Finance Chapter 2 questions

Commercial Banks

Commercial banks are depository institutions that take deposits (such as checking or savings deposits) and make loans (such as mortgage loans or auto loans). Commercial banks are also integral parts of our national payment system. Their importance to the functioning of our economy has led to their heavily regulated and subject to extensive oversight (for example, by the FDIC, which insures their deposits, and by the FED, which mandates their reserve requirements)

Hedge Funds

Hedge funds are intermediaries like mutual funds, gathering money from investors, then using those pooled funds to buy assets. However, hedge funds are less regulated than mutual funds, and therefore may engage in various strategies that are not available to mutual funds. For example, short positions are important parts of many hedge fund strategies. Only and accredited investor (an individual who's net worth exceed $1 million) can invest in a hedge fund. there are many types of hedge fund strategies; for example, funds following merger arbitrage strategies might short stock in acquiring firms and buy stock in targets; equity market neutral funds would match their long positions with shorts, ending up "neutral" to the direction of the market.

Investment Banks

Investment banks like Goldman Sachs and Morgan Stanley advise firms about their financing needs and investment opportunities and act as intermediaries when firms issue new securities. For example, an investment banker may advise a client about most favorable terms for a new bond issue, then underwrite the issuance of the bonds (buying the bonds from the issuer, then selling them to investors, taking inventory risk in return for a spread)

What is the primary difference between a debt security and equity security?

The primary difference between debt and equity is that debt has a contract: The amounts and the timing of its cash flows is contractually specified. For example, with a bond, you know that you will receive coupon payments equal to [coupon rate*par/2] twice per year, on specific dates, plus $1000 (the par value) at maturity (another specified date). Failure to make a promised payment on time and in full constitutes default, for which there are ramifications for the issuer. However, cash flows to equity may not be specified at all. If specified, do not trigger default when not made (preferred dividends may be skipped if the firm chooses). Equity funding provides much more flexibility for the issuer, and is therefore less risky for it. However, this comes at the cost of higher required returns to investors. Debt investors are willing to accept a lower return in exchange for contractual cash flows. However, less risk for investors means more risk for the issuer, which introduces leverage--risk-- into its capital structure when issuing debt

Primary Market.

The primary market is the market for newly issued securities, In this market, the issuer (for example, a corporation like General Electric) created a new financial asset and sells it to an investor. GE does this to raise money to finance a new project. The asset it creates can be either a debt security (like a bond), or and equity security ( like a new share of stock).Every asset must trade in the primary market once (and only once) because every asset must be "born". The Primary market transaction is the only point at which the issuer receives cash for the security. This is where the investment banks come in which are the ones who typically buy these securities from the companies initially

Private equity funds

These funds collect money from investors, then deploy it into equity that is not publicly traded. The most important types of private equity finds are VENTURE CAPITAL (VC) - which finance start-up firms, and LEVERAGED BUYOUT (LBOs) funds, which use debt (leverage) to buy up the public stock of poorly performing firms, taking them private. The purpose is to buy them out and making them profitable again.

What are the two types of private equity funds? What does each do with the money?

Venture Capital (VC): collect money form investors, then use it to finance start-up businesses. THis, these funds invest very early in a business' life, perhaps funding research and/or product development. Leverage buyout (LBO): target underperforming businesses, using leverage (debt) to finance the buyout of the firm's public shareholders --taking the firm private. The idea is to restructure the business without the distraction of public oversight, then take the firm public again. Investors in private equity make money when their incubated firms are brought out of have the IPO (VC funds), or when the firms are taken public again (LBO)

Mutual Funds

Mutual funds collect money from investors, then invest that money into specific types of financial assets. Each mutual fund has a prospectus that describes the particular type of assets that they fund may buy; for example; the fund may buy bonds, of stocks, or money market assets, or some combination. Mutual fund investors own shares of the fund that entitles them to a proportional share of the assets held by the fund. The price the you pay when you pay or sell is called the NAV (net asset value). A mutual fund can be either load or no-load ( no commission charge)

Capital Market

Deals in lending and borrowing of long-term finance

Money Market

deals in lending and borrowing of short term finance

Financial services corporations

financial services corporations (GE Capital) provide loans and credit to businesses and individuals (including credit cards). Some are in charge of financing large manufacturing companies like Ford Motor Credit. These institutions do not take deposits. They raise money to lend primarily by borrowing themselves and by issuing bonds (debt securities) in the securities market.

What is a hedge fund and how is it different from a mutual fund?

Hedge fund is a pool of assets, like the mutual. But hedge are much less regulated than mutual funds, which allows hedge fund managers to sue many strategies forbidden in a mutual fund. (like investing in illiquid assets) Hedge funds are not open to all investors; they are targeted at wealthy, sophisticated, "accredited" investors. The fee structures of hedge funds are also different from mutual. Annual fee of 2% ANF 20% of profits ("2-and20" scheme)

What makes preferred stock "preferred"?

