Investment chapter 1

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Questions and Answers

What is the primary role of financial intermediaries?

To connect borrowers and lenders (correct)

To provide loans directly to consumers

To trade securities on the stock exchange

To manage corporate finances

What is the function of investment bankers in the primary market?

To trade existing securities

To manage pension funds

To underwrite newly issued securities (correct)

To lend money directly to investors

How were investment banks affected by the collapse of the mortgage market in September 2008?

Many went bankrupt or were reorganized (correct)

They experienced record profits

They expanded their operations significantly

They became more regulated immediately

Which of the following is NOT a type of financial intermediary?

Real estate agents Signup and view all the answers

What significant change occurred to commercial banks post-1999?

They were allowed to engage in investment banking activities Signup and view all the answers

What advantage do investment banks gain if they become commercial banks?

They can obtain deposit funding Signup and view all the answers

Which market involves trading preexisting securities?

Secondary market Signup and view all the answers

What impact did the financial crisis have on regulations of major banks?

They are now under stricter regulations Signup and view all the answers

What is the primary function of securitization in housing finance?

Pooling loans into standardized securities that can be traded like other securities Signup and view all the answers

What is a characteristic of subprime loans included in housing finance?

They may have higher loan-to-value ratios Signup and view all the answers

How did CDOs (Collateralized Debt Obligations) affect investors during the financial crisis?

They consolidated default risk onto a single class of investor Signup and view all the answers

What role did credit default swaps play in the financial crisis of 2008-2009?

Functioned as insurance against borrower defaults Signup and view all the answers

What is meant by 'systemic risk' in the context of the financial system?

The potential for breakdowns in one market to affect others Signup and view all the answers

What issue arose from the way ratings agencies were compensated during the financial crisis?

They were incentivized to assign high ratings due to the pressure from issuers Signup and view all the answers

Which of the following describes the shift in trading practices during the financial crisis?

The replacement of formal exchange trading with over-the-counter markets lacking insolvency protections Signup and view all the answers

What consequence did rising loan-to-value ratios typically have on borrowers?

Higher risk of default for borrowers Signup and view all the answers

What action was taken regarding Fannie Mae and Freddie Mac during the financial crisis?

They were placed into conservatorship. Signup and view all the answers

What was one of the main purposes of the Dodd-Frank Reform Act?

To clarify the regulatory system. Signup and view all the answers

Which rule was implemented to separate investment banking from traditional lending?

Volcker Rule Signup and view all the answers

What significant event occurred on September 17 during the crisis?

AIG received $85 billion from the government. Signup and view all the answers

What was one of the effects of the money market panic during the financial crisis?

Freezing of the short-term financing market. Signup and view all the answers

What is the primary determinant of a portfolio's return?

Percentage of fund in asset classes Signup and view all the answers

Which investment strategy involves the selection of particular securities within an asset class?

Bottom up investment strategy Signup and view all the answers

How does the risk-return trade-off generally work?

Higher expected returns correlate with higher risk Signup and view all the answers

What characterizes passive management in investment strategies?

Buying and holding a diversified portfolio Signup and view all the answers

In competitive markets, what risk is associated with stock portfolios?

They lose money an average of 25% Signup and view all the answers

Which groups are typically considered net savers in financial markets?

Households and governments Signup and view all the answers

What is the main goal of active management in investment?

To forecast market trends and identify mispriced securities Signup and view all the answers

What does efficient market theory suggest regarding price movements?

All available information is already reflected in market prices Signup and view all the answers

What distinguishes real assets from financial assets?

Real assets produce goods and services, while financial assets represent claims on those assets. Signup and view all the answers

Which of the following statements about financial assets is accurate?

Financial assets and liabilities must balance on a balance sheet. Signup and view all the answers

Which type of financial asset indicates ownership in a corporation?

Equity Signup and view all the answers

How do financial markets perform an informational role?

They tend to allocate capital to companies with the best prospects. Signup and view all the answers

What is the primary advantage of using securities for consumption timing?

They allow for wealth storage and future consumption transfer. Signup and view all the answers

What factor does a derivative security depend on?

