Who supplies capital? What demands capital?House holds FirmsFinancial intermediaries:-Investment Companies -Banks -Insurance companies -Credit unionsChanges in Housing Finance Explain the old way and new wayOld way: -Local thrift institution made mortgage loans to homeowners -Thrift's possessed a portfolio of long-term mortgage loans -Thrift's main liability: Deposits -"Originate to hold" New Way: -Securitization: Fannie Mae and Freddie Mac bought mortgage loans and bundled them into large pools -Mortgage-backed securities are tradable claims against the underlying mortgage pool -"Originate to distribute"Cyclical movementsame as the marketCounter cyclical assetmoves in the opposite direction as the marketA sharpe ratio of 2.79 meansFor one unit of risk you are getting on average 279% over and above the risk free rateANSWER The existence of efficient capital markets and the liquid trading of financial assets make it easy for large firms to raise the capital needed to finance their investments in real assets. If Ford, for example, could not issue stocks or bonds to the general public, it would have a far more difficult time raising capital. Contraction of the supply of financial assets would make financing more difficult, thereby increasing the cost of capital. A higher cost of capital results in less investment and lower real growth.ANSWER a. The bank loan is a financial liability for Lanni, and a financial asset for the bank. The cash Lanni receives is a financial asset. The new financial asset created is Lanni's promissory note to repay the loan. b. Lanni transfers financial assets (cash) to the software developers. In return, Lanni receives the completed software package, which is a real asset. No financial assets are created or destroyed; cash is simply transferred from one party to another. c. Lanni exchanges the real asset (the software) for a financial asset, which is 2,500 shares of Microsoft stock. If Microsoft issues new shares in order to pay Lanni, then this would represent the creation of new financial assets. d. By selling its shares in Microsoft, Lanni exchanges one financial asset (2,500 shares of stock) for another ($125,000 in cash). Lanni uses the financial asset of $50,000 in cash to repay the bank and retire its promissory note. The bank must return its financial asset to Lanni. The loan is "destroyed" in the transaction, since it is retired when paid off and no longer exists.ANSWER Mutual funds accept funds from small investors and invest, on behalf of these investors, in the domestic and international securities markets. Pension funds accept funds and then invest in a wide range of financial securities, on behalf of current and future retirees, thereby channeling funds from one sector of the economy to another.Venture capital firms pool the funds of private investors and invest in start-up firms.Banks accept deposits from customers and loan those funds to businesses or use the funds to buy securities of large corporations.ANSWER Treasury bills serve a purpose for investors who prefer a low-risk investment. The lower average rate of return compared to stocks is the price investors pay for predictability of investment performance and portfolio value.What are the three main categories of asset classesFixed Income Equities DerivativesWhat are the two sub categories of fixed incomeMoney Markets Capital MarketsWhat are the main features of the money market ?Short-term Liquid Low risk *sometimes referred to as cash equivalentsWhat are the examples of the money market?T-bills CD Commerical Papers Banker's acceptance Repos and reserve repos LIBOR MarketWhat is the simplest form of borrowingT-BillsWhat is the proxy for the risk-free rate ?T-BillsWhat type of bond are T-BillsZero Coupon BondsWhat is a zero coupon bondNo interest is paid out between the purchase and maturityWhat taxes are T-Bills excused ofState and LocalWhat is a CDa time deposit with a bank you pay early exit fees if you pull your moneyWhat is commerical paperLarge, well-known companies often issue their own short-term unsecured debt notes rather than borrow directly from banks up to 270 days but often maturity less than 1 to 2 monthsWhat is a Banker's Acceptancebanker's acceptance starts as an order to bank by a bank's customer to pay a sum of money at future date Similar to a post-dated check -Difference: BAs are tradeable at discount in secondary markets Widely used in foreign trade where the creditworthiness of one trader is unknown to the trading partnerWhat are repos and reservesDealers in government securities use repurchase agreements as a form of short term, usually overnight, borrowingWhat is LIBORThe