FIN310 Exam 3

Because of this conflict of interest, the SEC imposed several rules

(1) analysts can no longer be supervised by the department of their securities firm that also provides the advisory services, and (2) securities firms are now required to disclose analyst summaries to investors for complete transparency.

The criteria that each borrower's mortgage application is being judged on

(1) their level of equity investment, (2) their income and debt levels, and (3) their credit scores. An individual's level of equity investment is represented by the down payment they make on a home. A home buyer who puts very little money down on a home (say, less than 20 percent) is seen as having a higher risk of defaulting on the loan than a buyer who puts a more significant amount of money down on a home (say, more than 20 percent). Consequently, if a home buyer plans to put less than 20 percent down on a home, they may be required to pay private mortgage insurance (PMI), which is insurance that protects the lender. Of the three home buyers, Nick plans to put the most money down, so he is seen as having the strongest application from a level of equity investment standpoint. On the opposite end of the spectrum, Tim plans to put the least amount of money down on a home, so he is seen as having the weakest application from a level of equity investment standpoint. Rosa plans to make a down payment that is in between the other two borrowers' amounts, so she is seen as having neither the strongest nor the weakest application from a level of equity investment standpoint.

two different markets companies in need of funding can turn to

1) the private equity market and (2) the public equity market. In the private equity market, the business owners cannot sell shares of their company to the public, so owners seek out private investors to give money to the company in exchange for things like equity, a seat on the board of directors, products, etc. In the public equity market, the business owners sell shares of their company to the public in exchange for a percentage ownership of the company

common stock

1) which gives an investor ownership in a company and a claim on a portion of profits (known as dividends). Common stock investors also get a perk in that they get the right to vote on key matters that concern the firm, like who is elected to the board of directors, whether or not they want the company to approve the issuance of new common stock, and whether or not amendments should be made to the corporate chapter.

preferred stock

1) which gives an investor ownership in a company and a claim on a portion of profits (similar to common stock). The main differences from common stock are that (1) preferred stockholders receive fixed dividends that are paid out perpetually (while common stockholders receive variable, non-perpetual dividends), (2) they receive fewer voting rights, and (3) most preferred stocks have provisions that give them first rights to dividends.

The dividend discount model uses the present value of a stock's future dividends in order to calculate the price of the stock. The model accounts for uncertainty in two ways: (1) It allows for dividends in various time periods to change based on the changes in expectations about a firm's future cash flows, and (2) it allows for the discount rate to change based on the changes in expectations in the required rate of return by investors. Although the dividend discount model has been widely used since its inception in 1931, it does have a tendency to inaccurately estimate a stock's price under the following circumstances:

1. The dividends to be paid in the next year are incorrectly estimated. If an investor overestimates the dividends they expect to be paid out, then the value of the shares will also be overestimated. If the dividends paid out are underestimated, then the value of the shares will be underestimated. 2. The required rate of return by investors is incorrectly estimated. If the required rate of return is overestimated, then the value of the shares will be underestimated. If the required rate of return is underestimated, then the value of the shares will be overestimated. 3. The dividend growth rate is incorrectly estimated. If the dividend growth rate is overestimated, then the value of the shares will also be overestimated. If the dividend growth rate is underestimated, then the value of the shares will also be underestimated. 4. The firm being evaluated retains most of its earnings, rather than distributing dividends (distorting its actual value as compared to the model's estimate).

When trying to determine the value of a firm's shares when the firm does not pay dividends, the free cash flow model can be used. This model uses the present value of the firm's free cash flows in conjunction with its liabilities and outstanding shares to determine the value and, furthermore, the value per share. Although this method has been used for years, it does have a tendency to inaccurately estimate a stock's price under the following circumstances:

1. The present value of the firm's free cash flows are incorrectly estimated. If the present value of the free cash flows is overestimated, then the value per share will also be overestimated. If the free cash flows are underestimated, then the value per share will also be underestimated. 2. The firm's forecasted earnings are incorrectly estimated. The firm's forecasted earnings can be used to calculate its free cash flows. If the forecasted earnings are overestimated, then the present value of the free cash flows will be overestimated, leading to the value per share being overestimated. If the forecasted earnings are underestimated, then the present value of the free cash flows will be underestimated, leading to the value per share being underestimated. 3. It can result in inaccurate valuations when the firm's noncash expenses are incorrectly estimated. The firm's noncash expenses can be used to calculate the present value of its free cash flows. If the forecasted noncash expenses are overestimated, then the present value of the free cash flows will be underestimated, leading to the value per share being underestimated. If the forecasted noncash expenses are underestimated, then the present value of the free cash flows will be overestimated, leading to the value per share being overestimated. 4. It can result in inaccurate valuations when the firm's capital investment is incorrectly estimated. The firm's capital investment can be used to calculate the present value of its free cash flows. If the forecasted capital investment expenses are overestimated, then the present value of the free cash flows will be underestimated, leading to the value per share being underestimated. If the forecasted capital investment expenses are underestimated, then the present value of the free cash flows will be overestimated, leading to the value per share being overestimated.

Role of Analysts

1. Analysts are often employed by securities firms and assigned to monitor a small set of publicly traded firms 2. Stock Exchange Rules: in the 2002-2004 period, U.S. stock exchanges imposed new rules to prevent some obvious conflicts of interest faced by analysts · Analysts cannot be supervised by the division that provides advisory services and their compensation cannot be based on the amount of advisory business they generate · Securities firms must disclose summaries of their analysts' ratings for all the firms that they rate so that investors can determine whether the ratings are excessively optimistic

Application of the CAPM

1. Given the risk-free rate as well as estimates of the firm's beta and the market risk premium, it is possible to estimate the required rate of return from investing in the firm's stock 2. At any given time, the required rates of return estimated by the CAPM will vary across stocks because of differences in their systematic risk (as measured by beta). Historical data for 30 or more years can be used to determine the average market risk premium over time

Estimating the Market Risk Premium

1. The yield on newly issued Treasury bonds is commonly used as a proxy for the risk-free rate 2. The term (Rm-Rr), is the market risk premium: the return of the market is excess of the risk-free rate 3. Historical data for 30 or more years can be used to determine the average market risk premium over time

International Exchange-Traded Funds

1. passive funds that track a specific index. International ETFs represent international stock indexes, and they have come popular in the last few years

Communication with the firm

1. shareholders can communicate their concerns to other investors in an effort to place more pressure on the firm's managers or its board members

A stock's beta is estimated to be 1.3. The risk-free rate is 5 percent, and the market return is expected to be 9 percent. What is the expected return on the stock based on the CAPM?

10.2 percent

LeBlanc Inc. currently has earnings of $10 per share, and investors expect that the earnings per share will grow by 3 percent per year. Furthermore, the mean PE ratio of all other firms in the same industry as LeBlanc Inc. is 15. LeBlanc is expected to pay a dividend of $3 per share over the next four years, and an investor in LeBlanc requires a return of 12 percent. What is the forecasted stock price of LeBlanc in four years, using the adjusted dividend discount model?

168.83

Protsky Inc. paid a dividend of $2.20 per share this year. The dividend growth rate for Protsky's dividends is 3 percent per year. If the required rate of return on Protsky stock is 12 percent, the stock should be valued at $____ per share according to the dividend discount model.

22.18

Suppose that TurboLight Co., a renewable energy startup, currently has earnings of $3 per share and that Yvette anticipates the earnings per share to grow by 6 percent per year. Using a mean industry PE ratio of 12 and the expected annual growth rate on the firm's existing earnings, the estimated stock price in three years is:

3*(1+0.06)^3 *12= 42.88

__________ percent of subprime mortgages had late payments of at least 30 days, compared to just ___________ percent of prime mortgages, and __________ percent of subprime mortgages were subject to foreclosure, compared to just ____________ percent of prime mortgages.

30%, 5%, 10%,3%

A firm is expected to generate earnings of $2.22 per share next year. The mean ratio of share price to expected earnings of competitors in the same industry is 15. Based on this information, the valuation of the firm's shares based on the price-earnings (PE) method is

33.30

The annual dividend on Grozky, Inc. stock is $5 per share and the stock's prevailing price is $93.13 per share. Thus, the stock's dividend yield is ____ percent.

5.37%, Div yield= annual div/price, 5/93.13=0.0537

Midway through 2008, approximately _________ percent of all home owners in the United States were either behind on their mortgage payments or in foreclosure.

9%

valuation

= expected earnings per share* mean industry PE ratio

Explain collateralized debt obligations (CDOs).

A CDO represents a package of debt securities backed by collateral that is sold to investors. It was a popular means by which a creditor could originate a loan and even service it without lending its own funds.

Explain the use of a balloon-payment mortgage.

A balloon mortgage payment requires interest payments for a three- to five-year period.

Describe the growing-equity mortgage.

A growing-equity mortgage requires continual increasing mortgage payments throughout the life of the mortgage.

Prospectus and Road Show. Explain the use of a prospectus developed before an IPO. Why does a firm do a road show before its IPO? What factors influence the offer price of stock at the time of the IPO?

A prospectus specifies how the proceeds of the offering are to be used, the past performance of the issuing firm, the risk involved in the firm's business, and the price range in which the shares will be offered. The firm does a road show to promote its offering. That is, it explains to various institutional investors how it will use the funds to support its expansion. The goal of the road show is to convince some large investors to invest in the shares of the firm. The offer price is influenced by market conditions, industry conditions, and the prevailing market multiples (such as price/earnings ratio). Firms prefer to engage in an IPO when market conditions allow for a high offer price.

are second mortgages offered by some home sellers?

A second mortgage is often used when financial institutions provide a first mortgage that does not fully cover the amount of funds the borrower needs. A second mortgage complements the first mortgage. It falls behind the first mortgage in priority claim against the property in the event of default.

Describe the shared-appreciation mortgage.

A shared-appreciation mortgage allows a home purchaser to obtain a mortgage at an interest rate below market rates. In return, the lender providing the loan will share in the price appreciation of the home.

Stock Portfolio Volatility. Identify the factors that affect a stock portfolio's volatility and explain their effects.

A stock portfolio has more volatility when its individual stock volatilities are high, other factors held constant. In addition, a stock portfolio has more volatility when its individual stock returns are highly correlated, other factors held constant. A stock portfolio containing some stocks with low or negative correlation will exhibit less volatility because the stocks will not experience peaks and troughs simultaneously. Some offsetting effects will occur, smoothing the returns of the portfolio over time.

Buy and sell orders on the OTC market are completed by

A telecommunications network

DCF (discounted cash flow)

A valuation method used to estimate the value of an investment based on its expected future cash flows. DCF analysis attempts to figure out the value of an investment today, based on projections of how much money it will generate in the future.

Possible disadvantages of private stock exchanges to investors include:

A. Required disclosures may be less than those required when a firm goes public B. Trading volume is limited

Describe spinning and laddering in the IPO market.

A. Spinning is the process in which an investment bank allocates shares from an IPO to corporate executives who may be considering an IPO or other business that would require the help of an investment bank. Laddering involves investors placing bids for IPO shares on the first day that are above the offer price.

ADRs. Explain how ADRs enable U.S. investors to become part owners of foreign companies.

American depository receipts (ADRs) are certificates that represent ownership of a foreign stock. They are traded in the United States. U.S. investors can purchase ADRs as a method of investing in foreign securities.

impact of Economic Growth on stock prices

An increase in economic growth is expected to increase the demand for products and services produced by firms and thereby increase a firm's cash flows and valuation. (multiples)

Asymmetric Information. Discuss the concept of asymmetric information. Explain why it may motivate firms to repurchase some of their stock.

Asymmetric information may allow a firm's managers to realize when its stock is undervalued, and they may repurchase shares at that time.

Discuss the concept of asymmetric information. Explain why it may motivate firms to repurchase some of their stock.

Asymmetric information may allow a firm's managers to realize when its stock is undervalued, and they may repurchase shares at that time.

Why might a financial institution prefer to offer balloon payment mortgage?

At the end of the period, full payment (a balloon payment) is required. Financial institutions may desire balloon mortgages because the interest rate risk is lower than for longer term, fixed-rate mortgages.

