Chapter 1: The Investment Environment

Question 1

What are Real Assets?

Answer 1

Has productive capacity: ex. Land Buildings, machines, intellectual property, patent, technology (we use them)

Question 2

What are Financial Assets?

Answer 2

Claims on real assets, do not contribute directly to productive capacity ex. Stocks, bonds (allocation of funds)

Question 3

What are fixed income securities?

Answer 3

Promises a fixed stream of income or a stream of income determined by a specific formula (bonds, mortgages)

Question 4

What is Equity?

Answer 4

Ownership share in a corporation, common stock, preferred stocks

Question 5

What are tips?

Answer 5

When coupons are affected by interest rates

Question 6

What is limited Liability?

Answer 6

The most you can lose is the amount you paid (whatever is left is paid to the stockholder)

Question 7

What are derivatives?

Answer 7

Provide payoffs that are determined by the prices of other assets, often used for risk management (options, swaps, futures)

Question 8

What is investment in currency?

Answer 8

Often for risk management (primary use) US $

Question 9

What are commodity futures?

Answer 9

Investment in metal or agriculture (corporations invest in commodity futures to hedge the risk)

Question 10

What is consumption timing? Draw the graph

Answer 10

Investing and based on earnings and consumption.

Question 11

What is the information role?

Answer 11

Efficient allocation of funds - which companies are doing between)

Question 12

What is allocation of risk?

Answer 12

(Issue stock/bonds to raise money they need. Then risk is on stockholders. (Diversifying portfolio)

Question 13

What are some benefits of separating ownership from management?

Answer 13

No interruption in company operation while there is a transfer in funds, owners don’t need expertise in company

Question 14

What are some disadvantages of separating ownership from management?

Answer 14

Activities not always in the best interest of stakeholders, conflicts of interest (ex. Fancy conference rooms), managers forego risky projects (cause they could lose their positions)

Question 15

What are some ways to mitigate agency problems?

Answer 15

Tie manager’s income to the success of the firms (then managers and stakeholders both want to increase share price), monitoring from the board of directors, monitoring by large investors and security analysis, takeover threat

Question 16

What is takeover threat?

Answer 16

When managers are not using assets correctly, other company can take over, claim to a better management, this threat makes managers work better

Question 17

What is an anti-takeover provision?

Answer 17

Manager put this in place to remain safe and avoid takeover threat

Question 18

What is a portfolio?

Answer 18

Collection of investment assets

Question 19

What are the three components of allocation for a portfolio?

Answer 19

Capital, asset, security

Question 20

What is asset allocation? What is a way to classify it?

Answer 20

By liquidity, it is a choice among broad asset classes

Question 21

What is security selection?

Answer 21

Choice of securities within each asset class ex. Risky asset (40% equity, 40% FI, 20% commodities)

Question 22

“Top down approach” is…

Answer 22

Asset allocation followed by security analysis

Question 23

“Bottom up” approach

Answer 23

Investment based solely on the price attractiveness (not the best approach for risk managment)

Question 24

What is the risk-return tradeoff

Answer 24

Higher-risk assets are priced to offer higher expected returns than lower-risk assets

Question 25

Are risk and expected return +ve or -ve correlation?

Answer 25

Positively

Question 26

What does no free lunch mean?

Answer 26

If you want a high return you need to pay for the price

Question 27

What is meant by Efficient Markets?

Answer 27

Prices quickly adjust to all relevant information. There should be neither underpriced nor overpriced securities.

Question 28

What is Passive Management and what do Passive Managers believe in?

Answer 28

They believe in the efficient market hypothesis. They hold a highly diversified portfolio, no attempt to find undervalued securities, and no attempt to time the market

Question 29

What is meant by Active Management? What do active managers believe in?

Answer 29

They believe markets are not efficient, near efficiency. They look to find mis-priced securities, and time the market

Question 30

Who are the three players in the market and what are their roles?

Answer 30

Firms (net borrowers), Households (net savers, extra $ invested), Governments (can be both borrowers and savers (Taxes-Government expenses = +ve fiscal balance = extra money to invest)

Question 31

What are financial intermediaries? What are four examples of financial intermediaries?

Answer 31

They are pool and investment funds. Examples include: 1. Investment companies (mutual or hedge funds), 2. Banks (owned by shareholders), 3. Insurance companies and 4. Credit unions

Question 32

What do investment banks do?

Answer 32

Underwrite new securities, sell newly issued securities to the public in the primary market (help corporations issue securities)

Question 33

What do commercial banks do?

Answer 33

Take deposits and make loans