Finance 310 - Unit 3 Exam Prep (Chapters 9,10,11)

Explain collateralized debt obligations (CDOs).

A CDO is a package combining a variety of debt securities, including subprime mortgages, prime mortgages, automobile loans and other credit card loans.

Explain the use of a balloon-payment mortgage.

A balloon mortgage payment requires interest payments for a three- to five-year period and full payment at the end of the period.

Describe the growing-equity mortgage.

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

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.

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.

Explain short sales in the mortgage markets.

In a short sale transaction, the lender allows homeowners to sell the home for less than what is owed on the existing mortgage.

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.

Exchange-traded funds are_________ 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 _________- . The net asset value of an international ETF is determined by translating the __________ value of the foreign securities into ____________. Thus, a weaker ____________ will reduce the net asset value in __________ .

Passive, dollars, foreign currency, dollars, foreign currency, dollars

In 2008, the number of all outstanding subprime mortgages with late payments of at least 30 days was ________ than the number of prime mortgages with the same characteristics. The number of prime mortgages that were subject to foreclosure was _________ than the number of such subprime mortgages.

higher, lower

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

The growing-equity mortgage lifetime ________ reduced, whereas a GPM's life ______ reduced.

is, isn't

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.

Financial institutions may desire balloon mortgages because the interest rate risk is lower than for ________ term, fixed-rate mortgages.

longer

The bookbuilding process dictates an offer price that is ________ than what some institutional investors would pay.

lower

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

Bear Stearns 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

When interest rates decline, prepayments on mortgages _______ because ______ homeowners refinance with a new mortgage with a ________ interest rate.

occur, some, lower

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, book building

At a given point in time, the price of a 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

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

risk-free rate

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

selling credit default swaps

The prices of ________ sold on the secondary market are more transparent, while the prices of _________ aren't. However, the secondary market for __________ has been enhanced because of securitization.

stocks and bonds, mortgages, mortgages

Federally insured mortgages are intended to protect

the loan repayment to lending institution.

The 15-year mortgage is popular because of the potential reduction in ___________ on a mortgage with a shorter lifetime.

total interest expenses paid

Emerging market stocks tend to exhibit all of the following except

very limited potential for high return.

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

Downward

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

High, many

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

Higher, lower

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

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

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

- Individual investors whose investments were pooled by mutual funds, hedge funds, and pension funds and used to purchase MBS experienced losses. - Home builders went bankrupt and many employees in the home building industry lost their jobs.

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

- 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.

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

- Managers of a private equity fund take a percentage of the profits they earn from their investments in return for managing the fund. So, they are motivated to improve firms' performance. - If private equity funds were able to improve the business substantially, they should be able to sell their stake to another firm for a much higher price than they paid for it.

Possible disadvantages of private stock exchanges to investors include:

- required disclosures may be less than those required when a firm goes public. - trading volume is limited.

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

-Prevents the SEC from relying on ratings within its regulations, so that it has to use its own assessment of risk. -Requires that credit rating agencies publicly disclose data on assumptions used to derive each credit rating.

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%

The interest rate risk is lower for a _________ mortgage because it has _________ mortgage period.

15 year, shorter

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.

25.18

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%

Explain the use of a prospectus developed before an IPO.

A prospectus contains detailed information about the firm and includes financial statements and a discussion of the risks involved in the firm's 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 public offering of stock may be feasible only if the firm will have a large enough shareholder base to support an active secondary market. Otherwise, the shares would be illiquid, and stockholders who want to sell shares would be forced to sell at a discount from the fundamental value.

Why are second mortgages offered by some home sellers?

A second mortgage is often used when a first mortgage does not fully cover the amount of funds the borrower needs and complements the first mortgage.

Describe the shared-appreciation mortgage.

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

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

ADRs are certificates that are traded in the United States and represent ownership of a foreign stock, so U.S. investors can purchase ADRs as a method of investing in foreign securities.

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

Common stockholders are permitted to vote on key matters concerning the firm such as approval of amendments to the corporate charter or adoption of bylaws.

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.

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

Collateralized mortgage obligations 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.

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

Commercial Banks

What types of financial institutions finance residential mortgages?

Commercial banks and savings and loan associations

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

Financial institutions may sell their mortgages if they desire to enhance liquidity.

Why do firms engage in IPOs?

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

Why are there many IPOs in some periods and few IPOs in other periods?