Assume that the standard deviation of daily returns for a particular stock in a recent historical period is 1.8 percent. Assume that the expected daily return of the stock is 0.01 percent. Estimate the maximum percentage one-day loss based on a 95 percent confidence level.

Based on an expected daily return of 0.01 percent, the maximum percentage one-day loss is 0.01% - [1.65 x (1.8%)] = -2.96%

Laddering

Brokers encourage investors to place first-day bids for the shares that are above the offer price. This helps to build upward price momentum investors multiplied Google's earnings per share by Yahoo!'s price- earnings ratio

Explain how caps on ARMs can affect a financial institution's exposure to interest rate risk.

Caps on adjustable-rate mortgages (ARMs) limit the degree to which the interest rate charged can move from the original interest rate at the time the mortgage was originated. If interest rates move beyond the boundaries implied by the caps, the mortgage rate will not fully adjust to the market interest rate. Therefore, if interest rates rise substantially, the mortgage rates may not fully offset the increased cost of funds.

What types of financial institutions finance residential mortgages?

Commercial banks and savings and loan associations dominate the one- to four-family mortgages.

What type of financial institution finances the majority of commercial mortgages?

Commercial banks dominate the commercial mortgages.

three main members of organized exchanges

Commission brokers, independent brokers, designated market makers

Explain the role of credit rating agencies in facilitating the flow of funds from investors into the mortgage market (through mortgage-backed securities).

Credit rating agencies rate the tranches of mortgage-backed securities based on the mortgages they represent.

Deriving the Required Rate of Return. A share of common stock currently sells for $110. Current dividends are $8 per share and are expected to grow at 6 percent per year indefinitely. What is the rate of return required by investors in the stock?

D1 = D0(1 + g) D1 = $8.00(1 + 0.06) = $8.48 k = (D1/PV of stock) + g k = (8.48/110) + 0.06 = 0.137 = 13.7%

Using the Dividend Discount Model. Suppose you know that a company just paid a dividend of $1.75 per share on its stock and that the dividend will continue to grow at a rate of 8 percent per year. If the required return on this stock is 10 percent, what is the current share price?

D1 = D0(1 + g) D1 = 1.75(1 + 0.08) = 1.89 PV of stock = D1/(k - g) PV of stock = 1.89/(0.10 - 0.08) = $94.5 per share

When the lockup period expires, the share price commonly

Decreases significantly

Describe a lockup provision and explain why it is required by the lead underwriter.

Describe the pressure of the share price at the lockup expiration date. The lockup provision restricts insiders and venture capital firms from selling their shares until a specified period (usually 6 months) after the IPO. Once the lockup provision expires, the insiders and venture capital firms can sell the shares that they own, which sometimes places downward pressure on the price of the stock at that time.

Distorted Financial Statements

Even though financial statements to summarize revenue, expenses, and financial conditions, accountants still have must flexibility in their reporting process, and therefore still can exaggerate earnings

Measuring Expected Return. Assume Mess stock has a beta of 1.2. If the risk-free rate is 7 percent, and the market return is 10 percent, what is the expected return on Mess stock?

Expected return = 7% + 1.2(10% - 7%) = 10.6%

Why some financial institutions prefer to sell the mortgages they originate?

Financial institutions may sell their mortgages if they desire to enhance liquidity, or if they expect interest rates to increase. Mortgage companies frequently sell mortgages after they are originated and continue to service them. Financial institutions may sell their mortgages if they do not have sufficient funds to maintain all the mortgages they originate.

IPOs. Why do firms engage in IPOs? What is the amount of fees that the lead underwriter and its syndicate charge a firm that is going public? Why are there many IPOs in some periods and few IPOs in other periods?

Firms engage in IPOs when they have feasible expansion plans but are already near their debt capacity. The transaction cost (fees) is normally about 7 percent of the gross proceeds received by the issuing firm. Firms prefer to engage in IPOs when business conditions and market conditions are favorable. They avoid IPOs if business conditions are poor, because they do not need funds to expand if the business outlook is poor. Also, when business conditions are poor, the market conditions are weak, meaning that they would have to sell their shares at a low price.

Causes for Mortgage defaults in 2006

First, an increase in interest rates spelled disaster for homeowners who had adjustable-rate mortgages. Recall that adjustable-rate mortgages are those that have interest rates that fluctuate over the life of the mortgage. So homeowners had mortgages with low interest rates initially, but the sudden increase in those rates meant that their mortgage payments also increased. Naturally, this caused the default rate to increase because some consumers could no longer afford to pay their mortgages. Second, to incentivize people to purchase new homes, mortgage companies offered "teaser" interest rates that were too good for some consumers to pass up. After a few years, the increase in interest rates made their mortgage payments increase, resulting in even more defaults.

An increase in home prices resulted in what outcomes for financial market participants.

First, the home price increase (in conjunction with the economic conditions) caused investors to have a more favorable view on the mortgage market, so they began investing in more mortgages. Second, in order to incentivize consumers to purchase homes, investors lowered their down payment, or equity investment, requirements, which resulted in a flood of consumers purchasing homes (even if they were not financially qualified). Last, because interest rates were so low and home prices were so high, home builders began constructing even more new homes, causing the supply of homes (or housing inventory) in the market to increase substantially.

What does it mean to "flip" shares? Why would investors want to flip shares?

Flipping shares refers to selling shares shortly after (such as a day or two) obtaining them at the IPO. Some institutional investors attempt to flip shares to take advantage of an initial return over the first day. IPO performance tends to be unusually high on the first day, followed by a downward drift. Some investors want to earn the initial return and then sell out. They may earn a very high return without tying their funds up for a long period of time.

Free Cash Flow model

For firms that do not pay dividends: a. Estimate the free cash flows that will result from operations b. Subtract existing liabilities to determine the value of the firm. (Capex) c. Divide the value of the firm by the number of shares to derive a value per share Limitations a. Difficulty of obtaining an accurate estimate of free cash flow per period

How do you think accounting irregularities affect the pricing of corporate stock in general?

Generally speaking, accounting irregularities introduce additional uncertainty and risk. Consequently, investors would require a higher rate of return, which would result in a lower stock price.

impact of interest rates on stock prices

Given a choice of risk-free Treasury securities or stocks, investors should purchase stocks only if they are appropriately priced to reflect a sufficiently high expected return on the risk-free rate. Interest rates commonly rise in response to an increase in economic growth

Impact of Interest Rates. How are the interest rate, the required rate of return on a stock, and the valuation of a stock related?

Given a choice of risk-free Treasury securities or stocks, stocks should be purchased only if they are appropriately priced to reflect a sufficiently high expected return above the risk-free rate. The relation between interest rates and stock prices is not constant over time. However, most of the largest stock market declines have occurred in periods when interest rates increased substantially. Furthermore, the stock market's rise in the late 1990s is partially attributed to the low interest rates during that period, which encouraged investors to shift from debt securities (with low rates) to equity securities.

A _____ allows the borrower to initially make small payments on the mortgage. The payments then increase over the first 5 to 10 years and then level off.

Graduated-payment mortgage

holding other factors constant, an increase in the capital gains tax rate will

Have less effect on the valuation of dividend-paying sticks than on stocks with high growth prospects

homework problem

Housing data has shown that the average home buyer puts less than 10 percent down as a down payment on a home. Alyssa put 5 percent down, which is well below average. Lenders typically want their borrowers to have debt-to-income ratios that are less than 30 percent, indicating that the borrower has sufficient income to cover their preexisting debts, as well as the mortgage loan. In this case, Alyssa has a debt-to-income ratio that is 41 percent, indicating that she may not be able to sufficiently cover her existing debts, as well as the loan she receives. Lastly, the average individual's credit score in the U.S. is right around 700, well above Alyssa's score of 595. A person's credit score takes into account all of the credit history of that individual. Individuals who constantly make late payments, have their credit limits lowered, have large amounts of outstanding debt, among other things, will have lower credit scores than individuals who never miss a payment, have healthy credit limits, and have small amounts of outstanding debt. The score indicates an individual's creditworthiness to a potential lender. The higher the credit score, the higher likelihood that a borrower will make good on their debt obligations. Because Alyssa's credit score is 595, she is seen as a borrower that may not be financially stable and, thus, may not make her loan payments on time. Everything mentioned about Alyssa indicates that she may be a borrower who presents a lot of risk if given a mortgage loan as compared to more "average" borrowers. As a result, when her loan is issued, it will be seen as a subprime mortgage, which is a mortgage given to a borrower that does not qualify for a prime mortgage loan.

How do IPOs perform over the long run?

IPOs perform poorly on average when compared to other firms over the long-term period.

Value at Risk. Assume that in the previous problem, an investor has invested $10 million in the stock of concern. Estimate the maximum dollar one-day loss based on a 95 percent confidence level.

If an investor has a $10 million investment in that stock, the maximum dollar one-day loss can be determined by applying the maximum percentage loss to the value of the investment. Since the maximum percentage loss was determined to be -2.96% in the previous problem, the maximum dollar one-day loss is estimated to be (-2.97%) ´ $10,000,000 = -$297,000

Venture capital firms commonly attempt to cash out as soon as is possible following IPOs. Describe the likely effect that would have on the stock price at the time of lockup expiration.

If many VC firms are selling their shares at lockup expiration, there is downward pressure on the stock price.

How did the repayment of subprime mortgages compare to that of prime mortgages during the credit crisis?

In 2008, about 25 percent of all outstanding subprime mortgages had late payments of at least 30 days, versus less than 5 percent for prime mortgages. In addition, about 10 percent of outstanding subprime mortgages were subject to foreclosure in 2008, versus less than 3 percent for prime mortgages.

Financial Reform Act

In July 2010 the Financial Reform Act was implemented, and one of its main goals was ensuring stability in the financial system The act mandated that financial institutions granting mortgages verify the income, job status, and credit history of mortgage applicants before approving mortgage applications The act also required that financial institutions that sell mortgage-backed securities retain 5% of the portfolio unless the portfolio meets specific standards that reflect low risk

Timing of IPOs

Initial public offerings tend to occur more frequently during bullish stock markets

_____________ are portfolios of international stocks created and managed by various financial institutions.

International mutual funds

Pension Funds

Invest a large portion of funds accumulated from contributions from employers and/or employees (pension funds) in the stock market.

Implied Volatility. Explain the meaning and use of implied volatility.

Investors can derive the stock's implied standard deviation (ISD) from the stock option pricing model. The premium on a call option for a stock is dependent on factors such as the relationship between the current stock price and the exercise (strike) price of the option, the number of days until the expiration date of the option, and the anticipated volatility of the stock price movements. There is a formula for estimating the call option premium based on various factors. The actual values of these factors are known, except for the anticipated volatility. However, by plugging in the actual option premium paid by investors for that specific stock, it is possible to derive the anticipated volatility level. Participants may use this measurement as their own forecast of that specific stock's volatility.

Price-Earnings Model. Explain the use of the price-earnings (PE) ratio for valuing a stock. Why might investors derive different valuations for a stock when using the price-earnings method? Why might investors derive an inaccurate valuation of a firm when using the price-earnings method?

Investors can value a stock by applying the industry PE ratio to the firm's expected earnings for the next year. This method implicitly assumes that the growth in earnings in future years will be similar to that of the industry. This method has several variations, which can result in different valuations. For example, investors may use different forecasts for the firm's earnings or the mean industry earnings over the next year. The previous year's earnings are often used as a base for forecasting future earnings, but the recent year's earnings do not always provide an accurate forecast of the future. A second reason for different valuations when using the PE method is that investors disagree on the proper measure of earnings. Some investors prefer to us operating earnings or exclude some unusually high expenses that result from one-time events. A third reason is that investors may disagree on the firms that should represent the industry norm. Some investors use a narrow industry composite composed of firms that are very similar (in terms of size, lines of business, etc.) to the firm being valued; other investors prefer a broad industry composite. Consequently, even if investors agree on a firm's forecasted earnings, they may still derive different values for that firm as a result of applying different PE ratios. Furthermore, even if investors agree on the firms to include, they may disagree on how to weight each firm.

