Chapter 1: An Introduction to Finance

Identify the transaction that does not take place in the primary market? 1. Buying a newly issued municipal bond 2. Buying shares of an initial public offering 3. Selling 100 shares of stock through a stock broker 4. Buying a US Treasury bill through the gov't auction

# 3 does not take place in the primary market but instead in the secondary market

Convertible Debt

* investors can exchange for the stock of the issuing company

"straight corporate debt"

* the typical notes and bonds

Securities Act of 1933

*Requires disclosure of specific information about securities offered to the public, and prohibits misrepresentations and fraud in the sale of securities. * "making information more public"

Common Stock

*The most common form of equity. *Represents the residual ownership of a corporation(they get what's left after creditors and preferred shareholders). -They get what's left over, the "residue" *CS owners are last in line, in terms of seniority of claims on the company, *yet they reap the benefits from the company's earnings and appreciation in value *CS owners generally have voting rights, with the ability to elect members of the company's BOD's

Capital Market Security

*a security with a maturity greater than one year [*long-term security] *includes notes, bonds, and debentures, as well as equity securities, which represent ownership in a company and generally have no maturity date.

Securities and Exchange Commission (SEC)

*agency that bears the responsibility of ensuring that financial markets are fair, orderly, and efficient, encouraging capital flows from investors to businesses, protecting investors, and oversight of self-regulatory organizations

The Federal Reserve System (the Fed)

*considered the central bank of the U.S. *consists of the board of governors & twelve district banks *established with the Federal Reserve Act of 1913

FOMC

*consists of seven members of the Board of Governors and the five Federal Reserve Bank presidents

When a company goes public, what is it selling ?

*equity interests to investors for the first time *we refer to the offering as an initial public offering (IPO)

"Block trades"

*extremely large transactions involving at least 10,000 shares or $100,000 *historically, block trades have been particularly important in the third market

IPO (Initial Public Offering)

*first sale of equity interests to the public * raises permanent capital

Glass-Steagall Act (1933)

*gave the Fed the power to regulate the maximum interest rate that banks provide on deposits *purpose of this power was to regulate competition among banks because it was believed that excessive competition led to the Great Depression of the 1930s

Fourth Markets

*involves the trading of securities directly between investors without the involvement of brokers or dealers * institution to institution trading without brokers or dealers

Self-Regulatory Organization (SRO)

*organization that OVERSEES and MONITORS its members and member organizations *SEC has the responsibility of oversight of SRO's

Securitization

*process of converting loans into securities(ex. creating a mortgage-backed security) *pooling of loans, and then creating and selling securities that have rights to specific cash flows from this pool *break down into small pieces that are easier to sell

Powers granted to the BOG of the Federal Reserve System:

*regulate competition among banks *establish margin requirements for securities *evaluate the reserve requirements of member banks

The NYSE Euronext (US)

*the world's largest stock market with a market capitalization at the end of January 2011 of $15.1 trillion *world's largest equity market in terms of the value of the stocks listed with the exchange, $11,233 billion as of November 2011

What is the primary responsibility of the Board of Governors and how does it operate this responsibility?

*to determine monetary policy *it operates through the Federal Open Market Committee

What are the primary markets a key to ?

- "the key to the wealth creation" process because they enable money to be transferred to those who can make the best use of it in terms of developing new real assets like houses & factories.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 is a wide-reaching act. Among other things, the act:

- Creates the Financial Stability Oversight Council, which provides a formal system of coordination among key regulators - Creates criteria and standards for systemically important financial companies - Provides for the orderly liquidation of financial companies that are insolvent - Regulates derivatives, including swaps - Regulates hedge funds, which previously operated without any required disclosures

"Underwater Mortgage"

- a home purchase loan with a higher balance than the free-market value of the home. - prevents the homeowner from selling the home unless s/he has cash to pay the loss out of pocket & prevents from refinancing

General Obligation Bond

- debt security backed by the general credit of the issuer - backed by the full faith and credit of the issuer, much like U.S. Treasury bonds. *type of municipal bond *an indebtedness by a state of local government

Primary Markets

- market that involves the issue of NEW securities by the borrower in return for cash from the investors (or lenders) -new securities are created thru an IPO

What was the creation of the Sarbanes-Oxley Act of 2002 a reaction to ?

