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Finance 3400
Exam 1 - Chapter 1-8
130
Finance
Undergraduate 3
10/02/2013

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Term
real assets
Definition
Determine the productive capacity and net income of the economy
Term
financial asset
Definition
Claims on real assets
3 types -
Fixed income or debt
Common stock or equity
Derivative securities
Term
fixed income or debt securities
Definition
promise a fixed stream of income or a stream of income determinded by a specified formula.

ex: corporate bond typically would promise that the bondholder will receive a fixed amount of interest each year
Term
equity
Definition
represents an ownership share in the corporation
Term
derivative securities
Definition
such as options or futures contracts procivdes payoffs that are determined by the prices of OTHER assets such as bond or bond price. Used to transfer risk
Term
asset allocation
Definition
decision is the choice among these broad asset classes (investment assets - stocks, bonds, real estate, commodities)
Term
security selection
Definition
the choice of which particular securities to hold within each asset class
Term
risk-return trade-off
Definition
in the securites market- with higher-risk assets priced to offer higher expected returns that lower-risk assets
Term
passive management
Definition
calls for hold high diversified portfolies without spending the effort or the resources attempting to improve investment performance through security analysis
Term
active management
Definition
attempting to improve performance of broad asset classes. For example, increasings one's commitment to stocks when on is bullish on the stock market.
Finding mispriced securities
Timing the market
Term
financial intermediaries
Definition
bring lendors and borrowers together. Include banks, investment companies, insurance companies, and credit unions.
Term
investment companies
Definition
pool and manage the money of many investors, also arise out of economies scale
Term
investment bankers
Definition
specialize in such activities can offer their services at a cost below that of maintaining an in-house security issuance division
Term
primary market
Definition
Investment banking handles the marketing securities in this market. New issues of securities are offered to the public
Term
secondary market
Definition
investors can trade previously issued securities amond themselves
Term
money market debt (fixed income)
Definition
short term, highly marketable, usually low credit risk
Term
captial market debt
Definition
long term bonds, can be safe or risky
Term
Information role
Definition
Capital flows to companies with best prospects
Term
consumption timing
Definition
Use securities to store wealth and transfer consumption to the future
Term
Allocation of Risk
Definition
Investors can select securities consistent with their tastes for risk
Term
Separation of Ownership and Management:
Definition
With stability comes agency problems
Term
security selection
Definition
Choice of which securities to hold within asset class
Security analysis to value securities and determine investment attractiveness
Term
securitization
Definition
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
Term
Collateralized debt obligations (CDOs)
Definition
Mortgage pool divided into slices or tranches to concentrate default risk - senior and junior tranuches
Term
senior traunch
Definition
lower risk, highest interest
Term
junior traunche
Definition
high risk, low or junk rating
Term
credit default swap
Definition
an insurance contract against the default of the borrower. Investors bought sub-prime loans and used CDS to insure their safety
Term
systematic risk
Definition
a potential breakdown of the financial system in which problems in one market spill over and disrupt others.
Term
systematic risk failure
Definition
Banks had a mismatch between the maturity and liquidity of their assets and liabilities.
Liabilities were short and liquid
Assets were long and illiquid
Constant need to refinance the asset portfolio
Banks were very highly levered, giving them almost no margin of safety.
Term
Capital market instruments
Definition
Bonds
Equity Securities
Derivative Securities
Term
Subsector of the fixed-income market:
Definition
Securities are short-term, liquid, low risk, and often have large denominations
Term
treasury bills
Definition
Short-term debt of U.S. government
Bid and asked price
Bank discount method
Term
asked price
Definition
price you would have to pay to buy a t-bill from a securities dealer
Term
bid price
Definition
slightly lower price you would ask receive if you wanted to sell abill to a dealer
Term
certificates of deposits
Definition
Time deposit with a bank
Term
commercial paper
Definition
Short-term, unsecured debt of a company
Term
banker's acceptance
Definition
An order to a bank by a bank’s customer to pay a sum of money on a future date
Term
repos and reserves
Definition
Short-term loan backed by government securities.
Term
fed funds
Definition
Very short-term loans between banks
Term
bond market
Definition
Treasury Notes and Bonds
Inflation-Protected Treasury Bonds
Federal Agency Debt
Municipal Bonds
Corporate Bonds
Mortgages and Mortgage-Backed Securities

International Bonds
Term
notes
Definition
maturities up to 10 years
Term
bonds
Definition
maturities from 10 to 30 years
Term
quotes
Definition
percentage of par
Term
inflation protected treasury bonds
Definition
TIPS: Provide inflation protection
Term
federal agency debt
Definition
Debt of mortgage-related agencies such as Fannie Mae and Freddie Mac
Term
municipal bonds
Definition
Issued by state and local governments
Interest is exempt from federal income tax and sometimes from state and local tax
Term
general obligation bonds
Definition
Backed by taxing power of issuer
Term
revenue bonds (municipal bonds)
Definition
backed by project’s revenues or by the municipal agency operating the project.