Finance Companies

Issue stock when they are starting to become inadequately funded and need to boost their capital base.

Stock-Owned Savings Institutions

Issue stock when they are starting to become inadequately funded and need to boost their capital base.

Insurance Companies

Issue stock when they are starting to become inadequately funded and need to boost their capital base. Invest a large portion of the premiums they collect in the stock market.

Commercial Banks

Issue stock when they are starting to become inadequately funded and need to boost their capital base. Manage trust funds, usually containing stocks, that are set up by individuals to be given to a beneficiary in the future.

Securities Firms

Issue stock when they are starting to become inadequately funded and need to boost their capital base. Place new issues of stock for companies that need to raise capital. Offer advice to corporations that are considering acquiring ownership of other companies by purchasing their issued stocks. Execute, buy, and sell transactions for investors looking to purchase stocks from a company or sell their existing stocks in a company.

Which of the following is not true regarding the Sarbanes-Oxley Act?

It prevents members of a firm's audit committee form receiving consulting or advising fees or other compensation from the firm beyond that earned from serving on the board It allows public accounting firms to offer non-audit consulting services to an audit client

Which of the following is TRUE regarding the Sarbanes-Oxley Act

It requires firms to establish an internal control process for their financial reporting It requires a firm's CEO and CFO to certify that the audited financial statements are accurate It prevents members of a firm's audit committee form receiving consulting or advising fees or other compensation from the firm beyond that earned from serving on the board

Stock X has a lower beta than Stock Y. The market return for next month is expected to be -1 percent, +1 percent, or +2 percent with an equal probability of each scenario. The probability distribution of Stock X returns for next month is

Less dispersed than that of Stock Y

OTC Bulletin Board

Lists stocks that have a price below $1 per share, which are sometimes referred to as penny stocks

Private Equity Funds. Explain the incentive for private equity funds to invest in a firm and improve its operations.

Managers of a private equity fund typically take a percentage of the profits they earn from their investments in return for managing the fund. They also charge an annual fee for managing the fund. If they were able to improve the business substantially while they managed it, they should be able to sell their stake to another firm for a much higher price than they paid for it. Alternatively, they may be able to take the business public through an initial public offering (IPO) and cash out at that time.

Listing Requirements

Minimum number of shares outstanding and a minimum level of earnings, cash flow and revenue over a recent period

The credit risk to a financial institution from investing in mortgage-backed securities representing subprime mortgages is ____ that of mortgage-backed securities representing prime mortgages.

More than

Explain how a mortgage company's degree of exposure to interest rate risk differs from other financial institutions.

Mortgage companies concentrate on servicing mortgages rather than investing in mortgages. Thus, they are not as concerned about hedging mortgages over the long run. However, they are exposed to interest rate risk during the period from when they originate mortgages until they sell them. If interest rates change over this period, the price at which they can sell the mortgages will change.

Explain how the credit crisis adversely affected many other people beyond homeowners and mortgage companies.

Mortgage insurers incurred expenses from foreclosures of the property they insured. Investors who invested in stocks of financial institutions experienced losses. Home builders went bankrupt and many employees in the home building industry lost their jobs.

Bear Sterns commonly used _____ as collateral when borrowing short-term funds, but its funding was cut off because prospective creditors questioned the quality of the collateral.

Mortgages

The process by which the lead underwriter solicits indications of interest by institutional investors in an IPO at various possible____ prices is referred to as ____.

Offer; bookbuilding

Which of the following is not true with respect to venture capital (VC) funds?

One common exit strategy for VC funds is to sell its equity stake to the public before the business engages in a public stock offering

Mortgage Companies

Originate mortgages by working with borrowers to create loans where the real estate or property is used as collateral for the loan and sell them in the secondary mortgage market.

Commercial Banks and Savings Institutions

Originate mortgages by working with borrowers to create loans where the real estate or property is used as collateral for the loan. Use securitization to pool a variety of mortgages and sell mortgage-backed securities Purchase mortgages and mortgage-backed securities in the secondary market.

Deriving the Required Rate of Return. The next expected dividend for Sun, Inc., will be $1.20 per share and analysts expect the dividend to grow at a rate of 7 percent indefinitely. If Sun stock currently sells for $22 per share, what is the required rate of return?

PV of stock = D1/(k - g) k = (D1/PV of stock) + g k = (1.20/22) + 0.07 = 0.1245 = 12.45%

Suppose TurboLight Co. is expected to pay a dividend of $3 per share over the next three years, that Yvette's required rate of return is 14 percent, and that she plans to sell the stock at the end of the three-year time period. Under these circumstances, using the adjusted dividend discount model, the value of the stock today is:

PV of stock=dividend/(1 + k)^1+dividend(1 + k)^2+dividend(1 + k)^3+estimated stock price in year 3/(1 + k)^3PV of stock= 3/(1 + 0.14)^1+3/(1 + 0.14)^2 +3/(1 + 0.14)^3+ 42.88/(1 + 0.14)^3. In this example, the valuation per share is: $35.90

Using the Dividend Discount Model. Suppose that you are interested in buying the stock of a company that has a policy of paying a $6 per share dividend every year. Assuming no changes in the firm's policies, what is the value of a share of stock if the required rate of return is 11 percent?

PVof stock = D/k = 6/0.11 = $54.5 per share

Using the Dividend Discount Model. Micro, Inc. will pay a dividend of $2.30 per share next year. If the company plans to increase its dividend by 9 percent per year indefinitely, and you require a 12 percent return on your investment, what should you pay for the company's stock?

PVof stock = D1/(k - g) PVof stock = 2.3/(0.12 - 0.09) = $76.67 per share

Measuring the Portfolio Beta. Assume the following information: Beta of Stock D = 1.31 Beta of Stock E = 0.85 Beta of Stock F = 0.94 If you invest 40 percent of your money in Stock D, 30 percent in Stock E and 30 percent in Stock F, what is your portfolio's beta?

Portfolio beta = 0.4(1.31) + 0.3(0.85) + 0.3(0.94) = 0.524 + 0.255 + 0.282 = 1.061

Measuring the Portfolio Beta. Using the information from Problem 12, suppose that you instead decide to invest $20,000 in Stock D, $30,000 in Stock E and $50,000 in Stock F. What is the beta of your portfolio now?

Portfolio beta = [(0.2 x 1.31) + (0.3 x 0.85) + (0.5 x0.94)] = (.262 + .255 + .47) = 0.987

At a given point in time, the price of credit default swap contract should be ______ related to the default risk of the securities covered by the contract. For a given set of securities that are covered by a credit default swap the price of the contract should be _____ related to the default risk as it changes over time.

Positively; positively

Which of the following is not a reason the PE ratio method may result in an inaccurate valuation for a firm?

Potential errors in the forecast of the firm's beta

The _____ market for mortgages is where mortgages are originated

Primary

_______ are backed by conventional mortgages

Private-label pass-through securities

Insurance Companies

Purchase mortgages and mortgage-backed securities in the secondary market.

Measuring Stock Returns. Suppose you bought a stock at the beginning of the year for $76.50. During the year, the stock paid a dividend of $0.70 per share and had an ending share price of $99.25. What is the total percentage return from investing in that stock over the year?

R= (SP-INV)+D/ INV =(99.25-76.5)+0.70/76.5 =30.6%

Price-Earnings Ratio

Represents its prevailing stock price per share divided by the firm's earnings per share (earnings divided by number of existing share of stock) generated over the last year

formula for a stock portfolio's volatility does not contain the

Risk-free rate

Deriving the Stock's Beta. You are considering investing in a stock that has an expected return of 13 percent. If the risk-free rate is 5 percent and the market risk premium is 7 percent, what is the beta of this stock?

Rj = Rf + Bj(Rm - Rf ) 0.13 = 0.05 + Bj (0.07) Bj = 1.142

Deriving the Required Rate of Return. A stock has a beta of 2.2, the risk-free rate is 6 percent, and the expected return on the market is 12 percent. Using the CAPM, what would you expect the required rate of return on this stock to be? What is the market risk premium?

Rj = Rf + Bj(Rm - Rf ) Rj = 6% + 2.2(12% - 6%) Rj = 19.2% The market risk premium is 6 percent.

Mutual Funds

Sell shares and use the proceeds to create portfolios consisting of mortgage-backed securities.

Stock Mutual Funds

Sell shares to individual investors and use the funds to invest in stocks.

American International Group (AIG) experienced financial problems during the credit crisis because it focused heavily on

Selling credit default swaps

Proxy Contest

Shareholder may also engage in proxy contests in an attempt to change the composition of the board

Risk-Adjusted Return Measurements. Assume the following information over a five-year period. ¨ Average risk-free rate = 6% ¨ Average return for Crane stock = 11% ¨ Average return for Load stock = 14% ¨ Standard deviation of Crane stock returns = 2% ¨ Standard deviation of Load stock returns = 4% ¨ Beta of Crane stock = 0.8 ¨ Beta of Load stock = 1.1 Determine which stock has higher risk-adjusted returns according to the Sharpe Index. Which stock has higher risk-adjusted returns according to the Treynor Index? Show your work.

Sharpe index= Average return-average risk-free rate/standard dev 11%-6%/2% =2.5 Treynor index= average return- average risk-free rate/ beta 11%-6%/0.8 =0.0625

Excessive Commissions

Some brokers have charged excessive commissions when demand was high for an IPO. Investors were willing to pay the price because they could normally recover the cost from the return on the first day

The government intervened in order to resolve problems in the mortgage markets during the credit crisis. Summarize the advantages and disadvantages of the government intervention during the credit crisis.

Some government programs stabilized the market for mortgage-backed securities, and therefore helped the financial institutions that invested in them. To the extent that the government's intervention stabilized the housing market, many homeowners benefitted. The government budget deficit increased due to the intervention, although one could argue that the deficit could have been worse due to a more pronounced crisis if the government did not intervene at all.

_________ occurs when the underwriter allocates share from an IPO to corporate executives who may be considering an IPO or other business that will require the help of a securities firm.

Spinning

Spinning and Laddering. Describe spinning and laddering in the IPO market. How do you think these actions influence the price of a newly issued stock? Who is adversely affected as a result of these actions?

Spinning is the process in which an investment bank allocates shares from an IPO to corporate executives who may be considering an IPO or other business that would require the help of an investment bank. Laddering involves investors placing bids for IPO shares on the first day that are above the offer price. Laddering ultimately results in upward price momentum, which may or may not accurately reflect the fair value of the underlying stock. If spinning occurs at favorable stock prices, this may keep the stock price from achieving its fair value. The initial owners of the firm may be adversely affected because the firm may not receive as much proceeds from the IPO due to spinning and laddering. Spinning may result in shares sold at a lower than market price. Laddering might only occur if there is an unusually strong demand for the shares. If there is such a strong demand, the IPO price must be too low.

Stock Repurchases. Explain why the stock price of a firm may rise when the firm announces that it is repurchasing its shares.

Stock repurchases may signal that the firm's managers believe the stock is undervalued, so the investors may purchase the stock based on this signal, and that places upward pressure on the stock price.

Emerging Markets. hat are the risks of investing in stocks in emerging markets?

Stocks in emerging markets are more exposed to major government turnover and other forms of political risk. They also expose U.S. investors to a high degree of exchange rate risk because their local currencies are typically very volatile.

Explain why stocks traded on the NYSE generally exhibit less risk than stocks that are traded on other exchanges.

Stocks traded on the NYSE tend to represent larger firms. These stocks also have a large trading volume, which enhances their liquidity.

Why is the 15-year mortgage attractive to homeowners?

The 15-year mortgage is popular because of the potential reduction in total interest expenses paid on a mortgage with a shorter lifetime.

Explain how the Dodd-Frank Act of 2010 attempted to prevent biased ratings of mortgage-backed securities by credit rating agencies.

The Dodd-Frank Act requires that credit rating agencies publicly disclose data on assumptions used to derive each credit rating. The agencies are also required to provide an annual report about their internal controls used to ensure an unbiased process of rating securities. The act also prevents the SEC from relying on ratings within its regulations, so that it has to use its own assessment of risk.

