CFA Foundations Exam Ch. 1 - Ch. 20
Subordinated debt
A bond contract may also specify that an unsecured bond has a lower priority in the event of default than other unsecured bonds
A buyer chooses whether to exercise an option based on the underlying price compared with the exercise price
A buyer will exercise the option only when doing so is advantageous compared with trading in the market, which puts the seller at a disadvantage
At the money (call)
A call option is "at the money" if the market price and exercise price are the same
Callable bonds
A call provision gives the issuer the right to buy back the bond issue prior to the maturity date (The call price typically represents the par value of the bond plus an amount referred to as the call premium)
Limit order
A ceiling price for a buy order and floor price for a sell order
Income effect
A change in demand for a product from a change in purchasing power is called the income effect
Common stock
A common share represents an ownership interest in a company
Public offerings
A company that sells securities to the public for the first time makes an initial public offering (IPO), sometimes also called a placing or placement
A risk management process provides a framework for identifying and prioritising risks; assessing their likelihood and potential severity; taking preventive or mitigating actions, if necessary; and constantly monitoring and making adjustments
A company's risk management process is not always consistently planned; it often evolves in response to crises, incorporating the lessons learned and the new regulatory requirements that sometimes follow these crises
Convertible bonds
A conversion provision gives the bondholder the right to exchange the bond for shares of the issuing company's stock prior to the bond's maturity date
Current account deficit
A country spends more than it earns and makes up the difference by borrowing or receiving investments from other countries
Floating rate
A country's central bank does not intervene and lets the market determine the value of the currency
Carried interest
A form of incentive fee that general partners deduct before distributing to the limited partners the profit made on investments (carried interest is designed to ensure that general partners' interests are aligned with limited partners' interests)
Listed closed-end funds are actively managed and generally trade at prices different from their NAV
A fund is said to trade at a discount if the trading price is lower than the fund's NAV or at a premium if the trading price is greater than its NAV
Futures
A futures contract is similar to a forward contract in that it is an agreement that obligates the seller, at a specified future date, to deliver to the buyer a specified underlying in exchange for the specified futures price (The buyers and sellers do not necessarily know who is on the other side of the contract)
Risk taking should also be considered in the structure of compensation, for example when defining bonus payments for employees
A good compensation system should take into account the level of risk undertaken for a given level of return and should reward those who achieve returns without taking excessive risks
Performance bond
A guarantee, usually provided by a third party, such as an insurance company, to ensure payment in case a party fails to fulfill its contractual obligations (defaults)
As a result of inflation
A lender's purchasing power may decline even if the money is repaid as promised (The greater the expected inflation → the higher the level of interest demanded by the lender)
Flows of money into and out of funds over time can be accounted for by dividing the measurement period into shorter holding periods
A new holding period starts each time a cash flow occurs—that is, each time money flows into or out of a fund (In practice, client cash inflows and outflows may occur on a daily basis, in which case an annual holding-period return is divided into daily holding-period returns)
Indices
A number of organisations produce financial market indices that allow investors to compare the holding-period return achieved by their fund manager with that generated by the wider market
Deflation
A persistent and pronounced decrease in prices across most products and services in an economy
Document
A piece of written, printed, or electronic matter that provides information or evidence or that serves as an official record
Stop price
A price that triggers the conversion of a stop order into a market order
Family office
A private company that manages the financial affairs of one or more members of a family or of multiple families
Venture capital
A private equity investment strategy that consists of financing the early stage of companies that have an innovative business idea
Putable bonds
A put provision gives the bondholder the right to sell the bond back to the issuer prior to the maturity date (Consequently, the coupon rate on a putable bond will generally be lower than the coupon rate on a comparable bond without an embedded put provision )
Annual percentage rate (APR)
A simple interest rate that does not involve compounding
Skill
A skilful fund manager is able to add value to a portfolio over and above changes to the portfolio's value that are driven by market movements and that could have been produced by a passive fund manager
Stock split
A stock split is when a company replaces one existing common share with a specified number of common shares
Reporting
A valuation (if a market price is available) or an appraisal (that is, an estimation if no market price is available) of each asset held is sent to the client on a regular basis
Back office
Accounting, human resources, payroll, and operations
Brokers
Act as agents and do not trade directly with investors but help buyers and sellers find and trade with each other
Depositories
Act not only as custodians but also as monitors
Front running
Act of placing an order ahead of a customer's order to take advantage of the price impact that the customer's order will have
Active approaches require a more detailed analysis of each relevant investment or asset class, which is costly because investment firms need skilled employees and/or expensive technology
Active management typically also has higher transaction costs because of more frequent trading in the portfolio
Much academic and practitioner research has shown that most active managers do not consistently outperform the market over long time periods
After accounting for fees and expenses
Collusion
Agreements between competitors to raise prices
External documents
Aim to articulate business relationships and obligations undertaken by the parties involved and are often legally binding
Expiration date
All derivatives have a finite life; each contract specifies a date on which the contract ends, called the expiration date
Orders
All orders specify what security to trade, whether to buy or sell, and how much should be bought or sold
Prospectus
All pooled investment vehicles disclose their investment policies, deposit and redemption procedures, fees and expenses, and past performance statistics in an official offering
Interest rate swap
Allows companies to swap their interest rate obligations (usually a fixed rate for a floating rate) to manage interest rate risk, to better match their streams of cash inflows and outflows, or to lower their borrowing costs
Price elasticity of demand
Allows for comparison of the responsiveness of quantity demanded with changes in price
It may also contain performance information, measured by the change in value over various periods of time—a quarter, a year, or perhaps a longer period
Along with valuation and performance statements, clients may receive a range of other documents, such as investment reports, annual financial statements, and risk management reports
An important distinction between exchanges and alternative trading venues is the regulatory authority that exchanges exert over users of their trading systems
Alternative trading venues only control the conduct of subscribers who use their trading systems
Tactical asset allocation
Although the chosen strategic asset allocation is expected to meet the investor's objectives over the long term, there are times when shorter-term fluctuations in asset class returns can be exploited to potentially increase portfolio returns (A short-term adjustment among asset classes)
Investment control problems
Although the majority of investment managers work faithfully to serve their clients, some are not always careful, conscientious, or honest, which can lead to investment losses from poor research, missed opportunities, self-serving advice, or outright fraud
Hedge
An action that reduces uncertainty or risk
Forward contract
An agreement between the two parties in which one party agrees to buy from the seller an underlying at a later date for a price established at the start of the contract
Appraisal
An assessment or estimation of the value of an asset and is subject to certain assumptions, which may not always be realistic
Capitalism
An economic system that promotes private ownership as the means of production and markets as the means of allocating scarce resources
Crossing network
An electronic trading system that matches buyers and sellers who are willing to trade at prices obtained from exchanges or other alternative trading venues (Crossing networks are popular with investors who want to trade large blocks of securities without risking moving the price of those securities by submitting an order to an exchange)
Document creation
An important aspect of document creation relates to the production style—for instance, the use of a standardised template (Any changes reflected in a policy document need to be similarly reflected in all associated procedure and process document)
Performance measurement
An important part of performance evaluation
The services offered by investment firms and the investments available will typically vary by the amount of money the client has to invest
An investment firm that focuses on retail investors has to service the needs of a large number of relatively small accounts (Often, this means consolidating the retail investors' assets into a smaller number of funds and having automated processes for the administration of client fund holdings)
Buy the physical commodity
An investor could buy a barrel of oil or a head of cattle or a bushel of wheat (transportation and storage difficulties associated with purchasing a physical commodity means that it is rare for investors to gain access to commodities this way)
Call option
An investor who buys a call option has the right (but not the obligation) to buy or call the underlying from the option seller at the exercise price until the option expires
Put option
An investor who buys a put option has the right (but not the obligation) to sell or put the underlying to the option seller at the exercise price until expiration
Risk management
An iterative process used by organisations to support the identification and management of risk (or uncertainty) and reduce the changes and/or effects of adverse events while enhancing the realisation of opportunities and the ability to achieve company objectives
Stop order
An order for which a trader has specified a stop price
Current yield
Annual coupon payment / current market price
Execution instructions
Another document is often attached giving instructions about order execution, exposure, and time-in-force
Anti-money-laundering
Anti-money-laundering legislation is a set of rules to prevent money derived from criminal activities from entering the financial system and acquiring the appearance of being from legitimate sources (These rules require companies in the financial services industry, including those in the investment industry, to obtain sufficient original or certified documentation to perform a formal risk assessment on each client and counterparty; the procedures of such an assessment are called know-your-customer procedures)
For active management to be successful
Any mispricing of investments has to be substantial enough to cover the costs of exploiting this mispricing
Effect of fixed costs on profitability
As production rises, costs are spread over more units and variable costs will increase as a result of additional inputs to the steel making process
Public consultation
Ask for public comment on proposed regulations
Depending on the nature of the fund, the performance itself might come from the following sources:
Asset allocation, sector selection, stock selection or currency exposure
Investment vehicles
Assets offered by the investment industry to help investors move money from the present to the future, with the hope of increasing the value of their money
Redemption
At some stage, a client may want to redeem or sell an investment
Making to market
At the end of each day, the exchange establishes a settlement price based on the closing trades and determines the difference between the current settlement price and the previous day's settlement price
Active managers
Attempt to add value to a portfolio by selecting investments that are expected, on the basis of analysis, to outperform a specified benchmark
Risk appetite
Attitude toward risk and on its risk culture
Thanks to the advent of straight-through processing (STP), also referred to as straight-through exception processing (STeP), the need for manual intervention has been removed
Automated processes also help reduce errors
Managing systems
Automated processes can reduce the frequency and severity of operational errors, but they are not infallible (One source of risk is the behaviour of employees who do not follow internal policies and, for instance, download unauthorised applications for personal or business use)
Major factors that affect the value of currency
Balance of payments, level of inflation, level of interest rates, level of government debt, political and economic environment and reserve currency
Professional standards
Based on fundamental ethical principles to guide practice
Basic earning power
Basic earning power = operating income / total assets (The income generated from a company's assets excluding how those assets are financed)***********************(operating income / revenues) x (revenues / total assets)
Examples of external documents in the investment industry are a contract between a buyer and a seller of an asset, an investment management agreement between a firm and a client, and a "know-your-client" (some people call it KYC) document for a new client
Because contracts and other legally binding documents are governed by law and are enforceable, parties are usually motivated to comply with them
Treasury Inflation-Protected Securities (TIPS)
Because of the inflation protection offered by inflation-linked bonds, the coupon rate on an inflation-linked bond is lower than the coupon rate on a similar fixed-rate bond
Option premium
Because of the unilateral future obligation (only the seller has an obligation), options have positive value for the buyer at the inception of the contract--the option buyer pays this value, or option premium, to the option seller at the time of the initial contract
Reduce risk by obtaining diversification benefits
Because there is a relatively low correlation between different types of alternative investments and also between alternative investments and other asset classes, adding private equity, real estate, and commodities to portfolios helps investors reduce risk
Prospectus
Before a public offering, the issuer typically provides detailed information about its business and inherent risks as well as the proposed uses for the money it hopes to raise
Confirmation
Before a trade can be settled, the buyer and seller must confirm that they traded and the exact terms of their trade
Benchmarks and the calculation of relative returns
Benchmarks can be used to assess the quality and/or quantity of a company's performance by comparing its performance with that of its peers and competitors
Bid-ask spreads
Bid-ask spreads tend to be wider in opaque markets because finding the best available price is harder for dealers in such markets
Convertible bonds
Bond issued by a company that offers the bondholder the right to convert the bond into a pre-specified number of common shares
Sovereign/government bonds
Bonds issued by central governments
Corporate bonds
Bonds issued by companies
Treasuries
Bonds issued by the US government
Aggressive accounting methods
Boost reported earnings
Economic profit
Both explicit and implicit costs are considered
For an investment management company, measuring and understanding fund manager performance is vital to managing and improving the investment process
Both investors and investment management companies will want to know how fund managers have performed relative to familiar and relevant financial market benchmarks (e.g., a stock index, such as the S&P 500 Index in the United States or the Hang Seng Index in Hong Kong SAR) and relative to their peers
Asset class
Broad grouping of similar types of investments, such as shares, bonds, real estate, and commodities
Investment industry participants
Brokers and dealers, clearing houses, settlement agents and analysts
Proxy voting rules
Brokers are required to distribute voting materials to their customers, gather voting instructions and submit them for inclusion in the counting of votes
Brokers
Brokers find sellers for their clients who want to buy and buyers for their clients who want to sell (For complex trades, such as real estate transactions, for which effective negotiation is essential to successful investment, brokers often serve as professional negotiators)
The commissions compensate brokers for the resources they use to fill orders
