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BA 327: Investments, Exam 1 WECKLE

Terms in this set (96)

What are the differences between equity and fixed-income securities?
Equity represents an ownership share in a corporation, these Investments are reliant on how successful the firm is, if the value of the firm increases then the value of your equity does as well. If the value of the firm decreases so does the value of your firm. This is why equity investments are far riskier than debt securities. Equity holders are not promised any particular payment because of this.

Whereas fixed income securities have a diverse variety of riskiness, they provide protection against the issuer going bankrupt, and they also have a lot of variety with payment provisions. On one end with money market securities, they are short term, highly marketable, and generally low risk while the Capital market includes a long term which can range from very safe in terms of default risk or relatively risky.
What is the difference between a primary asset and a derivative asset?
Primary assets can be though of as the equipment that goes into production, they are the real material that is of value. For example the Toyota power plant, these primary assets produce funds on their own. Derivative assets are allocating their profit from the profit of what comes from the primary assets. For example, the Toyota car that comes from the power plant. They don't have a manufacturer themselves, but they have claim on the real assets that are being used to produce those good and services.
What is the difference between asset allocation and security selection?
Asset allocation is an allocation of an investment portfolio across broad asset classes (different kinds of market/risk/ etc.) whereas security selection is specific securities within each asset class.
What are agency problems? What are some approaches to solving them?
Occur when agents/stockholders/manager pursue their own interests instead. To mitigate these issues there are a few different options - offer compensation meaning that the managers will not do well unless the price of the stock increases, benefiting shareholders (this can be taken advantage of if the managers manipulate information to make the stock price rise and cashing out before it goes back down), board of directors can also force out management teams that are underperforming, outsiders like security analysts, large institutional investors monitor the firms closely and make them very uncomfortable if they are poor performers.
Shareholders also have the ability to a proxy contest where they can ultimately elect a new board of management if they are consistently underperforming shareholders use their own funds to do this.
Other firms can also ultimately takeover another firm if they observe them underperforming and replace them with their own team, stock prices increase dramatically because of this which is why there's such a big incentive to do it.
What are the differences between real and financial assets?
Real assets are like property, plant, equipment, or consumer durables. Whereas financial assets are claims on the real assets or the profit produced by them. (stocks, bonds, etc.)
How does investment banking differ from commercial banking?
Investment banking primarily focuses in the sale of new securities to the public, typically by underwriting the issue but they are not considered underwriters. Commercial banking process the financial transactions of business such as checks, wire transfers and savings account management.
For each transaction, identify the real and/or financial assets that trade hands. Are any financial assets created or destroyed in the transaction?
a. Toyota takes out a bank loan to finance the construction of a new factory.
b. Toyota pays off its loan.
c. Toyota uses $10 million of cash on hand to purchase additional inventory of spare auto parts.
a. Toyota would have a real asset with the new factory but the bank would have a financial asset on the liability that Toyota owns them from taking out the loan.
b. Financial assets no longer exists for the bank, real asset of the factory still continues to exist.
c. real asset of inventory
Suppose that in a wave of pessimism, housing prices fall by 10% across the entire economy.
a. Has the stock of real assets of the economy changed?
b. are individuals less wealthy?
c. Can you reconcile your answers to (a) and (b)
Real assets has not changed because the houses still exist, only the perception of their value has. Yes because since the value of their real asset has changed, the balance sheet of individual investors has been reduced. The difference between these two answers goes back to the difference in real assets vs financial assets. Yes, the real assets still do exist, however the value of the financial asset changes on the claims on the cash flow they generate.
Why would you expect securitization to take place only in highly developed capital markets?
Securitization requires access to a large number of potential investors. To attract these investors, the capital market needs:
(1) a safe system of business laws and low probability of confiscatory taxation/regulation;
(2) a well-developed investment banking industry;
(3) a well-developed system of brokerage and financial transactions, and;
(4) well-developed media, particularly financial reporting.
What would you expect to be the relationship between securitization and the role of financial intermediaries in the economy? For example, what happens to the role of local banks in providing capital for mortgage loans when national markets in mortgage- backed securities become highly developed?
Securitization leads to disintermediation; that is, securitization provides a means for market participants to bypass intermediaries. For example, mortgage-backed securities channel funds to the housing market without requiring that banks or thrift institutions make loans from their own portfolios. As securitization progresses, financial intermediaries must increase other activities such as providing short-term liquidity to consumers and small business, and financial services.
