CFA Level I SS13
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Created by:
masterbaby on May 29, 2012
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108 terms
Terms | Definitions |
|---|---|
 Functions of Financial System | +Allow entities to save and borrow money, raise equity capital, manage risks and trade assets +Determine returns required for the supply of savings to equate to the demand for borrowing +Allocate capital to the most efficient uses |
| Debt Securities | Promises to repay borrowed funds |
| Equity Securities | Represent ownership positions |
| Publicly Traded Securities | Traded on exchanges or through securities dealers and are subject to regulatory oversight |
| Private Securities | Not traded on public markets, illiquid, and not subject to regulation |
| Derivative Contracts | Securities with values that depend on values of other assets |
| Spot Market | Market with immediate delivery |
| Primary Market | Market for newly issued securities secondary market is for subsequent sale of securities |
| Money Markets | Markets for debt securities with maturities of one year or less and capital markets are for longer term debt securities and equities |
| Traditional Investment Market | Market for debt and equity, alternative markets, alternatives markets are for everything else |
| Short-Term Fixed Income | Securities that have maturities less than 2 years; Usually called paper or notes |
| Long-Term Fixed Income | Securities that have maturities more than 5 years; Usually called bonds |
| Repo Agreement | A borrower sells a high quality asset and has both the right and obligation to buy it back at a higher price in the futures |
| Convertible Debt | Debt an investor can exchange for a specified number of equities in the issuing firm |
| Warrants | Give the holder the right to buy a firm's equity at a fixed price prior to the warrant's expiration; Similar to options |
| Asset Backed Securities | Represent a claim to a portion of a pool of assets and the return is passed through to investors with different tranches having different levels of risk and return |
| Forward Contract | Agreement to buy or sell an asset in the future at a specified price in the contract at its inception |
| Future Contract | Same as forward but are standardized in amount, asset characteristics and delivery time; Greater liquidity than forwards since they are traded on a secondary market |
| Swap Contract | When two parties make payments equivalent to one asset being traded for another one |
| Currency Swap | Swapping loans in different currencies |
| Interest Rate Swap | When floating rate interest payments are exchanged for fixed rate payments |
| Equity Swap | Swapping the return on an equity index for the interest payments on a debt instrument |
| Option Contract | Security that gives its owners a right to buy or sell an asset at a specified price at a specified time in the future |
| Call Option | The right to buy |
| Put Option | The right to sell |
| Insurance Contract | Security that pays a cash amount if a future event occurs; Used as a hedge |
| Credit Default Swap | Form of insurance pays if an issuer defaults on its bonds |
| Markets for Commodities | +Spot +Futures +Forwards |
| Real Assets | *Increasingly being held by institutions *Provide income, tax advantages and diversification, but also entail large management costs *Require increased due diligence *Illiquid *Can be bought indirectly through REITs and MLPs *Can get exposure by buying stock in companies that have large real asset ownership |
| Block Brokers | Trade large lots |
| Primary Dealers | Trade with central banks when they buy and sell securities |
| Broker Dealers | Have an inherent conflict of interest because they should seek the best prices for their clients but their goal is to profit through the transaction; Traders typically place limits on how their orders are filled when working through a broker dealer |
| Securitizers | Pool large amounts of securities or other assets and sell interests in the pool to other investors; The returns from the pool, net of fees, are passed through to investors; Cash flows are segregated by risk into traunches |
| Depository Institutions | Institutions pay interest on customer deposits and provide transaction services |
| Security (Prime) Brokers | Provide loans to investors who purchase securities on margin |
| Insurance Companies | Collect insurance premiums in return for providing risk reduction to the insured |
| Risks of Insurance Companies | ~Moral hazard when policy holders take more risk because they are insured ~Adverse selection that people who buy insurance are the ones who are most risky ~Fraud when the insured purely causes damage to collect a claim |
| Clearinghouses | Provide escrow services, guarantees of contract completion, assurance margin traders have necessary capital, and limits on orders; Reduce counterparty risk |
| Custodians | Improve market integrity by holding client securities and preventing their loss due to fraud or other events |
| Long Position | When an investor owns, or has the right to own, an asset |
| Short Position | Result from borrowing an asset and selling it, with the obligation to replace the asset at a later date; Must borrow the securities through a broker, return the securities at the request of the lender when the short sale is closed out, and keep a portion of the proceeds on deposit with the broker; Borrower must pay lender all dividends or interest the lender would have received; *Collateral earns interest, some of which is returned to the borrower at a short rebate rate |
| Leveraged Position | When borrowed funds are used to purchase assets; Funds are considered margin loans; Interest paid is called the call money rate; The initial margin requirement is the minimum amount of equity an investor is required to provide at time of new margin purpose; Additional risk in portfolio is considered risk from financial leverage |
| Components of an Order | +Bid-ask spread +Execution order +Validity instructions +Clearing instructions |
