended mutual funds

• investors can contribute to it at any time, the fund simply increases the number of shares outstanding

• fund agrees to buy back shares from investors at any time

• advantage: investment is very liquid, allows mutual funds to grow unchecked meaning as long as investors as funds it will keep growing

net asset value (NAV) calculation

total value of mutual fund stocks, bonds, cash, and other assets

MINUS liabilities (acrued fees)

DIVIDED by outstanding shares

index funds

• contains the stock in an index, the stocks are held in a proportion such that changes to fund the value closely match changes to the index level

• do not require managers to choose securities, leading to lower fees than other managed funds because they ignore outside factors (social media)

deferred load funds

• if a fee is charged when funds are taken out

• purpose of loads is to provide compensation for sales brokers, also to discourage early withdrawal of deposits

no-load funds

• funds that did not charge a direct load to fee

• can be purchased directly by individual investors and no middleman is required

adverse selection

• occurs when the individuals most likely to benefit from a transaction are the ones actively seeking it out

• how insurance companies combat: someone with cancer may seek out medical insurance, but insurance companies will avoid these costs by examining past medical records and then not include cancer treatments in their insurance policy

moral hazard

• occurs when the insured fails to take proper precautions to avoid losses because losses are covered by insurance

• how insurance companies combat: by requiring a deductible

deductible

• is the amount any loss that must be paid by the insured before the insurance company will pay anything, such as a downpayment for a repair

• example: business insured against fire may be required to install a sprinkler system

basic principles of insurance

• Must be a relationship between the insured (party covered by insurance) and the beneficiary (party who receives payment when loss occurs), beneficiary is someone who may suffer potential harm

• Insured must provide full and accurate insurance coverage

• The insured is not to profit as a result of insurance coverage 

• If a third party compensates the insured for the loss, the insurance company’s obligation is reduced by the amount of compensation

• The insurance company must have a large number of insureds so the risk can be spread out among different policies

• Loss must be quantifiable

• Insurance company must be able to compute the probability of the loss occurring

different types of insurance

• most common: life, property, and casualty

  • cost is based on age, life expectancy, health and lifestyle, and operating costs of the insurance

• life insurances: term life, whole life, universal life, annuities

• others: heath, homeowners, marine, disability, automobile

term life insurance

• pays out if the insured dies while the policy is in force

• contains no savings element

whole life insurance

• pays a death benefit if the policyholder dies

• required the insured to pay a level premium for the duration of the policy

law of large numbers

• that when many people are insured, the probability distribution of the losses will assume a normal probability distribution, which allows accurate predictions

• important because insurance companies insure so many millions of people, making predictions accurate, to be able to price the policies to earn a profit

distribution of life insurance company assets

1. Receive premiums that represent future obligations that must be met when insured person dies, and

2. Receive premiums paid into pension funds managed by the life insurance company.

annuity

• an insurance product that will help if you live longer than you expect

• for an initial fixed sum or stream of payments, the insurance company agrees to pay you a fixed amount for as long as you live

  • if you live shorter, then insurance pays out less than expected

  • if you live longer, then insurance pays out more than expected

• also susceptible to the adverse selection problem

defined benefit pension

• Defined benefit pension plan: plan sponsor promises employees a specific benefit when they retire. Formula payout normally uses years worked and final salary. 

  • Annual payment = 2% x average of final 3 years income x years of service 

  • So if worked 35 yearrs and avg wage of last 3 years is $50,000 - 0.2 x 50,000 x 35 = $35,000 per year 

  • Puts burden on employer to provide funds. 

  • Audits are required to be done on pension plans. It is fully funded if sufficient funds available. If more than enough it is overfunded. Insufficient underfunded.

defined contribution pension

• Defined contribution pension plan: specify only what will be contributed to fund. Corporate puts %  of employees wages in pension each pay period, sometimes employee can add more. Fund manager invests funds and employee can have a say where to invest. When employee rreites, investments transferred to annuity or other distribution.

underfunded pension plan

• Defined benefit pension plans can be underfunded if insufficient funds available.

social security

• Public pension plan: sponsored by govt body. Federal Old Age and Disability Insurance = social security. 

• Workers contribute 6.2% and so do employeers. 

• May have to increase tax, get benefits later, and reduce benefits.

private pension plan

• Sponsored by employers, groups, and individuals. Used to invest in govt securities and corporate bonds. Now ppl invest in those and corporate sock, mortgages, open market paper, and time deposits. In open markets, it can make pension plan managers powerful if they choose to exercise control over firm management.

Keoghs

• Keoghs plans: are a retirement savings option for self employed. Funds can be deposited with a depository institution, life insurance company, or securities firm. 

IRA

• IRAs: Individual retirement plans. Pension reform act of 1978 updated self employed individuals tax retirement act of 1962 to have IRAs. its so if not covered by pension plan, can contribute into a tax deferred savings account.