- reaction to the scandal involving Enron - deals with financial management issues, including disclosures, corporate governance, & the accounting profession

Morgan Stanley

- the investment banking firm that took Facebook from being a closely held company to issuing stock to the public for the first time

The Federal Reserve System (the Fed) has been given the power, among other things, to do the following:

1 Establish margin requirements, which affect the extent that stock is purchased with borrowed funds 2 Require disclosures regarding consumer lending 3 Assess reserve requirements of member banks and non-depository institutions ** Janet Yellen

Describe the features of a bond :

1 fixed maturity of more than 10 years 2 pays interest (which is referred to as a coupon) 3 repays the loan at maturity

Contributions to the 2007 - 2008 financial crisis :

1 housing bubble 2 lax lending standards 3 globalization of financial investments and instruments 4 loans with low loan-to-value ratios 5 push for gov't sponsored entities (GSEs) to purchase lower quality loans

Examples of Financial Institutions

Banks, Credit Unions, and financial firms

Examples of Market Intermediaries

Brokers, Brokerage firms, exchanges (markets) like NYSE, etc.

Examples of financial intermediaries

Commercial Banks, Insurance companies, etc.

Examples of Business Finance

Corporations, Sole Proprietorships, etc.

Securities Exchange Act of 1934

Created the Securities and Exchange Commission, giving the SEC the power and responsibility to regulate and oversee brokerage firms, agents, and self-regulatory organizations. Requires periodic reporting by companies with publicly traded securities.

Examples of Investments

Deals w/ stocks, bonds, and other securities

What are the two major categories of financial securities?

Debt and Equity

How can we view finance as "applied economics"?

Economics deals with the allocation of scarce resources in an economy, whereas finance focuses on how resources are allocated and by what channels, as well as the terms of the allocation.

What are the 2 types of secondary markets?

Exchange Market (Auction Market) or Dealer Market (OTC Market)

What are the 3 primary areas of finance?

Financial Institutions, Business (Corporate) Finance, and Investments

What are comprised of the financial system? (2 types)

Financial and Market Intermediaries

Sarbanes-Oxley Act of 2002

Increases disclosure requirements of publicly traded companies, creates oversight boards for independent public accountants, requires specific corporate governance provisions, and holds the chief executive officer and the chief financial officer accountable for a public company's disclosures.

Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010

Increases oversight responsibility and regulation of hedge funds, credit-rating agencies, and brokers and dealers, among other things. - deals with wide-reaching changes in the structure of financial regulation

Debt Instrument (Security)

Legal obligation to repay borrowed funds at a specified maturity date and to provide interim interest payments

Instinet

One of the most widely recognized privately owned automated system in the 4th market.

Investment Advisers Act of 1940

Regulates investment advisers, and specifies who must register with the SEC.

Investment Company Act of 1940

Regulates investment companies, such as mutual funds.

Trust Indenture Act of 1939

Regulates the provisions of indentures for bonds, debentures, and notes sold to the public.

Equity instrument or equity security

Represents an ownership stake in a company

Assessment Bond

Security backed by the property taxes of a gov't entity -A type of municipal bond -Interest earned by this bond is exempt from federal income tax

What is currently happening to the distinction between the exchange market and dealer market?

The distinction between these two types of secondary markets has become blurred in recent years because trading on most of the major exchanges in the world has become fully computerized, making the physical location of the exchanges of little consequence.

Finance

The study of how and under what terms funds are allocated between those with excess fund and those who need funds.

Why are secondary markets critical to the economy?

They are critical because governments and companies would be unable to get financing if investors were unable to sell their investments when necessary.

The primary responsibility of the FOMC is :

US monetary policy

Bond

a debt instrument that takes the form of a security, generally with a maturity of more than ten years. The owner of the bond is the creditor of the bond issuer.

Mortgage

a debt obligation that is secured by specific property such as a house (collateral)

Creditor

a party lending funding through a loan arrangement

the Federal Insurance Oversight committee :

a primarily advisory federal oversight committee for insurance

Money Market Security

a short-term (i.e., maturity of less than one year) security; examples include debt instruments such as T-bills, commercial paper, and bankers' acceptances.

