Investments Concepts in Review Ch. 1-5
What is the difference between bull and bear markets.
A bull market is a favorable market normally associated with rising prices, investor optimism, economic recovery, and governmental stimulus. In contrast, bear markets are associated with falling prices, investor pessimism, economic downturn, and government restraint.
Convertible Securities
A convertible security is a fixed-income security, either a bond or preferred stock, which has a conversion feature. Typically, it can be converted into a specified number of shares of common stock. Convertible securities are quasi-derivative securities, as their market value would depend on the price of the common stock and the conversion ratio.
What is the difference between market, limit, and stop-loss orders? What is the reason for using a stop-loss order rather than a limit order?
A market order is an order to buy or sell a security at the best price available at the time the order is placed. It is the quickest way to make securities transactions. A limit order is an order to buy stock at or below or to sell stock at or above a specified price. It is best used when securities prices fluctuate widely. A stop-loss order is an order to buy or sell the stock when its market price reaches or drops below a specified level. It is used primarily by investors who wish to protect themselves from a rapid decline in the price of the stock. The stop-loss order gives them the opportunity to sell the stock when the price declines to the stop price, thereby reducing their potential losses. It becomes a market order and may in fact be executed at a lower price than the price at which the order was initiated.
Mutual Funds
A mutual fund is a company that invests in a large portfolio of securities, whereas a money market mutual fund is a mutual fund that solely invests in short term "money market" securities . Investors might find mutual funds appealing because a large, well-diversified portfolio may be more consistent with their investment goals in terms of risk and return. As we will see later, a mutual fund offers the investor the benefits of diversification and professional management. Mutual funds do not offer fixed/certain returns. Exchange-traded funds are similar to mutual funds but are traded throughout the day on exchanges and priced continuously.
What is the difference between primary markets and secondary markets?
A new security is issued in the primary market. Once a security has been issued, it can be bought and sold in the secondary market.
What is an efficient portfolio and what role should such a portfolio play in investing?
A portfolio is simply a collection of investments. An efficient portfolio is a portfolio offering the highest expected return for a given level of risk. An efficient portfolio will offer the highest rate of return consistent with the investor's risk tolerance and investment opportunities. When confronted with the choice between two equally risky investments offering different returns, the investor would be expected to choose the alternative with the higher return. Likewise, given two investments offering the same returns but differing in risk, the risk-averse investor would prefer the investment with the lower risk.
Discuss how the correlations between asset returns affects the risk and return behavior of a portfolio. Describe the potential range of risk and return when the correlation between the two assets is a) perfectly positive, b) uncorrelated, and c) perfectly negative.
A portfolio's return is always a simple weighted average of the returns of the assets in the portfolio. In other words, a portfolio's return will be somewhere between the return of the asset with the highest return and the asset with the lowest return. But that statement is not necessarily true when it comes to a portfolio's risk. When the assets in a portfolio are less than perfectly positively correlated, the standard deviation (risk) of the portfolio will generally be less than a weighted average of the standard deviations of the assets that make up the portfolio. Furthermore, the lower is the correlation between the returns of assets in the portfolio, the lower will be the portfolio's standard deviation. In the extreme case when returns of the assets in the portfolio are perfectly negatively correlated, there will always be some combination of those assets that produces a perfectly risk-free portfolio. To summarize: A portfolio's return will always range between the return that the lowest-earning asset produces and the return that the highest-earning asset produces. Where in this range a portfolio's return lands depends entirely on the weights assigned to each asset in the portfolio, and it does not depend at all on the correlation between assets. However, a portfolio's standard deviation will have a range that depends on the correlation between assets in the portfolio. When assets in the portfolio are perfectly positively correlated, the portfolio's standard deviation will fall between the asset with the highest standard deviation and the asset with the lowest standard deviation. The portfolio's standard deviation will be a simple weighted average of the standard deviations of the assets in the portfolio. When assets in the portfolio have returns that are uncorrelated with each other (and indeed even when the assets' returns are simply less than perfectly positively correlated), the portfolio standard deviation will be greater than zero, but it will be less than a simple weighted average of the standard deviations of the assets in the portfolio. In other words, portfolios in scenario (b) are generally less volatile than portfolios in scenario (a). In the special and highly unusual case when returns of the assets in the portfolio are perfectly negatively correlated, there will be some combination of assets that produces a portfolio with no risk at all (i.e., a standard deviation equal to zero). Thus, in this case the portfolio's standard deviation ranges from a low of zero to a high equal to the standard deviation of the asset with the most volatile returns.
