Ch 1: Overview: Investments

junior tranches

Group investing in a CDO that would be paid only after the senior ones had received their cut

TED spread

What is a common measure of credit risk in the banking sector?

portfolio

a collection of an investor's investment assets

Collateralized debt obligations

a risk-shifting tool that enabled investment banks to carve out AAA-rated securities from original-issue "junk" loans

proxy contest

how can unhappy shareholders elect a different board

subprime

nonconforming loans with higher default risk are known as

investment

the current commitment of money or other resources in the expectation of reaping future benefits.

mutual fund

the pooling of money from many investors to buy a large selection of securities. This system gives small investors advantages they are willing to pay for via a management fee to the mutual fund operator. They usually charge a fixed percentage of assets under management.

real

these assets determine the wealth of an economy

financial

these assets represent claims on real assets

fixed-income security

type of security that pays a specified cash flow over a specific period

they receive any dividends the firm may pay and have prorated ownership in the real assets of the firm.

How are equity holders paid

These loans offered borrowers low initial or "teaser" interest rates, but these rates eventually would reset to current market interest yields, for example, the Treasury bill rate plus 3%

How do Adjustable rate mortgages work?

nonconforming loans

Loans that do not meet Fannie Mae/Freddie Mac standards

security analysis

analysis of the value of securities

real assets

assets used to produce goods/services (land, buildings, equipment, knowledge) are known as....

debt-security

fixed-income security is also called...

mortgage-backed securities

in the 1970s when Fannie Mae and Freddie Mac began buying large quantities of mortgage loans from originators and bundling them into pools that could be traded like any other financial asset. These pools, which were essentially claims on the underlying mortgages, were soon dubbed....

credit default swap

A swap designed to transfer the credit exposure of fixed income products between parties.

The Dodd-Frank Reform Act

Act passed in 2010 that proposed several mechanisms to mitigate systemic risk.

equity

An ownership share in a corporation.

a. Real b. Financial c. Real d. Real e. Financial

Are the following assets real or financial? a. Patents b. lease obligations c. customer goodwill d. a college education E. A $5 bill

a. real, financial b. financial, real c. financial, real

Choose the correct answer in the following statements about financial and real assets. a. Toyota takes out a bank loan to finance the construction of a new factory. Toyota creates a ______ asset—the factory. The loan is a _____ correct asset that is created correct in the transaction. b. Toyota pays off its loan. When the loan is repaid, the ____ asset is destroyed but the ____ asset continues to exist. c. Toyota uses $10 million of cash on hand to purchase additional inventory of spare auto parts. The cash is a _____ asset that is traded in exchange for a ___ asset, inventory.

compensation plans tie the income of managers to the success of the firm, board of directors can force out management teams that are underperforming, outsiders such as security analysts and large institutional investors such as mutual funds or pension funds monitor the firm closely and make the life of poor performers at the least uncomfortable, takeover

Describe some of the mechanisms that have evolved to mitigate potential agency problems

The ratings agencies were paid to provide ratings by the issuers of the securities—not the purchasers. They faced pressure from the issuers, who could shop around for the most favorable treatment, to provide generous ratings.

Describe the agency problems with rating agencies and mortgage backed securities

systemic risk

Economy-wide risk that affects everyone and cannot be diversified

Treasury bonds, as well as bonds issued by federal agencies, state and local municipalities, and corporations.

Examples of capital market securities

options, futures contracts, swap contracts

Examples of derivative securities (3)

U.S. Treasury bills or bank certificates of deposit (CDs)

Examples of money market securities (2)

When the market is more optimistic about the firm, its share price will rise. That higher price makes it easier for the firm to raise capital and therefore encourages investment. In this manner, stock prices play a major role in the allocation of capital in market economies, directing capital to the firms and applications with the greatest perceived potential.

Explain the Informational Role of Financial Markets

investment companies

Firms managing funds for investors. An investment company may manage several mutual funds.

investment bankers

Firms specializing in the sale of new securities to the public, typically by underwriting the issue.

1) Firms (net demanders of capital) 2) Households (suppliers of capital) 3) Governments

From a bird's-eye view, there would appear to be what three major players in the financial markets?

By the productive capacity of the economy (the goods and services its members can create)

How do you determine the material wealth of a society?

passive

If markets are efficient and prices reflect all relevant information, it is better to follow ____ strategies instead of spending resources in a futile attempt to outguess your competitors in the financial markets.

bottom-up strategy

In this process, the portfolio is constructed from the securities that seem attractively priced without as much concern for the resultant asset allocation.

pension funds,

In venture capital funds, a management company starts with its own money and raises additional capital from limited partners such as ______. That capital may then be invested in a variety of start-up companies.

financial intermediaries

Institutions that "connect" borrowers and lenders by accepting funds from lenders and loaning funds to borrowers.

stocks, bonds, real estate, commodities

Investment assets can be categorized into broad asset classes, such as.... (4)

private equity

Investments in companies that are not traded on a stock exchange.

asset allocation decision, security selection

Investors make what two types of decisions in constructing their portfolios.