| Bid-Ask Spread | The difference between the bid price and ask price; Bid price is the price that a dealer will sell a security; The ask or offer price is the price a dealer will pay for a security; How the dealer makes money |
| Types of Execution Orders | +Market order +Limit order +All or nothing order +Hidden order |
| Market Order | Instructs broker to execute trade immediately at best possible price |
| Limit Order | Places a minimum execution price for a sale or maximum execution price for a buy; Not guaranteed to be filled; Marketable or aggressively priced if buy/sell order is above the best ask/below the best bid; A limit between bid and ask is said to be making a new market or inside the market; Standing orders are limits waiting to be executed |
| Limit Order "Making the Market" | A buy order at the best bid or sell at the best ask |
| Limit Order "Behind the Market" | A buy order below the best bid or a sell order above the best ask |
| Limit Order "Far From the Market" | A buy considerably lower than the best bid or a sell considerably higher than the best ask |
| All or Nothing Orders | Trades that execute only if the entire lot can be bought |
| Hidden Orders | Orders where only the broker knows the trade size |
| Types of Validity Instructions | *Day orders *Good-till-cancelled orders *Immediate-or-cancelled, or fill-or-kill, orders *Good-on-close orders *Stop-loss orders |
| Clearing Instructions | Specify how to settle a trade |
| Book Building | When investment banks solicit indications of interest from market participants and adjust the offering price accordingly |
| Underwritten Offering | When the investment bank agrees to entire issue at a negotiated price; Bank is stuck with position if undersubscribed |
| Investment Bank's IPO Conflict of Interest | As an agent, they should set a high price to maximized the funds raised for the issuer but, as underwriters, they want the price to be low so the whole issue sells |
| Best Efforts IPO | When a bank agrees to distribute shares but if undersubscribed, bank does not buy unsold portion |
| Private Placement | When securities are sold directly to qualified investors with the help of an investment bank; Do not require the issuer to disclose as much information about the securities; Issuance costs are less; Offer price is lower since securities cannot be resold in the public markets |
| Shelf Registration | When a firm makes its public disclosures as a regular offering but it then the issues the registered securities as it needs capital or the markets are favorable |
| Rights Offering | Existing shareholders are given the right to buy new shares at a discount to the current market price; Dilutes ownership unless option is exercised; Sometimes the option can be sold |
| Call Market | When trades can only be placed during a specific time period; Very liquid when in session because all traders are present but illiquid between sessions; All trades, bids, ands asks are declared and then one negotiated price is set that clears the market for the stock |
| Continuous Markets | Trades occur any time a market is open |
| Quote Driven Markets | Investors trade with dealers; Dealers keep an inventory of securities; Most securities other than stocks trade in quote driven markets; Trading is often electronic |
| Order Driven Market | Rules are used to match buyers and sellers; Traders are usually anonymous; Order matching rules establish an order precedence hierarchy; *After orders are matched, trade pricing rules are used to determine the price; *In electronic markets, orders are batched together and matched at fixed points in time during the day at the average of the bid-ask quotes from the exchange |
| Price Priority | When trades with the highest bids and lowest asks are given the highest priorities |
| Uniform Pricing Rules | When all trades trade at the same price, which results from where the highest volume is |
| Discriminatory Pricing | Uses the limit price of the order that arrived first as the trading price |
| Brokered Markets | Where investors use brokers to locate a counterparty to a trade; Useful with unique or illiquid securities; Dealers do not carry inventory; Too few trades to trade in an order-driven market |
| Complete Markets | Allow investors to save for the future at fair rates of return, creditworthy borrowers obtain funds, hedgers manage risk and traders get assets |
| Operational Efficiency | Market with low trading costs; Will make markets more informationally efficient because low trading costs encourage trading on new information |
| Informational Efficiency | Prices reflect all information associated with fundamental value in a timely fashion; Allocationally efficient is capital is allocated to its most efficient use; Brought by traders who bid prices up and down in response to new information; Helped by accounting standards and financial reporting requirements |
| Functions of Intermediaries | *Organize trading venues *Supply liquidity *Securitize assets *Manage banks, insurance firms and investment advisory services *Providing clearinghouses to settle trades *Manage depositories |
| Benefits of Intermediaries | *Savers fund entrepreneurs *Companies share risk |
| Problems Fixed by Regulation | *Fraud and theft *Insider trading *Costly information *Defaults |
| Objectives of Regulation | *Protect unsophisticated investors *Promote minimum standards of performance reporting *Prevent insider trading *Require common financial reporting standards *Require minimum capital levels so all participants can honor their obligations |
| Security Market Index | Used to represent the performance of a certain asset; Constituent securities are those that make up an index; Have a numerical value calculated from constituent securities |
| Price Return | When an index uses only the prices of an index's constituency securities |
| Total Return | When an index includes both price changes and income from constituent securities |
| Decisions of an Index Maker | +What is the target market an asset is supposed to measure +What securities should be included +How should securities be weighted +How often should index be rebalanced +When should selection and weighting be reevaluated |
