Term
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Definition
The current commitment of money or other
resources in the expectation of reaping future benefits. |
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Term
| How do real and financial assets differ? |
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Definition
| The material wealth of a society is ultimately determined by the productive capacity of its economy, ie, the goods and services its members can create. This capacity is a function of the real assets - the land, buildings, machines, and knowledge that can be used to produce goods and services. Financial assets, such as stocks and bonds do not directly contribute to the productive capacity of the economy. Instead, these assets are claims to income generated by real assets of businesses and governments |
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Term
| What do financial markets allow participants to do? |
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Definition
1. To time their consumption: decide when they want to spend money earned
2. To choose the level of risk they are taking according to individual preference
3. To take ownership without active participation (separation of ownership &
mgt) |
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Term
| 2 Steps of valuing financial assets |
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Definition
1. Estimating cashflows – cashflow is the cash that is expected to be received
each period from investing in a particular financial asset 2. Appropriate interest rate for discounting cashflows |
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Term
| What types of risk determine the appropriate discount rate? |
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Definition
| Credit risk (default risk), inflation risk, and foreign exchange risk |
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Term
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Definition
Money or near money are used as medium of exchange or in
settlement of transactions. Near money is not money but it closely
approximates money in that they can be transformed into money at little
cost, delay or risk. |
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Term
| Divisibility and Denomination |
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Definition
| Divisibility relates to the minimum size at which a financial asset can be liquidated and exchanged for money. For some financial assets, the extent of divisibility depends on their denomination, eg many bonds come in $1000 denominations |
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Term
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Definition
Refers to the cost of investing in a financial asset and then
getting out of it and into cash again |
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Term
| What two variables determine the bid-ask spread? |
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Definition
1. The variability of the price – ie dispersion of relative price over time
2. The thickness of the market – ie the volume of trading in the market |
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Term
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Definition
| When the final payment is made, and the possibility of early termination either because of bankruptcy or clauses in contract |
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Term
| What determines the liquidity of an instrument? |
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Definition
| Type of asset and quantity that is to be transacted. Influenced also by the thickness of the market |
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Term
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Definition
| Timing, costs and conditions for conversion are clearly spelled out in the financial asset |
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Term
| Currency of a Financial Asset |
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Definition
| Most financial assets are denominated in one currency but dual currency securities are also available in which interest is paid in one currency and redemption value in another. |
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Term
| 10 Properties of Financial Assets |
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Definition
| 1. Moneyness 2. Divisibility and Denomination 3. Reversibility 4. Term to maturity 5. Liquidity 6. Convertibility 7. Currency 8. Cash flow and return probability 9. Complexity 10. Tax status |
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Term
| The functions of financial intermediaries |
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Definition
| 1. Pool the resources of many small investors and are therefore able to lend considerable sums to large borrowers. 2. Better able to diversify risks because they lend to many borrowers and can therefore accept loans that are risky 3. Reduce transactions costs by developing expertise and taking advantage of economies of scale 4. Provide liquidity services that make it easier for customers to conduct transactions 5. Build their expertise through the volume of business they do |
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Term
| The Role of Financial Markets |
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Definition
1. Provides a price discovery process
2. Provides a mechanism for an investor to sell a financial asset.
3. Reduces search and information costs of transacting |
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Term
| Internal vs. External Markets |
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Definition
1. Internal market (national market) comprises of domestic market (where issuers are locally incorporated companies) and foreign market (issuers are foreign companies). All internal market participants are subject to the regulation of the country in which they have issued the securities
2. External market (aka international market, offshore market, euromarket) securities are issued outside the jurisdiction of any single country and they are offered simultaneously offered to investors in a number of countries. |