debt, equity, derivatives

It is common to distinguish among what three broad types of financial assets

primary market

Market for new issues of securities.

venture capital (VC)

Money invested to finance a new firm.

securitization

Pooling loans into standardized securities backed by those loans, which can then be traded like any other security.

hedge fund

Private investment fund that pursues complex, high-risk investment strategies. They typically keep a portion of trading profits as part of their fees

derivative securities

Securities providing payoffs that depend on the values of other assets.

no, yes

Suppose that in a wave of pessimism, housing prices fall by 10% across the entire economy. a. Has the stock of real assets of the economy changed? b. Are individuals less wealthy?

tranches

The idea behind CDOs was to prioritize claims on loan repayments by dividing the pool into senior versus junior slices called...

real. your asset is someone else's liability. Therefore, when we aggregate over all balance sheets, these claims cancel out, leaving only real assets as the net wealth of the economy

The net wealth of the economy is defined as only the ____ assets. Explain why

equity

The performance of what type of investment is tied directly to the success of the firm? (debt/equity)

financial assets

These securities are no more than sheets of paper or, more likely, computer entries and do not directly contribute to the productive capacity of the economy. They are claims on real assets or the income generated by them are known as....

the investor in the private-label pool would bear the risk that homeowners might default on their loans. Thus, originating mortgage brokers had little incentive to perform due diligence on the loan as long as the loans could be sold to an investor.

What is one important difference between the government-agency pass-throughs and these so-called private-label pass-throughs

The rate at which banks borrow from each other

What is the LIBOR rate?

The spread between the LIBOR rate (at which banks borrow from each other) and the Treasury bill rate (at which the U.S. government borrows)

What is the TED spread

the rate at which the US gov borrows

What is the Treasury bill rate?

to hedge risks or transfer them to other parties

What is the primary use of derivatives?

fannie mae, freddie mac

What two organizations changed the landscape of mortgages in the 70s by securitizing home loans into financial assets that could be traded?

once the securitization model took hold, it created an opening for a new product: securitization by private firms of nonconforming "subprime" loans with higher default risk.

When did the trouble begin for freddie mac and fannie mae?

other companies (low stock price should rise to reflect the prospects of improved performance, which provides incentive for firms to engage in such takeover activity)

Where is the main takeover threat in a company?

senior tranches

Who had first claim on repayments from the entire pool of a CDO?

default probabilities had been estimated using historical data from an unrepresentative period characterized by a housing boom and an uncommonly prosperous economy. Also, the ratings analysts had extrapolated historical default experience to a new sort of borrower pool—one without down payments, with exploding payment loans, and with low- or no-documentation loans (often called liar loans). Past default experience was largely irrelevant given these profound changes in the market.

Why had the rating agencies so dramatically underestimated credit risk in these subprime securities?

stock prices

____ reflect investors' collective assessment of a firm's current performance and future prospects

passive management

calls for holding highly diversified portfolios without spending effort or other resources attempting to improve investment performance through security analysis.

agency problems

conflicts of interest between shareholders and management

financial intermediaries

investment companies, insurance companies and credit unions are all examples of ____

asset allocation decision

investment decision that is the choice among these broad asset classes

security selection decision

investment decision that is the choice of which particular securities to hold within each asset class

secondary market

investors can trade previously issued securities among themselves in this market

Adjustable rate mortgages

is a mortgage with an interest rate that changes based on marketing conditions.

active management

is the attempt to improve performance of a portfolio either by identifying mispriced securities or by timing the performance of broad asset classes—for example, increasing one's commitment to stocks when one is bullish on the stock market.

diversification

means that many assets are held in the portfolio so that the exposure to any particular asset is limited.

low conforming mortgages

mortgages that couldn't be too big and homeowners had to meet underwriting criteria establishing their ability to repay the loan. For example, the ratio of loan amount to house value could be no more than 80%.

limited partnerships

most venture capital funds are set up as...

"Top-down" portfolio construction

portfolio construction that starts with asset allocation

capital market

refers to fixed-income securities that are long-term, range from very safe in terms of default risk (for example, Treasury securities) to relatively risky (for example, high-yield or "junk" bonds). They also are designed with extremely diverse provisions regarding payments provided to the investor and protection against the bankruptcy of the issuer.

money market

refers to fixed-income securities that are short term, highly marketable, and generally of very low risk.

underwriting

refers to the process by which investment banks raise investment capital from investors on behalf of corporations and governments that are issuing securities (both equity and debt capital).

derivatives

securities with values derived from the prices of other assets

venture capital (VC)

start-up companies rely instead on bank loans and investors who are willing to invest in them in return for an ownership stake in the firm. The equity investment in these young companies is called....

top-down

this type of investor first makes crucial asset allocation decisions before turning to the decision of the particular securities to be held in each asset class.

CDO

were designed to concentrate the credit (i.e., default) risk of a bundle of loans on one class of investors, leaving the other investors in the pool relatively protected from that risk

proxy contest

when shareholders they seek to obtain enough proxies (i.e., rights to vote the shares of other shareholders) to take control of the firm and vote in another board.