Brokers must maintain order routing systems, market data systems, accounting systems, exchange memberships, office space, and personnel to manage the trading process
Brokered markets
Brokers organize markets for assets that are unique and thus of interest as potential investments to only a limited number of investors (Brokers who are organizing markets in unique assets try to know everyone who might now or in the future be willing to trade such assets)
Endowment funds are usually intended to exist in perpetuity and, as such, are regarded as very long-term investors
But they are also typically required to spend annually on the charitable or philanthropic purpose for their existence, so money needs to be drawn from their funds
Retail investors
Buy and sell relatively small amounts of securities and assets for their personal accounts (They also may invest indirectly by buying pooled investment products, such as mutual fund shares or insurance contracts)
Analysts
Buy side analysts are hired by institutional investors to review potential investors
Leveraged buyouts
Buyouts for which the financing of the transaction involves a high proportion of debt
Existing shareholders who do not want to exercise their rights will be "diluted"—that is, their proportional ownership will decrease because they will hold the same number of shares in a company that now has more shares outstanding
By selling their rights to others who will exercise them, they receive compensation for the decrease in their proportional ownership (Shareholders generally dislike rights offerings because they must provide additional capital to avoid dilution or sell their rights and experience dilution of ownership)
Expenses divided into different categories
COGS, SG&A, depreciation, interest expense and income tax expense
Net book value decreases each year
Calculated as the gross value of the asset minus accumulated depreciation
Net asset value (NAV)
Calculated by dividing the total net value of the fund (the value of all assets minus the value of all liabilities) by the fund's current total number of shares outstanding (Managers compute the fund's NAV each day following the normal close of exchange market trading)
Downside deviation
Calculated in almost exactly the same way as standard deviation, but instead of using all the deviations from the mean—positive and negative— downside deviation is calculated using only negative deviations (downside deviation may also be calculated by focussing on outcomes that are less than a specified return target; this target does not have to be the mean)
Immediate or cancel orders
Can be executed only on immediate receipt by the broker or trading venue
Good-until-cancelled orders
Can be executed until they are cancelled (Some brokers or trading venues may set a maximum number of days before the order is automatically cancelled)
Risk matrix
Can be used to prioritise risks and to select the appropriate risk response for each risk identified
To avoid the risk of recruiting the wrong people, companies typically take various precautions, such as the following:
Carrying out background checks, such as checking criminal records and disciplinary records with regulators for new hires, verifying credentials and previous work experience, performing personality assessment tests and getting character references to confirm suitability
Revenue is considered earned when a sales transaction is identified by certain conditions
Cash flow from the transaction usually occurs later (On the income statement, profits are measured on an accrual basis)
Cash flow rights
Cash flow rights are the rights of shareholders to distributions, such as dividends, made by the company
Cash flows from financing activities
Cash inflows resulting from raising new capital (an increase in borrowing and/or issuance of shares) and cash outflows for payment of dividends, repayment of debt, or repurchase of shares (also known as share buybacks
Margins
Cash or securities that are pledged as collateral
Cash flow statement
Cash received and spent during the period
Current assets
Cash, inventories and accounts receivable (assets converted to cash in 1 year)
Monetary policy
Central bank activities that are directed toward influencing the money supply
Managed floating rate
Central bank intervenes to stabilize its country's currency
Primary dealers
Central banks sell bonds to primary dealers to decrease the money supply → the primary dealers then sell the bonds to their clients
Effect of changes in general tastes and preferences on demand
Changes in consumers' general tastes and preferences may also affect a product's demand curve
Contingent claims
Claims are dependent on future conditions ( If the buyer decides to use (exercise) the option, the seller is obligated to satisfy the option buyer's claim) and if the buyer decides not to exercise the option, it expires without any action by the seller
Clearing houses and settlement agents
Clearing houses and settlement agents settle trades after they have been arranged
Front office
Client-facing activities that provide direct revenue generation
Banks
Collect deposits from savers and transform them into loans or borrowers
Financial institutions
Collect money from savers and to invest it in financial assets
Commodities
Commodities, such as precious and base metals, energy products, and agricultural products, tend to rise in price with inflation
Types of equity securities
Common stock, preferred stock, convertible bonds, warrants
Disposal
Companies have a responsibility to discard or destroy documentation after the retention period
Sweeteners
Companies may attach warrants to a bond issue or a preferred stock issue in an effort to make the bond or preferred stock more attractive (Allows the issuer to offer a lower coupon rate (interest rate) on a bond issue or a lower annual fixed dividend on a preferred stock issue)
Long-term investments are usually managed under the direction of the chief financial officer or the chief investment officer, if the company has one
Companies often invest long-term to finance future research, investments, and acquisitions of companies and products
Private placements
Companies sell securities directly to a small group of investors, usually with the assistance of an investment bank that helps identify potential investors and set the price of the securities (Investors in private placements are expected to have sufficient knowledge and experience to recognise the risks that they assume, so most countries require less disclosure for private placements than for public offerings)
Corporate policies
Companies set and enforce rules for their employees to ensure compliance with regulation and to guide employees with matters outside the scope of regulation
Shelf registration
Companies sometimes sell new issues of seasoned securities directly to the public over time via shelf registrations (In contrast to a seasoned offering in which all the shares are sold in a single transaction, a shelf registration allows the company to sell the shares directly to investors over a longer period of time)
SEC
Companies that go public have to comply with certain rules and regulations
Access
Companies usually have a centralised repository that is often electronic: a read-only drive, document database, or documentation management system capable of storing internal and external documents relevant to the company's business activities
Balance sheet
Company's financial position at a specific point in time, such as the end of the fiscal year or the end of the quarter (assets, liabilities and shareholders equity)
The typical KYC process requires the client to
Complete a questionnaire and provide personal background information, including documentary proof of identity (for instance a passport), addresses, and other personal details, be screened against various global databases to ascertain whether he or she is known or wanted by local or international law enforcement agencies, submit to anti-money-laundering checks at on-boarding and thereafter to identify any potential suspicious transactions that the company would be obligated to report to a regulator and provide proof of the source of funds to verify that the money does not originate from an illegal or criminal source
Comparing simple interest and compound interest
Compound interest is extremely powerful for savers; reinvesting the interest earned on investments is a way of growing savings
Investment industry
Comprises all the participants that are instrumental in helping savers invest their money and helping spenders raise capital in financial markets
Clearing houses and settlement agents
Confirm and sell trades after they have been agreed upon
Analysis
Consider all different regulatory approaches to achieve a desired outcome
Accounting profit
Considers only the explicit costs
Settlement
Consists of the final exchange of cash for securities
Sales practice rules
Consumers seeking financial advice find it difficult to assess the quality of the advice they are receiving
Derivatives
Contracts that derive their value from the performance of an underlying asset, event, or outcome
Communicates
Conveys ideas, concepts, or information
Economies of scale
Cost savings arising from a significant increase in output without a comparable rise in fixed costs
Selling general and administrative (SG&A)
Costs not associated with operations
Fixed costs
Costs that do not fluctuate with the level of output
Variable costs
Costs that fluctuate with the level of output by the company
Speculator
Counter party that is not hedging risk but is instead taking on risk in anticipation of earning a return
Counterparty risk
Counterparty risk is potentially very high in forward contracts but the presence of an exchange or a clearing house as the intermediary for all buyers and all sellers helps reduce counterparty risk for futures
Property insurers
Cover assets such as homes, cars and businesses
Money laundering
Criminals using companies in the financial services industry to transfer money from illegal operations into other legal activities
Liabilities (short term)
Current liabilities must be repaid in the next year and include operating debt such as accounts payable
Current ratio
Current ratio = current assets / current liabilities (Measures the current assets available to cover one unit of current liabilities)
Valuation of fixed rate and zero coupon bonds
Current value of the bond = (The bonds cash flows + par value)/(1 + discount rate)^(number of periods until maturity)
Business continuity planning rules
Customer records need to be backed up and companies have plans to recover in the event of a natural disaster
Conservative accounting
Dampen reported earnings
Dark pools
Dark pools do not display orders from clients to other market participants (Large institutional investors may transact in dark pools because market prices often move to their disadvantage when other traders know about their large orders)
Quote driven markets
Dealer markets or price-driven markets are markets in which investors trade with dealers (These markets take their name from the fact that investors trade with dealers at the prices quoted by the dealers)
Depending on the trading venue, these quotation sizes may or may not be exposed to other traders or dealers in that market
Dealers are said to quote a market when they expose their bids and offers (The highest bid in the market is the best bid and the lowest ask in the market is the best ask)
Notes
Debt securities with maturities from 1 to 10 years
Bonds
Debt securities with maturities longer than 10 years
Bills
Debt securities with maturities of one year or less
Debt to equity ratio
Debt-to-equity ratio = debt / equity
Technology
Decreased trade processing costs and increased trade processing capacity
Internal risk limits
Defining limits and then controlling and monitoring those limits allows firms to implement risk response strategies
Inferior goods
Demand for inferior goods decreases when income increases
Unrelated products
Demand is affected by prices of other products that are not substitute or complementary
Shares, units, or partnership interests
Depending on the form of the organization, ownership shares
Underlying
Derivatives can be created on any asset, event, or outcome, which is called the underlying
Swaps
Derivatives in which two parties exchange (swap) cash flows or other financial instruments over multiple periods (months or years) for mutual benefit, usually to manage risk
Performance attribution
Determining how much of performance is the result of the selection of asset classes, sectors, individual securities, and currencies
Spread
Difference between the bid and the offer
Real estate
Direct or indirect investments in land and buildings
Distressed
Distressed investing focuses on purchasing the debt of troubled companies that may have defaulted or are on the brink of defaulting (If the company can survive and prosper, the value of its debt will increase and the investor will realize significant value)
People invest in financial products and instruments because they expect to get future benefits in the form of future cash flows
Dividends and interest
Expect two types of cash flows
Dividends, proceeds from selling their shares
No-load funds
Do not charge deposit or redemption fees, set the same price for deposits and redemptions on any given day
Adverse opinion
Do not comply with the accounting standards
Fee-only professionals
Do not have incentives to generate commissions by recommending specific products or excessive trades
Trading
Documentation is important in trading—to provide a record of which assets were ordered and traded, in what quantity and at what price
Direction
Documents "flow" in different directions (Typically, documents associated with policies and procedures "flow down" through a company) ( In contrast, documents associated with reporting usually "flow up")
Calculate the geometric mean
Does consider compounding and is usually the preferred approach
Calculate the arithmetic mean by adding the two six-month returns
Does not consider compounding
If necessary, the underwriter provides price support for a limited period of time, typically about a month
During that time, if the price of the securities falls below a certain threshold, the underwriter will buy securities to stop or limit the price fall
EBITDA
EBITDA = EBIT (or operating income) + Depreciation and Amortisation
Earnings before taxes
Earnings before taxes = EBIT (or operating income) - Interest expense
Allocationally efficient economies
Economies that put resources to use where they are most valuable
Documentation in the context of the investment industry does the following:
Educates, communicates, authorizes, formalizes and organizes
Currency swap
Enables borrowers to exchange debt service obligations denominated in one currency for equivalent debt service obligations denominated in another currency
Organizes
Ensures thoroughness and consistency of action, allowing the company to function more efficiently and effectively
Compliance risk
Ensuring compliance with rules and regulations has often been viewed as a rather mundane chore, but the rapidly changing regulatory environment has recently brought compliance to the forefront of business priorities
Equity book value per share
Equity book value per share = equity reported on the balance sheet / number of shares outstanding
Total shareholders' equity
Equity reflects the residual value of the company's shares
Warrants
Equity-like security that entitles the holder to buy a pre-specified amount of common stock of the issuing company at a pre-specified per share price (called the exercise price or strike price) prior to a pre-specified expiration date
Formalises
Establishes roles, deliverables, and obligations
Discounted cash flow
Estimates the value of a security as the present value of all future cash flows that the investor expects to receive from the security
Asset-based valuation
Estimates the value of common stock by calculating the difference between the value of a company's total assets and its outstanding liabilities
Framework for legal and regulatory compliance
Every company has to follow a set of rules, beginning with the statutory laws and other regulations imposed by regulatory bodies and many investment firms must follow guidelines from regulators, stock exchanges, and industry associations that have been given powers to oversee members
Misappropriation
Excessive claims on expense reports and using company assets for personal purposes
International trade
Exchange of products, services and capital between countries
To respond to regulatory requirements, all trading venues offer post-trade transparency, although the speed at which it happens varies among trading venues
Exchanges are pre-trade transparent, but many alternative trading venues are not (Many investors value transparency because it allows them to better manage their trading, understand market prices, and estimate their transaction costs but dealers often prefer to trade in opaque markets because, as frequent traders, they have an informational advantage over those who trade less frequently)
Phases of the economic cycle
Expansion, peak, contraction, trough, recovery
Rules based
Explicit regulations that offer clarity and legal certainty to investment industry participants
Explicit trading costs
Explicit trading costs represent the direct costs associated with trading (Brokerage commissions are the largest explicit trading cost)
CAPM
Factor models, such as the CAPM, separate a fund's performance into return from market performance (beta), from luck or randomness, or from the investment skills of the fund manager (alpha)
Real assets
Factors of production like land, buildings, machinery, cattle and gold
Support economic stability
Failure of the entire financial system, including loss of access to credit and collapse of financial markets