London Interbank Offered Rate (LIBOR) is the rate at which large banks in London are willing to lend money among themselves. -LIBOR is quoted for loans in five currencies (U.S. dollars, yen, euro, British pound, and Swiss franc) and for seven maturities ranging from a day to a year. LIBOR is a key reference rate in the money market-Many trillion of dollars of loans and assets are tied to it.What are the features of the Capital Market (Bond Market)Long-term Liquid Low RiskWhat are examples of Capital MarketsTreasury Notes and Bonds Municipal Bonds Corporate BondsHow long are T-notes maturitiesup to 10 yearsHow long are T-bonds maturities10-30 yearsHow often are t-notes and t-bonds interest payments madesemiannually (coupon payments)What are municipal bondssimilar t-notes or t-bonds, but issued by state and local governments -They are similar to Treasury and corporate bonds except that their interest income is exempt from federal income taxation -The interest income also is usually exempt from state and local taxationin the issuing state -Capital gains taxes, however, must be paid on "munis" when the bonds mature or if they are sold for more than the investor's purchase priceWhat are corporate bondsCorporate bonds are the means by which private firms borrow money directly from the public.What are the three categories of equitiescommon stock preferred stock ADRsFeatures of common stockownership residual claim limited liabilityFeatures of preferred stockPerpetuity (no end) Fixed dividends Priority over common Tax treatmentFeatures of American Depository Receipts (ADR):Certificates traded in U.S. markets that represent ownership in shares of a foreign companyWhat are the two categories of derivativesOptions FuturesANSWER Preferred stock is like long-term debt in that it typically promises a fixed payment each year. In this way, it is a perpetuity. Preferred stock is also like long-term debt in that it does not give the holder voting rights in the firm. Preferred stock is like equity in that the firm is under no contractual obligation to make the preferred stock dividend payments. Failure to make payments does not set off corporate bankruptcy. With respect to the priority of claims to the assets of the firm in the event of corporate bankruptcy, preferred stock has a higher priority than common equity but a lower priority than bonds.What are the key differences between corporate bonds, preferred stock, and common stock?ANSWER a. At t = 0, the value of the index is: (90 + 50 + 100)/3 = 80 At t = 1, the value of the index is: (95 + 45 + 110)/3 = 83.333 The rate of return is: (83.333/80) 1 = 4.17% b. In the absence of a split, Stock C would sell for 110, so the value of the index would be: (95+45+110)/3 = 250/3 = 83.333 with a divisor of 3. After the split, stock C sells for 55. Therefore, we need to find the divisor (d) such that: 83.333 = (95 + 45 + 55)/d d = 2.340. The divisor fell, which is always the case after one of the firms in an index splits its shares. c. The return is zero. The index remains unchanged because the return for each stock separately equals zero.What problems would confront a mutual fund trying to create an index fund tied to an equally weighted index of a broad stock market?Primary marketmarket for newly-issued securities Firms issue new securities through underwriter to publicSecondaryInvestors trade previously issued securities among themselvesPrivately held firms-Up to 499 shareholders -Raise funds through private placement -Lower liquidity of shares -Fewer obligations to release financial statementsProspectusA preliminary registration statement must be filed with the Securities and Exchange Commission (SEC), describing the issue and the prospects of the company.Why do investors truthfully reveal their interest in an offering to the investment banker?in best interest of both parties investment bankers get commisson for higher priced stocks other parties may get cut deals and discountsDirect searchBuyers and sellers seek each otherBrokered marketsBrokers search out buyers and sellersDealer marketsDealers have inventories of assets from which they buy and sellAuction marketsTraders converge at one place to tradeBid PriceBids are offers to buyask priceAsked prices are sell offersinvestors "sell to thebid"Explict cost from brokercommissionImplicit cost from brokerdealer's bid-ask spreadSystematic Risk(beta) entire market -don't experience all with the same magnitudeIdiosyncraticnot compensated, because it can be eliminated through proper diversificationDo we the investor try to optimize idiosyncratic risk or systematic riskIdiosyncratic risk as systematic risk is out of our control