| Price Weighting Index | The arithmetic average of the prices of securities included in the index; Divisor is adjusted for stock splits and changes in composition when securities are added or subtracted; Advantage is it is simple to compute; Disadvantage is that a percentage change in a higher priced stock has a greater impact than an equal percentage increase in a lesser valued stock; Stock splits, repurchases or dividends can change the relative weight of a stock in the index; Having an equal weighting of stocks to the index will return an identical return; Major examples are the Nikkei and Dow Jones Industrial |
| Equal Weighting Index | The arithmetic average return of the index stocks; Matched by the returns of a portfolio that had equal dollar amounts invested in each stock; Simple to calculate; Replication portfolio would have to be periodically rebalanced, creating transaction costs; Percentage increases by smaller companies equal a proportionally larger weight in the index return; Value Line Composition Average and Financial Times Ordinary Share Index are major examples |
| Market Weighting Index | Weightings based on the market cap of each stock as a proportion of the index's market cap; Replicated by a portfolio in which the value of each security position is the same proportion of the security's market cap to the index's market cap; Not adjusted for dividends or stock splits; An alternative is to incorporate a security's number of shares available to the investing public, or a security's float |
| Float Adjusted Market Weighting Index | Like a market cap index but are based on the proportion of each firm's share value available to investors to the total market value of the index available to investors; Stock with large controlling shareholders will have less weighting in index; Advantage is weights represent total market value; Disadvantage is the relative impact of a stock's return on the index; S&P 500 is an example |
| Fundamental Weighting Index | Weights are based in firms' fundamentals, like earning, dividends or cash flow; Avoids bias of market cap indices to overvalued firms; Has a value tilt, overweighting firms with higher value-based metrics |
| Market Cap Index Value = | (Current Total Market Value of Stocks/Base Year Total Market Value of Stocks) * Base Year Index Value |
| Uses of Market Indices | +Reflection of market sentiment +Benchmark of manager performance +Measure of market risk and return +Measure of beta risk adjusted returns +Model portfolio for index funds |
| Types of Equity Indices | +Broad market index +Multi-market index +Multi-market index with fundamental weighting +Sector index +Style index |
| Factors Affecting Market Efficiency | +Number of market participants +Availability of Information +Impediments to trading +Transaction and information costs |
| Weak Form Market Efficiency | Current security prices fully reflect all currently available security market data |
| Semi-Strong Form Market Efficiency | Securities rapidly adjust without bias and reflect all current publicly available data; Best for passive investing; Suggested if fundamental analysis allows for profits |
| Strong Form Market Efficiency | Security prices fully reflect all information from both public and private sources |
| Market Anomaly | Something that would lead to a rejection of the hypothesis that markets are efficient |
| Market Anomalies | +The January effect is that in the first five days of January, stock returns are significantly higher than the rest of the year +The overreaction effect is the finding that firms with poor stock returns over the last 5 years subsequently have higher turns in the next period than firms that performed well +The momentum effect is that firms with high short-term returns are followed by continued high returns +The size effect is that small cap stocks outperform large caps +The value effect is that value stocks outperform growth stocks +Closed end investment funds typically deviate from NAV at a discount +Positive earnings surprises are generally followed by above average returns that last past the announcement day and can be exploited by buying positive surprises and selling negative surprises +IPOs typically rise after issuance and then fall in the long term |
| Behavioral Finance | Investigates investor behavior, it's effect on financial markets, how cognitive biases affect anomalies, and if investors are rational; Says investors have an asymmetric preference towards risk |
| Traditional Finance | Markets are rational even if individuals aren't |
| Representativeness | When investors assume good companies are good investments |
| Gambler's Fallacy | When recent events affect investors' perceptions of future probabilities |
| Mental Accounting | When investors classify different investments into separate mental accounts rather than viewing them as one portfolio |
| Conservatism | When investors react slowly to change |
| Disposition Effect | When investors are willing to realize gains but not losses |
| Narrow Framing | When investors see events in isolation |
| Information Cascades | Uninformed traders watch the actions of informed traders and follow when they are given a lot of unclear information; Consistent with investor rationality and improved market efficiency if they stem from uninformed traders; Said to be fragile if it does not lead towards the correct pricing of an asset |
| Value Weighted Indices Adjust for Stock Splits? | No, market cap does not change |
| Earnings Multiplier | Same as a PE ratio |
| Increasing Required Rate of Return and Decreasing Dividend Payout | Reduce a company's PE |
| Special Purpose Vehicle | A legal entity to which the assets used as collateral in an ABS issue are sold. This transaction separates the assets backing the ABS from the other assets of the company that creates the SPV. |
| Positive Abnormal Returns By Using Technical Analysis | No form of efficient market hypothesis supports this |
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