Front-end sales loads
Fees that investors may have to pay when they buy shares in a fund
Back-end sales loads
Fees that investors may have to pay when they sell shares in a fund that they have not held for more than some pre-specified period, typically a year or more
Management fees
Fees that limited partners must pay general partners to compensate them for managing the private equity investments
Two trends that have promoted international trade
Fewer trade barriers, international trade barriers have reduced and better transportation and communications
Securities
Financial assets that can be traded
Non-current assets
Financial assets, such as shares or bonds issued by another company, tangible assets, such as land, buildings, machinery, and equipment, and intangible assets, such as patents (Tangible assets are often grouped together on the balance sheet as property, plant, and equipment)
Co-operative and mutual banks
Financial institutions that their members own and sometimes run (Provide mortgages and commerical bank services but depositors earn a return without having to locate borrowers)
Investment banks
Financial intermediaries that have expertise in assisting companies and governments raise capital
Equity multiplier ratio
Financial leverage = equity multiplier / total assets equity (The amount of total assets supported by one monetary unit of equity)
Financial market integrity
Financial markets that are ethical and transparent and provide investor protection
Institutional and individual investor services
Financial planning, investment management, investment information, trading and custodial
10k
Financial statements, MD&A, results of operations, quantitative and quantitative disclosures about the risks the company faces
Private equity
Firms invest in private companies that are not publicly traded on the stock exchange
Buy side firms
Firms that manage portfolios for clients and/or themselves
There are at least two reasons why investors care about historical variability (the standard deviation of past returns)
First, past variability of returns might be indicative of how variable returns may be in the future and second, the variability of returns may affect an investor's objectives
Keynesian
Fiscal policy can have a powerful effect on aggregate demand, output and employment
Monetarists
Fiscal policy only has temporary effects
Capital gains and losses
Fluctuations in the prices and values of investments reflect the risk of investing
Growth equity
Focuses on financing companies with proven business models, good customer bases, and positive cash flows or profits (By providing additional money in return for equity of the company, growth equity investors help these companies expand and become more established)
Depreciation
For a capitalised, long-term asset, the company allocates the cost of that asset over the asset's estimated useful life
Fundamental analysis
For equity investors, this process means conducting a thorough analysis of a company's business model, its prospects, and its financial situation
These complementary techniques include scenario analysis and stress testing, which focus on the effect of more extreme situations that would not be fully captured or evaluated with VaR
For example, an asset management firm may perform a scenario analysis by identifying different scenarios for the economy (strong growth, moderate growth, slow growth, no growth, mild recession, and severe recession) and then determining how each scenario would affect the value of a portfolio and the firm's earnings and equity capital
After receiving the money, the company initiates the investment transaction and sends a formal confirmation to the client
For example, the documentation associated with the investment transaction could be a share certificate or confirmation of an investment in a mutual fund (Service providers may provide transaction, safekeeping, or administrative services to the client or the company, and external documentation would also be used to record activities related to these activities)
Likewise, the pension plans, foundations, and other institutional investors want to monitor the performance of their investments to ensure that the assets will be sufficient to meet their needs
For retail investors, the performance of their investments may determine whether they will enjoy a comfortable retirement, whether they will have enough money to send their children to university, or whether they can afford their dream holiday
Passive management of equity portfolios is a well-established discipline and replicating an equity market index is quite straightforward
For some markets, such as real estate, in which all properties are unique and trading is done in private transactions rather than on a public stock exchange, it is less clear how a passive approach can be used
Settlement risk
Form of counterparty risk in which one of the parties fails to honour their obligation between the time a trade is negotiated and the time the trade is settled (The shorter the settlement period, the fewer extreme price changes can occur before final settlement)
Adoption
Formally adopted by regulator
Bilateral contracts
Forward and futures contracts are sometimes termed forward commitments or bilateral contracts because both parties have a commitment in the future
Timing of cash flows
Forward contracts have no cash flows except at maturity while futures contracts are marked to market daily
Settlement
Forward contracts may settle with physical delivery or cash settlement and futures contracts are typically settled with cash
Liquidity
Forward contracts trade in the over-the-counter market and are illiquid but futures contracts are relatively liquid; they trade on exchanges and can be bought and sold at times other than initiation
Trading and flexibility of terms
Forward contracts transact in the over-the-counter market and terms are customized according to the contracting parties' needs where futures contracts trade on exchanges
Four types of derivatives contracts
Forwards, futures, options, swaps
Complements
Frequently consumed together
Employees/managers
Front-line employees and managers, through their daily responsibilities, form the first line of defence
Alpha
Fund manager skill
Benchmarks
Fund managers may not only use a benchmark for assessment, but some, such as index fund managers, may also manage their portfolios to a benchmark
Calculating a funds holding period is complex
Funds may consist of hundreds of individual investments that pay income at different times throughout the holding period and clients may make additional investments (cash inflows) in and withdrawals (cash outflows) from a fund throughout the holding period
Futures contracts trade on exchanges
Futures contracts are standardized regardless of buyers' and sellers' specific needs
Expenditure approach
G + C + I + (X - I)
GDP per capita
GDP / population
In 1999, a set of voluntary investment performance standards—the Global Investment Performance Standards (GIPS)—was proposed for this purpose
GIPS requires the use of the time-weighted rates of return method because this measure is not distorted by cash inflows and outflows
Law of diminishing returns
Gain in output will increase at a decreasing rate even if the fixed inputs of production remain unchanged
GAAP
Generally Accepted Accounting Principles
Internal documents
Generally administrative and formulate policies, procedures, and processes (They help reduce risk by preventing errors and unethical behaviour)
Companies can mitigate operational risks through education, by clearly communicating policies and procedures and by having efficient and effective internal controls
Good human resource management processes are also critical; hiring the right people and motivating them with the right incentives are well-known ingredients for success
Gatekeeping rules
Govern who is allowed to operate as an investment professional as well as if and how products can be marketed
Bond
Governed by a legal contract between the bond issuer and the bondholders
Parties that can be involved in external documents include the following:
Governments, legislators, and regulators, groups that help organise the market, such as stock exchanges, clearing houses, and depositories, market participants active in facilitating investments or transactions, such as banks, brokers, and asset managers, professional firms and individuals serving the needs of the industry, including credit rating agencies, auditors, lawyers, consultants, and trustees and investors, including retail clients and institutional investors
Sovereign wealth funds
Govts accumulate surpluses by collecting taxes in excess of current spending (Invest a government surpluses)
Foundations
Grant making institutions funded by financial gifts and by the investment income that they produce
Foundations
Grant-making institutions funded by gifts and by the investment income that they produce (They fund organisations that provide services in areas such as the arts or charities)
Gross profit
Gross profit = Revenues - cost of sales
Cartel
Group joins to control supply and pricing of products from the group
Economic growth
Growth in labor force, productivity gains and growth in availability of capital
Closed-end funds
Have a fixed number of shares; they do not issue or redeem shares on demand (They may issue additional shares in secondary offerings or through rights offerings or they may repurchase shares, but these events are uncommon)
Operationally efficient markets
Have low transaction costs and they can absorb large orders without substantial price impacts
Insurance companies
Help individuals and companies offset the risks they face, protect them from potential loss by providing payments in the event that losses occur
Block brokers
Help investors who want to trade large blocks of securities (Large block trades are hard to arrange because finding a counter party willing to buy or sell a large number of securities is often quite difficult)
Financial planners
Help their clients understand their current and future financial needs, the risks they face when investing, their ability to tolerate investment risks, and their preferences for capital preservation versus capital growth
Enterprise risk management
Helps a company manage all its risks together in an integrated way rather than managing each risk separately (The advantage of this approach is that it aligns risk management with objectives at all levels of the company, from the corporate level to the business unit level to the project level)
Financial system
Helps link savers who have money to invest and spenders who need money
High net worth individual
Higher amounts of investable assets
Preferred stock
Higher claim on the company's assets compared with common shareholders if the company ceases operations
VaR primarily relies on historical data to forecast future expected losses
History is not helpful in forecasting events that have far-reaching effects, but are unforeseen or considered impossible—that is, black swan events
Pension plan
Hold and manage investment assets for the benefit of the future and already retired people, called beneficiaries
Pension plans
Hold investment portfolios—pension funds—for the benefit of future and current retired members, who are called beneficiaries
Custodians and depositories
Hold money and securities on behalf of clients
Investors can reduce specific risk
Holding a number of different securities in their portfolios
Hotels
Hotels include branded short-term stay facilities and longer-stay facilities catering to contract workers in remote locations, as well as boutique and independent facilities
Current account
How much the country consumes and invests compared with how much it receives
Tracking error
How the performance of the investment fund deviates from the performance of its benchmark
Elasticity
How the quantity demanded or supplied changes in response to small changes in a related factor, such as price, income, or the price of a substitute or complementary product
Managing people
Human failures range from unintentional errors to fraudulent activities
Income statement
Identifies the profit or loss generated by the company during the period covered by the financial statements
Enforcement
Identify and punish lawbreakers
The clearing members guarantee settlement of the trades that their clearing clients present to them, and clearing houses guarantee settlement of all trades presented to them by their clearing members
If a clearing member fails to settle a trade, the clearing house settles the trade using its own capital or capital pledged by the other members of the clearing house
Bankruptcy
If a company files for bankruptcy or undergoes a reorganisation, the client may be affected, depending on the nature of the underlying transaction or investment
Merger and acquisition activity
If a company merges with, spins off from, or acquires another company, its business and operations may change, affecting the client's investment
Goodwill
If a company purchased another company, but paid more than the fair value of the net assets of the company it purchased (The additional value reflected in goodwill is created by other items not listed on the balance sheet)
Inelastic
If a product has no immediate substitutes
Elastic
If a product is easy to substitute because similar products exist, then own price elasticity will be large and negative
Normal goods
If income increases, demand increases too
Time horizon
If investors have a long time horizon, they have more scope to adjust their circumstances to cope with losses by saving more or waiting for markets to recover, although recovery and its timing cannot be guaranteed
Assets
If investors have far more assets than liabilities, any losses that result from risk taking may not alter their lifestyle
Effect of the expected future price of a product on demand
If people expect that price will rise → demand will increase
An informationally efficient market is one in which the prices of investments reflect available information about the fundamental values and return prospects of the assets they represent
If stock markets are believed to be informationally efficient, the investor will believe there is little point to actively managing stock market investments because share prices already reflect the potential of the underlying companies
Default
If the bond issuer fails to make the promised payments
In a defined benefit plan, the employer bears the risk—in this case, that the investments made by the pension fund fail to perform as expected
If the investments fail to perform as expected, the employer may be required to make additional contributions to the fund
An investor may set the strategic asset allocation and simply hold a portfolio for the life of the investment
If the investor does so, the proportions of the portfolio will likely depart from the original weights chosen as the different asset classes provide different rates of return over time and their values thus increase or decrease by different amounts
At the money (put)
If the market price and exercise price are the same. In this case
In the money (call)
If the market price is greater than the exercise price
Out of the money (put)
If the market price is greater than the exercise price
In the money (put)
If the market price is less than the exercise price
Out of the money (call)
If the market price is less than the exercise price
Pre-trade transparent
If the trading venue publishes real-time data about quotes and orders
Post-trade transparent
If the trading venue publishes trade prices and sizes soon after trades occur
Undersubscribed
If there are not enough buyers for all the securities that are for sale
Oversubscribed
If there is more demand than securities for sale
Implementation
Implemented by regulator and complied with by those who are affected by them
Implicit trading costs
Implicit trading costs are the indirect costs associated with trading
Key risk measures
Important for the risk management function to be proactive and predictive, key risk measures should provide a warning when risk levels are rising, they require the collection and compilation of data from various internal and external sources and the types of key risk measures vary among industries and companies, and they need to be reviewed regularly to ensure that the measures are still relevant and sensitive to risk events
Reinvestment risk
In a period of falling interest rates, the coupon payments received during the life of a bond and/or the principal payment received from a bond that is called early must be reinvested at a lower interest rate than the bond's original coupon rate
Rights offerings
In a rights offering, a company allows existing shareholders to buy shares at a fixed price (called the exercise price) in proportion to their holdings (The rights that existing shareholders receive are often known as pre-emptive rights because existing shareholders have the right of first refusal on any new equity offerings)
As mentioned earlier, a clear separation needs to exist between front and back offices
In accounting departments, there should also be a clear separation between those who enter items into the accounts and those who reconcile the bank statements with the cash balances in the accounting system
Many leading investment banks, such as Barclays Capital and Goldman Sachs, produce bond indices for different types of issuers located in developed or emerging countries
In addition to aggregate bond indices that are designed to cover the market as a whole, many index providers offer bond indices classified by maturity, credit rating, currency, and industrial category
Order driven markets