Impact of Sarbanes-Oxley Act. Briefly describe the provisions of the Sarbanes-Oxley Act. Discuss how this act affects the monitoring performed by shareholders.

The Sarbanes-Oxley Act: 1) Prevents a public accounting firm from auditing a client firm whose employees were employed by the client firm within one year prior to the audit. 2) Requires that only outside board members of a firm be on the firm's audit committee. 3) Prevents the members of a firm's audit committee from receiving consulting or advising fees or other compensation from the firm beyond that earned from serving on the board. 4) Requires that the CEO and CFO of firms that are of at least a specified size level to certify that the audited financial statements are accurate. 5) Specified major fines or imprisonment for employees who mislead investors or hide evidence. 6) Prevents public accounting firms from offering non-audit services to an audit client if the client's audit committee pre-approves the non-audit services to be rendered before the audit begins.

A decrease in interest rates from fixed-rate mortgage interest rates that were approximately 8.5 percent in 2000 and by 2003, they dropped to below 6 percent.

The decrease in interest rates made it less expensive for consumers to borrow money to purchase a home, and as a result, the demand for homes increased. Additionally, economic conditions were getting more and more favorable, which meant that consumers were feeling more confident about job security, their incomes increasing, etc., which also led to an increase in demand for homes. These two factors caused an increase in the demand for homes, which led to an increase in home prices.

Dividend Discount Model. Describe the dividend discount valuation model. What are some limitations when using this model?

The dividend discount valuation model measures the value of a firm as the present value of future expected dividends to be received by the investor. The model can account for uncertainty by allowing dividends to be revised in response to revised expectations about a firm's cash flows, or by allowing the required rate of return to be revised in response to changes in the required rate of return by investors. The dividend discount model may result in an inaccurate valuation of a firm because of potential errors in determining the dividend to be paid over the next year, or the growth rate, or the required rate of return by investors. The limitations of this model are more pronounced when valuing firms that retain most of their earnings rather than distribute them as dividends, because the model relies on the dividend as the base for applying the growth rate. For example, many Internet-related stocks retain any earnings to support growth and thus are not expected to pay any dividends.

The adjusted dividend discount model calculates the present value of future cash flows (or value of a stock) using (1) the firm's forecasted earnings, (2) the mean industry price-earnings ratio, (3) the expected dividends, and (4) the required rate of return. Although this method has been used for years, it does have a tendency to inaccurately estimate a stock's price under the following circumstances:

The expected growth in the firm's future earnings is incorrectly estimated. If the expected future earnings are overestimated, then the value per share will also be overestimated. If the expected future earnings are underestimated, then the value per share will also be underestimated. Investors rely on an industry mean price-earnings ratio that uses a collection of firms that is too narrow, broad, or has incorrectly weighted firms, when a more representative collection of firms is available. If investors use a collection of firms that is not representative of the firm that is being evaluated, then the industry's mean price-earnings ratio will cause the valuation per share to be incorrectly estimated. If the industry mean price-earnings ratio is overestimated, then the value per share will also be overestimated. If the industry mean price-earnings ratio is underestimated, then the value per share will also be underestimated. A stock buyback occurs unexpectedly, reducing the number of outstanding shares and consequently increasing the earnings per share, despite the firm's earnings not changing. This buyback would cause the valuation per share to have been underestimated. The required rate of return by investors is incorrectly estimated. If the required rate of return is overestimated, then the value of the shares will be underestimated. If the required rate of return is underestimated, then the value of the shares will be overestimated.

When a firm decides it needs additional funding to expand operations, it might decide to go public and issue an initial public offering (IPO) to raise the funding. There are several steps involved in issuing an IPO:

The firm decides it wants to issue stock to the public to raise the capital it needs for growth. The firm will need help from someone knowledgeable in the IPO process, so it hires a securities firm that serves as an underwriter for the IPO. The firm, with the help of the underwriter, develops a prospectus containing detailed information about the firm's business operations, finances, and potential risks, and files it with the Securities and Exchange Commission (SEC). Prior to issuing an IPO, the SEC needs to sign off on everything to ensure investors buying the stocks are not mislead. The SEC assesses the prospectus and determines whether or not there is enough information provided to give investors an adequate picture of the financial state of the firm. If there is not enough information, the SEC will ask the firm to provide sufficient details. The firm's prospectus is signed off by the SEC once it is determined that there is enough information provided as to not mislead investor decision making. The firm, alongside the underwriter, uses bookbuilding (a method used to estimate the demand for the firm's stock once the IPO is issued) to develop a valuation for the IPO stock. Once the firm has its prospectus and valuation for the stocks figured out, it sets up a road show to make presentations and answer questions about the firm and its IPO offering. Finally, the firm's IPO goes public and investors can begin purchasing stock in the firm.

The price-earnings model is a very simple way to value stock using (1) the estimated future earnings per share of a firm and (2) the mean industry price-earnings ratio (which takes into account the price-earnings ratios of several industry competitors). Although this method has been used for years, it does have a tendency to inaccurately estimate a stock's price under the following circumstances:

The firm's future earnings are incorrectly estimated. If a firm's future earnings are overestimated, then the value per share will also be overestimated. If the future earnings are underestimated, then the value per share will also be underestimated. Investors are misled by firms who use accounting methods to indicate that earnings in a particular period will be substantial, even though they will not be able to sustain that level of earnings in the future. Investors rely on an industry mean price-earnings ratio that uses a collection of firms that is too narrow, broad, or has incorrectly weighted firms. If investors use a collection of firms that is not representative of the firm that is being evaluated, then the industry mean price-earnings ratio will cause the valuation per share to be incorrectly estimated. If the industry mean price-earnings ratio is overestimated, then the value per share will also be overestimated. If the industry mean price-earnings ratio is underestimated, then the value per share will also be underestimated. A stock buyback occurs unexpectedly, reducing the number of outstanding shares and consequently increasing the earnings per share, despite the firm's earnings not changing. This buyback would cause the valuation per share to have been underestimated.

Impact of Economic Growth. Explain how economic growth affects the valuation of a stock.

The firm's value should reflect the present value of its future cash flows. Because earnings are a primary component of corporate cash flows, many investors use forecasted earnings to determine whether a firm's stock is over- or undervalued.

Describe the graduated-payment mortgage.

The graduated payment mortgage allows borrowers to repay their loans on a graduated basis over the first 5 to 10 years. They level off after a 5- or 10-year period

How does the growing-equity mortgage differ from a graduated-payment mortgage?

The growing-equity mortgage lifetime is reduced because of the accelerated payment schedule, whereas a GPM's life is not reduced.

Were initial returns of Internet IPOs in the late 1990s higher or lower than normal? Why?

The initial returns of Internet IPOs in the late 1990s were high, because many investors wanted to invest in them.

Is the interest rate risk to the financial institution higher for a 15-year or a 30-year mortgage? Why?

The interest rate risk is higher for a 30-year mortgage than for a 15-year mortgage, because the 15-year mortgage exists for only half the period.

Bookbuilding. Describe the process of bookbuilding. Why is bookbuilding sometimes criticized as a means of setting the offer price?

The lead underwriter engages in bookbuilding by soliciting indications of interest in the IPO by institutional investors, so as to determine demand. The bookbuilding process used in the United States is sometimes criticized because it dictates an offer price that is lower than what some institutional investors would pay.

Federally insured mortgages are intended to protect?

The loan repayment to lending institution

Value at Risk: Determine how the maximum expected loss on a stock would be affected by an increase in the expected return of the stock, based on a 95 percent confidence interval.

The maximum expected loss would now be less pronounced than before, because the expected outcome is higher and the deviation from that will result in a maximum loss that is not as bad.

Value at Risk: How is the maximum expected loss on a stock affected by an increase in the volatility (standard deviation), based on a 95 percent confidence interval?

The maximum expected loss would now be more pronounced (worse) than before, because the larger standard deviation creates a greater deviation from (below) the expected outcome.

Dividend model Relationships: When computing the price of the stock with the dividend discount model, how would the price of a stock be affected if the required rate of return is increased. Explain the logic of this relationship.

The price of the stock is reduced, because the cash flows would be discounted at a higher rate.

When computing the price of a stock using the constant-growth dividend discount model, determine how the price of a stock would be affected if the growth rate is reduced. Explain the logic of this relationship.

The price of the stock is reduced, because the expected future cash flows in distant periods are reduced if the growth rate is revised downward.

When using the CAPM, how would the required rate of return on a stock be affected if the beta were higher.

The required rate of return would be higher, because a given premium above the risk-free rate would now be higher.

CAPM Relationships: When using the CAPM, how would the required rate of return on a stock be affected if the risk-free rate were lower.

The required rate of return would be lower, because it should reflect a premium above the risk-free rate (which is now lower).

When using the CAPM, how would the required rate of return on a stock be affected if the market return were lower.

The required rate of return would be lower, because the premium that is added to the risk-free rate would now be lower.

Why do you think it is difficult for investors to assess the financial condition of a financial institution that has purchased a large amount of mortgage-backed securities?

The risk of mortgage-backed securities is dependent on the underlying mortgages and the details of the mortgages are not disclosed in financial statements.

Compare the secondary market activity for mortgages to the activity for other capital market instruments (such as stocks and bonds). Provide a general explanation for the difference in the activity level.

The secondary market for stocks and bonds is facilitated by an organized exchange such as the New York Stock Exchange. The prices of these securities sold in the secondary market are more transparent. The prices of mortgages sold in the secondary market are not transparent. However, the secondary market for mortgages has been enhanced because of securitization. This allows for the sale of smaller loans that could not be as easily sold if they were not packaged.

Impact of Exchange Rates. Explain how the value of the dollar affects stock valuations.

The value of the dollar can affect U.S. stock prices for a variety of reasons. First, foreign investors tend to purchase U.S. stocks when the dollar is weak and sell them when it is near its peak. Thus, the foreign demand for any given U.S. stock may be higher when the dollar is expected to strengthen, other things being equal. Also, stock prices are affected by the impact of the dollar's changing value on cash flows. Stock prices of U.S. firms primarily involved in exporting could be favorably affected by a weak dollar and adversely affected by a strong dollar. U.S. importing firms could be affected in the opposite manner. Stock prices of U.S. companies may also be affected by exchange rates if stock market participants measure performance by reported earnings. A multinational corporation's consolidated reported earnings will be affected by exchange rate fluctuations even if the company's cash flows are not affected. A weaker dollar tends to inflate the reported earnings of a U.S.-based company's foreign subsidiaries. Some analysts argue that any effect of exchange rate movements on financial statements is irrelevant unless cash flows are also affected. The changing value of the dollar can also affect stock prices by affecting expectations of economic factors that influence the firm's performance. For example, if a weak dollar stimulates the U.S. economy, it may enhance the value of a U.S. firm whose sales are dependent on the U.S. economy. A strong dollar could adversely affect such a firm if it dampens U.S. economic growth. Because inflation affects some firms, a weak dollar value could indirectly affect a firm's stock by putting upward pressure on inflation. A strong dollar would have the opposite indirect impact.

Market Efficiency. Explain the difference between weak-form, semistrong-form, and strong-form efficiency. Which of these forms of efficiency is most difficult to test? Which is most likely to be refuted? Explain how to test weak-form efficiency in the stock market.

The weak form suggests that security prices reflect recent price movements and trading information. The semistrong form suggests that security prices reflect all publicly traded information. The strong form suggests that security prices reflect public and private information. Weak-form efficiency can be tested by searching for a nonrandom pattern in stock prices. If future price movements can be predicted by assessing the past movements, a market inefficiency is detected.

What is the general relationship between mortgage rates and long-term government security rates?

There is a high positive correlation between mortgage rates and long-term government security rates.

Explain the problems in valuing MBS.

There is no centralized reporting system that reports the trading of MBS in the secondary market, as there is for other securities such as stocks and Treasury bonds. The only participants who know the price of MBS that was traded is the buyer and the seller.

