Investments Final
Identify and briefly describe the 5 types of risk to which bonds are exposed. What is the most important source of risk for bonds in general? Explain.
-Interest rate risk: This affects the market as a whole and therefore translates into market risk. When market interest rates rise, bond prices fall, and vice versa. -Purchasing power risk: this is caused by inflation. When price increases, bond yields lag behind inflation rates. -Business/financial risk: Also known as default risk, this refers to the risk that the issuer will default on principal payments. Business risk is related to the quality and integrity of the issuer, whereas financial risk relates to the amount of the issuer's leverage. -Liquidity risk: This is the risk that a bond will be difficult to sell if the investor wishes to do so. -Call risk: This refers to the risk that a bond will be retired before its scheduled maturity date. The most important source of risk for bonds in general is interest rate risk. It is the major cause of price volatility in the bond market. As interest rates become more volatile, so do bond prices.
Briefly describe each of the following types of bonds: treasury bonds, agency issues, municipal securities, corporate bonds. Note some of the major advantages and disadvantages of each.
-Treasury bonds are debt securities issued by the U.S. government to meet the needs of the federal budget. Advantages: low default risk, exempt from state and local taxes. Disadvantages: long maturities, low yield due to low risk -Agency bonds are debt securities issued by various agencies and organizations of the U.S. government like, Sallie Mae. Advantages: low risk, some pay interest monthly, exempt from state and local taxes. Disadvantages: low yield due to low risk -Municipal bonds are debt securities issued by states, counties, cities, and other political subdivisions like school,water, sewer districts. Advantages: Interest on most municipals is exempt from federal income tax and usually the state or local tax of the issuing government body. Disadvantages: Low yield for individuals in low tax brackets, require large capital investment (5,000). -Corporate bonds are debt securities issued by corporations. Advantages: Wide variety of issues, relatively attractive yields. Disadvantages: Higher risk than government-backed bonds, long life to maturity.
differentiate among market orders, limit orders, and stop-loss orders.
A limit order is an order to buy stock at or below or to sell stock at or above a specified price.
What are the advantages and disadvantages of mutual fund ownership?
A mutual fund is a financial service company that pool investor money together and invests in a diversified portfolio of securities.The major advantage of mutual funds is that they provide diversification and full-time professional management. Investors with modest amounts of capital can invest in mutual funds and receive the advantages of these services. Also, mutual funds may offer several attractive services like monthly withdrawal plans, automatic reinvestment of dividends. The disadvantages of mutual funds are the funds can be quite expensive to acquire if they are load funds, or they may have other types of charges and fees.
What is a stock split?
A stock split occurs when a company increases the number of shares outstanding by exchanging a specified number of new shares for each outstanding share of stock.
Define and briefly discuss the investment merits of each of the following: blue chips, income stocks, mid-cap stocks, american depository receipts, IPOs, tech stocks
A. blue chips- are common stocks of very high quality that have a long and proven record of earnings and dividends. They offer respectable dividend yields and modest growth potential. They are often viewed as long-term investments, have low risks, and provide modest but dependable rates of return b. income stocks- are issues that have a long and sustained record of higher than average dividends. These are ideal for investors who desire high current income with little risk. Unlike other types of income securities (bonds, for instance), holders of income stocks can expect the amount of dividends they receive to increase regularly over time. One disadvantage with these stocks is their generally low to modest growth potential. In recent years interest rates have remained extremely low so that many stocks have dividend yields exceeding the return on high-quality debt instruments. c. mid-cap stocks- are stocks with capitalization value between $1 billion and $4-$5 billion. Mid-caps offer investors attractive return opportunities—they have the sizzle of small-cap stocks without the high price volatility. They also provide characteristics of the big, established stocks. This mid-cap range is probably most appropriate for investors willing to tolerate a bit more risk and price volatility than large stocks. One type of mid-cap stock, a "baby blue chip," has all the characteristics of a regular blue chip, except for size. d. American depository receipts- (ADRs) are negotiable instruments issued by American banks. Each ADR represents a specific number of shares of stock in a specific foreign company. They are used as a way to purchase foreign stocks and are traded on U.S. exchanges (for example, the NYSE) or in the OTC markets; they trade just like shares of American stocks. Beyond the simplified trading, the investment merits of an ADR are a function of the investment merits of the foreign company that issued the stock, as well as the value of the dollar relative to the currency of the foreign company e. ipos- are initial public offerings of primarily small, relatively new companies. As the name suggests, these stocks are offered to the public for the first time. IPOs offer a chance to earn phenomenal capital gains. At the same time, it is very likely that investing in IPO stocks might result in a loss. As such, these should be considered only by experienced and knowledgeable investors. IPOs must be considered to be highly risky investments. f. tech stocks- are issued by companies in the technology sector. Issuing firms produce everything from computers to Internet content. They typically are growth stocks or speculative stocks because they pose considerable risk to the investor. This sector has done extremely well in good times and depreciated significantly in bear markets.