The values of other underlying assets. Signup and view all the answers

What does the relationship 'Financial Assets = Financial Liabilities' signify?

Financial assets and liabilities must balance to reflect real net worth. Signup and view all the answers

Which of the following is NOT a characteristic of fixed-income securities?

They represent an ownership stake in a corporation. Signup and view all the answers

What is primarily analyzed during security analysis?

The value of individual securities Signup and view all the answers

What best describes the bottom-up investment strategy?

Selecting individual securities without regard for the broader market Signup and view all the answers

What is a characteristic of portfolios containing stocks compared to bonds?

Stocks generally incur higher average losses than bonds Signup and view all the answers

Which is a primary goal of active management?

Identifying mispriced securities Signup and view all the answers

How does diversification typically affect risk in an investment portfolio?

It helps to spread risk across various assets Signup and view all the answers

What defines the role of households in financial markets?

They purchase securities issued by firms Signup and view all the answers

What does the term 'efficient markets' imply regarding security pricing?

Prices reflect all available information at any given time Signup and view all the answers

What is a common risk associated with passive management in investment?

Attempting to beat the market through trading Signup and view all the answers

What distinguishes an investment banker from a commercial banker?

Investment bankers specialize in underwriting newly issued securities. Signup and view all the answers

What was a major consequence of the mortgage-market collapse in September 2008 for investment banks?

Many investment banks went bankrupt and were reorganized or purchased. Signup and view all the answers

Which factor can convert an investment bank into a commercial bank?

Ability to obtain deposit funding and access government assistance. Signup and view all the answers

What is the role of financial intermediaries in the market?

They connect borrowers with lenders across various sectors. Signup and view all the answers

How did the role and profitability of investment banks change after 1999?

Large commercial banks increased their investment-banking activities, impacting profit margins. Signup and view all the answers

Which of the following best describes securities traded in the secondary market?

They represent preexisting securities exchanged among investors. Signup and view all the answers

Which statement about the operations of investment bankers is incorrect?

Investment bankers focus primarily on managing deposits. Signup and view all the answers

What type of market involves newly issued securities being offered to the public?

Primary market Signup and view all the answers

What is one potential consequence of a lack of trust in businesses and markets?

Additional costly laws and regulations Signup and view all the answers

What does the Sarbanes-Oxley Act (SOX) primarily require from corporations?

More independent directors on the board Signup and view all the answers

Which of the following can be considered a mitigating factor against agency problems in corporations?

Performance-based compensation systems Signup and view all the answers

Which accounting scandal is specifically mentioned as a notable example of corporate governance failure?

Enron scandal Signup and view all the answers

How does the presence of independent directors on a board contribute to corporate governance?

They provide unbiased oversight Signup and view all the answers

What factor is required by the Sarbanes-Oxley Act (SOX) regarding financial statements?

CFO must personally verify the statements Signup and view all the answers

Which of the following consequences can arise from governance and ethics failures in corporations?

Erosion of public support and confidence Signup and view all the answers

What is a primary role of auditors in the context of corporate governance?

To act as watchdogs and ensure compliance Signup and view all the answers

What defines real assets?

Assets used to produce goods and services Signup and view all the answers

Which type of financial asset pays a specified cash flow over a defined time period?

Fixed-income securities Signup and view all the answers

How do financial markets assist in the allocation of capital?

By directing funds to companies with the best prospects Signup and view all the answers

What is a characteristic of equity as a financial asset?

Provides an ownership share in a corporation Signup and view all the answers

What does the equation 'Financial Assets = Financial Liabilities' indicate?

Equal value of assets and obligations Signup and view all the answers

What role do derivative securities serve in financial markets?

They provide payoffs based on the performance of other assets. Signup and view all the answers

Which statement accurately describes financial assets and liabilities?

They reflect the net worth of households. Signup and view all the answers

What is one of the functions of using securities in the context of consumption timing?

To subsidize cash flows for future use Signup and view all the answers

What distinguishes venture capital from private equity?

Venture capital provides funding to new firms, while private equity invests in privately-held companies. Signup and view all the answers

Which of the following best describes the process of securitization in housing finance?

