FINC 325

Give an example of where you can buy stocks in a (1) dealer market (2) broker market (3) auction market (4) direct market

(1) The over-the-counter market (NASDAQ) - specialized traders buy and sell for own accounts, lower volume securities (2) the real estate market - broker in middle (3) the New York Stock Exchange - an exchange or elctronic platform where all traders can convene to buy/sell an asset (4) buyer has to look for shares, least organized (us on stocktrak)

For a two-stock portfolio, wha t would be the preferred corre lation coefficient between the two stocks?

-1 : unlimited diversification

The global minimum variance portfolio formed from two risky securities will be riskless when the correlation coefficient between the two securities is

-1.0 The global minimum variance portfolio will have a standard deviation of zero whenever the two securities are perfectly negatively correlated.

An adjust beta will be closer to ___

1 than the unadjusted beta

1. If you believe the US dollar is about to depreciate more dramatically than do other investors, what will be your stance on investments in US auto producers?

1. A depreciating dollar makes imported cars more expensive and American cars cheaper to foreign consumers. This should benefit the US auto industry.

1. Large tax cuts in the 1980s were followed by rapid growth in GDP. How would demand-side and supply-side economists differ in their interpretations of this phenomenon?

1. A traditional demand-side interpretation of the tax cuts is that the resulting increase in after-tax income increased consumption demand and stimulated the economy. A supply-side interpretation is that the reduction in marginal tax rates made it more attractive for businesses to invest and for individuals to work, thereby increasing economic output.

1. For each pair of firms, choose the one that you think would be more sensitive to the business cycle. a. General Autos or General Pharmaceuticals. b. Friendly Airlines or Happy Cinemas.

1. A. General Autos. Pharmaceuticals are less of a discretionary purchase than automobiles. B. Friendly Airlines. Travel expenditure is more sensitive to the business cycle than movie consumption.

1. Consider two firms producing videocassette recorders. One uses a highly automated robotics process, while the other uses human workers on an assembly line and pays overtime when there is heavy production demand. a. Which firm will have higher profits in a recession? In a boom? b. Which firm's stockwill have a higher beta?

1. A. The robotics process entails higher fixed costs and lower variable (labor) costs. This firm therefore will perform better in a boom and worse in a recession. For example, costs will rise less rapidly than revenue when sales volume expands during a boom. B. Because its profits are more sensitive to the business cycle, the robotics firm will have the higher beta.

What is bundling and unbundling? Give an example of each.

1. Creation of new securities either by combining primitive and derivative securities into one composite hybrid or by separating returns on an asset into classes. A convertible preferred stock is an example of bundling. A mortgage pass-through certificate is unbundled into classes.

1. Suppose the government wants to stimulate the economy without increasing interest rates. What combination of fiscal and monetary policy might accomplish this goal?

1. Expansionary fiscal policy coupled with expansionary monetary policy will stimulate the economy, with the loose monetary policy (possibly) keeping down interest rates.

1. Why is an insurance company considered a financial intermediary and a stockbroker is not?

1. Financial intermediaries are institutions that connect borrowers and lenders by accepting funds from lenders and loaning funds to borrowers. Insurance companies pool the resources of many small investors, and are able to lend considerable sums to large borrowers. A stockbroker is an investment company, which pool and manage the money of many investors, not borrowers and lenders.

1. What is the difference between a fixed income, equity and derivative asset? Give an example of each.

1. Fixed income securities are securities that pay a specified cash flow over a specific period. Equity is an ownership share in a corporation. Derivative securities are securities providing payoffs that depend on the values of other assets. A T-bill is a fixed income security. Common stockis equity. An option is a derivative security.

1. What is the relationship between market efficiency and undervalued/overvalued stocks?

1. If markets are extremely efficient, there would be no undervalued/overvalued stocks. If markets are not efficient or only near-efficient, profit opportunities may exist for especially diligent and creative investors, which means they might be able to find undervalued/overvalued stocks.

What is securitization? Give an example

1. Pooling loans into standardized securities backed by those loans, which can then be traded like any other security. Collateralized Automobile Receivables (CARs) are an example of securitization.

1. What is the difference between a real and a financial asset? Give an example of each.

1. Real assets are assets used to produce goods and services. Financial assets are claims on real assets or the income generated by them. Land is a real asset. Stocks are financial assets.

1. What is the difference between a bid and ask price?

1. The bid price is the price at which a dealer is willing to purchase a security. The ask price is the price at which a dealer will sell a security.

1. Consider an economy where the dominant industry is automobile production for domestic consumption as well as export. Now suppose the auto market is hurt by an increase in the length of time people use their cars before replacing them. Describe the probable effects of this change on (a) GDP, (b) unemployment, (c) the government budget deficit, and (d) interest rates.