What makes a asset liquid? Why hold liquid assets? Would 100 shares of IBM stock be considered a liquid investment? Explain.
An asset is liquid if it can be converted to cash (sold) easily and quickly, with little or no loss in value. You would want to hold liquid assets as emergency funds or to accumulate funds for some specific purpose. 100 shares of IBM stock is considered a liquid investment because it is a big company and highly traded.
describe how foreign security investments can be made, both indirectly and directly.
An investor can diversify indirectly by investing in shares of U.S.-based multinational companies with large overseas operations that receive more than 50% of their revenues from overseas operations. The investor can also purchase foreign stocks and bonds directly on foreign exchanges, or buy (ADRs) and Yankee bonds
What are bond ratings, and how can they affect investor returns? What are split ratings?
Bond ratings are letter grades that are assigned by rating agencies like Moody's, S&P 500, etc. to bond issues on the basis of extensive, professionally conducted financial analysis to designate investment quality. The higher the rating, the lower the default risk is and, hence, the lower the yield of an obligation. A lower rating means that the investor must assume more of the default risk and has to be compensated with a higher yield. Split ratings are like when Moody's and S&P assign different ratings.
What is the difference between a cash dividend and a stock dividend? Which would be more valuable to you? How does a stock dividend compare to a stock split? Is a 200% stock dividend the same as a 2-for-1 stock split?
Cash dividends are simply dividend payments made to the stockholder in cash. A stock dividend is an issue of new shares expressed and distributed as a percentage of each shareholder's existing shares. It really has no value since the market responds to stock dividends by adjusting the market price accordingly. As an example, consider a stock that is trading at $50 per share; if the issuing firm declared a 10% stock dividend, the price of this stock would drop by 9.1% to $45.45 ($50/1.1). Thus, an investor who held 100 shares before the stock dividend would hold 110 shares after, but the total market value of these shares would be basically the same: $50 x 100=$45.45 x 110.
What is the difference between a premium bond and a discount bond? What 3 attributes are most important in determining an issue's price volatility?
It illustrates the inverse relationship between bond prices and market interest rates. A premium bond sells for more than its par value, which occurs when market interest rates drop below the bond's coupon rate. In contrast, a discount bond sells for less than par and is the result of market rates rising above the coupon rate. The factors that affect a bond's price volatility are interest rates, coupon, and maturity of the issue.
What are LEAPS? Why would an investor want to use a LEAPS option rather than a regular listed option?
LEAPS, or long-term equity anticipation securities, are long-term options with expiration dates that could extend out as far as three years. LEAPS give an investor more time to be right about his or her bets on the direction of a stock or stock index than regular listed options with their shorter maturities. Similarly, LEAPS give investors with large portfolios the ability to protect their portfolios over a longer period of time. But there is a price for this longer-term protection: LEAPS have a higher time premium and are therefore more expensive.
Discuss the various types of risk to which mutual fund shareholders are exposed. What is the major risk exposure of mutual funds? Are all funds subject to the same level of risk? Explain.
Major risk for mutual funds is market risk because a mutual fund is a large, diversified portfolio. A second kind of risk arises from management practices. If a mutual fund is managed aggressively, the probability of a loss in capital may be high. This is not to imply that a conservative strategy is the only feasible strategy for a mutual fund. Obviously, all funds are not subject to the same amount of risk. The more aggressive the fund management, the greater the potential return and the greater the amount of risk. Moreover, since funds deal in different markets, their market risk may not be the same either.
Describe put and call options.
Puts and calls are negotiable options issued in bearer form that allow the holder to sell (put) or buy (call) a stipulated amount of a specific financial asset, at a specified strike price, during a specified time period.
define risk. Explain what we mean by the risk- return tradeoff.
Risk is the chance that the actual return from an investment may differ from what is expected. The risk-return tradeoff is the relationship between the expected returns from an investment and the risk associated with them.
differentiate among the three basic risk preferences: risk- indifferent, risk- averse, and risk-seeking. Which of these attitudes toward risk best describes most investors?
Risk-indifferent investors do not require a greater return in exchange for each unit of additional risk. Risk-averse investors require greater return in exchange for each unit of additional risk. The tradeoff here is positive; return must increase as risk increases. Risk-taking investors accept a lower return in exchange for greater risk. This tradeoff is negative; such investors enjoy risk and are therefore willing to accept lower returns for increasing levels of risk. In general, most investors are risk averse. They require increased returns from an investment as its risk increases. The risk preference of an investor is an important determinant of his or her investment decisions. Risk-averse investors may not make speculative investments, while risk-taking investors may. Thus, an investment that is considered unsatisfactory by a more risk-averse investor may be deemed satisfactory by a less risk-averse investor.
describe the basic philosophy and use of stock market indexes.