Gathering mortgage loans, combining them, and creating tradable securities. Signup and view all the answers

What was a key change in mortgage financing due to the financial crisis?

Shift from 'originate to hold' to 'originate to distribute' mortgage loans. Signup and view all the answers

What is a notable characteristic of the application of fintech in financial markets?

It emphasizes the integration of technology into trading and investment processes. Signup and view all the answers

Which statement accurately reflects the role of Fannie Mae and Freddie Mac in the housing finance system?

They purchase and securitize mortgage loans to provide liquidity. Signup and view all the answers

What was one of the significant impacts of the financial crisis on the structure of financial markets?

A shift towards more stringent regulatory measures for banks and financial institutions. Signup and view all the answers

How has the practice of mortgage financing evolved since the financial crisis?

Increased transparency and underwriting requirements for loans. Signup and view all the answers

Which of the following terms refers to the application of technology in financial markets?

Fintech Signup and view all the answers

Which type of mutual fund primarily invests in fixed income securities?

Bond Funds Signup and view all the answers

Which of the following is a strategy used to mitigate liquidity risk?

Diversification across asset classes Signup and view all the answers

What is a primary objective of growth investing?

Investing in stocks expected to grow at an above-average rate Signup and view all the answers

In technical analysis, which of the following is primarily examined?

Historical price data and trading volume Signup and view all the answers

Which type of real estate investment allows indirect investment in properties without direct ownership?

REITs Signup and view all the answers

Which risk refers to potential losses due to market fluctuations?

Market Risk Signup and view all the answers

Value investing is primarily concerned with selecting stocks that are:

Undervalued based on fundamental analysis Signup and view all the answers

What is a common disadvantage of mutual funds?

Management fees that can erode returns Signup and view all the answers

Study Notes

Changes in Housing Finance

Securitization involves pooling loans into standardized securities, backed by the loans, and traded like other financial instruments.
Securitization included nonconforming "subprime" loans, low or no-documentation loans, rising loan-to-value ratios, and adjustable-rate mortgages.

Financial Crisis of 2008-2009

Mortgage derivatives, such as Collateralized Debt Obligations (CDOs), consolidated default risk onto a single class of investors, with payments divided into tranches.
Ratings agencies, paid by issuers, were pressured to give high ratings.
Credit Default Swaps were insurance contracts against borrowers' default.
Issuers increased risk to unsustainable levels.
AIG sold $400 billion in credit default swap contracts.
Systemic risk arose from the possibility of a breakdown in the financial system, with spillover effects from one market to others.
Banks held high leverage and less liquid assets, while formal exchange trading was replaced by over-the-counter markets, lacking insolvency protection.

Real vs. Financial Assets

Real assets are used to produce goods and services.
Financial assets represent claims on real assets or their generated income.

Domestic Net Worth

Financial assets and liabilities must balance.
The aggregated balance sheets leave only real assets remaining.
Domestic net worth equates to the sum of real assets.

Financial Assets Types

Fixed-income (debt) securities provide specified cash flows over a specific period.
Equity represents ownership shares in a corporation.
Derivative securities offer payoffs based on the values of other assets.

Financial Markets and the Economy

Financial markets promote the flow of capital to businesses with the best prospects.
Markets help determine the fair value of assets, but their efficiency in allocating capital is questioned.
Other mechanisms for allocating capital exist, each with advantages and disadvantages.
Financial markets enable consumption timing by storing wealth and transferring consumption to the future.
Financial markets facilitate risk allocation by allowing investors to select their desired risk levels, based on their individual preferences.

Investment Process: Security Selection

Investment decisions are made by a top-down approach (allocating across asset classes) or a bottom-up approach (selecting specific securities within an asset class).
Security analysis involves evaluating the value of securities.

Markets are Competitive

Investors seek to maximize their returns.
Higher expected returns typically correspond with higher risk.
Stocks have a higher average rate of return but greater potential losses than bonds.
Risk assessment and diversification are critical in managing investment portfolios.

Market Efficiency

Passive management involves buying and holding a diversified portfolio, with no attempt to find undervalued securities.
Active management focuses on identifying mispriced securities or forecasting broad market trends.

