FINC 561
A characteristic of market orders is execution ___________ and price __________. Whereas a characteristic of limit orders is execution ___________ and price _________.
Certainty; Uncertainty; Uncertainty; Certainty
Asset allocation (Type of decision)
Choice among broad asset classes (stocks vs bonds vs cash). Asset allocation is the most important investment decision an investor can make as this decides the how much is invested in stocks and bonds. The reason this is so important is that stocks and bonds have different risk and return profiles and so the allocation to each of these can materially impact investment returns.
Financial Assets
Claims on real assets or the income generated by them. Claim on real assets in the form of a security. They are traded in securities markets
Portfolio
Collection of investment assets. Once is established, it is updated or rebalanced by selling securities and then buy new securities, by additional funding or by selling securities to decrease the size of the portfolio.
Agency problems
Conflicts of interest when managers may pursue their own interests instead. To mitigate problem: 1) Compensation plans tie to the income of managers to the success of the firm. (shares or stocks options). Although it can create an incentive for managers to manipulate information to prop up a stock price temporarily. 2) Board of directors can forced out management teams that are underperforming. 3) Outsiders such as security analysts, mutual funds or pension funds can monitor the firm closely. 4) Bad performers are subject to threat of takeover. Shareholders in principal can elect a different board.
A firm's preferred stock often sells at yields BELOW that of its bonds because
Corporations owning stock max exclude from income taxes most of the dividend income received
What are credit spreads and what do they reflect?
Credit spread is the difference in yield between corporate (or muni) bond and a US Government bond of comparable maturity. The spread reflects the credit risk (aka default risk) of the corporate or municipal borrower. The riskier the borrower (as measured by the borrower's credit rating) the larger the credit spread. The spread serves as compensation to the lender for taking on the borrower's credit or default risk.
Derivatives Markets
Depend on the values of other variables such as commodity prices, bond and stock prices. A security that derives its value from another asset(s). Options & futures provide payoffs that depend on the price of another asset or index.
Real Assets
Determine the productive capacity and net income of the economy Examples: Land, buildings, machines, knowledge used to produce goods and services
No free lunch-Risk Return Trade-off
Higher returns=higher risk. Can't have a high expected return with very low risk. If an asset offered a higher expected return without extra risk, investor would rush to buy it therefore the price would go up, the investor will find the investment less attractive. The price will rise until the expected return matches the risk.
If you believe that there is "no-free lunch" in investing, are you more likely to hire an active or passive manager to oversee your portfolio? Why?
Hire a passive manager. An implication of "no free lunch" is that markets are efficient which means stocks are fairly priced - no bargains. Active managers charge high fees and incur high transaction costs to seek underpriced and avoiding overpriced stocks. Even if markets are efficient, it's still possible for a manager to outperform the market average despite the odds against overcoming the performance hurdle of fees and transaction costs. In efficient markets, the odds favor a passive index fund over vs. active managers due to latter's higher fees and transactions costs. However, that doesn't preclude an active manager from being "lucky" in any given year or over multiple years and outperforming the S&P 500. It's possible in efficient markets, but not repeatable in the long run.
Passive Management
Holding highly diversified portfolios without spending effort or other resources attempting to improve investment performance through security analysis. Beliefs markets are efficient, match the index, low cost. Fees are a small fraction of that charged by active managers.
Which of the following statements is FALSE? Group of answer choices In efficient markets, the expected value of active management is negative after considering management fees and transaction costs. In efficient markets, investors can still make money in the stock market, but they cannot consistently achieve returns in excess of the market. Market efficiency means that securities are fairly priced meaning that one cannot consistently find over- or underpriced securities. If markets are efficient, then only those mutual fund managers that have skill will outperform the market. An implication of no free lunch is that investors seeking higher returns cannot achieve this without being exposed to higher risk.
If markets are efficient, then only those mutual fund managers that have skill will outperform the market.
Differences between Option and future contracts
Option: right (not obligation) to buy or sell and asset, exercised only when profitable, options are purchased, sold, the premium is the price of the option Futures contract: obligated to make or take delivery. Not up-front-cost it's a sale agreement.