What role does historical performance data play in estimating an investment's expected return? Discuss the key factors affecting investment returns.
Although future returns are not guaranteed by past performance, historical data often gives the investor a meaningful basis on which to form future expectations. Past return data, such as average returns or trends seen in certain time periods, can be used along with the investor's insights about future prospects of the investment. Together, the historical data and future prospects help the investor to formulate an expected return on the investment. The level of expected returns depends on many internal characteristics of the investment and the external forces on the investment. Internal characteristics include the type of investment, the quality of management, and the method by which the investment is financed. External forces include war, shortages, Federal Reserve actions, and political events, among others. External forces, unlike internal characteristics, cannot be controlled by the issuer of the investment. Investments are affected differently by these forces—the expected return of one investment may increase while the expected return of another may decrease in response to external forces. History tells us that stock market returns have averaged well above the interest rates payable on savings accounts at banks. In recent years, especially during the latter part of the 1990s, the returns were well above the stock market averages for the earlier part of the century. Unfortunately, investors often assume that history will repeat itself. Hence, they buy shares of firms that have experienced increased share prices. If the investor is looking for short-term gains over a year or two, the probabilities are mixed depending on what time periods are cited. The best advice, given these statistics, is for an investor to hold for the long term in order to ride out the market's twists and turns.
What makes an asset liquid? Why hold liquid assets? Would 100 shares of IBM stock be considered a liquid investment? Explain.
An asset is liquid if it can be converted to cash (sold) easily and quickly, with little or no loss in value. You would want to hold liquid assets as emergency funds or to accumulate funds for some specific purpose. IBM stock is a liquid investment. IBM common shares are heavily traded, and investor can sell IBM shares quickly without incurring high transactions costs or triggering a decline in the value of the shares. Keep in mind, however, that the value of IBM shares fluctuate, so it is not necessarily a safe investment even though it is a liquid investment. Common stock is not always a liquid investment. Some stocks are not heavily traded, so selling shares in some companies would trigger significant transactions costs and perhaps even a decline in the value of the shares.
Debt, Equity, and Derivative Securities
An investment in debt represents funds loaned in exchange for the receipt of interest income and repayment of the loan at a given future date. The bond, a common debt instrument, pays specified interest over a specified time period, then repays the face value of the loan. (Chapters 10 and 11 cover bonds in detail.) An equity investment provides an investor an ongoing fractional ownership interest in a firm. The most common example is an investment in a company's common stock. We will study equity instruments in greater detail in Chapters 6 through 8. Derivative securities are securities derived from debt or equity securities and structured to exhibit characteristics and value based upon the underlying securities. Options are derivative securities that allow an investor to sell or buy another security or asset at a specific price over a given time period. For example, an investor might purchase an option to buy Facebook stock for $50 within nine months.
Define 'Investment'. Why do people invest?
An investment is any asset into which funds can be placed with the expectation of preserving or increasing value and earning a positive rate of return. An investment can be a security or a property. Individuals invest because an investment has the potential to preserve or increase value and to earn income. It is important to stress that this does not imply that an investment will in fact preserve value or earn income. Investing often involves taking risk, so an investment's actual performance will often differ from its expected performance.
What is the primary motive for short-selling? Describe the basic short-sale procedure. Why must the short seller make an initial equity deposit?
An investor attempting to profit by selling short intends to "sell high and buy low," the reverse of the usual (long purchase) order of the transaction. The investor borrows shares and sells them, hoping to buy them back later (at a lower price) and return them to the lender. Short sales are regulated by the SEC and can be executed only after a transaction where the price of the security rises; in other words, short sales are feasible only when there is an uptick. Equity capital must be put up by a short seller; the amount is defined by an initial margin requirement that designates the amount of cash (or equity) the investor must deposit with a broker. For example, if an investor wishes to sell (short) $4,000 worth of stock when the prevailing short sale margin requirement is 50%, he or she must deposit $2,000 with the broker. This margin and the proceeds of the short sale provide the broker with assurance that the securities can be repurchased at a later date, even if their price increases.