In contrast to most bonds, currencies, and spot commodities that trade in quote-driven markets, many shares, futures contracts, and most standard options contracts trade on exchanges and alternative trading venues that use order-driven trading systems (Arrange trades using rules to match buy orders with sell orders)
Public market investments
In contrast to real estate limited partnerships and real estate equity funds that are private investments, real estate investment trusts (REITs) are investments through public markets
Investors choose when to buy or sell their direct investments to minimise their tax liabilities
In contrast, although the managers of indirect investments often try to minimize the collective tax liabilities of their investors, they cannot simultaneously best serve all investors when those investors have diverse tax circumstances
Trading venues that are call markets have the potential to be very liquid when they are called, but they are completely illiquid between calls
In contrast, traders can arrange and execute their trades at any time in continuous trading markets
In defined contribution plans, the member (or employee) bears the risk that the pension account's investments fail to perform as expected
In defined contribution plans, the employer has no obligation to make additional contributions if the investments perform poorly
Deposit taking institutions
In exchange for using the depositors' money, banks offer transaction services, such as check writing and check cashing and may pay interest on a deposit
One role of the board of directors is to ensure that the company works within the law and, in doing so, protects and represents the interests of all stakeholders
In general, regulation concentrates on outward-facing documentation, such as product disclosures and other client-focused material Many companies look externally to identify standards that should be followed
Other segments
In many developed markets, senior housing designed for people aged 55+ and student housing for post-secondary education have both received considerable investments
Leveraged positions
In many markets, investors can buy securities on margin—that is, by borrowing some of the purchase price
Money market funds are vulnerable to a run on assets
In particular, if investors expect the value of their money market funds will decline in the near future, they may rush to redeem their shares before the NAV falls
Bid prices
In quote-driven markets, the prices at which dealers are willing to buy from investors or other dealers
Factors that affect option premiums
In summary, an option's premium depends on the current spot price of the underlying, exercise price, time to expiration, and volatility of the underlying
Seniority ranking
In the event that the company is liquidated, assets are distributed following a priority of claims
Private market investments
In the private market, the primary way of investing in real estate is through real estate limited partnerships and real estate equity funds
Investment companies
Include mutual funds, hedge funds, and private equity funds (These companies exist solely to hold investments on behalf of their shareholders, partners, or unitholders)
Alternatively, an investor may distinguish
Income and capital gains, seeking income for current spending and capital gains for long-term needs
Dividends and interest
Income may also differ from what was expected
Three statements
Income statement, cash flow statement and the balance sheet
Commercial real estate
Income-generating real estate
Improve society
Increasing availability of credit financing to a specific group, encouraging home ownership or increasing national savings rates
Fundamental/intrinsic value
Indicates the price that investors would pay for the investment if they had a complete understanding of the investment's characteristics
Asset allocation
Indicates the proportion of a portfolio that should be invested in various asset classes to help meet financial goals (Cash, equity and debt securities, and alternative investments)
Less regulated and less transparent than traditional investments
Individual investors are less likely to invest in them
Savers
Individuals (households), companies, and governments that have money to invest
Inflation
Inflation is a general rise in prices for products and services
Inflation linked bonds
Inflation-linked bonds contain a provision that adjusts the bond's par value for inflation and thus protects the investor from inflation (The par value—not the coupon rate—of the bond is adjusted at each payment date to reflect changes in inflation (which is usually measured via a consumer price index))
Ensure fairness
Information asymmetries can deter investors from investing
Information technology
Information technology (IT) has greatly enhanced our ability to collect, collate, manage, and distribute documents
Educates
Informs or provides instruction
Institutional investors
Institutional investors are organisations that hold and manage portfolios of assets for themselves or others
Orders
Instructions that investors who want to trade give trading service providers, such as brokers and dealers
Market order
Instructs the broker or trading venue to obtain the best price immediately available when filling the order
Insurance companies
Insurance companies collect premiums from the individuals and companies they insure
Regulators often set requirements to restrict the types of investments insurance companies can hold
Insurance companies profit from income that they can earn on the float, which is the amount of money they have available to use after receiving premiums and before paying claims
Compound interest
Interest is assumed to be reinvested so future interest is earned on principal and reinvested interest, not just on the original principal
Internal audit
Internal auditors follow risk-based internal audit programmes, delving into the details of business processes and ensuring that information technology and accounting systems accurately reflect transactions
IASB
International Accounting Standards Board
IFRS
International Financial Reporting Standards
Sovereign wealth funds
Invest these surpluses for the benefit of current and future generations of their citizens
To help clients meet their objectives, a benchmark should meet certain criteria:
Investability, compatibility, clarity and pre-specification
Willingness to take risk
Investing experiences, attitude toward risk and investment knowledge
Pension funds invest to generate the returns necessary to pay their beneficiaries, insurance companies invest to generate returns to meet the claims on their policies, and individuals invest because they usually have a future expenditure in mind
Investing in a portfolio or fund whose returns vary significantly over time could potentially disrupt investors' plans
Investment analysis
Investment analysis involves estimating the fundamental value of potential investments and identifying attractive securities and assets
Companies generally contract with investment banks to help them sell their securities to the public
Investment banks play an important role in identifying potential investors and setting the offering price—that is, the price at which the securities are sold
Financial companies
Investment companies, banks and other lenders, and insurance companies
Institutional investors that invest to provide financial services to their clients
Investment companies, banks, and insurance companies
Endowment funds and foundations typically have a charitable or philanthropic purpose and receive gifts from donors interested in supporting their activities
Investment income and capital gains that these organisations receive from investing these funds may also be tax-exempt
Soft money agreement
Investment managers use arrangements in which broker commissions are used to pay for external research
Churning
Investment managers who receive commissions on trades that they recommend may execute too many trades
Standard deviation
Investment risk is often measured using some measure of variability (or volatility) of returns, and a common measure of variability is the standard deviation
Financial account
Investments domestic entities make in foreign entities and the investments foreign entities make in domestic entities
Commodities
Investments in physical products, such as precious and base metals (e.g., gold, copper), energy products (e.g., oil), and agricultural products that are typically consumed (e.g., corn, cattle, wheat) or used in the manufacture of goods (e.g., lumber, cotton, sugar)
Private equity
Investments in private companies—that is, companies that are not listed on a stock exchange
Separately managed accounts
Investor assets may still be invested in funds, but some high-net-worth investors will prefer their own segregated accounts
Reward to risk ratios
Investors are interested in maximising the return on their investments while simultaneously trying to minimise the risks
Buy commodity derivatives
Investors can buy derivatives in which the underlying asset is a commodity or a commodity index
Buy shares of natural resources or commodity-related companies
Investors can buy shares of companies that have a major portion of their operations in the exploration, recovery, production, and processing of commodities
Credit spreads
Investors commonly refer to the difference between a risky bond's yield to maturity and the yield to maturity on a government bond with the same maturity as the risky bond's credit spread
Management accountability
Investors in indirect investment vehicles cannot choose who will manage their investments
Pooled investment vehicles
Investors in these companies pool their money for common management
Globalization
Investors look outside their domestic markets to diversify their investments and generate higher returns
Investment research providers
Investors may also purchase reports directly from independent research firms, or they may obtain reports from research firms that issuers pay to produce reports about their securities
Credit rating
Investors may be able to assess the credit risk of a bond by reviewing its credit rating
Some funds also charge purchase or redemption fees
Investors pay these fees to the fund as opposed to paying them to the distributor as in a front-end or back-end sales load (Purchase and redemption fees help compensate existing shareholders for costs imposed on the fund when other shareholders buy and sell their shares)
Pooled investments
Investors pool their money together to gain the advantages of being part of a large group
Investors can choose not to invest directly in certain securities
Investors who are wealthy can often obtain high-quality investment advice at a lower cost when investing directly rather than indirectly
Limited partners
Investors who contribute capital to the partnership
How to invest in real estate?
Investors who have sufficient funds can buy real estate directly or gain exposure to real estate through either the private or public market
Investors exercise more control over direct investments than over indirect investments
Investors who hold indirect investments generally must accept all decisions made by the investment managers, and they can rarely provide input into those decisions
Investors are more concerned about the accountability of managers of actively managed open-end mutual funds and ETFs
Investors will withdraw their money from these funds if they are unhappy with the management, thus reducing the manager's assets under management and the fee paid to the manager
Investors may also have specific needs in relation to liquidity, tax considerations, regulatory requirement, consistency with particular religious or ethical standards, or other unique circumstances
Investors' circumstances and needs change over time, so it is important to re-evaluate their needs at least annually
The investment manager or adviser has to be comfortable that the investor's desired rate of return is achievable within the related constraints
Investors, particularly individual investors, will usually adjust the proportion they invest in different kinds of assets over time as they age and their circumstances change.
Hyperinflation
Involved price increases so large and rapid that consumers find it hard to afford many products and services
Fiscal policy
Involved the use of govt spending and tax policies
Secondaries
Involves buying or selling existing private equity investments that are organized in funds managed by partnerships
Rebalancing
Involves selling some of the holdings that have increased as a proportion of the portfolio and investing the proceeds into the holdings that have decreased as a proportion of the portfolio
Annuity
Involves the initial payment of an amount, usually to an insurance company, in exchange for a fixed number of future payments of a certain amount
Risk
It can be defined as the effect of uncertain future events on a company or on the outcomes the company achieves (Events that have or could have a negative effect, leading to losses or negative rates of return, tend to be emphasised in discussions of risk)
With many profit-motivated investors digesting corporate information
It is a challenge to interpret the information faster and better than the aggregate market view
VaR offers several advantages:
It is a standard metric that can be applied across different investments, portfolios, business units, companies, and markets
General partnership
It is responsible for raising capital, finding suitable investments, and making decisions (General partners have unlimited personal liability for all the debts of the partnership)
Note that the issuer only receives additional capital when it issues new securities in the primary market
It will not receive any new capital from the trading of its securities in the secondary market
Covenants
Legal agreements that describe actions the issuer must perform or is prohibited from performing
Non-investment grade
Less creditworthy and have a greater probability of default
Ad hoc documents
Letters, memos, and e-mails, are typically informal (The free-form nature of ad hoc documents means that they carry additional risk for the company, particularly if the records are subpoenaed in a legal dispute; consequently, companies may implement policies and procedures to impose a process of peer review for ad hoc communication--peer review should be documented and auditable)
Obstacles
Licenses, brand loyalty or control of natural resources
Casualty insurers
Life insurers that pay out a sum of money upon death or serious injury of the person insured
Ability to risk
Liquidity, assets and time horizon
Debt
Loans with interest payments
Endowment fund
Long term funds not for profit institutions
Endowment funds
Long-term funds of non-profit institutions, such as universities, colleges, schools, museums, theatres, opera companies, hospitals, and clinics (These organisations use their endowment funds to provide some services to their students, patrons, and patients)
Strategic asset allocation
Long-term mix of assets that is expected to meet the investor's objectives
Devaluation
Make a country's central bank decrease the value of the domestic currency relative to other countries, an action that many governments are reluctant to take
Dealers
Make it possible for their clients to trade without having to wait to find a counter party (Dealers thus participate in their clients' trades, in contrast to brokers who do not trade with their clients but only arrange trades on behalf of their clients)
Life insurance companies
Make payments to the policyholder's beneficiaries in the event the policyholder dies while the insurance coverage is in force (Life insurers have longer- term time horizons and more predictable payouts and, therefore, have more latitude to invest in riskier assets)
Companies must also make sure that all employees receive adequate training regarding existing procedures and processes, and that they are kept informed when changes are made
Making changes is never easy, so it is advisable to make processes modular—that is, they should be made up of separate elements that can be reviewed and replaced independently of each other
Passive managers
Manage a portfolio designed to match the performance of a specified benchmark
Select a risk response
Management must select an appropriate response and develop actions to align the company's risk profile with its risk tolerance
Technical and behavioral analysis
Managers using technical analysis study market information, including price patterns and trading volumes, whereas managers using behavioural analysis focus on indicators of market sentiment, such as manufacturers' new orders or indices of consumer expectations
Competition
Manifests through innovative investment product and service offerings, pricing and performance
Industrial properties
Manufacturing facilities, research and development space, and warehouse/distribution space
Monopolistic competition
Many buyers and sellers who are able to differentiate products
Strategic investments
Many companies invest directly in the shares and bonds of their suppliers and in the shares of potential merger partners to strengthen their relationships with them
Data vendors
Many data vendors provide such data, including historical data and real-time data
Life
Many equity securities are issued with an infinite life
The investment industry provides mostly standardised services to retail investors because they generate the least revenue per investor for investment firms
Many retail investment services are delivered over the internet or through customer service representatives working at call centres
Oligopoly
Market dominated by a small number of large companies
Systematic risk
Market or non-diversifiable risk
Disclosure rules
Market participants require information, including information about companies and governments raising funds, information about the specific financial instruments being sold and traded, and information about the markets for those instruments