When managers from one firm recognize that a competing firm is operating inefficiently, they might try to acquire that firm in order to reduce operational redundancies and to reap the synergistic benefits of combining their operations. If the right operational improvements are made, then the investing firm would benefit significantly from the increase in value of the acquired firm.

True

When managers from one firm recognize that a competing firm's stock price has plummeted as a result of poor management decisions, they might try to acquire that firm when its stock sits at a low value and improve its management in an attempt to increase the value of the firm. If the right management improvements are made, then the investing firm would benefit significantly from the increase in value of the acquired firm.

True

Managers of firms may consider a stock repurchase or even a leveraged buyout when they believe their stock is _____ by the market, or a secondary stock offering when they believe their stock is_____ by the market.

Undervalued; overvalued

Savings Banks

Use funds from their investment portfolios to invest in stocks.

Securities Firms

Use securitization to pool a variety of mortgages and sell mortgage-backed securities. Offer instruments to help institutions that invest in mortgages hedge (protect themselves) against large fluctuations in interest rates.

Using the PE Method. You discovered that Olmsted Stock is expected to generate earnings of $4.38 per share this year, and that the mean PE ratio for its industry is 27.195. Use the PE valuation method to determine the value of Olmsted shares.

Value = (Expected earnings of IBM per share) × (Mean industry P/E ratio) Value = $4.38 ´ 27.195 Value = $119.114

Value at Risk. Describe the value-at-risk method for measuring risk

Value at risk is a risk measurement that estimates the largest expected loss to a particular investment position for a specified confidence level. It is intended to warn investors about the potential maximum loss that could occur. If the investors are uncomfortable with the potential loss that could occur in a day or a week, they can revise their investment portfolio to make it less risky. The value at risk is also commonly used to measure the risk of a portfolio. Some stocks may be perceived to have high risk when assessed individually, but low risk when assessed as part of a portfolio. This is because the likelihood of a large loss in the portfolio is influenced by the probabilities of simultaneous losses in all of the component stocks for the period of concern.

market stocks tend to exhibit all of the following except

Very limited potential for high return

Which of the following is TRUE with respect to venture capital (VC) funds?

When a VC fund decides to invest in a business, it will negotiate the terms of its investment, including the amount of funds it is willing to invest VC funds receive money from wealthy investors and from pension funds that are willing to maintain the investment for a long-term period

Mortgage lenders with fixed-rate mortgages should benefit when interest rates decline, yet research has shown that this favorable impact is dampened. By what?

When interest rates decline, a large proportion of mortgages are refinanced. Therefore, the benefits to lenders that offer fixed-rate mortgages are limited.

Explain how the maturity on mortgage-backed securities can be affected by interest rate movements.

When interest rates rise, prepayments on mortgages don't occur because none of homeowners refinance with a new mortgage with a higher interest rate.

Oftentimes, a stock repurchase occurs if

a firm thinks its stock is undervalued. They will purchase the stock back from investors at a price below what the firm believes the actual price is. Consequently, many investors will see this as a sign that the shares are undervalued and begin purchasing more, driving the price up.

Collateralized mortgage obligations (CMOs) are generally perceived to have

a high degree of prepayment risk

The Dow Jones Industrial Average

a stock index that uses a price-weighted average of 30 large and popular U.S. firms' stocks. Some of the notable firms used in this index are Coca-Cola, IBM, Apple, Home Depot, Disney, and Nike

A private equity fund is

a type of private equity financing that typically invests money in businesses in exchange for a majority ownership in the company. Because they typically seek large stakes in the company (or sometimes even 100% ownership), private equity funds usually invest more money in a company than a venture capital fund would.

Crowdfunding

a type of private equity financing that typically invests money in businesses in exchange for either equity in the business or a tangible reward, such as the product that the company is producing. A common crowdfunding website is Kickstarter, which typically allows small-time investors to back the production of a new product in exchange for the product, special perks, and add-ons to the product.

Terms of a Venture Capital Deal

a. A VC fund will negotiate the terms of the deal when it decides to invest in a business b. The VC fund will set out requirements for the business and VC fund managers may serve as advisers to the business

Businesses valued at less than $50 million or so rarely go public. Explain the limitations to such businesses if they did go public.

a. A public offering of stock may be feasible only if the firm will have a large enough shareholder base to support an active secondary market. With an inactive secondary market, the shares would be illiquid. Investors who own shares and want to sell them would be forced to sell at a discount from the fundamental value, almost as if the firm were not publicly traded. This defeats the purpose of being public.

Explain how different factors affect a stock portfolio's volatility.

a. A stock portfolio has more volatility when its individual stock volatilities are high, other factors held constant. In addition, a stock portfolio has more volatility when its individual stock returns are highly correlated, other factors held constant. A stock portfolio containing some stocks with low or negative correlation will exhibit less volatility because the stocks will not experience peaks and troughs simultaneously. Some offsetting effects will occur, smoothing the returns of the portfolio over time

Explain how ADRs enable U.S. investors to become part owners of foreign companies.

a. American depository receipts (ADRs) are certificates that represent ownership of a foreign stock. They are traded in the United States. U.S. investors can purchase ADRs as a method of investing in foreign securities.

Assume that the expected inflation rate has just been revised upward by the market. Would the required return by investors who invest in the stocks be affected? Explain.

a. An increase in expected inflation can increase the risk-free interest rate, which is a key component of the required rate of return on stocks. Therefore, it should cause an increase in the required rate of return on stocks.

Private equity investments examples

a. Ana invests $100,000 of her own money in the business b. Ana gets a private equity fund to invest $600,000 in the business c. Ana gets venture capital fund to invest $5 million in the business d. Ana gets her father to invest $90,000 in the business e. Ana launches a crowdfunding campaign on Crowdfunder aimed at raising $2 million

Public equity investment examples

a. Ana issues preferred stock b. Ana issues common stock

Describe the January effect

a. Because many portfolio managers are evaluated over the calendar year, they tend to invest in riskier small stocks at the beginning of the year and shift to larger (more stable) companies near the end of the year to lock in their gains. This tendency places upward pressure on small stocks in January of every year, causing the so-called January effect.

Explain why beta serves as a measure of the stock's risk.

a. Beta serves as a measure of the stock's risk because it measures sensitivity to the market. The higher the sensitivity, the more likely that the stock will perform poorly under adverse market conditions.

Venture Capital Market

a. Brings together the private businesses that need equity funding and VC funds that can provide funding

Describe how collateralized mortgage obligations (CMOs) are used and why they have been popular.

a. Collateralized mortgage obligations (CMOs) are mortgage-backed securities that are segmented into classes representing the timing of payback of the principal. Investors can choose a class that fits their maturity preferences.

Choose the rights of common stockholder are not available to other individuals

a. Common stockholders are permitted to vote on key matters concerning the firm such as the election of the board of directors, authorization to issue new shares of common stock, approval of amendments to the corporate charter, and adoption of bylaws.

Choose the rights of common stockholders that are not available to other individuals.

a. Common stockholders are permitted to vote on key matters concerning the firm such as the election of the board of directors, authorization to issue new shares of common stock, approval of amendments to the corporate charter, and adoption of bylaws.

Dividend Yield. Over the last year, Calzone Corporation paid a quarterly dividend of $0.10 in each of the four quarters. The current stock price of Calzone Corporation is $39.78. What is the dividend yield for Calzone stock?

a. Dividend yield= (4*$0.10)/$39.78= 1.01%

· Limitations of the Dividend Discount Model

a. Errors can be made in determining the dividend to be paid, the growth rate, and the required rate of return b. Errors are more pronounced for firms that retain most of their earnings c. Pablo Fernandez research

Describe international ETFs, and explain how ETFs are exposed to exchange rate risk.

a. Exchange-traded funds are passive funds that track a specific index. By investing in an international exchange-traded fund, investors can invest in a specific index representing a foreign country's stock market. The ETFs are denominated in dollars. However, the net asset value of an international ETF is determined by translating the foreign currency value of the foreign securities into dollars. Thus, a weaker foreign currency will reduce the net asset value in dollars.

Distinguish between FHA and conventional mortgages.

a. FHA mortgages guarantee loan repayment, thereby covering against the possibility of default by the borrower. The guarantor is the Federal Housing Administration. Conventional mortgages are not federally insured, but they can be privately insured.

How do earnings surprises affect valuations of stocks?

a. Favorable earnings surprises increase the values of stocks. Negative earnings surprises decrease the values of stocks.

Why do firms engage in IPOs?

a. Firms engage in IPOs when they have feasible expansion plans but are already near their debt capacity.

Explain the use of a prospectus developed before an IPO.

a. Firms prefer to engage in IPOs when business conditions and market conditions are favorable. They avoid IPOs if business conditions are poor, because they do not need funds to expand if the business outlook is poor. Also, when business conditions are poor, the market conditions are weak, meaning that they would have to sell their shares at a low price.

What does it mean to "flip" shares?

a. Flipping shares refers to selling shares shortly after (such as a day or two) obtaining them at the IPO.

Explain why some public firms decided to go private in response to the passage of the Sarbanes-Oxley (SOX) Act.

a. For many firms, the cost of adhering to the guidelines of the act exceeds $1 million per year. Many small, publicly traded firms decided to revert back to private ownership as a result of the act. These firms perceived that they would have a higher value if they were private, rather than publicly held, because they could eliminate the substantial reporting costs required of publicly traded firms.

How are the interest rate, the required rate of return on a stock, and the valuation of a stock related?

a. Given a choice of risk-free Treasury securities or stocks, stocks should be purchased only if they are appropriately priced to reflect a sufficiently high expected return above the risk-free rate. b. The relation between interest rates and stock prices is not constant over time. However, most of the largest stock market declines have occurred in periods when interest rates increased substantially. Furthermore, the stock market's rise in the late 1990s is partially attributed to the low interest rates during that period, which encouraged investors to shift from debt securities (with low rates) to equity securities.

What type of homeowners would prefer this type of mortgage?

a. Homeowners whose incomes will rise over time may desire this type of a mortgage.

Explain (using intuition instead of math) why stock prices may increase in this situation even though the risk-free rate increases.

a. If the economic growth increases, there may be an increase in expected cash flows. This favorable effect can overwhelm the unfavorable effect of a rise in the discount rate used to discount cash flows.

short sales in the mortgage markets.

a. In a short sale transaction, the lender allows homeowners to sell the home for less than what is owed on the existing mortgage. The lender appraises the home and informs the homeowner of the price it is willing to accept on the home. Lenders involved in this program do not recover the full amount owed on the mortgage. However, they may minimize their losses because they do not have to go through the foreclosure process, and the homeowners reduce the potential damage to their credit report. Short sales serve as a reasonable compromise between homeowners and mortgage lenders.

How can investor sentiment affect stock prices?

a. Investor sentiment represents the general mood of investors in the stock market. Since the stock valuations reflect expectations, there are some periods in which the stock market performance is not highly correlated with existing economic conditions. For example, stock prices may rise when the economy is weak if most investors expect that the economy will improve in the near future.

Explain the use of the price-earnings (PE) ratio for valuing a stock.

a. Investors can value a stock by applying the industry PE ratio to the firm's expected earnings for the next year. This method implicitly assumes that the growth in earnings in future years will be similar to that of the industry.

Choose incentives for private equity funds to invest in a firm and improve its operations.

a. Managers of a private equity fund typically take a percentage of the profits they earn from their investments in return for managing the fund. They also charge an annual fee for managing the fund. If they were able to improve the business substantially while they managed it, they should be able to sell their stake to another firm for a much higher price than they paid for it. Alternatively, they may be able to take the business public through an initial public offering (IPO) and cash out at that time.

· Limitations of the PE Method

a. May result in an inaccurate valuation of a firm if errors are made in forecasting the firm's future earnings or in choosing the industry composite used to derive the PE ratio

Why are organized stock exchanges used?

a. Organized exchanges are used to facilitate secondary market transactions. They are not used to place newly issued stock.