All of the following are examples of financial assets except. Group of answer choices Patent & trademark Stock & bond Option & futures contract All are financial assets FX forward agreement
Patent & trademark
Equity securities-Preferred stock
Pay a fixed amount of income each year is similar to a infinite-maturity bond that is a perpetuity. It does not convey voting power. The firm retains discretion to make the dividend payment it has no contractual obligation to pay. Payments are treated as dividends they are not tax-deductible
Stop (loss) sell order
Placed at a stop price below the current market price, executes if stock trades at or below the stop price and can limit the losses on a long position. stop loss order- stock is to be sold if it falls below a stipulated level in order to avoid further losses
Stocks are a risky asset that have significantly outperformed Treasury Bills (a risk-less asset), over the long-term. Why then, would one invest in Treasury Bills instead of stocks?
Preference for a very low-risk investment would result in an individual choosing Treasury Bills over stocks despite lower expected returns Consider a person reaching retirement, this person would not want to take risk with their money, so they would choose treasury bills to protect the value of their money.
Preferred stock has characteristics of both debt and common stock. Which characteristics of preferred stock resemble that of common stock?
Preferred & common dividends are not tax deductible expenses; both preferred & common stock are classified as "Shareholder Equity" on balance sheet; preferred & common stock have infinite maturities; both pay dividends at management's discretion
Preferred stock has characteristics of both debt and common stock. Which characteristics of preferred stock resemble that of debt?
Preferred stock holders and debt holders do not have voting rights; preferred stock dividends are very stable making preferred stock like a perpetual bond
No free lunch-Market efficiency
Rarely find bargains in the security markets. No misprice securities: securities are fairly priced: difficult if not impossible to find under or over priced securities. Question the value of active management.
Time Value of Money
Relationship between present value and future value over a known time.
Bonds or Fixed income
Represents indebtedness a loan between borrower and lender. Principal must be repaid with interest. Promise either fixed stream (periodic schedule payments) of income or a stream of income determined by a specified formula. Value depends on changes in interest rates and changes in borrower's credit risk
Proxy contest
Shareholders seek to obtain enough proxies. Rights to vote the shares of other shareholder to take control of the firm and vote in another board. The odds of a successfully proxy contest has increased along with the rise of so-called activist investor. Large investors often hedge funds that identify firms they believe to be mismanaged, they buy large positions in shares and then campaign for slots on the board of directors for specific reforms.
The Dow Jones Industrial Average index (DJIA) is the most well-recognized and referenced index in the world. Yet despite its popularity, critics question its use a valid proxy for the US stock market. Which of the following are reasons why the DJIA is an inferior index to the S&P 500 or the Russell 1000?
The Dow contains only 30 names - a small percentage of the 4,000+ actively traded US stocks. Furthermore, it uses an arbitrary weighting scheme where the weight of each Dow component is proportional to its price per share.
The yield on a 10-year US Treasury bond is 2.5%. ABC Co. and XYZ Co. each issue a 10-year bond. ABC's bond has a yield of 3.5%; while XYZ's bond has a yield of 5%. Select the statement below that BEST describes this situation.
The credit spread of ABC's bond is 1%; and XYZ Co. should have greater default risk than ABC Co.
What is your maximum loss if you place a stop-buy order at $128/share?
The exact loss cannot be determined until the stop-buy is executed. Recall that for stop orders, you don't know the execution price since stop orders, when triggered become market orders and the execution price is uncertain for market orders until the investor receives the trade conformation.
What is your maximum payoff from being shot a put option?
The maximum profit is limited to the option premium received.Maximum loss is unlimited. The loss increases as the stock price decreases.
Market order
a buy or sell order to be executed immediately at current market prices
Derivative Securities
a contract between two or more parties based upon an underlying asset/s. Value derive from prices of other assets (stocks, bonds, currency, commodity). Use to hedge or transfer risk.
limit order
a request to buy or sell a stock at a specified price.