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Term
| 5 areas of classifying financial markets |
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Definition
1. Type of instruments – debt vs equity market
2. Maturity - money vs capital markets
3. Newly issued – primary vs secondary markets
4. Organizational structure – auction markets, over-the-counter markets
5. Within a specific country - Internal vs external market |
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Term
| Ways to mitigate Agency problems within corporations |
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Definition
1. Compensation of top executives are tied to the success of the firm
2. Board of Directors can force out management teams that are underperforming.
3. Security analysts and large institutional investors monitor firms closely
and make the life of poor performers uncomfortable
4. Bad performers face the threat of takeover |
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Term
| Adverse Selection in financial markets |
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Definition
1. Before transaction occurs
2. Potential borrowers most likely to produce adverse outcome
are ones most likely to seek loan and be selected |
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Term
| Moral Hazard in financial markets |
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Definition
1. After transaction occurs
2. Moral hazard arises because an individual or institution does not bear the full consequences of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to bear some responsibility for the consequences of those actions |
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Term
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Definition
| The precise strategy depends on investor’s perception of how good capital markets are at processing information. This is known as the efficient markets theory: If markets are perceived to be efficient – investment focus is on well diversified portfolios, immunized portfolios or hedging investment risks. If markets are not efficient – investors may try to acquire information to strategically alter the asset allocation or buy underpriced securities and sell overpriced securities |
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Term
| 5 Steps of the Investment Process |
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Definition
| 1. Determine Investor characteristics 2. Choose Investment vehicles 3. Strategy Development 4. Strategy Implementation 5. Strategy Monitoring |
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Term
| Primitive Securities vs. Derivatives |
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Definition
A primitive security offers returns based only on the status of the issuer. For example, bonds make stipulated interest payments depending only on the solvency of the issuing firm
Derivatives yield returns that depend on additional factors pertaining to the prices of other assets. For example, the payoff to stock options depends on the price of the underlying stock. |
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Term
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Definition
The process of bundling and unbundling is called financial engineering. Financial engineers view securities as bundles of possible risky cashflows that may be carved up and rearranged according to the needs or desires of traders in the security
markets |
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Term
| How do US investors participate in foreign investment opportunities? |
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Definition
1. Purchasing foreign securities using American Depositary Receipts (ADRs), which are domestically traded securities that represent claims to shares of
foreign stocks
2. Purchase foreign securities that are offered in dollars
3. Buy mutual funds that invest internationally
4. Buy derivative securities with payoffs that depend on prices in foreign security markets |
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Term
| 3 things securities represent |
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Definition
| 1. Claims to specified cashflows 2. Rights associated with ownership and 3. Claims to assets |
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Term
| Registered vs. Bearer securities |
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Definition
Registered - A bond whose owner is registered with the bond's issuer. The owner's name and contact information is recorded and kept on file with the company, allowing it to pay the bond's coupon payment to the appropriate person Bearer - A fixed-income instrument that is owned by whoever is holding it, rather than having a registered owner.
Coupons representing interest payments are likely to be physically attached to the security and it is the bondholder's responsibility to submit the coupons for payment. |
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Term
| What types of securities does the Money Market consist of? |
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Definition
| 1. Very short-term securities that usually are highly liquid & marketable 2.Many of these securities trade in large denominations and are out of the reach of individual investors |
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Term
| 6 Types of Money Market Securities |
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Definition
| 1. T-Bills 2. CD's 3. Commercial Paper 4. Banker's Acceptance 5. Repos and Reverse Repos 6. Eurobonds |
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Term
| How do mutual funds allow individuals to engage in money market activities? |
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Definition
| They pool the resources of many investors and purchase a wide variety of money market securities on their behalf. |
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Term
| What is the most marketable form of money market securities? |
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Definition
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Term
| Competitive vs. Non-competitive Treasury Bill bids |
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Definition
| Competitive bid - order filled only when bid is high enough and bidder gets order at bid price. Non-competitive bid- purchase bills at average price of successful competitive bids |
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Term
| Annualized Yield of a T-Bill Formula |
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Definition
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Term
| Characteristics of a Certificate of Deposit |
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Definition
| Time deposit with a bank. Time deposits may not be withdrawn on demand. The bank pays interest and principal to the depositor only at the end of the fixed term of the CD. |
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Term
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Definition
Issued by large, well-known companies. Cheaper option to borrowing from bank
CP trades in secondary market and is highly liquid
Short-term (1or 2mth) unsecured debt note backed by a bank line of credit (gives the issuer access to cash that can be used (if needed) to pay off the paper at maturity). |
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Term
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Definition
Definition: An order to pay a specified amount to the bearer on a given date if specified conditions have been met, usually delivery of promised goods.
Use: These are often used when buyers / sellers of expensive goods live in different countries.
Security: similar to a post-dated check. Commitment by bank to pay the bearer once it endorses the BA. |
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Term
| Advantages of Banker's Acceptance |
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Definition
1. Exporter paid immediately
2. Exporter shielded from foreign exchange risk
3. Exporter does not have to assess the financial security of the
importer
4. Importer’s bank guarantees payment
5. Crucial to international trade |
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Term
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Definition
| Dealers in government securities use Repos (repurchase agreements) as a form of short-term, usually overnight, borrowing. Dealer sells government securities to an investor on an overnight basis, with an agreement to buy back those securities the next day at a slightly higher price |
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Term
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Definition
| Similar to repos except term can be 30 days or more |
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Term
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Definition
| Dealer finds an investor holding government securities and buys with an agreement to resell them at a lower price on a future date |
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Term
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Definition
Eurobonds are bonds issued in a currency other than the issuer's home currency outside the issuer's home country.