The Players

Business firms typically borrow capital to fund investments.
Households are generally net savers, providing capital to businesses.
Governments can be either borrowers or lenders, depending on tax revenue and government expenditures.
Financial intermediaries, including banks, investment funds, and insurance companies, act as connectors between borrowers and lenders.

Investment Bankers

Investment bankers specialize in primary market transactions, issuing new securities to the public and underwriting those offerings.
Secondary markets involve trading preexisting securities among investors.
The separation of investment banking and commercial banking was legally enforced between 1933 and 1999.
After 1999, large commercial banks expanded into investment banking, impacting investment banks' profit margins.
The mortgage market collapse in 2008 led to the bankruptcy of major investment banks, which were either purchased or reorganized.
Investment banks may transition into commercial banks by obtaining deposit funding and accessing government assistance.
Major banks now face stricter regulations due to the financial crisis.

Financial Crisis of 2008-2009

The financial crisis began with Fannie Mae and Freddie Mac being placed under conservatorship in September 2008.
Lehman Brothers and Merrill Lynch faced imminent bankruptcy.
Government intervention included an $85 billion loan to AIG.
The crisis also led to a freeze in the short-term financing market.

Dodd-Frank Reform Act

The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) aimed to strengthen financial regulations.
Key provisions included stricter requirements for bank capital, liquidity, and risk management.
The act promoted transparency and aimed to simplify the regulatory system.
The Volcker Rule separated investment banking, private equity, and proprietary trading activities within financial institutions from lending counterparts.

Text Outline

Part One: Introduction to Financial Markets, Securities, and Trading Methods
Part Two: Modern Portfolio Theory
Part Three: Debt Securities
Part Four: Equity Security Analysis
Part Five: Derivative Markets
Part Six: Active Investment Management Strategies

Real Versus Financial Assets

Real assets are used to produce goods and services.
Financial assets are claims on real assets or the income generated by them.

Balance Sheet, U.S. Households

Total assets are $144 trillion.
Total liabilities are $19 trillion.
Net worth is $125 trillion.
Real estate represents the largest share of household assets.

Financial Assets = Financial Liabilities

Financial assets and liabilities must balance.
When aggregated across all investors, only real assets remain.
Domestic net worth is the sum of real assets.

Domestic Net Worth

Domestic net worth is $125 trillion in 2019.
Real estate is the largest component at $38 trillion.
Other real assets are $55 trillion.
Financial assets totaled $32 trillion.

Financial Assets

Fixed-income (debt) securities pay specified cash flow over a specific period.
Equity represents an ownership share in a corporation.
Derivative securities provide payoffs depending on the values of other assets.

Financial Markets and the Economy

Financial markets provide informational roles.
They facilitate consumption timing by enabling investors to transfer consumption to the future.
They allow the allocation of risk by allowing investors to select their desired risk level.

Separation of Ownership and Management

The separation of ownership and management creates agency problems.
Performance based compensation, boards of directors, and the threat of takeovers help mitigate agency problems.

Corporate Governance and Corporate Ethics

Corporate governance and ethics failures cost the economy.
They erode public support and confidence in the financial system.
Accounting scandals and misleading research reports have been identified as contributing factors.

Sarbanes-Oxley Act (SOX)

The Sarbanes-Oxley Act (SOX) requires stricter corporate governance and accounting standards.
It requires more independent directors, personal verification of financial statements by the CFO, and an accounting/audit industry oversight board.

The Investment Process: Asset Allocation

Asset allocation is the allocation of an investment portfolio across broad asset classes.
It is the primary determinant of a portfolio's return.
Top-down investment strategies focus on allocating capital across asset classes first.

The Investment Process: Security Selection

Security selection is the choice of particular securities within an asset class.
Security analysis is the analysis of the value of securities.

Risk-Return Trade-Off

Higher expected returns are associated with higher risk.
Stock portfolios lose money an average of 25% in any one year.
Bonds have lower average rates of return but are less likely to lose significant value.

Market Efficiency

Passive management involves buying and holding a diversified portfolio without attempting to identify mispriced securities.
Active management involves identifying mispriced securities or forecasting broad market trends.