Future contracts
a sale agreement of an asset. Long position: take delivery of asset at maturity Short position: make delivery of asset at maturity Some contracts are settled in cash: difference btw market price at delivery dat and previously agreed upon price.
Fungible
able to replace or be replaced by another identical item; mutually interchangeable. Money is fungible; commodities of the same grade. Ex: stocks
Active Management
attempting to identify mispriced securities or to forecast broad market trends. Believes markets are inefficient. Beat the market and high cost. They can beat the market on occasion and it would be a random event, not attribute to skill. Passive should "win" more often. The active manager charges a management fee for such a service and will also incur higher transaction cost due to the buying and selling of securities.
Options
call option: right to buy underlying asset at the strike or exercise price pit option: right to sell underlying asset at the strike or exercise price. Options have an expiration date-they don't last forever.
Security selection (Type of decision)
choice of which securities to hold within each asset class (Active or Passive management). You can hold the market (a representative sample of all the major stocks and bonds) or you can study various companies to see which companies have better business prospects and buy their equity and/or debt.
Yield curve
default-free interest rate vs maturity of US GOV issue debt. All other debt is price off US treasury yield curve: 30yr mortgages (10 years UST+spread) Prime rate (fed fund +3%) Broker call (T-bills +1%) Corporate bonds (UST+spread)
Type of orders
-market order -stop order -limit order
Municipal Bonds
Bonds issued by state and local governments, priced off the treasury yield curve based on the issuers credit rating, interest is exempt from federal, state & local income tax. Muni yields are lower than comparable taxable corporate bonds. Compare yield of a muni (tax free) vs corporate (taxable) on a AFTER TAX basis. To high-tax-bracket investor muni offer highly attractive equivalent taxable yields. The higher the yield ratio, the lower the cutoff tax bracket.
Governments
Borrowers or lenders, depending on the relationship between tax revenue and government expenditure. Typical borrowers.
Limit order sell
Broker to sell when the stock price rises above a specified limit
Role of Financial Markets
1) Consumption timing: securities store wealth and transfer consumption to the future. 2) Allocation of risk: select securities consistent with one's return preference and risk appetite. Investors are able to select security types with the risk-return characteristics that best suit their preferences, each security can be sold for the best possible price. 3) Separation of Ownership and Management: elect a board of directors. The owners and managers of the firm are different parties
The role of financial intermediaries
1) Pooling the resources of small investors to lend to large borrowers. 2) Lending to many borrowers achieving significant diversification. 3) Build expertise and can use economies of scale.
Financial markets
1) Provide access to financing 2) Place for investor to buy/sell securities
One of the US stock mutual funds in your 401(k) has outperformed the S&P 500 over the past 3 & 5 years net of all fees. Which is the most likely explanation assuming you believe in efficient markets?
This manager is just one of several thousand actively managed mutual funds seeking to outperform the S&P 500. While this is possible under efficient markets, it would be a random event.
Financial Asset
Three types: Derivative securities, stocks (equity), bonds & cash (fixed income)
Bond Market
US Treasury Notes & bonds, corporate bonds, municipal bonds
Moral hazard
When the act of insuring an event increases the likelihood that the event will happen
Why is money worth more today than it is next year?
Because of the interest the money can earn
Common stock
represents an ownership share of a corporation. Payments in the form of dividends. Value depends on the success of the firm.
Equity Securities-Common stock
represents ownership shares of a corporation. Is controlled by a board of directors elected by the shareholders. Residual claim: stockholders are the last in line of all those who have a claim on the assets. In a liquidation you have a claim to what is left after all other claimants. Not in liquidation you have a claim to the part of operating income left over after interest and taxes. Limited liability: shareholders can lose in the event of failure of the corporation. They are not personally liable for the firm's obligations. Entitled to voted rights and dividends.
Money Market
subsector of fixed-income market, securities are short-term, liquid, low risk & low return. Access via money market mutual funds. Ex: certificates of deposit, US T-bills, Commercial paper, LIBOR market, Repos.