Give an example of three financial intermediaries, and explain how they act as a bridge between small investors and large capital markets or corporations.
1. Mutual funds accept funds from small investors and invest, on behalf of these investors, in the national and international securities markets.
2. Pension funds accept funds and then invest, on behalf of current and future retirees, thereby channeling funds from one sector of the economy to another.
3. Venture capital firms pool the funds of private investors and invest in start-up firms.
4. Banks accept deposits from customers and loan those funds to businesses, or use the funds to buy securities of large corporations.
What are the key differences between common stock, preferred stock, and corporate bonds?
Common stock is an ownership share in publicly held corporation. Common shareholders have voting rights and may receive dividends. Preferred stock represents nonvoting shares in a corporation, usually paying a fixed stream of dividends. While corporate bonds are long term debt by corporations typically paying semi-annual coupons and returning the face value of the bond at maturity.
Why do most professionals consider the Wilshire 5000 a better index of the performance of the broad stock market than the Dow Jones Industrial Average?
Dow Jones does not represent the overall market as well as the 500 stocks contained in the Wilshire index. Its simply too small.
What features of money market securities distinguish them from other fixed-income securities?
Money market securities are short term, very safe, and highly liquid. Also, their unit value almost never changes
What are the major components of the money market?
Treasury bills, certificates of deposit, commercial paper, bankers acceptances, Eurodollars, repos, reserves, federal funds, and brokers calls
Describe alternative ways that an investor may add positions in international equity to his or her portfolio.
American Depository Receipts (ADRs) are certificates traded in U.S. Markets that represent ownership in shares of a foreign company. Investors may also purchase shares of foreign companies on foreign exchanges. Or international mutual funds to own shares indirectly.
Why are high-tax-bracket investors more inclined to invest in municipal bonds than are low-bracket investors?
Because they produce coupons that are tax free
What is the LIBOR rate? The federal funds rate?
Is a rate of interest on very short term loans among financial institutions. LIBOR (London Interbank Offer Rate) is the rate at which large banks in London are willing to lend money among themselves
How does a municipal revenue bond differ from a general obligation bond? Which would you expect to have a lower yield to maturity?
General obligation bonds are backed by the local governments, while revenue bonds have proceeds attached to specific projects. A revenue bond has less guarantees, so its riskier meaning a higher yield.
Why are corporations more apt to hold preferred stock than other potential investors?
Corporations may exclude 70% of dividends received from domestic corporations in the computation of their taxable income
What is meant by limited liability?
Limited liability means that the most shareholders can lose in event of the failure of the corporation is their original investment.
Why are money market securities often called "cash equivalents"?
Money market securities are referred to as "cash equivalents" because of their great liquidity. The prices of money market securities are very stable, and they can be converted to cash on very short notice and with very low transaction costs.
A municipal bond carries a coupon rate of 2.25% and is trading at par. What would be the equivalent taxable yield of this bond to a taxpayer in a 35% combined tax bracket?
Taxable Yield Equivalent = interest rate / (1-your tax rate)
After-Tax Yield Formula
(1- tax rate) x (before tax yield)
What is the difference between a put option and a short position in a futures contract?
A put option conveys the right to sell the underlying asset at the exercise price. A position in a futures contract carries obligation to sell to sell the underlying asset at the futures price.
What is the difference between a call option and a long position in a futures contract?
A call option conveys the right to buy the underlying asset at the exercise price. A long position in a futures contract carries an obligation to buy the underlying asset at the futures price.
Preferred stock yields are lower than yields on bonds of the same quality because of:
a. Marketability
b. Risk
C. Taxation
D. call protection
C. Taxation
Futures Contract
Obliges traders to purchase or sell an asset at an agreed upon price at a specified future date
derivative asset
a security with a payoff that depends on the prices of other securities
call option
the right to buy an asset at a specified price on or before a specified expiration date
put option
the right to sell an asset at a specified exercise price on or before a specified expiration date
What is the difference between an IPO (initial public offering) and an SEO (seasoned equity offering)?
An IPO is the first time a formerly privately owned company sells stock to the general public. A seasoned issue is the issuance of stock by a company that has already undergone an IPO.
What are some different components of the effective costs of buying or selling shares of stock?
The effective price paid or received for a stock include items such as bid-ask price spread, brokerage fees, commissions, and taxes (when applicable). These reduce the amount received by a seller and increase the cost incurred by a seller.