The Players

Business firms are net borrowers, raising capital to fund investments.
Households are net savers, purchasing securities issued by firms.
Governments can be both borrowers and savers depending on the relationship between tax revenue and government expenditures.

Financial Intermediaries

Financial intermediaries connect borrowers and lenders.
Examples include commercial banks, investment companies, insurance companies, pension funds, and hedge funds.

Investment Bankers

Investment bankers specialize in primary market transactions.
They underwrite newly issued securities offered to the public in primary markets.
Secondary markets involve the trading of preexisting securities among investors.

Venture Capital and Private Equity

Venture capital involves equity investments to finance new firms.
Private equity involves investments in privately-held companies.

Fintech and Financial Innovation

Fintech involves applying technology to financial markets.
Examples include cryptocurrencies and blockchain technology.

The Financial Crisis of 2008-2009

The financial crisis of 2008-2009 was caused by changes in housing finance and the securitization of mortgage loans.
Securitization involved bundling mortgage loans into large pools and creating tradable claims against the underlying mortgage pool.
The TED spread, the difference between LIBOR and T-bill rates, widened significantly during the crisis, indicating increased risk aversion and reduced trust in the financial system.

Mutual Funds

Definition: A pool of money from multiple investors used to buy securities.
Types:
- Equity Funds: Invest in stocks.
- Bond Funds: Invest in debt securities.
- Balanced Funds: Combine stocks and bonds.
- Index Funds: Track a specific market index.
Advantages:
- Diversification: Reduce risk by investing in various securities across different asset classes.
- Professional Management: Managed by experienced financial professionals.
- Accessibility: Allows investors with limited capital to participate in the market.
Disadvantages:
- Management Fees: Fees can reduce overall investment returns.
- Less Control: Investors have limited control over individual investment decisions.

Risk Management

Definition: Process of identifying, assessing, and prioritizing risks to minimize their impact.
Types:
- Market Risk: Potential losses due to market fluctuations.
- Credit Risk: Risk of borrowers not repaying loans.
- Liquidity Risk: Difficulty in selling investments quickly without significant losses.
- Operational Risk: Risks arising from internal processes or systems.
Strategies:
- Diversification: Spreading investments across various asset classes.
- Stop-Loss Orders: Automatic sell orders triggered when investment reaches a predetermined price.
- Insurance: Using insurance products to mitigate specific risks.

Investment Strategies

Growth Investing: Focuses on companies expected to grow at above-average rates.
Value Investing: Identifying undervalued stocks based on fundamental analysis.
Income Investing: Emphasizes investments that generate regular income, like dividends or interest.
Index Investing: Investing in an entire index to match the market's performance.
Dollar-Cost Averaging: Regularly investing a fixed amount regardless of market fluctuations.

Stock Market Analysis

Fundamental Analysis: Evaluating a company's financial health through metrics like earnings, revenue, and price-to-earnings ratio.
Technical Analysis: Analyzing historical price data and trading volume to predict future price movements.
Market Indicators:
- Bull Market: Rising prices and investor confidence.
- Bear Market: Falling prices and investor pessimism.
- Sentiment Analysis: Gauging investor mood to anticipate market trends.

Real Estate Investment

Types:
- Residential Properties: Single-family homes and condominiums.
- Commercial Properties: Office buildings and retail spaces.
- REITs: Real Estate Investment Trusts allow investors to participate in real estate without direct ownership.
Benefits:
- Passive Income: Potential for rental income.
- Tax Advantages: Potential tax benefits for real estate investments.
- Appreciation: Historical potential for property value appreciation.
Risks:
- Market Fluctuations: Property values can be affected by market conditions.
- Management and Maintenance: Requires effort and costs to manage and maintain properties.
- Illiquidity: Real estate can be harder to sell quickly compared to other investments.

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Description

Explore the intricate relationship between housing finance and the financial crisis of 2008-2009. This quiz covers important concepts such as securitization, mortgage derivatives, and the role of ratings agencies in the crisis. Test your understanding of how these elements contributed to systemic risk in the financial system.