TED spread
the difference between the interest rate at which banks lend to each other (LIBOR) and the interest rate on Treasury bill Rate. It reflects the credit spread of banks When market is turbulent Libor goes up, T-bills decrease and Ted spread increase.
securitization of mortgages
- the pooling and packaging of mortgage loans for sale in the form of bonds. Non-conforming sub-prime mortgages which were lower credit quality. Include fraud during loan application fraud in overstating home values , inadequate government regulations.
Which of the following statements is FALSE regarding financial intermediaries? Group of answer choices Insurance companies act as financial intermediaries by pooling risk amongst households thereby reducing the cost of insuring such risks. A financial advisor is a financial intermediary since he/she gives financial advice to households regarding saving for retirement. Investment companies act as a financial intermediary by pooling investors' funds enabling those with small sums of money to obtain diversified portfolios. A stock broker acts as a financial intermediary by bringing together buyers and sellers of stocks. Banks & credit unions are a financial intermediaries since they act as a middle man between households wanting to borrow and those wanting to lend.
A financial advisor is a financial intermediary since he/she gives financial advice to households regarding saving for retirement.
What is a security?
A fungible, negotiable financial instrument that represents an interest or a right in something else.
Sarbanes-Oxley Act
A law passed by Congress that requires the CEO and CFO to certify that their firm's financial statements are accurate. To tighten the rules of corporate governance and disclosure. Have more independent directs that are not managers. Prohibits auditors from providing various services to clients.
Explain the difference between a long call option and a long futures position
A long call option is when an investor buys a call that gives the right to buy an asset at a strike price or exercise the price. This is only the right of an option is not an obligation, whereas in a long future position is an obligation to take delivery of the asset at maturity.
Stop order
At current market price. (unknown) an order to execute a transaction when the stock price reaches a specified price (stop price)
Why is a put option like insurance?
Because if the price of the asset fall below the strike price the option enables you to sell for at the insured price.
which of the following is a false regarding options and futures? A. A long call option gives the holder the right to buy an asset at the strike price whereas a long futures position obligates the holder to buy the asset at a future price. B. buying a put option is like buying insurance on an asset. If the asset price declines, the put holder can sell the asset at the strike price to defray any losses in the asset value. C. A short call option exposes the seller to unlimited potential loss D. In a short put option, the seller maximum loss on the strike price E. Derivatives such as options and futures are risky securities and therefore rarely used for hedging purposes since hedging is designed to reduce risk.
E. Derivatives such as options and futures are risky securities and therefore rarely used for hedging purposes since hedging is designed to reduce risk.
State whether the following is a real or financial asset.
FX forward contract: Financial Trademark: Real Stamping press: Real Stock option: Financial Oil futures contract: Financial
What are the players in the financial markets?
Firms, Households, Governments
Financial intermediaries
Firms, such as banks, mutual funds, pension funds, and insurance companies, that bring the suppliers of capital (investors) together with the demanders of capital (corporations and federal government). They issue their own securities to raise funds to purchase the securities of other corporations. Is an institution (or individual) that serves as a middleman among parties to facilitate financial transactions. Commercial banks & credit unions: match borrowers & lenders. The difference between the lending and borrowing rate serves as compensation for performing the service. Stockbrokers: match buyers and sellers of securities. Commissions charged by the broker serves (service) Mutual funds: investment company where smaller investors pool their money into large fund enabling the manager of the fund to create a diversified portfolio. Charges a fee paid by the investors for this pooling service. Insurance companies: use economies of scale and scope to pool risk among individuals for a fee. Financial Advisor or consultant: provides investment advice and knowledge. Is NOT a financial intermediary. Simply providing advice.
All of the following are examples of real assets except. Group of answer choices FX forward agreement None are real assets Stock & bond Option & futures contract Debt secured by plant equipment
None are real assets
A work colleague was bragging that the actively managed mutual fund he selected among your employer's 401(k) electives outperformed the S&P 500 over the past 3 years. The colleague (who did not take FINC 561) claims that it's a great fund, that the manager is a genius and is urging you to invest in that fund as well. However, you believe that markets are efficient. Do you take your colleague's advice? Explain your rationale by applying concepts of market efficiency learned so far in the course. Include whether the mutual fund's performance violates or disproves efficient markets and why or why not?