What should an investor establish before developing and executing an investment program? Briefly describe the elements of an investment policy statement.
Before establishing an investment program, an investor should write down an Investment Policy Statement. The elements of this statement include an overview of the investor's current situation, a description of the investor's goals and investment philosophy, a list of investment selection guidelines, and a statement explaining how, when, and by whom the investment portfolio will be monitored.
Beta
Beta is a measure of systematic or undiversifiable risk. It is found by relating the historical returns on a security with the historical returns for the market: in general, the higher the beta, the riskier the security. The market return refers to the return on a broad portfolio of stocks, and it is typically measured by the average return of all (or a large sample of) stocks. Usually, the Standard & Poor's 500 stock composite index or some other broad index is used to measure market return. By definition, the beta for the overall market is 1.0, and other betas are viewed in relation to this benchmark. The positive or negative sign on a beta indicates whether the stock's return changes in the same direction as the general market (positive beta) or in the opposite direction (negative beta). In terms of the size of beta, the higher the stock's beta, the riskier the security. Stocks with betas greater than 1.0 are more responsive to changes in market returns, and stocks with betas less than 1.0 are less responsive to the market.
Define Beta and explain how to find the Beta of a portfolio when you know the beta of each of the assets within it.
Beta is an index that, according to the CAPM, measures the expected change in a security's or portfolio's return relative to a change in the market return. For example, if a security has a beta of 2.0 and the market return moves up by 10%, the CAPM predicts that the security return increases by 2.0 times that amount—that is, 20%. Beta measures only the undiversifiable, or relevant, risk of a security or portfolio. Typical beta values fall between 0.5 and 1.75. The portfolio beta is the weighted average of the betas of the individual assets in the portfolio.
Bonds
Bonds are debt obligations of corporations or governments. A bondholder receives a stated interest return, typically semi-annually, plus the face value at maturity. Bonds are usually issued in $1,000 denominations, pay semi-annual interest, and have 10 - to 30-year maturities. Bonds offer fixed/certain returns, if held until maturity.
What is the difference between broker markets and dealer markets?
Broker markets are organized securities exchanges that are centralized institutions where securities listed on a particular exchange are traded. The dealer market is a complex system of buyers and sellers linked by a sophisticated telecommunication network. Dealer markets include Nasdaq and OTC markets.
Business Risk
Business risk is concerned with the degree of uncertainty associated with an investment's earnings and the investment's ability to pay investors interest, dividends, and other returns owed them. Business risk is usually related to the firm's line of business.
What is common stock, and what are its two sources of potential return?
Common stock is an equity investment that represents a fractional ownership interest in a corporation. The return on a common stock investment derives from two sources: dividends, which are periodic payments made by the firm to its shareholders from current and past earnings, and capital gains, which result from selling the stock at a price above the original purchase price. Because common stock offers a broad range of return-risk combinations, it is one of the most popular investments s.
Comparative Data Sources
Comparative data sources enable investors to analyze the financial condition of companies and are typically grouped by industry and size of firm. These include Dun & Bradstreet's Key Business Ratios; RMA's Annual Statement Studies; the Quarterly Financial Report for U.S. Manufacturing, Mining, and Wholesale Trade Corporations; and the Almanac of Business & Industrial Financial Ratios.
What is day trading and why is it risky? How can you avoid problems with online trading?
Day trading is the opposite of a buy-and-hold strategy since true day traders do not even own stocks overnight. The method is highly risky because short-term price movements can be erratic and because day trading often involves margin and short transactions that may result in a total loss. In addition, day traders have high expenses for brokerage commissions, training, and computer equipment. You should consider several important factors before trading securities. First, know how to place and confirm your order before you begin trading. Second, verify the stock symbol of the security you wish to buy. Third, use limit orders. Fourth, don't ignore the online reminders that ask you to check and recheck. Fifth, don't get carried away with ease and speed of trading online.. Sixth, open accounts with two brokers. Lastly, double-check orders for accuracy. Many investors set aside an amount of their capital that is designated for purely speculative purposes and not required for day-to-day survival. In this way, they are not jeopardizing themselves or their loved ones if they suffer heavy losses.