- It has priority in liquidation--preferred shareholders must be paid in full before common shareholders can receive any pf the proceed from the liquidates assets of the firm. -It has priority in dividend payment-- common dividends cannot be paid before preferred dividends are paid. If the preferred is cumulative, then there can be no common dividends before all accrued preferred dividends are paid *just priority of payment. However, preferred stock does not dominate common. Common shares come with voting rights and preferred does no. Preferred shares are not residual claims, and will not enjoy the unlimited upside that common shareholders prize.

What are the three principle sets of players that interact in the financial markets?

Borrowers - Those who need money to finance their purchases Savers- those who have money to invest Financial Institutions (Intermediaries) - financial institutions(commercial bank) and markets that help being borrowers and savers together.

List the principal types of financial intermediaries in the U.S. financial markets

-Commerical Banks -NONBANK Financial Intermediaries: financial services corporations, insurance companies, Investment companies, and Investment banks. -Investment Companies: Mutual funds, Exchange-traded funds(ETF) -Hedge funds -Private equity funds

What is a financial intermediary?

A financial intermediary is what brings borrowers and savers together. These institution stands between those who need money and those who have money.

What is a mutual fund and how does it differ from an exchange-traded fund (ETF)?

A mutual fund provides intermediated investing. Investors pool their funds together, then hire a manager to deploy those funds into an approved asset class or classes. For example, investors might pool their funds to buy equity, to buy debt, or to buy some combination of the two. Pooling their investments allows investors to achieve diversification simply , and with minimum investment. Benefits of Mutual fund: - Ease of diversification - Access to asset classes (some are more easily, or only accessible to institutional investors, requiring retail investors to use an intermediary like a mutual fund) - Ability to establish ongoing, automated investment programs (taking money form each month's paycheck for example, and having it automatically invested in your funds) -

Exchange-traded funds (ETF)

ETFs are like mutual funds except that the shares in the ETF trade on exchanges, as stocks do. Investors trade mutual funds shares with the fund themselves-- they send the money to the fund, receiving mutual find shares in return; they submit sell requests to the mutual fund, receiving cash in return. In contrast, investors who wish to buy or sell requests to the mutual fund, receiving cash in return. In contrast, investors who wish to buy or sell ETF shares can simply enter a sell order with their brokers. They can also do the other types of things that one can do with shares of stock; for example, buy ETF shares on margin or sell ETF shares short. ETFs usually track an index like the S&P 500 and have a relatively low expenses compared to mutual funds. Nonetheless, investors who wish to make small, periodic contributions to a diversified fund many want to stick with mutual funds, since ETFs require brokerage commissions with every trade

Insurance Companies

Insurance companies insure individuals and businesses against certain types of risks (car accidents, fires, death, etc)They are major players in the financial markets, because they must invest the premiums they collect until the money is needed to pay claims. The type of insurance a firm provides tends to determine the type of market in which they invest most frequently. (capital markets vs money markets)

What do investment banks do in the financial market?

Investment bankers advise clients on raising money (for example, what type of securities to issue, and what the features of those securities should be). They also perform underwriting services (buying the securities from the issuer, then selling them to investors). Investment bankers also provide merger, acquisition, and divestment advice.

Capital Structure

The mix of debt and equity securities a firm uses to finance its assets

Secondary Market

The secondary market is the market for investor-to-investor trading. The markets that we hear about every day (NYSE, the American Stock Exchange, the NASDAQ) are all secondary markets. These allow investors to trade our of securities that they have purchased (or to buy new ones); that is, they provide liquidity. Investors are more willing to buy securities in the first place if they know they can sell them easily. This securities are more attractive to investors-- and therefore are less costly to issuers-- if they are backed by a large, liquid secondary market.

Investment Companies

These companies take savings and invest them in other companies' securities. As the text puts its, they are "financial institutions that pool the savings of the individual savers and invest the money, purely for investment purposes, in the securities issued by other companies. Perhaps the most familiar type of investment company is the mutual fund.

NONBANK Financial Intermediaries

While these businesses channel money to those who need it, they do not both take deposits and make loans, as a depository institution does.

ETF

an ETF also allows investors to basket of assets. However, ETF shares trade on an exchange. They therefore can be traded multiple times per day, while mutual fund shares can be traded only ONCE per day. (investors who wish to buy or sell mutual fund shares place orders with the fund directly, which then performs the trades once, at the end of they day). Since ETFs trade like stocks, they can be sold short and bought on margin. There may also be certain tax advantages to ETFs over mutual funds. However, each transaction incurs a brokerage commission, so that investors desiring to setup an automatic investment program may be better off using mutual funds for those programs, depending on the mutual fund fees and expenses.