Market risk
Market risk, which arises from price movements in financial markets, can be classified into the risks associated with the underlying market instruments: equity price risk, interest rate risk (for debt securities), foreign exchange rate risk, and commodity price risk
They often implement an approach called risk budgeting to determine how risk should be allocated among different business units, portfolios, or individuals
Market risks that cannot be tolerated must be mitigated, and companies have different alternatives available (One of them is to hedge unwanted risks by using derivative instruments)
Typical client interaction cycle
Marketing, client on-boarding, funding, ongoing reporting, investment events and redemption
Although directors and senior managers are in charge of setting the appropriate level of risk to support the corporate strategy, risk management should involve all employees
Markets are increasingly interdependent, and media and the internet can spread the news of a mistake or scandal across the globe in a matter of minutes
Primary markets
Markets in which companies and governments sell their securities to investors
MR = MC
Maximises profit
Operations rules
May dictate some aspects of how a company operates
Anti-money-laundering rules
May require companies to confirm and record the identity of their clients, report payments (such as dividends) to tax authorities and report other activities like large transactions
The performance evaluation process includes four discrete but related components:
Measure absolute returns, adjust returns for risk, measure relative returns and attribute performance
Reward to risk ratio
Measure of portfolio return / measure of portfolio risk (The higher the value of the reward-to-risk ratio, the better the risk-adjusted return— that is, the higher the return per unit of risk)
Utility
Measure of relative satisfaction
Economic indicators
Measures that offer insight regarding economic activity and are reported with greater frequency than GDP
Producer price index
Measures the average selling price of products in the economy
By measuring relative returns investors can determine whether they could have made more money in other investments
Measuring relative returns allows them to assess their opportunity cost and determine whether their investments are generating appropriate returns
Liabilities (long term)
Money borrowed from banks or other lenders that is to be repaid over periods greater than one year
Accounts receivable
Money owed to the company by customers who purchase on credit, sometimes called debtors
Debt
Money that has been borrowed and must be repaid at some future date
Monitoring
Monitor companies and individuals to assess whether they are complying with regulation
Income elasticity of demand
Most products have positive income elasticities As a person's income increases → they buy more of a product
Transfer agent
Most transfer agents are banks or trust companies, but sometimes companies keep their own records and act as their own transfer agents
Mutual funds pool the assets of many investors into a single investment vehicle, which is professionally managed and benefits from economies of scale
Mutual funds are typically categorised by their investment(s)
Sources of comparative advantage
Natural, human and capital
Dispute resolution
Need for a fast, fair and efficient dispute resolution system to improve market's reputation for integrity
Value at Risk (VaR)
Need to estimate the potential loss on an investment if their forecasts for the asset or security turn out to be inaccurate
Return on Equity (ROE)
Net income / equity (How much return, as measured by net income, is available to a monetary unit of equity)**************(net income / equity) = (net income / revenues) x (revenues / total assets) x (total assets / equity)
Net income
Net income = EBIT (or operating income) - Interest expense - Tax expense = Earnings before taxes - Tax expense
Net profit margin
Net profit margin = net income / revenues
Monopoly
No competition
Fixed rate
No fluctuations of currencies
Assess and prioritise risks
No matter what form risk takes, two elements of it are typically considered, in particular for undesirable events: the expected frequency of the event and the expected severity of its consequences
Real GDP
Nominal GDP adjusted for changes in price levels
Open-end mutual funds
Not exchange traded
Retention
Not only for business reasons but also often for legal or regulatory reasons, that all documents are retained until the risk associated with the action described in the document no longer exists
Endowment funds
Not-for-profit institutions with long term investment objectives
Size and price
Note that the price specified in the contract is not the current or spot price for the underlying but a price that is good for future delivery
A common format for an IPS is to split it into sections covering objectives and constraints
Objectives and constraints
Fixed rate bonds
Offers a coupon rate that does not change over the life of the bond
Financial services industry
Offers a range of products and services to savers and spenders and helps channel funds between them
The consequences of not doing so can be severe and can include financial penalties, loss of business licenses, lawsuits by clients, and in serious cases, prison terms
Often the greatest consequences are the damage to the company's reputation and the loss of existing and potential business opportunities
Many endowment funds and foundations establish spending rules; for example, they may set spending goals of a percentage range of their assets
Often, their challenge lies in balancing long-term growth with shorter-term income or cash flow requirements
Limit orders do not execute if the limit price on a buy order is too low or if the limit price on a sell order is too high
On average, limit orders trade at better prices than market orders when they trade, but they often do not trade
Funding
Once the client on-boarding process is complete and the relationship has been initiated and approved by the compliance department, the next stage is the cash transfer and the investment of the money
Investments in private equity partnerships tend to be illiquid
Once the limited partners have committed capital to the partnership, it is difficult, if not impossible, for them to exit the investment before the end of the commitment term
Basis points
One hundred basis points = 1%
Credit default swaps (CDS)
One party buys a CDS to protect itself against a loss of value in a debt security or index of debt securities (The premium compensates the seller for the risk of the contract)
Security
Only authorised staff should be able to access restricted documents, such as compensation data or confidential client information
Operating profit margin
Operating income / revenues
Operating income (EBIT)
Operating income = Gross profit - Other operating expenses
Operational risk
Operational risk is the risk of losses from inadequate or failed people, systems, and internal policies and procedures, as well as from external events that are beyond the control of the company but that affect its operations
Interest is determined by two factors
Opportunity cost and risk
Trading
Order document, execution instructions, submitted for dealing note, confirmation note, contract note and otification to issuer's transfer agent
Order exposure instructions
Order exposure instructions indicate whether, how, and sometimes, by whom an order should be seen
Institutional
Organizations that invest either for themselves or to advance their missions or on behalf of others Pension plans, endowments, foundations and sovereign wealth funds)
Origin
Origin relates to the source of the document (Original documents, derived documents, associated documents)
Underlying
Originally, all derivatives were based only on tangible assets, but now some contracts are based on outcomes
The consequences of inadequate risk management include investment losses and even bankruptcy
Other costly consequences are also possible, such as sanctions for the breach of regulations, loss of licenses to provide financial services, and damage to the company's reputation and the reputations of its employees
For asset management firms, the marketing documentation also contains information about the managers, including their investment strategy and competitive advantages
Other features include past performance, risk analytics, and characteristics of the product, such as liquidity, distributed income, and fees that will be borne by the client
Investment events
Over the life of the investment, numerous events may take place that affect the client or require the client to take action
Brokers and agents
Paid commissions on the trades and contracts they recommend
Continuous trading markets
Participants can arrange and execute trades any time the market is open
Call market
Participants can arrange trades only when the market is called, which is usually once a day
Interest
Payment for the use of borrowed money
Defined benefit pension funds, particularly those of government-sponsored plans, are among the largest institutional investors
Pension funds may invest in equity securities, debt securities, and alternative investments because they typically have relatively long time horizons
Institutional investors that invest to advance their missions
Pension plans, endowment funds and foundations, trusts, governments and sovereign wealth funds, and non- financial companies
Stagflation
Periods of little or no economic growth (high inflation, high unemployment and stagnant demand)
Discretionary relationships
Permit the service provider to act on behalf of the client— for example, as an investment manager with a specific mandate or as a trustee of a trust
Non-discretionary relationship
Permits the service provider to undertake only specific tasks that are authorised by the client on a per task basis
Financial market
Places where buyers and sellers trade securities are known as securities makers or financial markets
Complying with internal policies and procedures
Policies and procedures should explicitly set out the delegation of authority and define clear responsibilities and accountability (The segregation of duties is an important principle that international companies and regulators and other authorities in many countries require and recommend)
Documents that are clearly presented in a style that most people are familiar with help individuals read and understand these documents
Policies, procedures, and processes are living documents and should be subject to a regular review and confirmation process as a function of good governance
Policy documentation
Policy documents often describe the company's mission, values, and objectives (These documents should be consistent with the company's documents and bylaws, which summarise the legal identity, purpose, and activities of the company)
Identification of perceived need
Political pressure, anticipation of future need, in response to a scandal
The directors appoint a professional investment management firm, which is almost always an affiliate of the sponsor
Pooled investment vehicles are overseen by a board of directors, a board of trustees, a general partner, or a single trustee; the governance structure depends on the form of legal organization
Exchange traded funds
Pooled investment vehicles that are typically passively managed to track a particular index or sector, although an increasing number of ETFs are actively managed
Short positions
Positions that increase in value when prices fall (To take short positions, investors must sell assets or securities that they do not own, a process that involves borrowing the assets or securities, selling them, and repurchasing them later to return them to their owner)
Intangible assets
Ppatents, trademarks, copyrights, franchises, and goodwill
Standardized documents
Pre-established (They are crafted for a range of specific purposes; some standard contracts are tailored by negotiation, but their form, content, and purpose are still pre-established)
Unqualified or clean opinion
Prepared in accordance with the applicable accounting standards
Marketing documentation for a company in the investment industry typically includes the following:
Presentation materials that provide background on the company, its products, and/or its services, offering documentation, such as a prospectus or term sheet, which are legal documents that contain detailed information about the terms and conditions of the investment opportunity, highlight various risks, and make other required disclosures and fact sheets about the company's products that provide short summaries of the investments and typically detail historical performance
Records
Preserves learning within the company (also known as institutional memory)
External documents may also be used to inform the public or other external parties about a company's activities or changes in its business
Press release announcing the appointment of a new chief executive officer, a marketing presentation for a new investment product, or a statement about the launch of a new website
Price to book ratio
Price-to-book ratio = market price per share / equity book value per share
Price to earnings ratio (P/E)
Price-to-earnings ratio = market price per share / earnings per share
Accurately predicting mispricing is difficult
Prices generally should already reflect most publicly available information about fundamental values
Sell side firms
Primarily provide investment products and services; they are typically investment banks, brokers, and dealers
Ethical standards
Principles that support and promote desired values or behaviors
Buyouts
Private equity investment strategy that consists of financing established companies that require money to restructure and facilitate a change of ownership
Policies broadly set the rules, procedures help apply policies, and processes divide procedures into manageable actions
Procedure and process documents communicate how best to undertake an activity while taking into account internal and external constraints
Non financial companies
Produce goods and non- financial services for their customers
Substitute
Product that could take the place for another product
Imports
Products and services that are produced outside a country's borders and then brought into the country
Exports
Products and services that are produced within a country's borders and then transported to another country
Comparative advantage
Products and services that countries can produce relatively better than other countries
Three components of current account
Products and services, income and current transfers
Indirect investments are professionally managed
Professional management is particularly important when direct investments are hard to find and must be managed
Actuaries
Professionals who specialize in assessing insurance risks using statistical models
Defined benefit plans
Promise a defined annual amount to their retired members
From a legal perspective, documents also establish proof
Proof of existence, authority, activity, and obligation
Property and casualty insurance companies
Protect their policyholders from the financial loss caused by such incidents as accidents and theft (Property and casualty insurers have short-term horizons and relatively unpredictable payouts; therefore, they prefer shorter-term investments that are more conservative and liquid)
Commerical banks
Provide a wide range of products and services to companies and other financial institutions
Retail banks
Provide banking products to individuals and small businesses
Brokerage services
Provided to clients who want to buy and sell securities; they include not only execution services (that is, processing orders on behalf of clients) but also investment advice and research
Measures
Provides a benchmark for measurement and audit
Protects
Provides assurance of a system to safeguard interests and manage risks
Authorises
Provides the basis, and often the authority, for action
PRA
Prudential Regulation Authority (UK)
Open market operations
Purchase and sale of government notes and bonds, sell instruments to commercial banks, the central bank creates a shortage or surplus of money
Quantitative easing
Purchase of instruments and other short term government instruments
Difficult to value
Purchases and sales of start-up companies, land, or buildings are infrequent, so valuation is challenging and is often based on an appraisal
Cross price elasticity
Quantity demanded of a product as a result of a price change in price of another product
Quick ratio
Quick ratio = current assets - inventories / current liabilities (Excludes inventories, which are the least liquid current asset)
Return on assets (ROA)
ROA = net income / total assets ********* (net income / total assets) = (net income / revenues) x (revenues / total assets)
Assets
Real assets and financial assets
Capital and financial account
Records the ownership of assets like investments by domestic entities in foreign entities and investments by foreign entities in domestic entities
Primer brokerage
Refers to a bundle of services that brokers provide to some of their clients, usually investment professionals engaged in trading
Clearing
Refers to all activities that occur from the arrangement of the trade to its settlement
Positions
Refers to the quantity of an asset or security that a person or institution owns or owes
Operational risk
Refers to the risk of losses from inadequate or failed people, systems, and internal policies and procedures, as well as from external events that are beyond the control of the company but that affect its operations
Informationally efficient prices
Reflect all available information about fundamental values