What is the difference between a primary and a secondary market?
The primary market is the market for new issue of securities, while the secondary market is the market for already existing securities. Corporations sell stock in the primary market, while investors purchase stock from other investors in the secondary market.
How do security dealers earn their profits?
One course is the frequent trading at the bid and ask prices, with the spread as a trading profit. since the specialist also takes a position in securities and maintains the ultimate diary of buyers and sells, the trader has the ability to profit by trading on information not available to others.
In what circumstances are private placements more likely to be used than public
offerings?
When a firm as a willing buyer of securities and wishes to avoid the extensive time and cost associated with preparing a public issue, they may issues shares privately.
What are the differences between a limit order and a market order?
A stop order is a trade is not to be executed unless stock hits a price limit. The stop-loss is used to limit losses when prices are falling. An order specifying a price at which an investor is willing to buy or sell a security is a limit order, while a market order directs that broker to buy or sell at whatever price is available in the market.
Why have average trade sizes declined in recent years?
The advent of electronic trading now permits trades to be broken into smaller units, thus avoiding the negative impact on prices usually experienced by block trades (the buying or selling or large quantities of stock)
What is the role of an underwriter? A prospectus?
they purchase securities from the issuing company and resell them. A prospectus is a description of the firm and the security it is issuing.
How does buying on margin magnify both the upside potential and downside risk of an
investment portfolio?
Margin is a type of leverage that allows investors to post only a portion of the value of the security they purchase. As such, when the price of the security rises or falls, gain or loss represents a much higher percentage, relative to the actual money invested.
Roadshows serve two purposes, what are they?
1. they generate interest among potential investors and provide information about the offering
2. they provide information to the issuing firm and its underwriters about the price at which they will be bale to market the securities.
direct listing
A previously private company floats existing shares on the stock market but does not raise funds by issuing new shares to the public
Direct Search Markets
Buyers and sellers locate one another on their own (Craigslist)
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
Dealer Markets
markets in which traders specializing in particular assets buy and sell for their own accounts
Auction market
a market where all traders meet at one place to buy or sell an asset
NASDAQ
A nationwide electronic system that links dealers across the nation so that they can buy and sell securities electronically.
Electronic Communication Networks (ECNs)
computer networks that allow direct trading without the need for market makers
margin
Describes securities purchased with money borrowed in part from a broker. The margin is the net worth of the investor's account.
margin formula
equity in account/value of stock
short sale
the sale of shares not owned by the investor but borrowed through a broker and later purchased to replace the loan
Investment company roles
1. Record keeping and administration
2. Diversification and divisibility
3. professional management
4. lower transaction costs
Net Asset Value (NAV)
assets minus liabilities expressed on a per-share basis
NAV = market value of assets minus liabilites / shares outstanding
What are the benefits to small investors of investing via mutual funds? What are the disadvantages?
Benefits include advanced portfolio management, dividend reinvestment, risk reduction, convenience, and fair pricing. Disadvantages include high fees, tax inefficiency, poor trade execution, and the potential for management abuses.
Why can closed-end funds sell at prices that differ from net value while open-end funds do not?
Close- end funds trade on the open market and are thus subject to market pricing. Open end funds, are sold by the mutual fund are must reflect the NAV of the investments.
What is a 12b-1 fee?
Annual fees charged by a mutual fund to pay for marketing and distribution costs.
What are some differences between a unit investment trust and a closed-end
fund?
A unit investment trust is an unmanaged mutual fund. Its portfolio is fixed and does not change due to asset trades, as does a close end fund.
What are the advantages and disadvantages of exchange-traded funds versus mutual funds?
Exchange traded funds can be traded during the day, just as the stocks they represent. They are most tax effective, in that they do not have as many distributions. They also have much lower transaction costs. They also do not require load charges, management fees, and minimum investment amounts.
What are some differences between hedge funds and mutual funds?
Hedge funds have much less regulation since they are part of private partnerships and free from mist SEC regulation. They permit investors to take on many risks unavailable to mutual funds. Hedge funds may require higher fees and provide less transparency to investors. This offers significant counter party risk and hedge fund investors need to be more careful about the firm they invest with.
Would you expect a typical open-end fixed-income mutual fund to have higher or lower operating expenses than a fixed-income unit investment trust? Why?
An open end fund will have higher fees since they are actively marketing and managing their investor base. The fund is always looking for new investors. A unit investment trust need not spend too much time on such matters since investors find each other.