In a no-free lunch market we believe that the markets are efficient and in this case it is preferred to use passive management to oversee the 401k. Since the markets are efficient the stocks are fairly priced therefore it is pointless to spend money, time and resources trying to outperform the market. I will not take my colleague's advice because I believe in the efficiency of the markets and I am aware that some investors like my colleague can in fact, outperform it, however this is just a matter of luck such as flipping coins and not attributable skill.
Suppose you sell short 100 shares of IBM currently selling at $120/share. What is your maximum possible loss?
In principle, the loss is unlimited and increases with the price of IBM which is unbounded.
Limit order to buy
Instruct the broker to buy at or below a stipulated price
Purchasing stock on margin
Investor borrow a portion of the stock's purchase price form the broker. Margin: is the portion contributed by investor Loan: remainder borrowed from the broker. Federal reserve limits at 50%, broker can stipulate more. Broker borrows from a bank at "broker call" Broker charge "broker call" + service charge
What is the "magic" of compounding interest?
Investors earn interest on interest. The more frequent the compounding period, the more interest they earn on interest.
Which of the following is FALSE? Group of answer choices An example of moral hazard in the housing market that led to the 2008 financial crisis is when issuers of sub-prime mortgages had little incentive to perform adequate due diligence since the loans were sold to banks who then securitized the loans which were then sold to investors. Investors that believe markets are efficient should seek skilled investment managers based on their past performance track record. Security selection is the process of deciding which securities to hold within each of the various asset classes. After several accounting scandals in late 1990's and early 2000, the Sarbanes-Oxley Act helped restore investor confidence in markets by tightening the rules of corporate governance which reduced the likelihood of corporate executives falsifying financial results. Asset allocation is the most important step in the investment process and involves the selection of asset classes such as US stocks; non-US stocks; corporate bonds; US Treasuries; municipal bonds; real estate; commodities; and cash.
Investors that believe markets are efficient should seek skilled investment managers based on their past performance track record.
stop (loss) buy order
Is placed by short sellers at a "stop" price above the current market price, executes if the stock trades at or above the stop price, and can limit loses on a short position. stop buy orders- stock is to be bought if it rises above a certain limit.
Corporate Bonds
Issued by public and private companies, issuer's credit rating that reflect its ability to repay debt, priced off the treasury curve, credit spread reflect a firms ability to repay its debt. Firms with HIGHER credit rating have lower or tighter credit spreads. Spreads widen in recession: investors driven by fear. Spreads tighten in a recovery: fear subsides investors driven by greed.
Treasury Notes and bonds
Notes-maturities >1 to 10 years Bonds- maturities >10 to 30 years Semiannual interest payments called coupon payment Default-free
Explain how it is possible for one proxy (S&P 500) to have a positive return while the other (DJIA) has a negative return on any given day. Include in your explanation some of the names that could have caused this discrepancy. Which return (S&P 500 or DJIA) is more indicative of the 'true market return'?
It is possible for one proxy to have a positive return vs a negative return mostly because the DJIA index contains a limited number of holders which are only 30 companies. There are some sizable, important companies that are not considered in their report such as Amazon, Alphabet (Google) and Facebook . If we only ponder these three companies in the S&P 500, they represent 13.42% of the Index weight that DJIA is not contemplating in their report. Also, DJIA is an arbitrary index because it uses a price-weighted model instead of considering the proportional market value. For example, Apple in the S&P 500 has a weight of 4.90% while in the DJIA has a weight of 8%. In the DJIA index we can observe that the biggest player is United Health Group with 8.22% but their total Market Cap is only $283 versus the total market capitalization of Apple that is 1,254. However, United has a first and more weighted place because of their price-weighted model. Their stocks are held in proportion to their price. S&P 500 is the most accurate index.