What is the role of the securities firm that serves as the underwriter, and how can it ensure that the firm does not issue too much stock?

a. Securities firms distribute or place stock for corporations. They serve as intermediaries since corporations issuing stock typically do not have the expertise to place their own stock. They have experience to know how much stock can be digested by the market.

Why would investors want to flip shares?

a. Some institutional investors attempt to flip shares to take advantage of an initial return over the first day. IPO performance tends to be unusually high on the first day, followed by a downward drift. Some investors want to earn the initial return and then sell out. They may earn a very high return without tying their funds up for a long period of time.

Explain how stock volatility changed during the credit crisis.

a. Stock prices became much more volatile due to uncertainty about economic conditions. The prices of some stocks were frequently changing by more than 5 percent on a single day.

What are the risks of investing in stocks in emerging markets?

a. Stocks in emerging markets are more exposed to major government turnover and other forms of political risk. They also expose U.S. investors to a high degree of exchange rate risk because their local currencies are typically very volatile.

Which of these forms of efficiency is most difficult to test?

a. Strong-form of market efficiency is most difficult to test because the inside information used is not publicly available and cannot be properly tested

Explain subprime mortgages. Why were mortgage companies aggressively offering subprime mortgages?

a. Subprime mortgages were provided by mortgage companies to borrowers who would not have qualified for prime loans. Thus, these mortgages enabled more people with relatively lower income, or high existing debt, or a small down payment to purchase homes. Many financial institutions such as mortgage companies were willing to provide subprime loans because it allowed them a way to expand their business. In addition, they could charge higher fees (such as appraisal fees) and higher interest rates on the mortgage in order to compensate for the risk of default.

Performance of VC Funds

a. Tends to vary over time b. Funds can be invested more wisely when stock prices are low, for obvious reasons c. Also influenced by the amount of investment received by investors

Pink Sheets

a. The OTC market has where even smaller stocks are traded. Some of the stocks have very little trading volume and may not be traded at all for the several weeks.

· Relationship with PE Ratio for Valuing

a. The PE multiple is influenced by the required rate of return and expected growth rate of competitors

Use a stock valuation framework to explain why the Sarbanes-Oxley Act (SOX) could improve the valuation of a stock. Why might SOX cause a reduction in the valuation of a stock?

a. The Sarbanes-Oxley Act of 2002 was intended to improve the reporting of financial statements. It may allow firms to detect problems that they would not have recognized otherwise, so that they can increase their cash inflows. However, the costs of complying with SOX result in higher cash outflows.

Explain how to estimate the beta of a stock.

a. The beta of a stock can be estimated by obtaining returns of the firm and the stock market over the last 12 quarters and applying regression analysis to derive the slope coefficient as in this model: a. Some investors or analysts prefer to use monthly returns rather than quarterly returns to estimate the beta. The choice is dependent on the holding period for which one wants to assess sensitivity. If the goal is to assess sensitivity to monthly returns, then monthly data would be more appropriate. b. The regression analysis estimates the intercept (B0) and the slope coefficient (B1), which serves as the estimate of beta.

Why is bookbuilding sometimes criticized as a means of setting the offer price?

a. The bookbuilding process used in the United States is sometimes criticized because it dictates an offer price that is lower than what some institutional investors would pay.

What are some limitations of the dividend discount model?

a. The dividend discount model may result in an inaccurate valuation of a firm because of potential errors in determining the dividend to be paid over the next year, or the growth rate, or the required rate of return by investors. The limitations of this model are more pronounced when valuing firms that retain most of their earnings rather than distribute them as dividends, because the model relies on the dividend as the base for applying the growth rate. For example, many Internet-related stocks retain any earnings to support growth and thus are not expected to pay any dividends.

Would the effect be different for a firm that relied more heavily on VC firms than other investors for its funds?

a. The downward pressure might be especially pronounced for firms that received a proportionately large amount of funding from VC firms before they went public.

From an investor's viewpoint, how do you think the information used to price stocks changes in response to accounting irregularities?

a. The existence of accounting irregularities probably results in closer scrutiny of financial statements for investors. Furthermore, investors will probably seek additional sources of information and opinions in addition to the firm's financial statements as part of their decision-making process.

Why can expectations of an acquisition affect the value of the target's stock?

a. The expected acquisition of a firm typically results in an increased demand for the target's stock and therefore raises the stock price. Investors recognize that the target's stock price will be bid up once the acquiring firm attempts to acquire the target's stock.

Why does a firm do a road show before its IPO?

a. The firm does a road show to promote its offering. That is, it explains to various institutional investors how it will use the funds to support its expansion. The goal of the road show is to convince some large investors to invest in the shares of the firm.

Explain how economic growth affects the valuation of a stock.

a. The firm's value should reflect the present value of its future cash flows. Because earnings are a primary component of corporate cash flows, many investors use forecasted earnings to determine whether a firm's stock is over- or undervalued. An increase in economic growth is expected to increase the demand for products and services produced by firms and thereby increase a firm's cash flows and valuation.

What is the meaning of an initial return for an IPO?

a. The initial return is the return from the offer price until the end of the first day of trading

Describe the process of bookbuilding.

a. The lead underwriter engages in bookbuilding by soliciting indications of interest in the IPO by institutional investors, so as to determine demand.

Describe a lockup provision and explain why it is required by the lead underwriter.

a. The lockup provision restricts insiders and venture capital firms from selling their shares until a specified period (usually 6 months) after the IPO. Once the lockup provision expires, the insiders and venture capital firms can sell the shares that they own, which sometimes places downward pressure on the price of the stock at that time.

What factors influence the offer price of stock at the time of the IPO?

a. The offer price is influenced by market conditions, industry conditions, and the prevailing market multiples (such as price/earnings ratio). Firms prefer to engage in an IPO when market conditions allow for a high offer price.

Explain how underwriters use the overallotment option in IPOs.

a. The overallotment option gives the lead underwriter the right to purchase extra shares from the issuing firm at the IPO offer price. A lead underwriter who has an overallotment option issues the additional shares to investors at the offer price, so it does not gain or lose from issuing these shares, but earns a commission on the extra shares that are sold. If the market price of the stock declines below the offer price, the lead underwriter purchases all or a portion of the extra shares at a lower price than the offer price in which it initially sold those shares. The underwriter's actions can stabilize the stock price.

At the time a management group of RJR Nabisco initially considered engaging in a leveraged buyout, RJR's stock price was less than $70 per share. Ultimately, RJR was acquired by the firm Kohlberg, Kravis, and Roberts (KKR) for about $108 per share. Does the large discrepancy between the stock price before an acquisition was considered versus after the acquisition mean that RJR's price was initially undervalued? If so, does this imply that the market was inefficient?

a. The stock price may have been appropriate under the conditions of unchanged management. However, when management is changed in a manner that will reduce the waste and improve cash flows, the firm's value increases, and investors revalue the stock higher. Thus, the market could still be efficient even though there was a discrepancy in price.

What are some possible disadvantages to investors who invest in stocks listed on a private stock market?

a. The trading volume in a private stock market is very limited. With such limited participation by investors, it is difficult to determine the appropriate market price. Investors need to register with the private stock exchange, and prove that they have sufficient income (such as about $200,000 per year) and sufficient net worth (such as at least $1 million). There is limited transparency because the required disclosure of information by private firms listed on private stock exchanges may be less than what is required when firms go public. Firms are required to have their financial statements audited when their shares are publicly-traded.

What is the amount of fees that the lead underwriter and its syndicate charge a firm that is going public?

a. The transaction cost (fees) is normally about 7 percent of the gross proceeds received by the issuing firm.

Explain the difference between weak-form, semistrong-form, and strong-form efficiency.

a. The weak-form suggests that security prices reflect recent price movements and trading information. The semistrong-form suggests that security prices reflect all publicly traded information. The strong-form suggests that security prices reflect public and private information.

What are some possible disadvantages to investors who invest in stocks listed on a private stock market?

a. There is limited transparency because the required disclosure of information by private firms listed on private stock exchanges may be less than what is required when firms go public. Firms are required to have their financial statements audited when their shares are publicly-traded. The trading volume in a private stock market is very limited. With such limited participation by investors, it is difficult to determine the appropriate market price.

Exit Strategy of VC Funds

a. VC funds typically plan to exit in 4 to 7 years by selling the equity stake to the public. At 30-50% per year gain

Describe the value-at-risk method for measuring risk.

a. Value at risk is a risk measurement that estimates the largest expected loss to a particular investment position for a specified confidence level. It is intended to warn investors about the potential maximum loss that could occur. If the investors are uncomfortable with the potential loss that could occur in a day or a week, they can revise their investment portfolio to make it less risky. b. The value at risk is also commonly used to measure the risk of a portfolio. Some stocks may be perceived to have high risk when assessed individually, but low risk when assessed as part of a portfolio. This is because the likelihood of a large loss in the portfolio is influenced by the probabilities of simultaneous losses in all of the component stocks for the period of concern.

Explain how to test weak-form efficiency in the stock market.

a. Weak-form efficiency can be tested by searching for a nonrandom pattern in stock prices. If future price movements can be predicted by assessing the past movements, a market inefficiency is detected.

Which is most likely to be refuted?

a. Weak-form of market efficiency is most likely to be refuted.

Explain (using intuition instead of math) why stock prices may decrease in response to a higher risk-free rate according to the CAPM.

a. When the risk-free rate rises, the required rate of return rises, and therefore expected cash flows generated by the stock are discounted at a higher discount rate, which results in a lower value.

Explain how mortgage lenders can be affected by interest rate movements. Also explain how they can insulate against interest rate movements.

a. mortgage lenders that provide fixed-rate mortgages could be adversely affected by rising interest rates, because their cost of financing the mortgages would increase while the interest revenues received on mortgages is unchanged. The lenders could reduce their exposure to interest rate risk by offering adjustable-rate mortgages, so that the revenues received from mortgages could change in the same direction as the cost of financing as interest rates change.

Explain why the stock price of a firm may rise when the firm announces that it is repurchasing its shares.

a. stock repurchases may signal that the firm's managers believe the stock is undervalued, so the investors may purchase the stock based on this signal, and that places upward pressure on the stock price.

Denton Co. plans to engage in an IPO and will issue 4 million shares of stock. It is hoping to sell the shares for an offer price of $14. It hires a securities firm, which suggests that the offer price for the stock be $12 per share to ensure that all the shares can be easily sold. What is the advantage of following the advice of the securities firm? What is the disadvantage?

a. the advantage is that Denton Co. wants to have a successful offering in which it can sell all of its shares, and it wants investors to believe that they made a good investment. This could help Denton engage in a secondary offering at some point in the future when it needs to raise more funds. b. The disadvantage of using an offer price of $12 instead of $14 is that Denton gives up $2 per share, and therefore may receive $8 million less in proceeds from selling the stock.

Describe the dividend discount valuation model.

a. the dividend discount valuation model measures the value of a firm as the present value of future expected dividends to be received by the investor. The model can account for uncertainty by allowing dividends to be revised in response to revised expectations about a firm's cash flows, or by allowing the required rate of return to be revised in response to changes in the required rate of return by investors.

Designated market makers

act as an intermediary between the firm associated with a particular stock and the brokers. Oftentimes, they provide valuable details to the brokers that help maintain fair and orderly markets.

how does the initial rate on adjustable rate mortgages (ARMs) differ from the rate on fixed-rate mortgages? Why?

an adjustable rate mortgage typically offers a lower initial rate than a fixed-rate mortgage to compensate borrowers for incurring the interest rate risk.

A poison pill provision is

an anti-takeover strategy that is intended to make it more expensive and difficult for an acquiring firm to purchase a target firm

An antitakeover amendment is

an anti-takeover strategy that is intended to make it more expensive and difficult for an acquiring firm to purchase a target firm

A golden parachute provision is

an anti-takeover strategy that is intended to make it more expensive and difficult for an acquiring firm to purchase a target firm. A golden parachute provision acts as protection for managers against decisions that may harm a firm's stock price in the short run but that are intended to maximize shareholder value in the long run. Without this provision, managers may be tempted to make decisions that boost a firm's stock price (making it appear like the firm is successful), while not taking into account the long-term health of the firm. By giving managers golden parachutes like the right to receive shares if the firm is taken over, they effectively dilute the percentage holding of the takeover investor and increase the cost of acquiring the target firm

Purchasing shares in an international mutual fund allows

an investor to purchase a variety of international stocks across several different countries or within a single country. Oftentimes, investors do this if they want to diversify risk and are taking things like exchange rate fluctuations into account.