Time value of money
Reflect the principle that the timing of a cash flow affects the cash flow's value
Nominal GDP
Reflects current market value of products and services, unadjusted for price changes
Fair value
Reflects the amount the asset could be sold for in a transaction between willing and unrelated parties, called an "arm's length transaction" (only applied to a few assets like financial instruments)
Registers
Registers of the previous and next review dates should be maintained by a control function (generally, the compliance or internal audit function) and scheduled for discussion
Trading rules
Regulations are designed to set investment industry standards as well as to prevent abusive trading practices
Review
Regulations can become obsolete as technology and the investment industry change
Regulatory issues
Regulations on the holdings of insurance companies are typically extensive
Merit based
Regulators attempt to protect investors by limiting the products sold to them
Investment grade
Regulators often specify that certain investors, such as insurance companies and pension funds, must restrict their investments to or largely hold bonds with a high degree of creditworthiness
Foster capital formation and economic growth
Regulators seek to ensure healthy financial markets in order to foster economic development
Principle based
Regulators set up broad principles within the investment industry in which it is expected to operate
Identification of legal authority
Regulatory bodies need to have authority to regulate
Cash flows from operating activities
Relate to the company's profit-making activities and occur on an ongoing basis
Compliance risk
Relates to the risk that a company fails to follow all applicable rules, laws, and regulations and faces sanctions as a result
Capital account
Reports capital transfers between domestic entities and foreign entities
Liabilities and equity
Represent how the company's assets are financed
Portfolio construction
Requires investment managers to invest in the attractive securities and assets they identified through their investment analysis, taking into account the client's requirements and appropriate asset allocation
Excessive trading (churning)
Results in high trading costs to the client and reduces the client's return after transaction costs and is no in the client's best interest
Individual
Retail investors and high net worth individuals
Relative returns
Returns relative to a suitable benchmark
Coincident indicator
Reveals current economic conditions, but do not have predictive value
Profit (loss)
Revenues - expenses
Asset turnover
Revenues / total assets (How effectively the company uses its assets to generate revenues)
Accrual basis
Revenues are recorded when the revenues are earned rather than when they are received in cash
Currency risk
Risk associated with the fluctuations of exchange rates
Set objectives
Risk management enables management to identify potential events that could affect the realisation of those objectives (A company may set strategic objectives, which are typically high-level objectives connected to its mission)
Risk management functions
Risk management functions vary by company, but it is typical for companies in the investment industry to have a stand-alone risk management function with a senior head, often called the chief risk officer, who is capable of independent judgment and action
Middle office
Risk management, information technology (IT), corporate finance, portfolio management, and research are generally considered middle-office activities
Credit risk
Risk of loss if the borrower, or bond issuer, fails to make full and timely payments of interest and/or principal
Specific risk
Risk that is specific to a certain company or security is variously known as specific, idiosyncratic, non-systematic, or unsystematic risk
Regulations
Rules that set standards for conduct and that carry the force of law
Seniority ranking of debt securities
Secured debt, unsecured debt: senior unsecured debt, senior subordinated debt, junior subordinated debt
SEC
Securities and Exchange Commission (USA)
Over the counter (OTC) markets
Securities once literally traded over a counter in the dealer's office
Depositary receipts
Security representing an economic interest in a foreign company that trades like a common share on a domestic stock exchange (Depositary receipts facilitate trading of a company's stock in countries other than the country where the company is located)
Passive investment managers
Seek to match the return and risk of an appropriate benchmark
There are various approaches to managing credit risk, including the following:
Set limits on the amount of exposure to a particular counterparty or level of credit rating allowed and Require additional collateral and impose covenants
Ethics
Set of moral principles, or the principles of conduct governing an individual or a group
Settlement
Settlement describes how a contract is satisfied at expiration (Some contracts require settlement by physical delivery of the underlying and other contracts allow for or even require cash settlement)
Financial assets
Share of a stock represents ownership in a company
Managers of closed-end funds are largely insulated from their shareholders
Shareholders can sell their shares to new investors, but the assets under management remain the same
Accounts payable
Short-term borrowing and a portion of long term debt due in that period
Term structure of interest rates
Shows how interest rates on government bonds vary with maturity
Lagging indicator
Signal a change in economic activity after output has already changed
The return over the holding period usually comes from two sources: changes in the price (capital gain or loss) and income (dividends or interest)
Similarly, the holding-period returns from owning bonds result from changes in price (capital gain or loss) and receipt of interest (income)
Ethical dilemmas
Situations in which values, interests, and/or rules potentially conflict
Rogue trading
Situations wherein traders bypass management controls and place unauthorised trades, at times causing large losses for the companies they work for
These objectives may take different forms, but they are typically driven by a company's mission and strategy
So, an important objective of the risk management process is to help managers deal with this uncertainty and identify the threats and opportunities their company faces
Adjust returns for risk
So, if two investments have a holding-period return of 10% but the first investment has very little risk whereas the second one is very risky, the first investment is better than the second one on a risk-adjusted basis.
Marketing
So, most companies' documentation at the marketing stage of the cycle shares the same purpose: to promote and position the company's products and services to persuade the client to invest
The choice between internal and external management will often be driven by the size of the institutional investor, with larger institutional investors better able to afford the resources required for internal management
Some institutional investors will adopt a mixed model, managing some assets internally in which they have expertise and outsourcing more specialised investments
Unique circumstances
Some investors have social, religious, or ethical preferences that affect how their assets can be invested
The markets for such investments as real estate or private equity may not be efficient for a number of reasons
Some investors may have access to information and deals that are not available to other investors
Quantitative analysis
Some managers build statistical models to try to identify shares that are likely to outperform
Premiums are payments that insurance companies require to provide insurance coverage
Some of these premiums are put into reserve funds from which insurance companies pay out claims (The premiums in the reserve funds are invested in highly diversified portfolios of securities and assets that aim to ensure that sufficient funds are always available to satisfy all claims)
Voting rights
Some shares give their holders the right to vote on certain matters
Taxes
Some types of investors are taxed on their investment returns, and others are not
Money market funds
Special class of open-end mutual funds that investors view as uninsured interest-paying bank accounts (In particular, they may only hold money market securities—that is, generally very short-term, low-risk debt securities issued by entities with very high-quality credit)
Credit rating agencies
Specialize in providing opinions about the credit quality of bonds and their issuers
Building societies (savings and loan associations)
Specializes in financing long-term residential mortgages
Payout policies
Specify how much money can be taken from long-term funds to use for current spending
The organizer is often called the sponsor
Sponsors can organize investment vehicles as business trusts, limited partnerships, or limited liability companies
Enhance efficiency
Standardized documentation or transmission can reduce costs and increase economic efficiency
Financial statements
Statements show the monetary value of the economic resources under the company's control and how those resources have been used to create value
Equity
Stock/shares in a company
Financial capital
Synonym for money, cash, funds and capital
Control and monitor
Taking action in response to risk involves a range of controlling and monitoring activities that must be performed in a timely manner
Positive covenant
Terms for loans that specify both what a borrower must do
The "reward" part of the information ratio is the difference between the holding-period return on the portfolio and the return on an appropriate benchmark over the same period
The "risk" part of the information ratio is based on the tracking error of the fund—that is, its deviation from the performance of the benchmark (Difference in average return between portfolio and benchmark / fund tracking error)
Implicit GDP deflator
The GDP price deflator is a ratio of price levels in two different years that accounts for inflation in the prices of goods and services so that comparisons of real GDP can be made
Monetizing
The IPO provides founders and other early investors with a means of converting their investments into cash
The IPS serves as a guide to what is required and what is acceptable in the investment portfolio
The IPS helps guide asset allocation—that is, which asset classes and how much of each asset class should be included in the investor's portfolio
The heavy penalties imposed by most regulators globally help combat identity theft, criminal activity, and the flow of money from illegal sources into the financial services industry, including the investment industry
The KYC process also serves to define the client's level of knowledge and sophistication, assign associated and specific risk profiles, and assess any possible restrictions
Risk tolerance
The ability to handle risk is primarily driven by the company's financial health and depends on its level of earnings, cash flows, and equity capital
Corruption
The abuse of power for private gain (To safeguard against corruption, companies must start by establishing a tone at the top, with senior management communicating an unambiguous policy of zero tolerance for unethical business practices and bribery)
Historical cost
The actual cost of acquiring the asset minus any cost expensed to date
Depreciation expense
The amount allocated for each year
Central bank duties
The amount of money in circulation, the amount of money available for borrowing and at what cost or interest rate and macroeconomic targets
Equity
The amount received from selling stock to common shareholders and retained earnings
Auditor
The auditor issues an opinion on their correctness and presentation, which indicates to the reader how trustworthy the statements are in reflecting the financial performance of the company
Geometric mean
The average return assuming that returns are compounding
Book values
The balance sheet values are commonly known as the book values of the company's assets, liabilities, and equity
Investability
The benchmark should be composed of assets that can be bought and sold by the fund manager (For passive fund managers, it would be difficult to mimic the benchmark if it contained assets that they could not buy)
Pre-specification
The benchmark should be specified before an investment is made so that the manager is clear about the client's objectives and expectations and so the manager can construct a portfolio accordingly
Compatibility
The benchmark should have an appropriate composition and level of risk for the investor
The tracking error is measured by taking the standard deviation of the differences between the returns on the fund and the returns on its benchmark
The bigger these differences, the larger the tracking error (A passive fund manager may be expected to have a very low tracking error because the manager is seeking to replicate a benchmark)
Secondary market
The bondholders may later sell their bonds to other investors in the secondary market
Interest is all about timing: someone needs money now while someone else is willing and able to give up money now, but at a price
The borrower pays a price for not being able to wait to have money and to compensate the lender for giving up potential current consumption or other investment opportunities (Interest is paid by a borrower and earned by the lender to compensate the lender for opportunity cost and risk)
Option contract
The buyer of the option has the right, but not the obligation, to buy or sell the underlying
Skill vs. luck
The calculation and analysis of reward-to-risk ratios allow an understanding of the price fund investors have to pay in terms of units of reward for each unit of risk—the total return—generated by the fund's manager
Three elements to consider
The cash flows each investment will generate in the future, the timing of these cash flows, the risk associated with each investment, which is reflected in the discount rate
Price impact
The change in the market price when you try to trade
Pension sponsors or plan sponsors
The companies and governments that sponsor a pension plan to provide benefits to its employees
Retained earnings
The company's undistributed income (as opposed to dividends) which represents a link between the company's income statement and the balance sheet
Employees also generally contribute to their own retirement plan accounts, usually through employee payroll deductions
The contributions are then invested, normally in funds that the employee chooses from a list of eligible funds within the plan
Money from employer and/or employee contributions is set aside to provide income to plan members when they retire
The contributions must be invested until the employee retires and receives the retirement benefits
Expenses
The cost of company resources (cash, inventories and equipment)
Operating expenses/cost of goods sold (COGS)
The cost of sales
Simple interest rate
The cost to the borrower or the rate of return to the lender, per period, on the original principal
Costs
The costs incurred by pooled investment vehicles are deducted from their assets, reducing their investment performance
Coupon rate
The coupon rate is the promised interest rate on the bon
Floating rate bonds
The coupon rate of a floating-rate bond is usually linked to a reference rate (The floating rate is equal to the reference rate plus a percentage that depends on the borrower's (issuer's) creditworthiness and the bond's features *floating rate = reference rate + spread*)
Call risk
The coupon rate on a callable bond will generally be higher than a comparable bond without an embedded call provision to compensate the bondholder for the risk that the bond may be retired early
Securitization
The creation and issuance of new debt securities (asset backed securities)
Passive investment managers attempt to minimise tracking error
The deviation of the return on the portfolio from the return on the benchmark being tracked
Market bid-ask spread
The difference between the best bid and the best offer
Yield to maturity
The discount rate that equates the present value of a bond's promised cash flows to its market price
Effect of prices of other products on demand
The effect of a change in the prices of other products on a product's demand curve depends on the type of relationship between the products
Bid exchange rate
The exchange rate at which the bank or currency dealer will buy the foreign currency
Offer exchange rate
The exchange rate at which the bank or dealer will sell the foreign currency
Forward rate
The exchange rate for the transaction
The choice between the two approaches typically hinges on the relative costs of active management compared with passive management and on the investor's expectation of the success of active management
The expectation is related to the investor's beliefs about the efficiency of the markets being invested in
Operating leverage
The extent to which fixed costs are used in production
Pricing is less challenging in a seasoned offering because the issuer's securities already trade in the secondary market
The fees charged for a seasoned offering are lower than for an initial public offering because there is less risk
Links between the financial statements
The income statement is linked to the balance sheet through net income and retained earnings, the revenues and expenses reported on the income statement that have not been settled in cash are reflected on the balance sheet as current assets or current liabilities and cash expenditures are shown as an increase in the gross fixed assets on the balance sheet
Processes
The individual steps that the company must take, from start to finish, to achieve that desired outcome