Diversification
Many assets are held in the portfolio so that the exposure to any particular asset is limited.
What is your maximum payoff from being long a put option?
Maximum profit is equal to the strike price minus option premium. Maximum loss is equal to the option premium paid
Financial markets
Money markets: short term, liquid, low risk, cash or eq. Capital markets: long-term, riskier. EX: bonds, equity, derivatives securities
Dow Jones Industrial Average (DJIA)
Most well-recognized stock index in the world. Limited number of holdings (30) Arbitrary construction methodology-price weighted. Excludes: AMZN, GOOG, FB, BRK. Highly Exclusionary and Arbitrary Construction Methodology. Is a price weighted index where each stock is held in proportion to its price- not is market value. This can result in spurious performance due to inadequate diversification.
Households
Net suppliers of capital. They purchase securities issued by firms that need to raise funds.
Prior to the 2010 Dodd-Frank Act "Volker Rule", banks employed proprietary traders (aka Prop Traders) whose job was to invest the Bank's capital in various short-term trading strategies. Prop Traders often took large risks (using leverage) and were rewarded with yearly bonuses worth millions of dollars. Prop Trading was eventually disallowed by the Volker Rule, which was part of Dodd-Frank Act. Explain the moral hazard associated with such proprietary trading activity.
The moral hazard is when banks trade their own accounts and invest in hedge fund or private equity fund there is a chance of insolvency not only of the bank but all the money of the small investors that the bank will use. The more capital supporting banks, the potential for one insolvency to tiger another should be contained. Bank capital levels are higher today than they were before the crisis.
Moral hazard in banks that securitize sub-prime mortgages
The originator didn't hold the loans they rather sold them to investment bank that pool them and sold them to investors. Originators had no risk and therefore incentivized to make as many loans as possible even if it was risky. The banks backed the pools using bonds that they purchased with insurance policies, when the mortgage fail the bank would collect a credit-default swap. The moral hazard fell on the companies that insured the sub-prime.
What option strategy (e.g. long put, short put, long call, short call) has the greatest risk of loss?
The short call option has the greatest risk because it has unlimited loss. You sold the right to a trader to buy an asset at the strike price, anytime the price goes beyond the strike price the sort call option decrease dollar for dollar.
Presidential administrations often like to "tinker" with the tax code. Assume the tax code under former President O'Bomba listed the highest marginal tax rate at 40% and that President Chump reduced the highest marginal rate to 30%. Which scenario below describes the most likely impact this change in tax policy will have on municipal and corporate bonds? (no calculations are required)
The tax cut causes an increase in the after-tax yield on corporate bonds. In response, muni bond yields would rise (prices fall) to make them equally attractive as the after-tax yields on corporate bonds for investors in the top tax bracket.
Firms
They raise capital now to pay for investments in plant and equipment. The income generated by real assets provides the returns to investors who purchase the securities.
You see an advertisement in a book that shows how to make lot of money in the stock market with little or no risk. Apply the concepts of "no free lunch" to explain i) Whether or not you would buy the book and why or why not? ii) What the value of the information contained within the book and why?
i) No, I would not buy the book because under a no free lunch market there will always be risk associated with investment. If you want higher expected returns (to make a lot of money) you will have to pay higher prices. If the market is efficient and the investors find a return that offers high returns without extra risk, all the investors will rush to buy it and that would raise the price until expected return matches the imminent risk. ii) The value of the information contained in the book would be zero because in an efficient market I will always have to place a high amount of money if I want the highest reward. Most of these books promise unrealistic probabilities in a market that is public and the information is open to all bidders.
What is your maximum payoff from being a short call option?
infinite negative
What is your maximum payoff from being long call option?
infinite positive
All of the following are examples of real assets except: a warehouse a hammer a data set an insurance policy
insurance policy
What is the cost of money?
interest rate
Security analysis
involves the valuation of particular securities that might be included in the portfolio
negotiable
legally transferable in title from one party to another. Used cars are NOT fungible due to differences how the cars were maintained. A loan contract collateralized by a car is a security.
