FoF - Unit 1

Question 1

The Axioms about investors

Answer 1

1. investors prefer more to less
2. investors are risk averse
3. money paid in the future is worth less than same amount paid today (“time value of money”, opprotunity cost)

Question 2

Axioms about the market

Answer 2

4. financial markets are highly competitive
5. no arbitrage condition (“no free lunch”)

Question 3

Axiom 4: What is the riskless arbitrage you could undertake in financial markets?

Answer 3

having a diverse profile

Question 4

real assets

Answer 4

assets used to produce goods and services
EX: land, patents, human capital

Question 5

financial assets

Answer 5

claims to the returns generated by real assets. They allocate the proceeds from a real activity according to pre-determined rules
EX: cash, derivatives, bonds, stocks (2 main)

Question 6

Derivatives

Answer 6

(contingent claims) on other financial assets (pay a premium). Options, futures, swaps, swaptions.

Question 7

bonds

Answer 7

paied interest, then face value on maturity date. If company brankupt paid first bc creditors.

Question 8

Use of Financial Instruments

Answer 8

1. Allocation of capital
2. Allocation of risk (diversification/hedging)
3. Consumption Smoothing (saving-borrowing)
4. meeting place for investors with different needs

Question 9

hedging

Answer 9

a risk management strategy employed to offset losses in investments by taking an opposite position in a related asset (insurance)

Question 10

Fixed Income Securities (Bonds)

Answer 10

fixed promised cash-flows: coupon/interest payments and principal payments (aka face value)

Ex: treasuries, municipal, and corporate bonds.

Question 11

Valuation of Bonds

Answer 11

time value of money (TVM) adjustment, credit risk adjustment

Question 12

Types of treasury bonds:

Answer 12

Treasury bills (less than 1-year maturity)

Treasury notes (1-10 year maturity)

Treasury bonds (10-30 year maturity)

Question 13

Which bond pays the highest interest rate? A 10-year T-bond or 1-year T-note?

Answer 13

Bond with higher maturity have higher yield, because it has more time. Value of duration. If more risk for a longer time then higher yield.

Question 14

Municipal Bonds:

Answer 14

Issued by state and local governments.
-Exempt from Federal Income taxes
-Exempt from issuing State local tax (how they attract investors)

Question 15

Types of Municipal Bonds:

Answer 15

General obligation bonds: backed by the “full faith of credit” of the issuer (taxing power)

Revenue bonds (riskier): Issued to finance specific projects (airports, hospitals, etc.)

Question 16

A (general obligation) muni bond pays 4% interest. A Treasury bond pays 5% interest. Which bond would you rather buy if your marginal tax rate on interest income is 20%?

Municipal bond

Treasury bond

Indifferent

Answer 16

Treasury bond

Question 17

What if your marginal rate is higher than 20% and they are equally safe?

Municipal bond

Treasury bond

Indifferent

Answer 17

Municipal bond

Question 18

Corporate Bonds (risker)

Answer 18

Fixed payments, but subject to default and prepayment risk.

Different “seniority” classes:
Senior, Junior/subordinated.

Question 19

Types of Corporate Bonds:

Answer 19

Short term: Commercial paper

Long term: Corporate bonds.

Question 20

Equity

Answer 20

is the residual claim and has control rights on/over the firm

Stock investment is risky because cash flows (dividends) are uncertain. Also risk from changes in liquidity.

Maturity is indefinite, cash flows can occur far away.

Question 21

Equity Valuation

Answer 21

TVM adjustment + risk adjustment.

Question 22

Two main classes of equities:

Answer 22

Common stock: voting rights (“junior”) - may have some coupon/fixed income

Preferred stock: non-voting (“senior”)

Question 23

Derivatives

Answer 23

securities whose cash flows depend on other assets

Derivatives can be written on equity, credit default, interest rates, commodities, exchange rates, etc.

Question 24

Derivative Valuation

Answer 24

TVM + option adjustment

Question 25

Call (Put) option

Answer 25

right, but not the obligation, to buy (sell) the underlying asset. At a specified price (strike price) On a specified date (maturity)

Question 26

Long Futures

Answer 26

an obligation to buy the underlying asset: At a specified price,On a specified date. Two kinds: commodities or financial

Question 27

Securitization

Answer 27

the process in which certain types of assets are pooled so that they can be repackaged into interest-bearing securities.

Answer 28

Tranches are pieces of a pooled collection of securities, usually debt instruments, that are split up by risk or other characteristics in order to be marketable to different investors

Question 29

Tranches

Answer 29

Tranches are pieces of a pooled collection of securities, usually debt instruments, that are split up by risk or other characteristics in order to be marketable to different investors

Question 30

Mutual Funds

Answer 30

financial intermediaries that pool funds from small investors and invest in a diversified portfolio of stocks and/or bonds

Question 31

WHAT DETERMINES THE PRICE OF A SECURITY?

Answer 31

Equilibrium price is when demand = supply Supply up if more stocks issued and then drops when people buy stocks Demand up and down on news

Question 32

How are new securities sold ("floated")?

Answer 32

Government securities: typically auctioned Corporate securities (stocks and bonds), federal agency debt, municipal bonds, mortgage-backed securities: typically underwritten by investment banks

Question 33

Underwriters

Answer 33

a syndicate of investment banks.  1. Firm commitment: 2. Best effort: 3. Road show and Book-building: Registration through Securities and Exchange Commission (SEC) (Red Herring Prospectus and Form S-1).

Question 34

Firm Commitment

Answer 34

Investment banks buys all the securities and takes the risk that it won’t be able to sell all the securities.

Question 35

Best Effort

Answer 35

investment bank doesn’t purchase the securities but just helps the firm to place as many shares as possible with the public.

Question 36

Road show and Book-building:

Answer 36

Goal is to trace out an aggregate demand curve. Based on the status of the book, underwriters determine the price and quantity at which they will offer the security to the public.

Question 37

SECONDARY MARKETS:

Answer 37

Brokers help investors trade without taking positions themselves (no inventory)

Question 38

Brokers guarantee counterparties that:

Answer 38

1. An investor can pay for a security she is buying 2. An investor can deliver the security she is selling

Question 39

Two types of margin requirement:

Answer 39

initial margin: represents the minimum amount an investor must put up to purchase a stock Maintenance margin: represents the minimum amount required to be maintained in the margin account to maintain an open position

Question 40

In the US, regulations govern the margin requirement. (Long Position)

Answer 40

the Federal Reserve Regulation T initial margin requirement is 50% and the maintenance margin requirement is 25%

Question 41

In the US, regulations govern the margin requirement. (Short Position)

Answer 41

the initial margin requirement is 150% and maintenance margin is 130%

Question 42

Short sales

Answer 42

Selling shares of a firm not owned by borrowing security, and later replacing it (cover it). A profit is made is the short position is covered at a price lower than the one at which it was established (Bearish investment or as a hedge)

Question 43

Short Sale Requirements

Answer 43

Short sale proceeds must remain with the broker The investor is also required to deposit collateral (to post margin) as a guarantee against default. The margin requirement is 50% Short selling is subject to an uptick rule

Question 44

Risk in Short Sale:

Answer 44

Over the long term equity markets have a tendency to rise The standard lending practice is that the securities must be returned on demand. This can lead to a short squeeze Crowded Short: When a large number of investors short the same security they create a “crowded short.” A rise in the security’s price may induce a number of them to cover their shorts at the same time. A broker-dealer needs to explicitly obtain the right to borrow securities from one customer before lending them to another. Most brokerage firms require a stock to be trading above a given price level to be margined, typically $5 to $7 per share. Low-cost shares are almost impossible to borrow.