Initial margin
The initial margin should be sufficient to protect the exchange against movements in the underlying price (The greater the underlying price volatility, the higher the margin)
Best efforts offering
The investment bank acts only as a broker and does not assume the risk associated with buying the securities
Underwritten offering
The investment bank buys the securities from the issuer at a price that is negotiated with the issuer, thus guaranteeing that the issuer gets the amount of capital it requires (The objective of the investment bank is not to become a long-term shareholder of the issuer but to be an intermediary between the issuer and the investors for a fee)
Subscribers
The investment bank identifies investors who are willing to buy the securities (These investors are known in the industry as subscribers)
Book building
The investment bank tries to build a book of orders from clients or other interested buyers to whom they can resell the securities
The investment manager works on a contractual basis in exchange for a management fee paid by the investment vehicle from its assets
The investment manager chooses the securities and other assets held by the investment vehicle
Risk tolerance
The investor's risk tolerance is a function of his or her ability and willingness to take risk
One of the main functions of risk management is to find the right balance between risk and return
The involvement of the board of directors and senior management in risk management is critical because they set corporate strategy and strategic business objectives
Bond indenture or offering circular
The legal bond contract (In the event that the issuer does not meet the contractual obligations and make the promised payments, the bondholders typically have legal recourse)
Maturity date
The life of the bond ends on its maturity date, assuming that all promised payments have been made
Retail investors
The lowest amount of investable assets
Providers, such as brokers and dealers and exchanges
The main distinction between exchanges and brokers is their regulatory operations (Most exchanges regulate their members' actions when trading on the exchange and sometimes also away from the exchange)
Trends and momentum in markets
The manager could also look at stock and bond market trends as a way of gauging investor sentiment
Market valuation measures relative to past data
The manager may then look at the level of the price-to-earnings ratio of the stock market and how it compares with recent decades as a measure of valuation or with the level of bond yields relative to historical ranges
If the share price is significantly below the estimated value
The manager will increase the weighting of the shares in the portfolio or add the shares to the portfolio
Active investment managers
The managers then act on their opinions by buying the securities and assets that they expect to outperform and selling (or simply not buying) the securities and assets that they expect to underperform
Law of diminishing marginal utility
The marginal satisfaction derived from an additional unit of a product decreases as more of the product is consumed
Primary market
The market in which new securities are issued and sold to investors
Treynor ratio
The measure of portfolio reward is the same as that used in the Sharpe ratio but the measure of portfolio risk is different (the chosen measure of portfolio risk is beta of the portfolio, a measure of the portfolio's systematic risk (also called market or non-diversifiable risk)
Principal
The money originally borrowed, which interest is calculated on
Clearing
The most important clearing activity is confirmation
Private equity strategies
The most widely used strategies are venture capital, growth equity, buyouts, and distressed... as well as secondaries
Dematerialization
The move from physical certificates to electronic bookkeeping
Other primary market transactions
The national governments of financially strong countries generally issue their debt securities in public auctions
Detect and identify events
The next step in the risk management process is to detect and identify events that may affect achieving the company's objectives
Zero coupon bonds
The only cash flow offered by a zero coupon bond is a single payment equal to the bond's par value that is paid on the bond's maturity date (Zero-coupon bonds are issued at a discount to the bond's par value)
Option premiums
The option premium represents the maximum profit that the option seller can make (option premiums are expected to compensate option sellers for their risk)
Par value
The par (principal) value is the amount that will be paid by the issuer to the bondholders at maturity to retire the bonds
Real estate limited partnerships
The partnership is often set by a real estate development firm that becomes the general partner
Passive management is typically cheaper to implement than active management because successfully replicating or tracking a benchmark requires fewer analytical resources than researching and identifying investments with superior return potential
The passive approach requires some skill, such as knowing which investments to include in the benchmark and their respective values and weights in the benchmark
Own price elasticity
The percentage change in the quantity demanded of a product as a result of the percentage price change in that products (Luxury goods have a positive own price elasticities)
Sales loads are calculated as a percentage of the sales price
The percentage is usually around 3%, but can be as high as 9%
Spread
The percentage paid above the reference rate
Holding period returns
The performance of a security, such as an equity (stock) or debt (bond) security, over a specific time period—called the holding period—is referred to as the holding-period return
Immobilisation
The placement of certificates or other documents of title evidencing ownership of financial instruments in a central securities depository to reduce the movement of physical securities in the marketplace and to facilitate book entry transfers
Sharpe ratio
The portfolio reward is measured as the portfolio's excess return, which is equal to the difference between the portfolio's holding-period return and the return on a "risk-free" investment
Present value
The present value is obtained by discounting the future cash flow by the interest rate
Net present value
The present value of future cash flows or returns minus the present value of the cost of the investment
Exercise price/strike price
The price is what the underlying will be purchased or sold for under the terms of the contract
Offer/ask prices
The prices at which they are willing to sell
Luck
The prices of financial assets held in portfolios are affected by events that cannot be foreseen by a fund manager
Client on-boarding
The process by which a company accepts a new client and inputs the client's details into its records to enable the company to conduct transactions with and on behalf of the client
Inflation risk
The promised interest payments and final principal payment from most debt securities are nominal amounts—that is, the amounts do not change with inflation
Portfolio construction
The proportion of the portfolio to invest in each asset class
Exchange rate
The rate at which one currency can be exchanged for another
Required return
The rate of return required—before and after tax—can be calculated using some goal for future wealth or portfolio value
Marketing materials are typically regulated to ensure that companies in the investment industry provide fair representations of their products
The regulation is usually more onerous as the client's level of investment sophistication decreases
Relative valuation
The relative valuation approach estimates the value of a common share as the multiple of some measures, such as earnings per share (EPS) or revenue per share
Multifamily residential dwellings
The retail segment includes such assets as shopping malls, commercial shopping centres, and other buildings designated for retail purposes
The costs of passive management are lower than the costs of active management
The return earned by the passive investor will typically be less than the index return because of costs
Positive deviation
The return is greater than the mean
Absolute returns
The returns achieved over a certain time period (absolute returns do not consider the risk of the investment or the returns achieved by similar investments)
Investment risk
The risk associated with investing that arises from the fluctuation in the value of investments
Systematic risk
The risk created by general economic conditions is known as systematic or market risk because the risk stems from the wider economic system
Credit risk
The risk for a lender that a borrower fails to honour a contract and make timely payments of interest and principal
Risk management and compliance
The risk management and compliance groups operate as a second line of defence, assisting and advising employees and managers while maintaining a certain level of independence
Risk managers assess, monitor, and report on risks, and in some cases, they may have an approval function or veto authority
The risk manager must ensure that all relevant risks are identified, but the final judgment on the business decision lies with the decision makers
Liquidity risk
The risk of being unable to sell a bond prior to the maturity date without having to accept a significant discount to market value
Political risk
The risk that a change in the ruling political party of a country will lead to changes in policies that can affect everything from monetary policy (money supply, interest rates, and credit) and fiscal policy (taxation) to investment incentives, public investments, and procurement
Sovereign risk
The risk that a government will not repay its debt because it does not have either the ability or the willingness to do so (The unique aspect of sovereign risk is that lenders have limited legal remedies available to compel the borrower to repay or to be able to recover the assets themselves)
Liquidity risk
The risk that an asset or security cannot be bought or sold quickly without a significant concession in price
Legal risk
The risk that an external party will sue the company for breach of contract or other violations
Settlement risk
The risk that counterparties will not settle their trades
Interest rate risk
The risk that interest rates will change
Call risk
The risk that the issuer will buy back (redeem or call) the bond issue prior to maturity through the exercise of a call provision
Counterparty risk
The risk that the other party to the contract will not fulfill its contractual obligations
Settlement risk (counterparty risk)
The risk that when settling a transaction, a company performs one side of the deal, such as transferring a security or money, but the counterparty does not complete its side of the deal as agreed, often because it has declared bankruptcy
The lender also bears risks, such as the risk of not getting the money back if the borrower defaults
The riskier the borrower or the less certain the borrower's ability to repay the loan → the higher the level of interest demanded by the lender
Procedure and process documentation
The role of procedure documentation is often to provide a bridge between the activities that are allowed at the policy level and what needs to happen at the process level
Clarity
The rules governing the construction of the benchmark should be clear
Arbitrage opportunity
The same product sells for different prices
Secondary, or seasoned equity offering
The selling of new shares by a publicly traded company subsequent to its IPO
Settlement
The settlement cycle refers to the timing of the procedures used to settle trades and differs across markets (The seller must deliver the security to the clearing house and the buyer must deliver cash--the settlement agent then makes the exchange in a process called delivery versus payment)
An investor may take a total-return perspective, which makes no distinction between income (for example, dividends and interest) and capital gains (that is, increases in market value)
The source of return—changes in value or income—does not matter to a total-return-oriented investor
Par value
The stated value, or face value, of the equity security
Reporting documentation usually takes the form of a statement, often provided by a third-party custodian or administrator
The statement typically contains information on the asset, including its fair value per unit and the quantity of units held at a particular point in time
Macroeconomics
The study of an economy as a whole
Economics
The study of choices in the presence of scarce resources and it is divided into two broad areas
Microeconomics
The study of how individuals and companies make decisions to allocate scarce resources
A single investment bank may not have the distribution network, capital, or risk appetite to organize a large offering, so large offerings are often organized by a syndicate that includes several investment banks
The syndicate helps the investment bank that leads the offering (known as the lead underwriter) to build the book of orders
Individual investors
The term "retail investor" can be used to refer to all individual investors, but it is common to use the term to refer to individual investors with modest resources to invest
Yield curve
The term structure is often presented in graphical form
Application of the time value of money
The time value of money concept can help to solve many common financial problems, time value of money can also help determine the value of a financial instrument,
Time weighted rate of return
The timing of each individual cash flow identifies the sub-periods to use for calculating holding-period returns (By calculating holding-period returns in this manner, client cash inflows and outflows do not distort the measurement and reporting of a fund's investment performance)
Managing the environment
The type of environment in which a company operates can add layers of uncertainty that need to be addressed
DCF
The value of a debt security is usually estimated by using a discounted cash flow (DCF) approach
Opportunity cost
The value of alternative opportunities that have been given up by the lender
Distribution
The values a variable can take and the number of observations associated with each of these values
Relative returns
The wide range of financial market indices available allows investors to set performance targets (passive or active) for their fund managers and enables them to compare the performance of their fund manager over time against an independent benchmark
Alternative trading venues
There are a number of alternative trading venues that are owned and operated by broker/dealers, exchanges, banks, and private companies (In the United States, such venues are generally referred to as alternative trading systems, whereas in Europe, they are commonly called multilateral trading facilities) (Most alternative trading venues allow institutional traders to trade directly with each other without the intermediation of dealers or brokers, which makes them lower-cost trading venues)
Insider trading
There are laws that prohibit the trading of a security when in possession of important confidential information pertaining to the security in question
Call options and put options
There are two basic types of options: options to buy the underlying, known as call options, and options to sell the underlying, known as put options
Tax reporting
There is a technical difference between "tax avoidance", which means using tax code provisions to minimise the tax that is owed, and "tax evasion", which means not paying taxes in violation of the tax law (From a risk-management perspective, tax risk should be managed in a consistent manner, incorporating the appropriate expertise at each stage of a transaction or financial reporting cycle)
Many investment firms make a distinction between their retail clients, more affluent clients with larger amounts, and high- and ultra-high-net-worth investors with the largest amounts of investable assets
There is no defined standard in the industry to classify individual investors by investable assets; each investment firm designates its own categories and values within those categories
The corporate treasurer usually manages the short- term investment assets
These assets typically include cash that the company will need soon to pay salaries and accounts payable and financial vehicles that are safe and liquid, including demand deposits (checking accounts), money market funds, and short- term debt securities issued by governments or other companies
Other documents are for external use
These documents convey information to and from the public domain and often help limit the risks that interaction with the public creates
Security lenders
These investors who lend their securities
Market return
These managers, however, are not looking to add value to the portfolios by picking securities that they believe will outperform other securities
Open-end mutual funds
These pooled investment vehicles are called open-end because they have the ability to issue or redeem (repurchase) shares on demand (When investors want to invest in a mutual fund, the fund issues new shares in exchange for cash that the investors deposit)
Dealers may also indicate the quantities that they will trade at their bid and ask prices
These quantities are called bid sizes for bids and ask sizes for offers
An alternative approach for such companies is to apply standards that suit their own specific circumstances
These standards are known as "fit for purpose", and a company using this approach has to critically assess and document its own needs and requirements
