Ch 01 - The Investment Environment Flashcards
How is the material wealth of a society determined?
By the productive capacity of its economy
What are Real assets?
Land, buildings, and equipment that are used to produce goods and services
What are Financial assets?
Claims such as securities to the income generated by real assets
What are the three broad types of financial assets?
Fixed-income or debt securities, equities, and derivatives
Fixed-income or debt securities
A security such as a bond that pays a specified cash flow over a specific period
Equity
Represents ownership in a firm
Derivative security
A security whose payoff depends on the value of other financial variables such as stock prices, interest rates, or exchange rates
How do stock prices play a role in the allocation of capital in market economies?
They reflect investors’ collective assesment of a firm’s current performance and future prospects directing capital to the firms with the greatest perceived potential
How can you allocate your consumption to periods that provide the greatest satisfaction?
You can “store” your wealth in financial assets to shift your purchasing power from high-earnings periods to low-earnings periods of life
How do financial assets allow for the allocation of risk?
Financial assets and the diverse financial instruments traded in those markets allow investors with the greatest taste for risk to bear that risk, while other, less risk-tolerant individuals can, to a greater extent, stay on the sidelines.
Why is it beneficial for capital markets to allow risk to be borne by the investors most willing to bear that risk?
When investors are able to select security types with the risk-return characteristics that best suit their preferences, each security can be sold fo the best possible price
How do financial assets allow for the separation of ownership and management?
Stockholders elect a board of directors that in turn hires and supervises the management of the firm. If some stockholders decide they no longer wish to hold shares in the firm, they can sell their shares with no impact on the management of the firm
Agency problems
Conflicts of interest among stockholders, bondholders, and managers
What are some mechanisms that help mitigate potential agency problems?
- compensation plans tie the income of managers to the success of the firm
- boards of directors can force out management teams that are underperforming
- outsiders such as security analysts and large institutional investors such as mutual funds monitor the firm closely
- bad performers are subject to the threat of takeover
How can a portfolio be rebalanced?
By selling existing securities and using the proceeds to buy new securities, by investing additional funds to increase the overall size of the portfolio, or by selling securities to decrease the size of the portfolio