Interest-Rate Swaps

agreements to exchange sets of cash flows, e.g., fixed interest for floating interest

Business Finance

an entity that deals w/ financial decision making for a business

Financial Institutions

an entity that serves as an intermediary in the financial system.

Financial Derivative

an investment whose value is based on some other investment, such as options and interest-rate swaps

The predominant regulator of insurance companies in the US :

are the States

List the types of short-term debt?

bank loan, commercial paper, bankers acceptance, & US treasury bill

How do we often compare stock?

by referring to their market capitalization

Mortgage-Backed Security

claims on the cash flows of a pool of mortgages

What are the two forms of ownership companies issue?

common and preferred stock

Investments

deals w/ financial markets and securities

Revenue Bond

debt obligation backed by a specific revenue stream of the issuing entity - a type of municipal bond

Dealer Market (OTC Market)

do not have a physical location, but rather consist of a network of dealers who trade directly with one another.

Market Intermediary

entity that facilitates the working of markets and helps provide direct intermediation; simply makes the markets work better.

Preferred Stock

equity security that usually entitles the owner to fixed dividend payments that must be made before any dividends are paid to common shareholders.

Federal Insurance Office (FIO)

federal agency responsible for MONITORING and ADVISING regulators about insurance companies' risk and solvency

Government Sponsored Entities (GSE)

financial service corporations that are created by the gov't to perform a service, such as buying mortgages

Subprime Mortgage

home loan to a borrower w/ POOR CREDIT who would NOT otherwise qualify for a conventional mortgage

What does financial decision making encompasses?

investment and financing decisions, which may be short-term or long-term decisions

Broker

is a market intermediary who facilitates exchanges in a market

Security

is a negotiable financial instrument that is evidence of indebtedness or ownership. Securities include the following: debt obligations, equity interests, and hybrid securities.

Financial Instrument

is any legal agreement that represents an ownership interest, a debt obligation, or other claim on assets or income.

List the types of long-term debt?

mortgage loan, municipal bond, corporate bond

"Chartered bank"

obtained government permission on some level to do business in the banking sector

Financial System

of any country provides an environment in which households provide funds to businesses and government.

Secondary Financial Markets

provides trading environments that permit investors to buy and sell existing securities *trading among investors

Loan-to-Value Ratio

ratio of the amount of a loan to the value of the collateral used as security on the loan

Exchange Market (Auction Market)

referred to as auction markets because they involve a bidding process that takes place in a specific location (i.e., similar to an auction).

Third Markets

refers to the trading of securities that are listed on organized exchanges in the OTC market.

Options

securities that give the investor the right to buy or sell a stock

Note

similar to a bond, but with a maturity in the range of one to ten years. In common usage, however, the term "bond" is often used interchangeably with the term "note."

Debt Obligations (Security)

such as a bond or a note with a fixed term for repayment and interest to compensate the lender for the use of the funds

Equity Interests (Security)

such as common stock, which represent the ownership interest that the provider of funds has in the user of funds.

Hybrid Securities (Security)

such as convertible bonds, that have characteristics of both equity and debt.

Collateral

the borrower's pledge of specific property, which may be a building, aircraft, or any other identifiable, tangible asset.

Financial Industry Regulatory Authority (FINRA)

the largest SRO that MONITORS and REGULATES brokerage firms, brokers, and market intermediaries * registers brokers and brokerage firms, enforces securities laws among the registered brokers and firms, and regulate the stock markets.

A Company's Market Capitalization =

the product of the market price of a share and the number of shares outstanding

Market Capitalization

the product of the market price of a share and the number of shares outstanding

NASDAQ

the second-largest stock market in the world, based on its market capitalization of $3.6 trillion.

Intermediation

the transfer of funds from lenders to borrowers; process of bringing these parties together

What does the fourth market operate through?

through the use of privately owned automated systems

Financial Intermediary

transforms the nature of the securities they issue and invest in Examples: mutual funds, pension funds, investment dealers, insurance companies

Debenture

unsecured debt obligation; backed by the "full faith and credit" of the issuer