Stock market indexes are used to measure the general behavior of securities markets. indexes measure the current price behavior of the group relative to a base value set at an earlier point in time.
What is a stock spin- off? In very general terms, explain how a stock spin-off works.
Stock spin-offs involve conversion of one of a firm's subsidiaries to a stand-alone company by distribution of stock in that new company to existing shareholders. For example, Kraft Foods recently spun off its snack food operations into a separate company from consumer staples.
why is globalization of securities markets an important issue today?
The globalization of securities markets is important because today investors seek out securities with high returns in markets other than their home country.
What are the main investment attractions of put and call options? What are the risks?
The main attractions of puts and calls are: The low unit cost, they can be used profitably when security prices go up or down. Puts and calls have some disadvantages as well: With puts and calls, as with any option, there is always the risk of losing the entire premium because the option could not be exercised profitably over its limited life. They cannot be margined. They require special knowledge to be utilized successfully.
briefly describe the IPO process and the role of the investment banker in underwriting a public offering. Differentiate among the terms public offering, rights offering, and private placement.
When a company decides to go public, it first must obtain the approval of its current shareholders, the investors who own its privately issued stock. Next, the company's auditors and lawyers must certify that all financial disclosure documents for the company are legitimate. The company then finds an investment bank willing to underwrite the offering. The bank is the lead underwriter and is responsible for promoting the company's stock and facilitating the sale of the company's IPO shares. Underwriting involves the purchase of the security issue from the issuing firm at an agreed-on price and bearing the risk of reselling it to the public at a profit. For very large issues, an investment banker brings in other bankers as partners to form the underwriting syndicate and thus spread the financial risk. The investment banker also provides the issuer with advice about pricing and other important aspects of the issue. In a public offering, a firm offers its shares for sale to the general public after registering the shares with the SEC. Rather than issue shares publicly, a firm can make a rights offering, in which it offers shares to existing stockholders on a pro rata basis, right to buy additional shares at a certain price. In a private placement of its shares, a firm sells directly to groups of investors, such as insurance companies and pension funds, and does not register with the SEC.
Define each of the following: open-end investment company, closed-end investment company, exchange- traded fund, real estate investment trust, hedge funds
a. An open-end investment company- is a mutual fund in which investors actually buy their shares from and sell them back to the mutual fund itself. b. A closed-end investment company- is a mutual fund that operates with a fixed number of outstanding shares and does not regularly issue new shares of stock. c. An exchange-traded fund (ETF) -mutual fund is a type of open-end investment company that trades as a listed security on one of the stock exchanges. d. A real estate investment trust (REIT) - mutual fund is a type of closed-end investment company that invests money in mortgages and various types of real estate investments. e. hedge funds-mutual fund that sell shares in a professionally managed portfolio of securities. However, hedge funds are private partnerships that tend to limit their clientele to rich individuals.
describes the differing investment philosophies typically applied during each of the following stages of an investor's life cycle. a. youth (20-45) b. middle age (45 to 60) c. Retirement ( 60 +)
a. Youth- tend to prefer growth-oriented investments that stress capital gains rather than income. These investors have little investable funds, and capital gains are seen as the quickest way to build up investment capital b. Middle Age- While growth-oriented securities are still used, investing becomes less speculative. Quality-growth vehicles are employed, and more attention is given to current income. The foundation is being set for retirement. c. retirement- preservation of capital and current income become the principal concerns. High-quality stocks and bonds and money market instruments are used as the investor's objective is to live as comfortable as possible from the investment income. During retirement, one tries to reap the rewards of a lifetime of saving and investing.
Briefly explain how you would make money on (a) a call option and (b) a put option. Do you have to exercise the option to capture the profit? numerical example
a. call option- buy 100 shares @ $10 within next 3 months. buyer= investor seller= broker option premium/fee= $50 next month= $15 exercise the option profit= 100($15-$10)-$50= 500-$50=$450 b. put option- (contract) sell 100 shares @$10 within 3 months buyer= investor seller= broker next month=$5 exercise the option profit= 100($10-$5)-$50=$450
Briefly describe each of the following types of mutual funds: equity- income funds, bond funds, sector funds.
b. Equity-income funds- emphasize current income by investing primarily in high-yielding common stocks. These funds also invest in convertible securities, preferred stocks, and even bonds. They like securities that provide high current yields but also consider potential price appreciation over the longer haul. These funds are generally viewed as a fairly low risk way of investing in stocks. d. Bond funds- come in all shapes and colors. They invest principally in some type(s) of fixed-income security. While current income is the primary objective of these funds, capital gains is not ignored altogether. Today, there's a full range of bond funds, ranging from the very conservative to the very risky. e. Sector funds- are mutual funds that concentrate their holdings in one or more industries that make up a target sector. For instance, a health care sector fund may hold drug companies, medical suppliers, biotech companies, and hospital management companies. They are not widely diversified and, therefore, are riskier than diversified funds.