Firms prefer to engage in IPOs when business conditions and market conditions are favorable because when business conditions are poor, the market conditions are weak, meaning that firms would have to sell their shares at a low price.

Lenders of ________ mortgages can be adversely affected by rising interest rates, because their cost of financing the mortgages would increase _________ while the interest revenues received on mortgages would _________. They could reduce their exposure to interest rate risk by offering ____________ mortgages.

Fixed rate, increase, remain unchanged, adjustable rate mortgages

What does it mean to "flip" shares?

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

The lockup provision restricts ___________ from selling their shares until a specified period (usually 6 months) after the IPO in order to prevent ___________ pressure on the price of the stock.

Insiders and venture capital firms, downward

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

International mutual funds

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

It allows public accounting firms to offer non-audit consulting services to an audit client

Caps on ARMS

Limit the degree to which the interest rate charged can move from the original interest rate at the time the mortgage was originated.

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

____ are backed by conventional mortgages.

Private-label pass-through securities

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

The cost of adhering to the guidelines of the act substantially reduces the value of many small publicly held firms so that they would have a higher value if they were private.

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?

Securities firms distribute or place stock for corporations and serve as intermediaries since they have experience to know how much stock can be digested by the market.

Mortgage companies concentrate on _______ mortgages, thus, they ________ as concerned about hedging mortgages over the long run. Mortgage companies' exposure to interest rate risk exists _______.

Servicing, are not, before the mortgage is sold

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

Sharpe

Why would investors want to flip shares?

Some institutional investors flip shares in order to take advantage of an initial return over the first day because IPO performance tends to be unusually high on the first day, followed by a downward drift.

__________ 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

________ 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. ___________involves investors placing bids for IPO shares on the first day that are above the offer price.

Spinning, laddering

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

Stocks of relatively large firms with large trading volume are mostly traded on the NYSE.

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

Subprime mortgages are a type of mortgage offered to borrowers that have relatively low income or high existing debt, or can make only a small down payment. Many financial institutions were aggressively offering subprime mortgages to expand their business.

Distinguish between FHA and conventional mortgages.

The Federal Housing Administration protects FHA mortgages against the possibility of default by the borrower, while conventional mortgages doesn't.

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?

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. The disadvantage is that Denton may receive less in proceeds from selling the stock than expected.

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

The existence of accounting irregularities probably results in closer scrutiny of financial statements for investors as well as seeking additional sources of information in addition to the firm's financial statements as part of their decision-making process.

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

The firm does a road show to promote its offering and to convince some large investors to invest in the shares of the firm.

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.

The government intervention stabilized the market for mortgage-backed securities, and therefore helped the financial institutions and homeowners. However, the government budget deficit increased due to the intervention.

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 and then they level off after this period.

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

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

Describe the process of bookbuilding.

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

Why are organized stock exchanges used?

They are used to facilitate secondary market transactions.

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

The offer price is influenced by market and industry conditions and the prevailing market multiples.

Explain the problems in valuing MBS.

The only participants who know the price of MBS that was traded is the buyer and the seller.

Explain how underwriters use the overallotment option in IPOs.

The overallotment option gives the lead underwriter the right to purchase extra shares from the issuing firm at the IPO offer price and issue additional shares to investors at the offer price and earn a commission. The lead underwriter purchases the extra shares at a lower than the offer price if the market price declines below the offer price.

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

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

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.

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

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

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.

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

The announcement of stock repurchases implies that investors interpret the announcement as signaling management's perception that the shares are ___________. Investors respond favorably to this signal so that the _______________ placing upward pressure on the stock price.

Undervalued, demand for the stock increases

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 and the benefits are limited.

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

When interest rates decline, prepayments on mortgages occur because some homeowners refinance with a new mortgage with the lower interest rate. If these mortgages were financed with pass-through securities, the payments will be channeled to the investors that purchased the pass-through securities.

Collateralized mortgage obligations (CMOs) are generally perceived to have

a high degree of prepayment risk

Buy and sell orders on the OTC market are completed by

a telecommunications network

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

have less effect on the valuation of dividend-paying stocks than on stocks with high growth prospects.

If interest rates move _________ the boundaries implied by the caps, the exposure to interest rate risk will be adversely affected as the mortgage rates may not fully offset the increased cost of funds.

beyond

When the lockup period expires, the share price commonly

decreases significantly