Investment firms that face a high risk of insider trading, such as investment banks, have "control rooms" to monitor information flowing between teams
They also have virtual walls or information barriers to restrict and segregate information and to manage other conflicts of interest
Illiquid
They are difficult to sell quickly without accepting a lower price
Hedge funds and private equity funds can similarly be considered institutional investors that manage private investment pools and as investment vehicles
They are distinguished by their use of strategies beyond the scope of most traditional mutual funds
Some documents are for internal use only
They are generally administrative and reflect a company's philosophy, approach, and activities
It is important to note that investors in an investment vehicle do not share ownership of the investment securities and assets held by the investment vehicle
They are the beneficial owners of the investment vehicle's securities and assets, but not their legal owners
Offices
They are usually owned by real estate investment companies that lease space to tenants in varying terms, from short-term monthly leases to longer multi year leases
Market makers
They are willing to make a market (that is, trade on demand) in specified securities at their bid and ask prices
Investors cannot diversify away systematic risk
They can do little to avoid systematic risk because all investments will be affected to some extent by systematic risk—for instance, a recession
Minimising transaction costs
They employ skilful brokers, use electronic algorithms to manage their trading, or as mentioned before, use hidden orders or dark pools so other market participants cannot see their orders and exploit them
Factors needed for active management to be successful
They have to be better than other investors at assessing the potential of investments
Active management
They may attempt to select assets that will outperform the benchmark or active managers may also try to time the market (buying when they believe the market is undervalued and selling when they believe the market is overvalued)
When active managers buy a security or investment because their analysis suggests it has good return potential
They may be buying it from another active manager who believes the prospects for the security are poor
Protect customers
They might not have the skill or information needed to determine quality
For active managers to identify outperforming securities on a consistent basis
They must either have access to better information than other investors or be able to respond and use the same information faster or with better models to process the information
The investment professionals who work in family offices generally manage these investments using the same methods and systems that institutional investors use
They pay especially close attention to personal and estate tax issues that may significantly affect the family's wealth and its ability to pass wealth on to future generations or charitable institutions
Most market participants employ brokers to trade on their behalf
They pay their brokers commissions for arranging their trades (The commissions are usually a fixed percentage of the principal value of the transaction or a fixed price per share, bond, or contract)
Dealers act as principles
They use their own accounts and their own capital to trade with buyers and sellers in proprietary trading, they "make markets" in securities by acting as buyers when investors want to sell and as sellers when investors want to buy
The return requirement, particularly for a long-term horizon, should be specified in real terms, which means adjusting for the effect of inflation
This adjustment is important because it maintains the focus on what the accumulated portfolio will provide at the end of the time horizon (An increase in value that simply matches inflation does not give a client increased spending power)
One such model is the capital asset pricing model (CAPM), from which the term alpha comes
This model includes a measure of systematic risk: beta
Seniority ranking
This priority of claims can affect the amount that an investor will receive upon liquidation
Effective annual rate (EAR)
This rate involves annualizing, through compounding, a rate that is paid more than once a year
Because individual investors are often thought of as less knowledgeable and less experienced than institutional investors, regulators in many countries try to protect them by putting restrictions on the investments that can be sold to them
This restriction is presumably based on the logic that wealthier investors are expected to have a higher level of investment knowledge or at least be better able to pay for advice and better able to bear risk
Tolerate
This strategy involves accepting the risk and its effect
Terminate
This strategy involves avoiding the risk and its effect by ceasing an activity
Transfer
This strategy involves moving the risk and its effect to a third party
Treat
This strategy involves taking action to reduce the risk and its effect
Insurance companies try to match their investments to their liabilities
This strategy of matching investment assets to liabilities, called asset/liability matching, reduces the risk that the company will fail to pay its claims
Natural disaster
This type of event may affect a real asset or even a financial asset
Multiplier effect
Those who benefit from additional spending, in turn, increase their own spending
Asset managers
Those who have such discretionary authority from their clients to trade securities and assets on their behalf
Spenders
Those who need money
Clearing houses
Thus, brokers and dealers who are not members of the clearing house must arrange to have a clearing member settle their trades at the clearing house
Limitations of fiscal policy
Time lags, unexpected responses by consumers and companies, Unintended consequences
Order time in force instructions
Time-in-force instructions indicate when an order can be filled
A manager might be given a specific mandate reflecting specific risk requirements, return targets, or style or sector preferences, such as investing in biotech companies
To beat this benchmark, the manager will have to be an active manager and to use analytical and trading skills and deliver high levels of client service to satisfy the mandate
Mortgage backed securities
To create mortgage-backed securities, a financial intermediary bundles a pool of mortgage loans from lenders and then issues debt securities against the pool of mortgages
Security lending is subject to the risk that one of the parties to the contract will fail to honor their obligation, a risk called counter party risk
To limit counter party risk, security lenders require that short sellers leave the proceeds of the short sale on deposit with them as collateral for the loan
Posting margin
To protect itself against one of the parties defaulting, the exchange typically requires that parties to the contract deposit funds as collateral (The buyer's and seller's margin accounts are adjusted to reflect the change in settlement price and whether it was to their advantage or disadvantage)
Fundamental relationship underlying the balance sheet
Total assets = Total liabilities + Total shareholders' equity
GDP
Total value of all final products and services produced in a country over a period of time
Information ratio
Tracking error can also be used to formulate another widely used reward-to-risk ratio
Balance of payments
Tracks transactions between a country and the rest of the world over a period of time, usually a year
Closed-end funds and exchange-traded funds
Trade in organized secondary markets just like common stocks
Opportunity costs
Traders who are willing to wait until other traders want to trade with them generally incur lower transaction costs on their trades (They lose the opportunity to profit if their buy orders fail to execute when prices are rising, and they lose the opportunity to avoid losses if their sell orders fail to execute when prices are falling)
Stop-loss order
Traders who want to protect their long positions often use stop orders that trigger market sell orders if prices are falling with the hope of stopping losses on positions that they have established
Insider trading
Trading while in possession of information that is not publicly available and that is likely to affect the price
Transaction costs
Transaction costs usually are embedded in forward contracts and are not easily visible to the customers. Futures contracts, however, are traded on exchanges through brokerage firms or brokers (agents authorized to trade directly with the exchange), and the transaction costs are visible
Regulation
Trend toward greater regulation of the financial services industry
Custodians
Typically banks and brokerage firms that hold money and securities for safekeeping on behalf of their clients
Cash flows from investing activities
Typically cash outflows related to purchases of long-term assets, such as equipment or buildings, as the company invests in its long-term resources
Primary markets are where securities first become available to all investors Issuers
Typically companies and governments; selling securities to investors in exchange for cash is a way for these companies and governments to raise money
Real estate equity funds
Typically hold investments in hundreds of commercial properties (real estate equity funds are often open-end funds, meaning that they issue or redeem shares when investors want to buy or sell)
The defined amount typically varies by member based on factors such as years of service and annual compensation while employed
Typically, employees do not have the right to receive benefits until they have worked for the company or government for a period specified by the pension plan
All contracts specify four things
Underlying, size and price, expiration date and settlement
An important consideration when creating or reviewing procedures is risk management—without a strong control environment, processes are at risk of error.
Understanding where inputs come from, where outputs go, and what they will be used for provides that context
Land
Undeveloped, or raw, land can be highly speculative because there are no cash inflows from tenants or occupants, only cash outflows in the form of real estate taxes and other costs of holding the land
Unilateral contract
Unilateral contracts because only one party to the contract (the seller) has a future commitment that, if broken, represents a breach of contract (The buyer of the contract will exercise the right or option if conditions are favorable or if specified conditions are met)
Accrued liabilities
Unpaid operating expenses, such as money due to workers but not yet paid
Unsecured
Unsecured debt securities are not backed by collateral
Inventories
Unsold units of production on hand called stocks in some parts of the world
Indirect finance
Use financial intermediaries that act as the middlemen between savers and spenders (no direct claims)
Consumer price index
Used to measure the change in price of a basket of goods typically purchased by a consumer or household over time
Private equity partnership
Usually includes two types of partners
Leading indicator
Usually signal changes in the economy in the future, and are considered useful for economic prediction and policy formulation
(VaR) was developed in the late 1980s and is now a widely used metric
VaR gives an estimate of the minimum loss of value that can be expected for a given period with a given level of probability
Weaknesses of VaR
VaR often underestimates the frequency and magnitude of losses, mainly because of erroneous assumptions and models
The value of a security can be viewed as the present value of all the cash flows the security will generate in the future
Value that is estimated this way is called the stock's fundamental value or intrinsic value
Ultra high net worth investors and family offices
Very wealthy individuals usually employ professionals who help them manage their investments, future estates, and legal affairs
High net worth investors
Wealthier investors generally receive more personal attention from investment personnel (They either pay directly for these services on a fee- for- service basis or indirectly through commissions and other transaction costs)
An investment firm or division within an investment firm focussing on high-networth investors may have fewer clients, but higher average account balances, than one that focuses on retail investors
Wealthy clients may have higher expectations of client service than retail customers, and usually the services that are provided to them are more personalised
Negative covenants
What a borrower is not allowed to do
Income approach
What an economy spends is another economic entity's income (factor incomes + factors of production)
Instead of full replication, passive managers may use a tracking approach and hold a subset of the market that is expected to closely track the benchmark's returns and risk
Whatever passive investment approach is used, a passive investor must be willing to accept the risk of the underlying market
Secured
When a borrower issues secured debt securities, it pledges certain specific assets as collateral to the bondholders
Occupational fraud (sometimes called internal fraud or employee fraud)
When an employee abuses his or her position for personal gain by misappropriating the company's assets or resources
Order document
When an order is placed, a document is sent to the chosen trading venue, specifying what security to trade, whether to buy or sell, and how much should be bought or sold
Diversification
When assets and/ or asset classes with different characteristics are combined in a portfolio, the overall level of risk is typically reduced
Internalisation
When brokers fill their clients' orders by acting as proprietary traders rather than as agents (When acting as dealers, however, they profit most when they sell to their clients at high prices or buy from their clients at low prices)
Fundamental analyses of economic and political conditions and their likely effects on market returns
When considering tactically altering a portfolio's asset allocation, a manager may look at the strength of the economy and likely future trends to gain a perspective on how the central bank might change interest rates and on what might happen to corporate profits
Conflict of interest
When either the employee's personal interest or the employer's interests conflict with the interests of the client
Financial contagion
When financial shocks spread from their place of origin to other locales
Direct investments
When investors buy securities issued by companies and governments and when they buy real assets, such as precious metals, art, or timber
Liquidity
When liquidity is required, the investments will need to be able to be converted to cash relatively quickly and without too much cost (keeping transaction costs and changes in price low) when the cash is needed
Moral hazard
When people are less careful about avoiding losses once they have purchased insurance
Fraud
When people deliberately cause or falsely report losses to collect insurance settlements
Objectives of documentation
When policies, procedures, and processes are undocumented or poorly documented, there is room for doubt
Indirect investments
When they buy the securities of companies, trusts, and partnerships that make direct investments
Governments receive money from collecting taxes or selling bonds
When they do not have to spend this money immediately, they usually invest it
Long position
When they own assets or securities (Long positions increase in value when prices rise)
Adverse selection
When those who are at most risk buy insurance, causing insured losses to be greater than average losses
Secondary market
When trading securities and contracts in secondary markets, investors often obtain assistance from trading services providers, such as brokers and dealers
Document classification systems
When using, developing, or reviewing a document, companies and individuals should consider three factors
Foreign exchange market
Where currencies are traded
Spot market
Where currencies are traded now and delivered immediately
Forward market
Where currencies are traded now but delivered at some future date
Direct finance
Where savers and spenders can buy and sell securities as well as have a direct claim on the users of capital (If you own shares of Nestle, you have a claim on the assets and earnings of Nestle)
Disclosure based
Whether or not an investment is appropriate for investors but only whether all material information is disclosed to investors
Asset allocation
Which asset classes are suitable (e.g., global equities, domestic government bonds, commodities, or domestic real estate investment trusts)
Day orders
Which can be executed only on the day they are submitted and are cancelled at the end of that day
Companies should have internal reporting procedures to encourage employees to come forward and report instances in which they suspect someone has violated internal policies, procedures, laws, or regulations
Whistle-blowing has become an important way for authorities to learn of violations, and provisions to protect and reward whistle-blowers have been strengthened in the wake of financial scandals
Purchasing power parity
a theory of exchange rates whereby a unit of any given currency should be able to buy the same quantity of goods in all countries
Defined contribution pension plans
defined contribution—to an account set up for each employee
Investment policy statement
for both individual and institutional investors—serves as a guide for the investor and investment manager or adviser regarding what is required of and acceptable in the investment portfolio
Hidden order
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