Diversifiable Risk
Diversifiable (unsystematic) risk is the part of an investment's risk that the investor can eliminate through diversification. Also called firm-specific risk, this kind of risk can be eliminated by holding a diversified portfolio of assets. As an example, suppose that there are two airplane manufacturers bidding for a government contract to produce a new fighter jet. If you invest in just one of these companies, you are exposed to the risk that your company may or may not win the contract. If you hold a portfolio containing some shares in both companies, your portfolio will benefit no matter which company wins the bid. Thus, this type of risk is diversifiable.
Event Risk
Event risk is the risk that comes from a largely or totally unexpected event that has a significant and usually immediate effect on the underlying value of an investment. The effect of this risk seems to be isolated in most cases, affecting only certain companies and properties.
Financial Risk
Financial risk is the risk associated with the mix of debt and equity (capital structure) used to finance the firm. The greater the firm's debts and interest obligations, the greater is its financial risk.
Futures
Futures represent contractual arrangements in which a seller will deliver or a buyer will take delivery of a specified quantity of an asset at a given price by a certain date. Unlike an option, which gives the investor the right to purchase or sell another security, futures contracts obligate the investor to deliver or take delivery of the asset. The primary factor affecting returns on commodity contracts is the price of the underlying asset.
Differentiate among the terms public offering, rights offering, and private placement.
In a public offering, a firm offers its shares for sale to the general public after registering the shares with the SEC. Rather than issue shares publicly, a firm can make a rights offering, in which it offers shares to existing stockholders on a pro rata basis. In a private placement of its shares, a firm sells directly to groups of investors, such as insurance companies and pension funds, and does not register with the SEC.
Describe the procedures and regulations associated with margin trading. Define debt balance, and explain the common uses of margin trading.
In order to execute a margin transaction, an investor first must establish a margin account. Although the Federal Reserve Board sets the minimum amount of equity for margin transactions, it is not unusual for brokerage houses and exchanges to establish their own, more restrictive, requirements. Once a margin account has been established, the investor must provide the minimum amount of required equity at the time of purchase. This is called the initial margin, and it is required to prevent excessive trading and speculation. If the value of the investor's account drops below this initial margin requirement, the investor will have a restricted account. The maintenance margin is the absolute minimum amount of equity that an investor must maintain in the margin account. If the value of the account drops below the maintenance margin, the investor receives a margin call, in which case the investor has limited time to replenish the equity up to the initial margin. If the investor cannot meet the margin call, the broker is authorized to sell the investor's holdings to bring the account up to the required initial margin. The size of the margin loan is called the debit balance and is used along with the value of the securities being margined (the collateral) to calculate the amount of the investor's margin. Typically, margin is used to magnify the returns to a long purchase. However, when a margin account has more equity than is required by the initial margin, an investor can use this "paper" equity to purchase more securities. This tactic is called pyramiding and takes the concept of magnifying returns to the limit.
What is the difference between money markets and capital markets?
In the money market, short-term securities such as CDs, T-bills, and bankers' acceptances are traded. Long-term securities such as stocks and bonds are traded in the capital markets.
Interest Rate Risk
Interest rate risk is risk associated with changes in the prices of fixed-income securities resulting from changing market interest rates. As the market interest rates change, the prices of these securities change in the opposite direction, thereby changing the level of return that an investor can expect to obtain from them. Another important aspect of interest rate risk involves the ability to reinvest income received at the initial rate of return in order to earn the fully compounded rate of return.
Liquidity Risk
Liquidity risk is the risk of not being able to sell an investment quickly and at a reasonable price. In general, investments traded in thin markets without much trading activity tend to be less liquid than those traded in broad markets.
Market Risk
Market risk is the risk of changes in investment returns caused by factors independent of the given investment. It results from factors such as political, economic, and social events, or changes in investor tastes and preferences.
Mergent
Mergent provides detailed financial information on companies and industries.
In what two ways, based on the number of shares transacted, do brokers typically charge for executing transactions? How are online transaction fees structured relative to the degree of broker involvement?
Most firms use a fixed-commission schedule for individual investors with accounts less than $50,000. Traditional brokers generally charge on the basis of the number of shares and price per share (e.g., market value of the purchase). They sometimes charge an annual management fee and lower commissions. Online brokers, by comparison, charge a flat rate for transactions of up to 1,000 shares. Online investors will pay a surcharge if they seek personalized broker assistance.