Balanced funds and asset allocation funds each invest in both the stock and bond markets. What is the difference between these types of funds?
Asset allocation funds may dramatically vary the proportions allocated to each market in accord with the portfolios mangers forecast of the relative performance of each sector. Hence, these funds are engaged in market timing and are not designed to be low risk investment vehicles.
What are some comparative advantages of investing your assets in the following:
a. Unit investment trusts.
b. Open-end mutual funds.
c. Individual stocks and bonds that you choose for yourself.
a. A unit investment trusts offer low costs and stable portfolios. Since they do not change their portfolio, the investor knows exactly what they own. They are better suited to sophisticated investors.
b. Open-end mutual funds offer higher levels of service to investors. The investors do not have any administrative burdens and their money is actively managed. This is better suited for less knowledgeable investors.
c. Individual securities offer the most sophisticated investors ultimate flexibility. They are able to save money since they are only charged the expenses they incur. All decisions are under the control of the investor.
Open-end equity mutual funds commonly keep a small fraction of total investments in very liquid money market assets. Closed-end funds do not have to maintain such a position in "cash-equivalent" securities. What difference between open-end and closed-end funds might account for their differing policies?
Open-end funds must honor redemptions and receive deposits from investors. This flow of money necessitates retaining cash. Close-end funds no longer take and receive money from investors. As such, they are free to be fully invested at all times.
An open-end fund has a net asset value of $10.70 per share. It is sold with a front-end load of 6%. What is the offering price?
The offering price includes a 6% front-end load, or sales commission, meaning that every dollar paid results in only $0.94 going toward purchase of shares. Therefore: Offering price = NAV/ (1 - load) = $10.70/ (1-0.06) = $11.38
If the offering price of an open-end fund is $12.30 per share and the fund is sold with a front-end load of 5%, what is its net asset value?
NAV = offering price x(1 - load) = $12.30 x 0.95 = $11.69
rate of return formula
Change in (NAV) + distributions/ start of year NAV
401(k) plan
a tax-advantaged savings plan where the employer matches a portion of the employees contribution
traditional retirement plans
contributions to the account and investment earninds are tax sheltered until retirement
Roth plans
Contributions are not tax sheltered, but investment earnings are never taxed.
deferred annuities
tax-sheltered accounts offered by life insurance companies. investment earnings are tax free until the payout phase.
What type of investors would be interested in a target-date retirement fund? Why?
an investor who is age 30 and wishes to retire at age 65.
Real Assets in the economy include all but which one of the following?
a. land
b. buildings
c. Consumer durables
d. common stock
d. Common stock
____ is not a derivative security.
a. a share of common stock
b. a call option
c. a futures contract
d. a put option
a. a share of common stoc,
Active trading in markets and competition among securities analysts helps ensure that:
1. security prices approach informational efficiency
2. riskier securities are priced to offer higher potential returns
3. investors are unlikely to be able to consistently find under or overvalued securities.

a. 1 only
b. 1 and 2 only
c. 2 and 3 only
d. all of the above
d. all of the above
Asset Allocation refers to:
a. the allocation of the investment portfolio across broad asset classes
b. the analysis of the value of securities
c. the choice of specific assets within each asset class.
d. none of the choices are correct.
a. the allocation of the investment portfolio across broad asset classes.
The value of a derivative security:
a. depends on the value of another related security
b. affects the value of a related security
c. is unrelated to the value of a related security
d. can be integrated only by a calculus professors
a. depends on the value of another related security
money market securities are sometimes referred to as cash equivalents because:
a. they are safe, marketable, and offer low returns
b. they are not liquid
c. they are high risk
d. they are low denomination
a. they are safe, marketable, and offer low returns
an investor in a T-bill earns interest by:
a. receiving interest payments every 90 days
b. receiving dividend payments every 30 days
c. converting the T-bill at maturity into a higher-valued T-note
d. buying the bill at a discount from the face value to be received at maturity
d. buying the bill at a discount from the face value to be received at maturity
____ is considered to be an emerging market country.
A) France
B) Norway
C) Brazil
D) Canada
C. Brazil
Deposits of commercial banks at the federal reserve are called:
a. bankers' acceptances
b. federal funds
c. repurchase agreements
d. time deposits
b. federal funds
the benchmark index has three stocks priced at $23, $43, and $56. The number of outstanding shares for each is 350,000 shares, 405,000 shares, and 553,000 shares, respectively. If the market value-weighted index was 970 yesterday and the prices changed to $23, $41, and $58 today, what is the new index value?