1. The downturn in the auto industry will reduce the demand for the product in this economy. The economy will, at least in the short term, enter a recession. This would suggest that: a. GDP will fall. b. The unemployment rate will rise. c. The government deficit will increase. Income tax receipts will fall, and government expenditures on social welfare programs probably will increase. d. Interest rates should fall. The contraction in the economy will reduce the demand for credit. Moreover, the lower inflation rate will reduce nominal interest rates.

1. I buy a stock in the primary market. Who gets the money? I buy a stock in the secondary market, who gets the money?

1. The issuing corporation gets the money in the primary market. Stockholder who sells you the stockget the money in the secondary market.

1. What is the difference between a top-down and bottom-up strategy?

1. Top-down portfolio construction starts with asset allocation. For example, an individual who currently holds all of his money in a bank account would first decide what proportion of the overall portfolio ought to be moved into stocks, bonds and so on. In this way, the broad features of the portfolio are established. Only after the asset allocation decision is made would the investor turn to the particular securities to be held. Bottom-up strategy constructs portfolio from the securities that seem attractively priced without as much concern for the resultant asset allocation. Such a technique can result in unintended betas on one or another sector of the economy. However, a bottom-up strategy does focus the portfolio on the assets that seem to offer the most attractive investment opportunities.

1. When borrowing and lending at a risk-free rate are allowed, which Capital Allocation Line (CAL) should the investor choose to combine with the efficient frontier? I) The one with the highest reward-to-variability ratio. II) The one that will maximize his utility. III) The one with the steepest slope. IV) The one with the lowest slope.

A. I, II, and III The optimal CAL is the one that is tangent to the efficient frontier. This CAL offers the highest reward-to-variability ratio, which is the slope of the CAL. It will also allow the investor to reach his highest feasible level of utility.

As the number of securities in a portfolio is increased, what happens to the average portfolio standard deviation?

A. It decreases at a decreasing rate.

1. In words, the covariance considers the probability of each scenario happening and the interaction between

A. securities' returns relative to their mean returns.

1. A two-asset portfolio with a standard deviation of zero can be formed when

A. the assets have a correlation coefficient equal to negative one. When there is a perfect negative correlation, the equation for the portfolio variance simplifies to a perfect square. The result is that the portfolio's standard deviation equals |wAsA - wBsB|, which can be set equal to zero. The solution wA = sB/(sA + sB) and wB = 1 - wA will yield a zero- standard deviation portfolio.

1. The standard deviation of a two-asset portfolio is a linear function of the assets' weights when

A. the assets have a correlation coefficient equal to one. When there is a perfect positive correlation (or a perfect negative correlation), the equation for the portfolio variance simplifies to a perfect square. The result is that the portfolio's standard deviation is linear relative to the assets' weights in the portfolio.

1. The separation property refers to the conclusion that

A. the determination of the best risky portfolio is objective and the choice of the best complete portfolio is subjective.

In a two-security minimum variance portfolio where the correlation between securities is greater than -1.0

A. the security with the higher standard deviation will be weighted less heavily. The security with the higher standard deviation will be weighted less heavily to produce minimum variance. The return will not be zero; the risk will not be zero unless the correlation coefficient is -1.

1. What is an ADR? What is a Web?

ADRs, American Depository Receipts are domestically traded securities that represent claims to shares of foreign stock. WEBs (World Equity Benchmark shares) are tradable securities that represent an investment in a portfolio of publicly trade foreign stocks in a selected country.

1. Determining what fraction of your wealth to place in cash, fixed income and equities is called ______.

Asset Allocation

1. If the currency of your country is depreciating, this should _________ __ exports and _________ _ imports. a. stimulate, stimulate b. stimulate, discourage c. discourage, stimulate d. discourage, discourage

B

1. If you expect a larger interest rate increase than other market participants do, you would a. buy long-term bonds b. buy short-term bonds c. buy long-term government bonds only d. buy short-term government bonds only

B

Illiquid Securities are sold on _____

Broker Markets

Best way to repay investors?

Buy back stock

____________ is a false statement regarding best efforts: a) Investment Bankers' fees are usually lower for best efforts than underwriting b) the investment banker agrees to find buyers for the firms new securities c) the investment banker buys the stock issued from the company and resells them to the public

C

1. __________ _ _ _ will determine the sensitivity of a firm's earnings to the business cycle. a. Financial leverage b. Necessity of the firm's output c. Operating leverage d. All of the above

D

Investment Bankers A) act as intermediaries between issuers of stock and investors B) act as advisors to companies in helping them analyze their financial needs and find buyers for newly issued securities C) accept deposits from savers and lend them to companies D) A & B E) A, B, & C

D

Specialists on the stock exchanges may do all of the following except _________. A)make a market in shares of the firms for which they specialize B)keep the order book C)us their privileged info to make speculative investments on their own account D)use their privileged info to make speculative investments on behalf of clients of brokerage firms with which they do business

D

Firm-Specific Risk

Firm-specific risk (a.k.a. unique risk, non-systematic risk, diversifiable risk) is risk that affects only one security (e.g., poor earnings).