Options
Options are derivative securities that provide holders the right to buy or sell another security (typically stock) or property at a specified price over a given time period. Factors like the time until expiration, the underlying stock price behavior, and supply and demand conditions affect the returns.
Preferred Stock
Preferred stock is very much like common stock in that it represents an ownership interest in a corporation. But preferred stock pays only a fixed stated dividend, which has precedence over common stock dividends, and does not share in other earnings of the firm.
Purchasing Power Risk
Purchasing power risk arises because of uncertain inflation rates and price-level changes in the future. When prices rise, each dollar invested has less value—it can buy less, and vice versa. Although so-called risk free assets are free of default risk, they do expose investors to purchasing power risk.
Regulation Fair Disclosure (2000)
Reg FD requires companies to disclose material information to all investors at the same time.
Explain what is meant by the return on an investment. Differentiate between the two components of return - income and capital gains (or losses).
Return on investment can come from either income or capital gains, or both. Income, most commonly, is periodic payments, such as interest received on bonds, dividends on stock, or rent received from real estate. To be considered income, these payments must be received in cash or be readily convertible to cash. Capital gain refers to the change in the market value of the investment. The amount by which the proceeds from the sale of an investment exceed the original purchase is called a capital gain. If it is sold for less than the original purchase price, a capital loss is realized. The use of percentage returns is generally preferred to dollar returns to allow investors to directly compare different sizes and types of investments.
Define "risk". Explain "risk-return tradeoff". What happens to the required return as risk increases?
Risk is the uncertainty surrounding the actual return that an investment will provide. The standard deviation is a statistic that is often used to measure risk. The risk-return tradeoff is the relationship between the expected returns from an investment and the risk associated with them. The required returns from an investment increase as risk increases to provide an incentive for the investors to take higher risks; i.e., in order to accept higher risks, the investors have to be compensated with higher returns.
Securities and Properties Investments
Securities and property are simply two classes of investments. Securities are investments issued by firms, governments, or other organizations that represent a legal claim on the resources of the issuer. For example, a bond represents a loan that the borrower is legally obligated to repay, and a stock represents a proportionate ownership in a firm. An option, on the other hand, represents the legal right to either buy or sell an asset at a predetermined price within a specified time period. Property constitutes investments in either real property (land and buildings) or tangible personal property (e.g., Rembrandt paintings, Ming vases, or antique cars).
Short-Term and Long-Term Investments
Short-term investments typically mature within one year while long-term investments have longer maturities, including common stock, which has no maturity at all. However, long-term investments can be used to satisfy short-term financial goals.
What are short-term investments? How do they provide liquidity?
Short-term investments usually have lives of less than one year. These investments may be used to "warehouse" temporarily idle funds until suitable long-term investments are found. Due to their safety and convenience, they are popular with those who wish to earn a return on temporarily idle funds or with the very conservative investor who may use these short-term investments as a primary investment outlet. In addition to their "warehousing" function, short-term investments provide liquidity—they can be converted into cash quickly and with little or no loss in value. This characteristic is very useful when investors need to meet unexpected expenses or take advantage of attractive opportunities.
Hedge Funds
Similar to mutual funds, hedge funds pool investors' funds to invest in securities, but hedge funds are open to a narrower group of investors than mutual funds. Hedge funds may employ high-risk strategies. They do not offer a fixed return and the management fees are much higher than for typical mutual funds. Although the term hedge implies limiting risks with derivatives, many hedge funds use derivatives to increase leverage rather than for managing risk.
Standard & Poor's Corporation
Standard & Poor's Stock Reports is a major service of the Standard & Poor's Corporation. It contains up-to-date reports on numerous firms, including a summary of the firm's financial history, its current financial situation, and for NYSE companies, an opinion on the firm's future prospects.
Describe standard deviation as a measure of risk or variability.
Standard deviation is a common, but somewhat flawed measure of an asset's risk. It measures the dispersion of returns around an asset's average or expected return. Intuitively, the more widely returns are scattered, the more difficult they are to predict and therefore the riskier the asset. Standard deviation is an absolute measure of risk and thus can be used to compare the riskiness of competing investments with the same expected return.