A) 960
B) 970
C) 975
D) 985
C. 975
Index = ($23 x 350,000 + $41 x 405,000 + $58 x 553,000) / ($23 x 350,000 + $43 x 405,000 + $56 x 553,000) x 970 = 975
The margin requirement on a stock purchase is 25%. You fully use the margin allowed to purchase 100 shares of MSFT at $25. If the price drops to $22, what is your percentage loss?
A) 9%
B) 15%
C) 48%
D) 57%
C. 48%

Loss = ($22-$25) x100 = -$300
Invested Capital = 0.25 x $25 x 100 = $625
return= -$300/$625 = -0.48 = -48%
Purchases of new issues of stock take place _______.
A) at the desk of the Fed
B) in the primary market
C) in the secondary market
D) in the tertiary markets
B. in the primary market
Restrictions on trading involving insider information apply to:
1. Corporate officers and directors
2. Major stockholders
3. Relatives of corporate directors and officers

A) 1 only
B) 1 and 2 only
C) 2 and 3 only
D) 1, 2, and 3
D) 1, 2, and 3
If an investor places a _______ order, the stock will be sold if its price falls to the stipulated level. If an investor places a _______ order, the stock will be bought if its price rises above the stipulated level.
A) buy stop; stop-loss
B) market; limit
C) stop-loss; buy stop
D) limit; market
C) stop-loss; buy stop
You short-sell 200 shares of Tuckerton Trading Company, now selling for $50 per share. What is your maximum possible gain, ignoring transactions cost?
A) $50
B) $150
C) $10,000
D) Unlimited
C) $10,000
You are considering investing in one of several mutual funds. All the funds under consideration have various combinations of front-end and back-end loads and/or 12b-1 fees. The longer you plan on remaining in the fund you choose, the more likely you will prefer a fund with a _______ rather than a _______, everything else equal.
A) 12b-1 fee; front-end load
B) front-end load; back-end load
C) back-end load; front-end load
D) 12b-1 fee; back-end load
C) back-end load; front-end load
Consider a no-load mutual fund with $200 million in assets and 10 million shares at the start of the year and with $250 million in assets and 11 million shares at the end of the year. During the year investors have received income distributions of $2 per share and capital gain distributions of $.25 per share. Assuming that the fund carries no debt, and that the total expense ratio is 1%, what is the rate of return on the fund?
A) 11.19%
B) 23.75%
C) 24.64%
D) The answer cannot be determined from the information given.
B) 23.75%
An open-end fund has a NAV of $16.50 per share. The fund charges a 6% load. What is the offering price?
A) $14.57
B) $15.95
C) $17.55
D) $16.49
C) $17.55
$16.50/1-0.06 = $17.55
Which type of fund generally has the lowest average expense ratio?A) Actively managed bond funds
B) Hedge funds
C) Indexed funds
D) Actively managed international funds
C) Indexed funds
Disadvantages of ETFs include all of the following except:
A) investors incur a bid-ask spread when purchasing.
B) investors must pay a broker fee when purchasing.
C) prices are only quoted once each day.
D) prices can depart from NAV at times.
C) prices are only quoted once each day.
Contributions to a __________ are not tax deductible.
A) traditional retirement plan
B) Roth retirement plan
C) 401k plan
D) 403b plan
B) Roth retirement plan
You earn 6% on your corporate bond portfolio this year, and you are in a 24% federal tax bracket and an 9% state tax bracket. Your after-tax return is __________. (Assume that federal taxes are not deductible against state taxes and vice versa).
A) 4.10%
B) 3.84%
C) 4.02%
D) 3.12%
C) 4.02%
rp × [1 − (tFed + tState)] = 0.06× [1 − (0.24 + 0.09)] = 0.0402 = 4.02%
It would be costly to provide wage insurance because of the __________ problem.
A) moral hazard
B) adverse selection
C) Texas hedge
D) actuarial error
A) moral hazard
The major asset most people have during their early working years is their __________.
A) home
B) stock portfolio
C) earning power derived from their skills
D) bond portfolio
C) earning power derived from their skills
The amount of risk an individual should take depends on her:
1. Return requirements
2. Risk tolerance
3. Time horizon

A) 1 only
B) 1 and 2 only
C) 2 and 3 only
D) 1, 2, and 3
D) 1, 2, and 3
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