Purchasing shares in an exchange-traded fund (ETF) allows

an investor to tie their returns to the performance of a specific foreign stock market. For instance, if an investor expects the Nikkei 225 stock index (a Japanese index) to perform well in the future, then they might purchase shares in an ETF that follows the Nikkei 225.

Securities firms usually employ

analysts to monitor and rate publicly traded firms' stocks. These analysts can be very valuable to current and potential investors, because they shed light on the current state of the company. There have been instances, however, when analysts have been known to overrate a firm due to a conflict of interest between the analyst and the firm they are analyzing. In many cases, the analyst's employer also provides advisory services to the firms they rate, which puts them in an awkward position. If they rate the firm lower than the firm believes it should be rated, then the firm may shy away from hiring the securities firm for other services. As a result, analysts might feel pressured into giving the firms higher ratings than they should be given.

Dividend Yield

annual dividend per share as a percentage of the stock's prevailing price. Shown next to the annual dividend

An antitakeover amendment requires

approval from at least two-thirds of the voting shareholders before the firm can be acquired. It is used to protect shareholders from an acquisition that would reduce the value of their investment. It's possible that the majority of shareholders feel that the takeover would increase the value of their investment, in which case, they would vote in favor of the acquisition.

Floor brokers

are either commission brokers or independent brokers

Commission brokers

are employed by a brokerage firm to execute, buy, and sell orders for clients

Independent brokers

are not employed by a specific firm and use their own accounts to execute, buy, and sell orders for clients

Emergency Economic Stabilization Act of 2008

authorized the Treasury to supply banks with cash though the purchase of distressed assets including mortgage-backed securities · On October3, 2008, the Emergency Economic Stabilization Act of 2008 (also referred to as the bailout act) enabled the Treasury to inject $700 billion into the financial system and improve the liquidity of financial institutions with MBS holdings · The act also allowed the Treasury to invest in the large commercial banks as a means of providing the banks with capital to cushion their losses

The required rate of return on a mortgage, k, is determined

by the prevailing risk-free rate, Rf, and the credit risk premium, RP. Since movements in mortgage prices are associated with changes in an investor's required rate of return and investor's required rates of return are determined by the prevailing risk-free rate and the credit risk premium, the general price movement of bonds can be modeled as follows: ΔPb=f(Δk)=f(ΔRf,ΔRP)

An American depository receipt (ADR) is something that

can be purchased on a U.S. stock exchange that represents stock in a firm. Typically, ADRs are purchased by investors when they want to have ownership in a foreign firm that is not publicly traded on a U.S. stock exchange. Usually, a broker will buy the shares trading on the foreign firm's domestic exchange and put them in a bank. The broker then uses a separate bank to create receipts, based on the shares, that are then traded on a U.S. exchange or OTC market. This is a way for an investor to indirectly purchase stock in a foreign firm.

Specialists

can match orders of buyers and sellers

Asking for a lower market price than the bookbuilding analysis suggests can

cause a shortage of shares being offered, placing upward pressure on prices. This is not a strategy that an underwriter would use to prevent prices from dropping.

American Depository Receipts

certificates representing shares of non-U.S. stock. Many non-U.S. companies establish ADRs in order to develop name recognition in the United States

If a firm's shareholders are dissatisfied with the way that management is running the firm, they could

choose to wait out the decisions, hold onto their shares, and see whether they were wrong about management's decision making. If they want to be more active about changing the direction of the company, there's a few things they could do: (1) sell their stock in the company if they believe management's decisions are ultimately going to reduce the value of the stocks, (2) communicate their concerns to other shareholders in an attempt to get a large enough team of advocates together to pressure board members into changing the direction that the company is going in, (3) participate in proxy contests to remove and replace members of the firm's board of directors with members that have ideas that better align with the shareholder's vision, or (4) sue the board of directors for not putting the interest of the shareholders above all else.

two main types of stock that investors can purchase when looking to invest in a public company

common stock, preferred stock

If a firm's shareholders are dissatisfied with the way that management is running the firm, they

could always choose to wait out the decisions, hold onto their shares, and see whether they were wrong about management's decision making. If they want to be more active about changing the direction of the company, there's a few things they could do: (1) sell their stock in the company if they believe management's decisions are ultimately going to reduce the value of the stocks, (2) communicate their concerns to other shareholders in an attempt to get a large enough team of advocates together to pressure board members into changing the direction that the company is going in, (3) participate in proxy contests to remove and replace members of the firm's board of directors with members that have ideas that better align with the shareholder's vision, or (4) sue the board of directors for not putting the interest of the shareholders above all else.

If an investment bank is trying to sell mortgage-backed securities but is unable to get pension and hedge fund managers to invest in the 8% yield securities, then they can

create collateralized mortgage obligations (CMOs) or collateralized debt obligations (CODs) to segment the original MBSs into securities that better fit the needs of their targeted investors. In this case, pension fund managers are looking for the safest and highest-rated securities regardless of the yield, and hedge fund managers are looking for high-risk, high-yield securities.

Capital Asset Pricing Model (CAPM)

estimate the required rate of return of an firm with publicly traded. Rj=Rf+Bj(Rm-Rf) Suggests that the return of a stock (Rj) is influenced by the prevailing risk-free rate (Rr), the market return (Rm), and the beta (Bj):

An institution that originates and holds a fixed-rate mortgage is adversely affected by ____ interest rates; the borrower who was provided the mortgage is adversely affected by ___ interest rates.

increasing; decreasing

Direct Purchases

investors can easily invest in stocks of foreign companies that are listed on the local stock exchanges

Shareholder Lawsuits

investors may sue the board if they believe that the directors are not fulfilling their responsibilities to shareholders

Flipping occurs when

investors recognize unusually high returns in an IPO and attempt to purchase stock at the offer price with the intention of selling the stock in the near future to capitalize on the price increase. The way that an underwriter can prevent this is by agreeing to make more shares of future IPOs available to investors that hold on to the initial shares for a relatively long period of time. Additionally, they can include a lockout clause in the underwriting agreement, which is explained next.

Private equity

is a business that is privately held and the owners cannot sell their shares to the public.

A graduated-payment mortgage

is the type of mortgage that allows borrowers to make small payments at the beginning of the mortgage's life and larger payments that eventually level off over the life of the loan. This type of mortgage is attractive to borrowers who expect their incomes to increase over time and who want to make small payments at the beginning of the loan and larger payments that will level off at a certain amount in the future. A good example of this is first-time home owners who have just gotten their first job out of college and want to make small mortgage payments early on and larger payments as they begin to receive raises and promotions at work.

A shared-appreciation mortgage

is the type of mortgage that has an interest rate below the market rate and where the lender receives a portion of any increase in the home value over the life of the loan. This type of mortgage is attractive to borrowers like a house flipper (someone who buys rundown houses and restores them for a profit in a matter of months) because they can get a loan at a lower interest rate than other types of mortgages and may not mind giving a portion of their profits to the lender in exchange for that lower rate.

A second mortgage

is the type of mortgage that is given out when there is already a mortgage on a home, and it typically has a higher interest rate than the initial mortgage. A second mortgage is considered to be "second" in priority. It has a higher interest rate not just because it was taken out after the first one, but it gets paid only after the first one is paid if there is not enough money for both to be paid. This type of mortgage is attractive to borrowers who need substantial financing for something like home renovation projects (remodeling a kitchen, bathrooms, a basement, or making an addition to the home).

A balloon-payment mortgage

is the type of mortgage that requires the borrower to make only interest payments for a few years and then one large principal payment (for the value of the loan) after that time period. This type of mortgage is attractive to borrowers like a company that needs financing to build a manufacturing facility, wants a low interest rate, and plans to use the profits from manufacturing at the new facility to pay the loan off with one large payment in just a few years.

Securities that are rated very highly have

little default risk associated with them, while securities that are rated very lowly have much more default risk associated with them. As is true with various types of insurance, securities that are unlikely to default cost less to insure, while securities that have a higher potential to default cost more to insure.

An individual's income and debt level are typically measured using a debt-to-income ratio, which looks at their

monthly debt obligations as compared to their monthly income. An individual who has a low debt-to-equity ratio is seen as having a lower risk of defaulting on their loan than an individual who has a high debt-to-equity ratio. Typically, a mortgage lender will not provide a loan to a borrower who has a debt-to-income ratio that exceeds 43 percent. This means that a borrower whose monthly debt obligations exceed 43 percent of their monthly income will likely not be given a loan because they are seen as having too high a risk of defaulting on their loan. Of the three home buyers, Nick has the lowest debt-to-equity ratio, so he is seen as having the strongest application from an income and debt level standpoint. On the opposite end of the spectrum, Tim has the highest debt-to-equity ratio, so he is seen as having the weakest application from an income and debt level standpoint. Rosa has a debt-to-equity ratio that is in between the other two borrowers', so she is seen as having neither the strongest nor the weakest application from an income and debt level standpoint.

An adjustable-rate mortgage

mortgage is the type of mortgage that modifies the borrower's interest rate over the life of the mortgage. The loan interest rate fluctuates periodically to keep up with the current market rate and does not stay constant over time (unless the market rate does not change). Borrowers might choose this type of loan if they believe interest rates will decrease substantially over the life of the loan. If they are locked in at, say, 7 percent, and they anticipate interest rates will fall to 4 percent over the life of the loan, then they would be paying interest on their loan that is much lower than their initial rate once interest rates decrease.

Charging excessive commission

occurs when a broker charges a higher-than-usual fee (or commission) to sell highly demanded IPO shares to an investor. Oftentimes, investors don't mind the higher fee, because they will more than make up with the return on the shares once the price increases.

Laddering

occurs when an underwriter encourages investors to place first-day bids for IPO shares that are above the offer price in exchange for reserving highly demanded IPO shares for them in the future. Usually investors don't mind paying higher than market price for the shares because they will make up the difference with the return they get on the future shares.

Distorting financial statements

occurs when an underwriter knows that a firm has weak internal controls (and thus inaccurate financial statements) and engages its IPO at an offer price that is well above what it should be. The firm brings in more funding than it should have been able to by misleading the investors (something that the SEC tries to prevent prior to the engagement of the IPO).

Spinning

occurs when an underwriter offers shares from an IPO to an investor for a favor in the future. They might offer this type of deal to (1) a business requiring assistance from a securities firm or (2) corporate executives from a third-party firm who have indicated that they may purchase shares from a different IPO.

Credit Unions and Finance Companies

originate mortgages by working with borrowers to create loan where the real estate or property is used as collateral for the loan Maintain mortgage-backed securities in their investment portfolios

International Mutual Funds

portfolios of international stocks created and managed by various financial institutions

A lockout clause in the underwriting agreement of the IPO allows them to

prevent the original owners of the firm from selling their shares for a specified time period, preventing them from selling their shares right after the IPO, causing a price drop.

An individual's credit score is typically measured by several different criteria, including

previous credit payment history, their balance-to-limit ratio on credit cards, their length of credit history, their recent credit activity, etc. An individual with a high credit score is seen as having a lower risk of defaulting on their loan than an individual with a low credit score. Of the three home buyers, Nick has the highest credit score, so he is seen as having the strongest application from a credit score standpoint. On the opposite end of the spectrum, Tim has the lowest credit score, so he is seen as having the weakest application from a credit score standpoint. Rosa has a credit score that is in between the other two borrowers' scores, so she is seen as having neither the strongest nor the weakest application from a credit score standpoint.

A venture capital fund is a type of

private equity financing that typically invests money in businesses in exchange for a minority ownership in the company. In addition, sometimes venture capitalists will ask for seats on advisory boards in order to ensure that the company is moving in the right direction. A venture capital fund will typically exit from its original investment within four to seven years, after the business has opened up a round of financing to the public via a public stock offering.