Describe the basic philosophy and use of stock market averages and indexes. Explain how the behavior of an average can be used to classify general market conditions as bull or bear.
Stock market averages and indexes are used to measure the general behavior of securities markets. Averages reflect the arithmetic average price behavior of a certain group of stocks at a given point in time, whereas indexes measure the current price behavior of the group relative to a base value set at an earlier point in time. Averages and indexes provide a convenient way of capturing the general mood of the market. When the averages or indexes reflect an upward trend in prices, a bull market is said to exist. Likewise, when these measures exhibit a downward trend, a bear market exists.
Task Risk
Tax risk is the risk that tax laws enacted by Congress will adversely affect certain types of investments and decrease their after-tax returns.
Dodd-Frank Wall St. Reform and Consumer Protection Act of 2010
The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 was passed to promote financial stability, accountability and transparency in the U.S.. It created the Bureau of Consumer Financial Protection and other agencies.
Insider Trading and Fraud Act of 1988
The Insider Trading and Fraud Act of 1988 established penalties for using nonpublic information to make personal gain. An insider, which originally referred only to a company's employees, directors, and their relatives, was expanded to include anyone who obtains private information about a company. To allow the SEC to monitor insider trades, the SEC requires corporate insiders to file monthly reports detailing all transactions made in the company stock.
Investment Advisors Act of 1940
The Investment Advisers Act of 1940 was passed to protect the public from potential abuses by investment advisers. Advisers were required to register and file regular reports with the SEC. In a 1960 amendment, the SEC was authorized to inspect the records of advisers and to revoke their registration if they violated the provisions of this act.
Investment Company Act of 1940
The Investment Company Act of 1940 set certain rules and regulations for investment companies. It also empowered the SEC to regulate their practices and procedures. Investment companies were required to register with the SEC and fulfill certain disclosure requirements. The act was amended in 1970 to prohibit investment companies from paying excessive fees to advisers and charging excessive commissions to purchasers of shares.
NYSE Market Composite Index
The NYSE Market Composite Index includes all stocks listed on the NYSE. It generally tends to move in the same direction as other major market indexes and averages.
Nasdaq Stock Market Indexes
The Nasdaq Stock Market Indexes reflect the behavior of the Nasdaq stock market. The most popular, the Nasdaq Composite Index, is calculated using more than 3000 common stocks traded on the Nasdaq system. The index is based on a value of 100 set on February 5, 1971. Another popular Nasdaq index is the Nasdaq 100, which includes 100 of the largest domestic and international nonfinancial companies that are listed on the Nasdaq.
New York Stock Exchange Composite Index
The New York Stock Exchange Composite Index includes the approximately 1,900 stocks listed on the New York Stock Exchange. It is calculated in a manner similar to the S&P indexes.
Sarbanes-Oxley Act of 2002
The Sarbanes-Oxley Act of 2002 attempts to eliminate fraudulent accounting and regulate information releases. Heavy penalties are applied to CEOs and financial officers who release deliberately misleading information. The law also establishes guidelines minimizing analyst conflicts of interest, increases SEC authority, and requires instant disclosure of stock sales by corporate executives.
Securities Act of 1933
The Securities Act of 1933 requires companies to disclose all information relevant to new security issues. The company must file a registration statement with the Securities and Exchange Commission (SEC) giving required and accurate information about the new issue. No new securities can be sold publicly unless the SEC approves the registration statement.
Value Line Composite Average
The Value Line Composite Average includes the approximately 1,700 stocks in the Value Line Investment Survey, which are traded on a broad cross section of exchanges as well as in the over- the-counter market. The base of 100 reflects the June 30, 1961, average of the stocks. A unique characteristic of the Value Line indexes is that they are value weighted (they assume equal investments in each stock) which perhaps makes them a better proxy for the average investor's portfolio.
What is CAPM?
The capital asset pricing model (CAPM) links together risk and return to help investors make investment decisions. It describes the relationship between required return and systematic risk, as measured by beta. As beta increases, so does the required return for a given investment. Investors in Treasury bills do not earn a risk premium.
Explain how the dealer market works. What role does the dealer market play in IPO's and secondary distributions?