How do you measure firm-specific risk?

Firm-specific risk is measured as the variance (or standard deviation) of the residual in a single-index model.

If you believe the economy is about to go into recession you might change your asset allocation by selling __________ and buying __________.

Growth stocks, long term bonds

The risk that can be diversified away in a portfolio is referred to as: I) diversifiable risk II) unique risk III) systematic risk IV) firm-specific risk

I, II, and IV All of these terms are used interchangeably to refer to the risk that can be removed from a portfolio through diversification.

According to Tobin's separation property, portfolio choice can be separated into two independent tasks consisting of __________ __ and _____ _ _ _.

Identifying the optimal risky portfolio; constructing a complete portfolio from T-bills and the optimal risky portfolio based on the investor's degree of risk aversion

Money Left on the Table

It is defined as the difference between the closing price on the first day of trading and the offer price, multiplied by the number of shares sold.

Limit Buy

Limit buy orders specify that a stock should be bought when its price is below the limit.

Limit Sell

Limit sell orders specify that a stock should be bought when its price is above the limit.

Market Risk

Market risk (a.k.a., systematic risk, nondiversifiable risk) is risk that is common to all securities (e.g., a change in interest rates).

How does diversification affect each of these risks?

Market risk is not diversifiable. Firm-specific risk can be eliminated by diversification. Diversification can only eliminate the firm-specific risk portion of the total risk, it cannot eliminate the market risk portion.

How do you measure market risk?

Market risk is typically measured with beta.

1. If markets are efficient should you look for undervalued stocks? If markets are efficient should you pay a professional to look for undervalued stocks?

No - there won't be any

Which of the following is not a source of systematic risk?

Personnel changes Personnel changes are a firm-specific event that is a component of non-systematic risk. The others are all sources of systematic risk.

If you thought prices of stock would be rising over the next few months, you might want to __________________ on the stock.

Place a short sale order

How do you measure total risk?

Portfolio standard deviation is a measure of total risk of a portfolio.

Top 3 Axioms and explain

Risk Return Tradeoff - as risk rises expected returns rise Time Value of Money - a dollar today is greater than a dollar tomorrow Cash is King - you can do anything with it and it is liquid

1. Determining which individual securities to hold is called ________.

Security Selection

1. An inverted yield curve is one

Slopes Downword Short term rates are higher than long term rates

Stop Buy

Stop-buy orders specify that a stock should be bought when its price rises above a limit.

Stop Loss

Stop-loss orders are orders to sell the stock if its price falls below a stipulated level.

According to _______ economists, the growth of the US economy in the 1980s can be atrributed to lower tax rates which improved incentives for people to work.

Supply Side

Optimal Complete Portfolio

The optimal complete portfolio is the best combination of both risk-free asset and risky assets.

Optimal Risky Portfolio

The optimal risky portfolio is the best combination of risky assets to form the complete portfolio.

The individual investor's optimal portfolio is designated by:

The point of tangency with the indifference curve and the capital allocation line.

Risk Free Portfolio

The risk-free portfolio is a portfolio whose rate of return to some specific future date is certain and known in advance.

Total Risk

Total risk is the sum of firm-specific and market risk.

Which statement about portfolio diversification is correct?

Typically, as more securities are added to a portfolio, total risk would be expected to decrease at a decreasing rate.

Standard Deviation is generally less than the ____________

Weighted Average of component assets

Correlation Coefficient

how often stocks move in the same direction

Lower tax rates do what to the GDP

increase the GDP

Covariance

measures magnitude

The line representing all combinations of portfolio expected returns and standard deviations that can be constructed from two available assets is called the

portfolio opportunity set The portfolio opportunity set is the line describing all combinations of expected returns and standard deviations that can be achieved by a portfolio of risky assets.

__________ is a true statement regarding the variance of risky portfolios.

the degree to which the portfolio variance is reduced depends on the degree of correlation between the securities

When two risky securities that are positively correlated but not perfectly correlated are held in a portfolio,

the portfolio standard deviation will be less than the weighted average of the individual security standard deviations. Whenever two securities are less than perfectly positively correlated, the standard deviation of the portfolio of the two assets will be less than the weighted average of the two securities' standard deviations. There is some benefit to diversification in this case.

Fama and French claim that after controlling for firm size and the ratio of firm's book value to market value, beta is relatively useless in predicting future stock returns. This claim is supported by

their analysis of stock return data

IPO's are usually _______ relative to the levels at which their prices stabilize after they begin trading in the secondary market

underpriced

Factor 1

unexpected GDP

Factor 2

unexpected inflation

Adding additional risky assets will generally move the efficient frontier

up and to the left

The term efficient frontier refers to the set of portfolios that _________

yield the greatest return for a given level of risk and involve the least risk for a given level of return