Term
corporate bonds
Definition
Issued by private firms
Semi-annual interest payments
Subject to larger default risk than government securities
Options in corporate bonds
Callable
Convertible
Term
mortgage backed securities
Definition
Proportional ownership of a mortgage pool or a specified obligation secured by a pool
Term
mortgage-backed securities
Definition
are called pass-throughs because the cash flows produced by homeowners paying off their mortgages are passed through to investors.
Term
preferred stock
Definition
perpetuity
Fixed dividends
Priority over common
Tax treatment
Term
Dow Jones Industrial Average
Definition
Includes 30 large blue-chip corporations
Computed since 1896
Price-weighted average
Term
US indexes
Definition
NYSE Composite
NASDAQ Composite
Wilshire 5000
Term
call
Definition
Right to buy underlying asset at the strike or exercise price.
Value of calls decrease as strike price increases
Term
put
Definition
Right to sell underlying asset at the strike or exercise price.
Value of puts increase with strike price
Term
strike price
Definition
the price fixed by the seller of a security after receiving bids in a tender offer
Term
futures contract
Definition
calls for delivery of an asset (or in some cases, its cash value) at a specified delivery or maturity date for an agreed-upon price, called the futures price, to be paid at contract maturity.
Term
short position
Definition
Make delivery at maturity. must sell at futures price
Term
long position
Definition
Take delivery at maturity. must buy at the futures price
Term
primary markets
Definition
Firms issue new securities through underwriter to public
Investors get new securities; firm gets funding
Term
secondary market
Definition
Investors trade previously issued securities among themselves
Term
stocks
Definition
IPO
Seasoned offering
Term
bonds
Definition
Public offering
Private placement
Term
underwriting
Definition
Investment bank helps the firm to issue and market new securities
Term
propectus
Definition
Describes the issue and the prospects of the company. investment objectives
Fund investment adviser and portfolio manager
Fees and costs
Term
firm committment
Definition
investment bank purchases securities from the issuing company and then resells them to the public.
Term
private placements
Definition
Firm uses underwriter to sell securities to a small group of institutional or wealthy investors.
Cheaper than public offerings
Private placements not traded in secondary markets
Term
types of markets - direct search
Definition
Buyers and sellers seek each other
Term
types of markets - brockered market
Definition
Brokers search out buyers and sellers
Term
dealers market
Definition
Dealers have inventories of assets from which they buy and sell
Term
auction market
Definition
traders converge at one place to trade
Term
bid-asked spread
Definition
the profit for making a market in a security. Difference between the bid and asked prices
Implicit cost of trading
Term
market order
Definition
Executed immediately
Trader receives current market price
Term
price contingent order
Definition
Traders specify buying or selling price
Term
NASDAQ
Definition
Lists about 3,200 firms
Originally, NASDAQ was primarily a dealer market with a price quotation system
Today, NASDAQ’s Market Center offers a sophisticated electronic trading platform with automatic trade execution.
Large orders may still be negotiated through brokers and dealers
Term
New York stock exchange
Definition
Lists about 2,800 firms
Automatic electronic trading runs side-by-side with traditional broker/specialist system
Term
NY stock exchange - super dot
Definition
electronic order-routing system
Term
NY stock exchange - direct plus
Definition
fully automated execution for small orders
Term
Electronic Communication Networks
Definition
Private computer networks that directly link buyers with sellers for automated order execution
Term
major ecns
Definition
NASDAQ’s Market Center, ArcaEx, Direct Edge, BATS, and LavaFlow.
Term
flash trading
Definition
Computer programs look for even the smallest mispricing opportunity and execute trades in tiny fractions of a second.
Term
NYSE
Definition
Archipelago (ECN)
American Stock Exchange
Euronext
Term
NASDAQ mergers and acquistions
Definition
Instinet/INET (ECN)
Boston Stock Exchange
Term
brockerage commission
Definition
fee paid to broker for making the transaction
Explicit cost of trading
Full Service vs. Discount brokerage
Term
margin
Definition
refers to the percentage or amount contributed by the investor
Term
maintenance margin
Definition
Minimum equity that must be kept in the margin account
Margin call if value of securities falls too much
Term
short sales
Definition
Purpose: to profit from a decline in the price of a stock or security
Mechanics
Borrow stock through a dealer
Sell it and deposit proceeds and margin in an account
Closing out the position: buy the stock and return to the party from which it was borrowed
Term
investment companies
Definition
Pool funds of individual investors and invest in a wide range of securities or other assets.