Federal National Mortgage Association (Fannie Mae) mortgage-backed securities and Federal Home Loan Mortgage Association (Freddie Mac) participation certificates are

securities that are issued to financial institutions where the funds are used to increase liquidity in the secondary mortgage market by financing the origination of mortgages.

Government National Mortgage Association (Ginnie Mae) mortgage-backed securities

securities that guarantee timely interest and principal payments are made for moderate- to low-income, single-family home mortgages, issued by the FHA and VA. Ginne Mae mortgage-backed securities only back mortgages issued by government agencies and do not back conventional loans (as private-label pass-through securities do).

If you are deciding between security A, a security that is rated as being the highest quality, and security B, a security that is rated as being the lowest quality, then

security B has a higher risk associated with it and, consequently, will be more expensive to insure with a CDS. This means that security A will cost less to insure.

An overallotment clause in the underwriting agreement of the IPO allows them to

sell an additional percentage of the firm's shares for up to 30 days after the IPO has finished, which is a strategy that an underwriter can use if the firm thinks they could use additional money but is afraid that issuing too many shares will cause a price drop.

Under a poison pill provision

shareholders of the target firm have the right to purchase additional shares of the firm if a shareholder purchases a certain percentage of the firm's shares. The shareholder that acquires the triggering purchase percentage is generally perceived to be a takeover investor. By allowing the shareholders to purchase additional shares, they effectively dilute the percentage holding of the takeover investor and increase the cost of acquiring the target firm.

The ____ index can be used to measure risk-adjusted performance of a stock while controlling or the stock's volatility.

sharpe

Amortization schedule

shows the monthly payment broken down into principal and interest

Examples of organized stock exchanges are

the New York Stock Exchange (NYSE) and the National Association of Securities Dealers Association (Nasdaq), while examples of over-the-counter markets are OTCQB, OTCQX, and Pink. Organized stock exchanges are made up of firms that have had their financials highly vetted by the SEC, while firms in OTC markets do not face the same amount of scrutiny.

credit risk

the risk that borrower will make a late payment or will default

Prepayment risk

the risk that the borrower will prepay the mortgage when interest rates fall

Interest rate risk

the risk that value of mortgage will fall when interest rates rise

A growing-equity mortgage

the type of mortgage that allows borrowers to make small payments at the beginning of the mortgage's life and larger payments that continue to grow over the life of the loan. This type of mortgage is attractive to borrowers who expect their incomes to increase over time, want to make small payments at the beginning of the loan, and want to pay off the loan on an expedited schedule.

If an investor simply wants to purchase foreign stock on a local U.S. stock exchange, then

they first need to look to see whether shares of the foreign firm are traded on a U.S. stock exchange. If they are, then the investor can purchase them directly from the exchange.

The Composite Index

uses a price average of all stocks traded on the NYSE

The Wilshire 5000 Total Market Index

uses a price-weighted average of approximately 3,500 U.S. firms' stocks. Some of the notable firms used in this index are American Airlines, Aflac, Clorox, and American Eagle Outfitters.

The Standard and Poor's 500

uses a value-weighted average of 500 of the largest U.S. firms' stocks. Some of the notable firms used in this index are Microsoft, Apple, Amazon, and Facebook.

An initial public offering occurs when a firm

wants to go public and sell shares for the first time. This is usually done when firms need to foster growth or support expansion (similar to a secondary stock offering)

The Securitization Process

· A financial institution such as a securities firm or commercial bank combine individual mortgages together into packages · The issuer of the MBS assigns a trustee to hold the mortgages as collateral for the investors who purchase the securities · After the securities are sold, the financial institution that issued the MBS receives interest and principal payments on the mortgages and then transfers (passes through) the payments to investors that purchased the securities

Private label pass-through securities

· Backed by conventional rather than FHA or VA mortgages · Insured through private insurance companies

ARMs from the Financial Institution's Perspective

· Because the interest rate of ARM moves with prevailing interest rates, financial institutions can stabilize their profit margin · If market interest rates move outside given boundaries, the profit margin are ARMs could be affected

Cost of Being Public

· Establishing a process that satisfies the Sarbanes-Oxley provisions can be very costly. For many firms, the cost of adhering to the guidelines of the act exceeds $1 million per year

Flipping Shares

· Investors flip shares by buying the stock at its offer price and selling the stock shortly afterward. (legal) · If many institutional investors flip their shares, the market price of the stock may decline shortly after the IPO

Fixed-rate mortgages

· Locks in the borrower's interest rate over the life of the mortgage · A financial institution that holds fixed-rate mortgages is exposed to interest rate risk because it commonly uses funds obtained from short-term customer deposits to make long-term mortgages · Borrowers with fixed-rate mortgages do not suffer from rising rates, but they do not benefit from declining rates

Who is to Blame?

· Mortgage Originators a. Some mortgage originators were aggressively seeking new business without exercising adequate control over quality · Credit rating agencies a. The rating agencies, which are paid by the issuers that want their MBS rated, were criticized for being too lenient in their rating shortly before the credit crisis · Financial Institutions that packaged MBS a. Could have verified the credit ratings assigned by the credit rating agencies by making their own assessment of the risks involved · Institutional investors that purchased MBS a. Relied heavily on the rating assigned to MBS by credit rating agencies without the due diligence of performing their own independent assessment · Financial institutions that insured MBS a. Presumed, incorrectly, that the MBS would not default · Speculators of Credit Default Swaps a. Many buyers of CDS contracts on MNS were not holding any mortgages of MBS that they needed to hedge · Conclusion about blame= the question of who is to blame will be argued in courtrooms

Systemic Risk Due to the Credit Crisis

· Mortgage insurers that provided insurance to homeowners incurred larger expenses · Some financial institutions with larger investments in MBS were no longer able to access sufficient funds to support their operations during the credit crisis · Individual investors whose investments were pooled (by mutual funds, hedge funds, and pension funds) and then used to purchase MBS experienced losses · International Systemic Risk Financial institutions in other countries (e.g., the United Kingdom) had offered subprime loans, and they also experienced high delinquency and default rakes

Collateralized Mortgage Obligations (CMOs)

· Mortgages are segmented into tranches (classes), according to their maturity, and the cash flows provided by each tranche are typically structured in a sequential manner · Any repaid principal is initially sent to owners of the first tranche until the total principal amount is fully repaid. Then, principal is paid to the second tranche. This process continues until principal payments are made to owners of the last-tranche CMOs. Issues of CMOs typically have from three to ten tranches · Sometimes segmented into interest-only (IO) and principal-only (PO) tranches · Some mortgages are also sold through a collateralized debt obligation (CDO), which is a package of debt securities backed by collateral that is sold to investors

How Mortgage Markets Facilitate the Flow of Funds

· Mortgages originators obtain their funding from household deposits and by selling some of the mortgages that they originate directly to institutional investors in the secondary market · These funds are then used to finance more purchases of homes, condominiums, and commercial property · Mortgage markets allow households and corporations to increase their purchases of homes, condominiums, and commercial property and finance economic growth

Lockup

· Prevents the original owners of the firm and the VC firms from selling their shares for a specified period · Prevents downward pressure that could occur if the original owners or VC firms immediately sold their share in the secondary market

Preferred Stock

· Represents an equity interest in a firm that usually does not allow for significant voting rights a. Preferred shareholders share the ownership of the firm with common shareholders and are therefore compensated only when earnings have been generated b. A cumulative provision on most preferred stock prevents dividends from being paid on common stock until all preferred stock dividends have been paid c. Because the dividends on preferred stock can be omitted, a firm assumes less risk when issuing it than when issuing bonds d. Dividends are not tax-deductible for the firm, making preferred stock less-desirable than bonds

Volume

· Stock quotations also usually include the volume of shares traded on the previous day. The volume is normally quoted in hundreds of shares[F1] [F1]Look at stocks that have 10-15 thousand trades a day

Closing Price Quotations

· Stock quotations show the closing price ("Last") on the day (on the previous day if the quotations are in a newspaper). In addition, the change in the price ("Net Chg") is typically provided and indicates the increase or decrease in the stock price from the closing price on the day before

FHLMC (Freddie Mae) Participation Certificates

· The Federal Home Loan Mortgage Association was chartered as a corporation in 1970 to ensure that sufficient funds flow into the mortgage market · Sells participation certificates and uses the proceeds to finance the origination of conventional mortgages from financial institutions · Fannie Mae and Freddie Mae enhance liquidity in the mortgage market

FNMA (Fannie Mae) Mortgage-backed Securities

· The Federal National Mortgage Association was created in 1938 to develop a more liquid secondary market for mortgages · Channels funds from institutional investors to financial institutions that desire to sell their mortgages

GNMA (Ginnie Mae) mortgage-backed securities

· The Government National Mortgage Association (called GNMA, or Ginnie Mae) was created in 1968 as a corporation that is wholly owned by the federal government · Guarantees timely payment of principal and interest to investors who purchase securities backed by FHA and VA mortgages

New York Stock Exchange Indexes—

· The composite Index is the average of all stock traded on the NYSE, NYSE also provides indexes for four sectors: 1. Industrial 2. Transportation 3. Utility 4. Financial

Adjusted Dividend Discount Model

· The dividend discount model can be adapted to assess the value of any firm, even those that retain most or all of their earnings a. The value of the stock is equal to the present value of the future dividends plus the present value of the forecasted stock price · Limitations of the Adjusted Dividend Discount Model: may be inaccurate if errors are made in: a. Deriving the present value of dividends over the investment horizon or b. The present value of the forecasted price at which the stock can be sold at the end of the investment horizon

Securitization:

· The pooling and repackaging of loans into securities · Securities are then sold to investors, who become the owners of the loans represented by those securities

Standard & Poor's 500—

· a value weighted index of stock prices of 500 large U.S. firms

If a firm has already gone public but determines that it now needs additional funding to support new growth or expansion of the business, it might

· conduct a secondary stock offering. A secondary stock offering is a new stock offering from a company that is already publicly traded and is trying to raise capital, usually to foster the growth of the company or to support its expansion.

A firm will create a shelf registration if it thinks it might need

· funding within the next two years and doesn't want a time lag between when it determines it wants to issue stock and when the stock is actually issued. Because of the amount of time it takes the SEC to review and approve financial records, a shelf registration can help a firm quickly raise capital by having the SEC pre-approve their financials.

Wilshire 5000 total Market Index

· index now contains less than 5000 stocks, just under 3500. The Wilshire 5000 is the broadest index of the U.S. stock market

Nasdaq Stock Indexes

· the National Association of Securities Dealers (NASD) provides quotations on the indexes of stocks traded on the Nasdaq

Dow Jones Industrial Average

· value weighted average of stock prices of 30 large U.S. firms

If there is a change in one of these factors that affects a firm's cash flows, then it will also affect the valuation of a firm's stock, because cash flows are used in that valuation. There are several reasons why these factors might lead to a decrease in stock prices

• An expected increase in GDP over the next few months is a direct indication that firm production is expected to increase over the next few months. This means that firm cash flows should be expected to increase, resulting in an increase in stock valuations. • An announcement from the government stating there is going to be a decrease in the tax rate in the coming months means that consumers' disposable incomes will increase in the coming months. As a result, they will consume (and save) more, resulting in an increase in gross domestic product. Consequently, there will be an increase in firm cash flows, which results in an increase in stock valuations. • An appreciating dollar causes foreign goods to become relatively cheaper than domestic goods. As a result, it now becomes cheaper to import goods than it does to export them. Consequently, importing firms will benefit from the exchange rate change, while exporting firms will be negatively impacted by the change. The result is an increase in stock valuation for importing firms, but a decrease in valuation for exporting firms. • A firm that announces a dividend increase over the next few quarters thinks that they will have the available free cash flows to cover that increase. As a result, their stock valuation should be expected to increase. • A firm that is expected to be the target of an acquisition by another company usually results in an increased demand for the target firm's stock, which in turn places upward pressure on its stock price.