The dealer market is really a system of markets spread all over the country and linked together by a sophisticated telecommunication system. It accounts for about 40% of the total dollar volume of all shares traded. These markets are made up of traders known as dealers, who offer to buy or sell stocks at specific prices. The "bid" price is the highest price offered by the dealer to purchase a security; the "ask" price is the lowest price at which the dealer is willing to sell the security. The dealers are linked together through Nasdaq. In order to create a continuous market for unlisted securities, IPOs, both listed and unlisted, are sold in the dealer market. About 3000 Nasdaq stocks are included in the Nasdaq/National Market System, which lists, carefully tracks, and provides detailed quotations on these actively traded stocks. The Nasdaq Global Select Market contains the 1450 biggest and most actively traded companies. An additional 1,000 firms are included in the Nasdaq National Market listing. Another 700 firms that are generally smaller can be found on the Nasdaq Capital Markets list. Companies that do not make the Nasdaq listing standards are traded on the OTC market's Bulletin Board or "Pink Sheets." Trading in large blocks of outstanding securities, known as secondary distributions, also takes place in the OTC market in order to reduce potential negative effects of such transactions on the price of listed securities. Third markets are over-the-counter transactions made in securities listed on the NYSE, the Amex, or any other organized exchange. Mutual funds, pension funds, and life insurance companies use third markets to make large transactions at a reduced cost. Fourth markets include transactions made directly between large institutional investors. Unlike the third market, this market bypasses the dealer; however, sometimes an institution will hire a firm to find a suitable buyer or seller and facilitate the transaction.
What is the efficient frontier? How can it be used to optimize a portfolio?
The efficient frontier consists of all efficient portfolios (those that maximize the portfolio's return for each risk level). Thus, the efficient frontier is part of the feasible set—indeed the most desirable part from an investor's perspective. All portfolios on the efficient frontier are preferable to the others in the feasible or attainable set. Plotting an investor's utility function or risk indifference curves on the graph with the feasible or attainable set of portfolios will indicate the investor's optimal portfolio—the one at which an indifference curve meets the efficient frontier. This represents the highest level of satisfaction for that investor.
Expected Inflation Premium
The expected inflation premium represents the expected average future rate of inflation over an investment's life. It is the compensation that investors demand for future expected inflation; that is, the decline in the purchasing power of the dollar.
Describe Standard & Poor's (S&P)
The five Standard & Poor's (S&P) Indexes include the 500 Index comprising 500 large companies, the 100 Index comprising 100 large companies each having stock options available for investors to trade, the MidCap Index (400 medium-sized companies); the SmallCap Index (made up of 600 small-sized companies); and the Total Market Index, which includes all stocks listed on the NYSE and Nasdaq.
Describe the Dow Jones Averages
The four Dow Jones Averages include the Dow Jones Industrial Average (30 widely held stocks issued by large firms), the Dow Jones Transportation Average (20 transportation stocks), the Dow Jones Utility Average (15 public utility stocks), and the Dow Jones Composite Average (includes all of the above).
Briefly describe the IPO process and the role of the investment banker in underwriting a public offering.
The investment banker is a financial intermediary who specializes in selling new security issues in what is known as an initial public offering (IPO). Underwriting involves the purchase of the security issue from the issuing firm at an agreed-on price and bearing the risk of reselling it to the public at a profit. For very large issues, an investment banker brings in other bankers as partners to form the underwriting syndicate and thus spread the financial risk. The investment banker also provides the issuer with advice about pricing and other important aspects of the issue.
Describe the structure of the overall investment process. Explain the role played by financial institutions and financial markets.
The investment process brings together suppliers and demanders of funds. This may occur directly (as with property investments). More often the investment process is aided by a financial institution (such as a bank, savings and loan, savings bank, credit union, insurance company, or pension fund) that channels funds to investments and/or a financial market (either the money market or the capital market) where transactions occur between suppliers and demanders of funds.
Real Rate of Return
The real rate of return on an investment measures the increase in purchasing power the investment provides. It is approximately equal to the nominal rate of return on a security less inflation. Historically, the real rate of return on risk-free investments has been in the range of 0.5% to 2%, although with the Federal Reserve holding nominal interest rates near zero for short- term government securities since the 2008 recession, the real return on short-term risk-free securities has often been below 0$.