service : Administration & record keeping, Diversification & divisibility, Professional management,Reduced transaction costs
Term
NET ASSET VALUE
Definition
Market Value of Assets - Liabilities/ shares otustanding
Term
managed investment companies - open-end
Definition
Fund issues new shares when investors buy in and redeems shares when investors cash out
Priced at Net Asset Value (NAV)
Term
managed investment companies
Definition
no change in shares outstanding; old investors cash out by selling to new investors
Priced at premium or discount to NAV
Term
mutual funds: open-end investment companies
Definition
Money Market
Equity
Sector
Bond
Balanced
Asset Allocation and Flexible
Index
International
Term
how funds are sold
Definition
Direct-marketed funds
Sales force distributed---
Revenue sharing on sales force distributed & Potential conflicts of interest
Financial Supermarkets
Term
fee structure
Definition
Four types
1. Operating expenses
2. Front-end load
3. Back-end load
4. 12 b-1 charge
Fees must be disclosed in the prospectus
Share classes with different fee combinations
Term
12b1 charges
Definition
use fund assets to pay for distribution costs. must be added to operating expenses
Term
late trading
Definition
accepting buy or sell orders after the market closes and NAV is determined
Term
market timing
Definition
rapid in-and-out trading on stale net asset values
Term
taxation of mutual fund income
Definition
Pass-through status under the U.S. tax code
Taxes are paid only by the investor
Fund investors do not control the timing of the sales of securities from the portfolio
High portfolio turnover leads to tax inefficiency
Average turnover = 60%
Term
Exchange traded funds
Definition
Potential advantages:
Trade continuously like stocks
Can be sold short or purchased on margin
Lower costs
Tax efficient
Potential disadvantages:
Prices can depart by small amounts from NAV
Must be purchased from a broker
Term
nominal interest rate
Definition
Growth rate of your money
Term
real interest rate
Definition
Growth rate of your purchasing power
Term
Equation
Definition
nominal rate = real - inflation
Term
EAR
Definition
percentage increase in funds invested over a 1-year horizon
Term
APR
Definition
annualizing using simple interest
Term
estimated variance
Definition
expected value of squared deviations
Term
sharpe ratio
Definition
risk premium / SD of excess returns
Term
normal distribution
Definition
Investment management is easier when returns are normal.
Standard deviation is a good measure of risk when returns are symmetric.
If security returns are symmetric, portfolio returns will be, too.
Future scenarios can be estimated using only the mean and the standard deviation.
Term
value at risk
Definition
A measure of loss most frequently associated with extreme negative returns
VaR is the quantile of a distribution below which lies q % of the possible values of that distribution
Term
expected shortfall (ES)
Definition
conditional tail expectation.
More conservative measure of downside risk than VaR
VaR takes the highest return from the worst cases
ES takes an average return of the worst cases
Term
lower partitial standard deviation
Definition
similar to usual standard deviation, but uses only negative deviations from rf
Term
terminal value with continuing compounding
Definition
When the continuously compounded rate of return on an asset is normally distributed, the effective rate of return will be lognormally distributed.
Term
allocation of risky assets
Definition
The utility model gives the optimal allocation between a risky portfolio and a risk-free asset.
Term
speculation
Definition
Taking considerable risk for a commensurate gain
Parties have heterogeneous expectations
Term
controlling risk with asset allocation
Definition
Manipulate the fraction of the portfolio invested in risk-free assets versus the portion invested in the risky assets
Term
risk-free asset
Definition
Only the government can issue default-free bonds.
Risk-free in real terms only if price indexed and maturity equal to investor’s holding period.
t-bill and money market fund
Term
risk tollerance and asset allocation
Definition
The investor must choose one optimal portfolio, C, from the set of feasible choices
Term
passive strategies: capital market line
Definition
The passive strategy avoids any direct or indirect security analysis
Supply and demand forces may make such a strategy a reasonable choice for many investors
Term
capital market line
Definition
is the capital allocation line formed from 1-month T-bills and a broad index of common stocks (e.g. the S&P 500).
Term
CML passive strategies
Definition
1. virtually risk-free short-term T-bills (or a money market fund)
2. a fund of common stocks that mimics a broad market index.
Term
top-down approach
Definition
1. Capital allocation between the risky portfolio and risk-free asset
2. Asset allocation across broad asset classes
3. Security selection of individual assets within each asset class
Term
market risk
Definition
Systematic or nondiversifiable
Term
firm-specific risk
Definition
Diversifiable or nonsystematic
Term
portfolio risk
Definition
depends on the correlation between the returns of the assets in the portfolio
Term
covariance and correlation coefficient
Definition
provide a measure of the way returns of two assets vary
Term
securities are perfectly positively correlated
Definition
p = 1.0
Term
the securities are perfectly negatively correlated
Definition
p = -1
Term
minimum variance portfolio
Definition
portfolio composed of the risky assets that has the smallest standard deviation, the portfolio with least risk.
Term
minimum variance portfolio
Definition
correlation is -1, the standard deviation of the minimum variance portfolio is zero.

When correlation is less than +1, the portfolio standard deviation may be smaller than that of either of the individual component assets.
Term
correlation effect
Definition
If r = +1.0, no risk reduction is possible.
If r = 0, σP may be less than the standard deviation of either component asset.
If r = -1.0, a riskless hedge is possible.
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