- Eurobonds are usually bearer bonds that pay interest annually without deduction of tax and are largely free from government regulation. |
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Term
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Definition
| The London Interbank Offered Rate (LIBOR) is the rate at which large banks in London are willing to lend money among themselves. This rate, which is quoted on dollar-denominated loans, has become the premier short-term interest rate quoted in the European money market, and it serves as a reference rate for a wide range of transactions. |
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Term
| Secondary Market Definition |
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Definition
| Where previously issued securities are traded between investors. The proceeds from selling the securities go to the current owners of the securities, not to the original issuers |
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Term
| Types of Secondary Market Brokers |
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Definition
1. Discount broker – executes trades only
- standard discounters- commissions are at least 50% less than full service brokers
- deep discounters- commissions are 60-90% less than full service brokers
- online brokers – allows investors to execute trades using the internet
2. Full service broker – provides a wide range of additional services to clients, eg advisory services |
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Term
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Definition
| Buy or sell orders to be executed immediately (ie at current prices) |
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Term
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Definition
Buy or sell a set number of shares at a specified price or better.
Limit orders cost more than market orders and are especially useful on a low-volume or highly volatile stock. |
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Term
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Definition
| Expire at the close of trading day |
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Term
| Open or good-till cancelled orders |
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Definition
| Remain in force for up to 6 mths unless cancelled by the customer |
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Term
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Definition
| Sell or buy a security when it reaches a certain price. It is Designed to limit an investor's loss on a security position |
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Term
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Definition
| Dealers (or market makers) are the only providers of liquidity; they are counterparties to every transaction. The dealers maintain their own inventory of securities and buy or sell securities from this inventory. They do not serve as intermediaries but rather take the risk of holding securities in their own account. Eg Nasdaq |
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Term
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Definition
| Auction system has no designated dealers or market makers. Investors trade directly with each other or with the intervention of a broker acting only as intermediary. The quotes come from limit orders submitted to a centralised limit order book. Orders are executed according to price-time priority and this requires that no market execute a trade at a worse price than available on another market |
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Term
| Auction Market advantages |
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Definition
1. If orders execute, they avoid paying the bid-ask spread
2. Anonymity is appealing to investors who do not want to reveal their identity |
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Term
| Auction Market disadvantages |
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Definition
1. Provides little liquidity for securities that have low trading volume
2. Large traders have no possibility of negotiating deals for large blocks of securities |
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Term
| Electronic limit order book systems |
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Definition
| Combining auction market with communication and computer technology |
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Term
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Definition
| Combines dealer and auction system. The specialist system on NYSE and AMEX is an example. The specialist maintains a fair and orderly market for one or more securities. They buy and sell (or even short sell) securities for their own account to counteract any temporary imbalance in demand and supply. They also maintain their own limit order book but are prohibited from trading on their own account if there are any outstanding orders that they have not executed. |
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Term
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Definition
| The OTC market is not a formal exchange. It is a loosely organized network of brokers and dealers who negotiate sales of securities. Security dealers quote prices at which they are willing to buy or sell securities. Buyers use a broker to locate the dealer with the lowest offer price and sellers locate the dealer with the highest bid price. |
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Term
| Distinguishing features of OTC markets |
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Definition
1. No membership requirements
2. No listing requirements
3. Multiple dealers per security
4. OTC stocks are considered very risky since they are the stocks not considered large or stable enough to trade on a major exchange. Stocks are less frequently traded (bid-ask spread wider). Research/information on these stocks are less readily available |
