Ch 01 - The Investment Environment

Question 1

How is the material wealth of a society determined?

Answer 1

By the productive capacity of its economy

Question 2

What are Real assets?

Answer 2

Land, buildings, and equipment that are used to produce goods and services

Question 3

What are Financial assets?

Answer 3

Claims such as securities to the income generated by real assets

Question 4

What are the three broad types of financial assets?

Answer 4

Fixed-income or debt securities, equities, and derivatives

Question 5

Fixed-income or debt securities

Answer 5

A security such as a bond that pays a specified cash flow over a specific period

Question 6

Equity

Answer 6

Represents ownership in a firm

Question 7

Derivative security

Answer 7

A security whose payoff depends on the value of other financial variables such as stock prices, interest rates, or exchange rates

Question 8

How do stock prices play a role in the allocation of capital in market economies?

Answer 8

They reflect investors’ collective assesment of a firm’s current performance and future prospects directing capital to the firms with the greatest perceived potential

Question 9

How can you allocate your consumption to periods that provide the greatest satisfaction?

Answer 9

You can “store” your wealth in financial assets to shift your purchasing power from high-earnings periods to low-earnings periods of life

Question 10

How do financial assets allow for the allocation of risk?

Answer 10

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.

Question 11

Why is it beneficial for capital markets to allow risk to be borne by the investors most willing to bear that risk?

Answer 11

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

Question 12

How do financial assets allow for the separation of ownership and management?

Answer 12

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

Question 13

Agency problems

Answer 13

Conflicts of interest among stockholders, bondholders, and managers

Question 14

What are some mechanisms that help mitigate potential agency problems?

Answer 14

• 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

Question 15

How can a portfolio be rebalanced?

Answer 15

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

Question 16

Asset Allocation

Answer 16

Choosing among broad asset classes such as stocks, bonds, real estate, commodities, and so on. Also includes the decision of how much of one’s portfolio to place in safe assets versus risky assets

Question 17

Security selection

Answer 17

The choice of which particular securities to hold within each asset class

Question 18

Security analysis

Answer 18

Involves the valuation of particular securities that might be included in the porfolio