Risk Premium
The risk premium varies for different security issues and represents the additional return required to compensate an investor for the risk characteristics of the issue and the issuer. It is the return on a risk security (e.g., stocks, bonds) minus the risk-free rate of return, (e.g., the rate on a 90-day T- bill. The risk free security is the treasury issue, bill, note or bond, that matches the expected term of the investment. Often the ten year and 30 year bonds are considered the risk free rate for stock investments. The risk-free rate of return equals the real rate of return plus the expected inflation premium: RF = r*IP. It is the return on a risk-free security, commonly represented as the return on the 90-day T-bill, or a longer term treasury security, depending on the term of the investment under consideration. The required rate of return equals the real rate of return plus the expected inflation premium (together, the risk-free rate) and the risk premium: ri = RF + RPj. Alternatively, it equals the risk-free rate of return plus the risk premium.
What is the SML?
The security market line (SML) is a graphic representation of the CAPM and shows the required return for each level of beta.
Stockholders' Report
The stockholder's report, also called the "annual report," is an annual publication of publicly held corporations. These reports are usually free and contain a wealth of descriptive and analytical information, including financial statements, about the firm. Stockholder reports are just one of the pieces of information that can be downloaded from company websites.
-The prospectus describes the key aspects of a security offering. -Underwriting is buying securities from firms and reselling them to investors. -The NYSE is the largest stock exchange in the world. -The Nasdaq OMX BX is a regional stock exchange. -Listing requirements are the conditions a firm must meet before its stock can be traded on an exchange. -The OTC trades unlisted securities.
Understand these concepts.
Undiversifiable Risk
Undiversifiable (systematic) risk refers to macroeconomic events or forces such as war, inflation, or political events that affect nearly all investments. Undiversifiable risk, which cannot be eliminated by holding a diversified portfolio, is the risk that matters most. Because investors can easily and at very low cost eliminate diversifiable risk from their portfolios, the market offers no reward to investors for bearing diversifiable risk. In other words, investors who fail to eliminate unsystematic risk by diversifying their portfolios cannot expect to earn higher returns for the extra risk that they bear. The market only compensates investors for bearing systematic risk.
Value Line Investment Survey
Value Line Investment Survey offers industry analysis and ratings for all widely held stocks with full-page reports including financial data, descriptions, analysis, and advice.
How does margin trading magnify profits and losses? What are the key advantages and disadvantages of margin trading?
When buying on margin, the investor puts up part of the required capital (perhaps 50% to 70% of the total); this is the equity portion of the investment and represents the investor's margin. The investor's broker (or banker) then lends the rest of the money required to make the transaction. Magnification of profits (and losses) is the main advantage of margin trading. This is called financial leverage and is created when the investor purchases stocks or other securities on margin. Only the equity portion is financed by the investor, but if the stock goes up, the investor gets all the capital gains, so leverage magnifies the return. Through leverage, an investor can (1) increase the size of his or her total investment, or (2) purchase the same investment with less of his or her own funds. Either way, the investor increases the potential rate of return (or potential loss). If the margin requirement is, say, 50%, the investor puts up only half the funds and borrows the other half. Suppose the security goes up 10%. If the investor bought the stock without using margin, he or she would earn 10%. However, if the investor used 50% margin, ignoring margin interest, he or she would earn the same dollar return with only half the funds, so the rate of return would double to 20%. On the other hand, suppose the stock fell by 10%. Without margin trading, he or she has a 10% loss. With margin trading, the loss is also doubled. Both profits and losses are magnified using leverage. Margin trading has both advantages and disadvantages. Advantages: Margin trading provides the investor leverage and the ability to magnify potential profits. It can also be used to improve current dividend income. Through margin trading, an investor can gain greater diversification or be able to take larger positions in the securities he or she finds attractive. Disadvantages: With greater leverage comes greater risk, and this is a disadvantage of margin trading. Interest rates on the debit balance can be high, a further disadvantage since these costs can significantly lower returns.
Direct and Indirect Investments
With a direct investment, an individual acquires a direct claim on a security or property. For example, an investment in one share of IBM stock directly provides the stockholder a proportionate ownership in IBM. An indirect investment provides an indirect claim on a security or property. For example, if you bought one share of Fidelity Growth Fund (a mutual fund), you are in effect buying a portion of a portfolio of securities owned by the fund. Thus, you will have a claim on a fraction of an entire portfolio of securities.