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Term
| OTC markets role in the primary market |
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Definition
1. New issues are first sold on OTC markets before the exchange listing
2. Large blocks of outstanding shares offered for sale by a single investor are sometimes sold in OTC market.
3. OTC includes stocks listed on Nasdaq
4. Corporate bonds are traded on both exchanges and OTC markets but Fed and municipal bonds & forwards/swaps are traded only on OTC markets |
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Term
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Definition
- Large institutional investors go through market makers that are not members of a securities exchange
- Institutional investors (mutual funds, life insurance companies, pension funds) receive reduced trading costs due to large size of transactions |
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Term
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Definition
1. Large institutional investors deal directly with each other to bypass market makers
2. Electronic Communications Networks (ECNs) allow direct trading
3. ECNs most effective for high-volume, actively traded securities |
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Term
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Definition
1. Uses borrowed funds to purchase securities
2. Currently owned securities used as collateral for margin loan from broker
3. Margin requirements set by Federal Reserve Board
4. Can be used for common stocks, preferred stocks, bonds, mutual funds,
options, warrants and futures |
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Term
| Advantages of Margin Trading |
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Definition
1. Allows use of financial leverage
2. Magnifies profits |
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Term
| Disadvantages of Margin Trading |
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Definition
1. Magnifies losses
2. Interest expense on margin loan
3. Margin calls |
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Term
| What does it mean to "Buy on Margin" |
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Definition
| Borrowing money from a broker to purchase stock. You can think of it as a loan from your brokerage. Margin trading allows you to buy more stock than you could otherwise normally do. |
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Term
| Criteria of keeping a margin loan |
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Definition
1. When you sell stock in a margin account, the proceeds go to your broker against the repayment of a loan, until it is fully paid
2. There is a restriction called maintenance margin, which is the minimum account balance you must maintain before your broker will force you (via a margin call) to deposit more funds or sell stocks to pay down your loan |
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Term
| Maintenance Margin formula |
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Definition
| Maintenance Margin = Equity in account / value of stock |
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Term
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Definition
| The underlying or inherent value of a stock, as determined through fundamental analysis |
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Term
| Factors that affect intrinsic value |
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Definition
1. Estimates of future cash flows
2. Discount rate
3. Amount of risk |
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Term
| 2 approaches to analyzing equity investments |
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Definition
1. Top down approach (global environment, economic factors, industry factors and companies) - used by institutional portfolio managers vs
2. Bottom up approach (management, firm, industry and economy). |
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Term
| Structure of the Top Down Security Analysis Approach |
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Definition
Step 1: Economic Analysis
- State of overall economy
Step 2: Industry Analysis
- Outlook for specific industry
- Level of competition in industry
Step 3: Fundamental Analysis
- Financial condition of specific company
- Historical behavior of specific company’s stock |
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Term
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Definition
| The concept that the market is so efficient in processing new information that securities trade very close to or at their correct values at all times |
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Term
| What do efficient market advocates believe? |
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Definition
1. Securities are rarely substantially mispriced in the marketplace
2. No security analysis is capable of finding mispriced securities more frequently than using random chance |
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Term
| Economic Security Analysis |
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Definition
| The study of general economic conditions that is used in the valuation of common stock. Stock prices are heavily influenced by the state of the economy and by economic events on both a global and domestic basis. |
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Term
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Definition
| Market value of all goods and services produced in a country over the period of a year |
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Term
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Definition
| Measure of the activity/output in the industrial or productive segment of the economy |
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Term
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Definition
| Economic series that usually reach peaks or troughs before corresponding peaks or troughs in aggregate economy activity |
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Term
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Definition
| Economic series that have peaks and troughs that roughly coincide with the peaks and troughs in the business cycle |
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Term
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Definition
| Economic series that experience their peaks and troughs after those of the aggregate economy |
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Term
| What type of indicator is the stock market? |
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Definition
Leading Indicator - Stock prices reflect expectations of earnings, dividends, and interest rates
- Stock market reacts to various leading indicator series
- Stock prices consistently turn before the economy
does |
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Term
| 4 Stages of an Industry's Cycle |
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Definition
| 1. Initial Development 2. Rapid Expansion 3. Maturity 4. Stability/Decline |
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Term
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Definition
| Finding the dollar value of ownership interest in a company. |
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Term
| 3 Valuation methods we focused on |
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Definition
1. Asset valuation
2. Relative valuation
3. Discounted cashflow approach |
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Term
| 3 Types of Asset Valuation |
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Definition
| 1. Net Asset Value 2. Break-up Value 3. Replacement Value |
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Term
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Definition
The most straight-forward asset valuation is the balance sheet or book value of a company’s assets.
Net Asset Value = Fixed assets + net current asset – Long term debt (Stockholder's Equity) |
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Term
| Disadvantages of Net Asset Value |
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Definition
- Balance sheet historical costs do not reflect current asset valuations
- Intangible assets such as goodwill, human capital and brands are ignored |
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Term
| Realizable or Break-Up Value |
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Definition
Valuation is based on the amount that could be realized if the company’s assets were sold in the open market. In theory, the market value of a company should be higher or at least equal to its break-up value. If the market value is lower than its break-up value, the implication is that the company is undervalued, and a acquirer can make a
riskless profit by acquiring the company and stripping it off its assets |
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Term
| Main Disadvantage of Break-Up Value |
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Definition
It is difficult to calculate the net realizable value of a company’s assets.
There are problems trying to value assets that are unique and also what is obtained during a forced sale/liquidation is always less than in a normal situation |
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Term
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Definition
| Valuation is based on the cost of acquiring the separate assets of a target company on an open market basis. It requires the identification of the company’s separate assets and the determination of the replacement value of these individual assets. |
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Term
| Disadvantages of Replacement Value |
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Definition
1. As the majority of corporate assets are part-used, it will prove difficult finding second hand assets of equivalent condition
2. It does not take into account goodwill and any other intangible assets of the company since they are not on the books
3. It is not easy to find the replacement or realizable value of the assets of a target company unless one has access to the necessary inside information |
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Term
| Steps in Relative Valuation |
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Definition
| Step 1: Identify similar or comparable investments and recent market prices for each Step 2: Calculate a “valuation metric” for use in valuing the asset. Step 3: Calculate an initial estimate of value. Step 4: Refine or tailor your initial valuation estimate to the specific characteristics of the investment |
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