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Questions and Answers
What do corporate bonds typically promise to bondholders?
What do corporate bonds typically promise to bondholders?
- Protection against all types of investments
- Equity ownership in the corporation
- A variable amount of interest each year
- A fixed amount of interest each year (correct)
Why are equity investments considered riskier than investments in debt securities?
Why are equity investments considered riskier than investments in debt securities?
- Debt securities have more diverse provisions
- Equity holders receive guaranteed payments
- Equity investments are fully insured
- The value of equity is tied to the firm's success (correct)
What do derivatives primarily provide payoffs based on?
What do derivatives primarily provide payoffs based on?
- The economic conditions of a country
- The performance of real assets
- The prices of other assets like stocks and bonds (correct)
- The guaranteed returns from the issuer
What crucial role do financial assets play in developed economies?
What crucial role do financial assets play in developed economies?
What reflects the investors' collective assessment of a firm's performance in financial markets?
What reflects the investors' collective assessment of a firm's performance in financial markets?
How can derivatives be used in risk management?
How can derivatives be used in risk management?
What happens to the value of equity if a firm is not successful?
What happens to the value of equity if a firm is not successful?
Which of the following is NOT a type of financial asset?
Which of the following is NOT a type of financial asset?
What distinguishes real assets from financial assets?
What distinguishes real assets from financial assets?
Which of the following is an example of a financial asset?
Which of the following is an example of a financial asset?
What are the three broad types of financial assets?
What are the three broad types of financial assets?
How do financial markets contribute to the economy?
How do financial markets contribute to the economy?
What impact did the 2008 financial crisis have on the investment environment?
What impact did the 2008 financial crisis have on the investment environment?
What does fixed income refer to in financial assets?
What does fixed income refer to in financial assets?
What role do investors play when purchasing securities from a company?
What role do investors play when purchasing securities from a company?
Which statement exemplifies the risk-return trade-off in investments?
Which statement exemplifies the risk-return trade-off in investments?
What was the most common form of business organization before the Industrial Revolution?
What was the most common form of business organization before the Industrial Revolution?
What role does the board of directors play in a corporation?
What role does the board of directors play in a corporation?
What is a key requirement established by the Sarbanes-Oxley Act?
What is a key requirement established by the Sarbanes-Oxley Act?
Why is market transparency important for investors?
Why is market transparency important for investors?
What happens when an investor rebalances their portfolio?
What happens when an investor rebalances their portfolio?
Which of the following is an example of an asset class that may be included in an investment portfolio?
Which of the following is an example of an asset class that may be included in an investment portfolio?
What is a potential consequence if firms can mislead the public about their prospects?
What is a potential consequence if firms can mislead the public about their prospects?
What distinguishes an independent director from other directors in a company?
What distinguishes an independent director from other directors in a company?
What is primarily used as collateral in a repurchase agreement?
What is primarily used as collateral in a repurchase agreement?
How do stock prices influence capital allocation in market economies?
How do stock prices influence capital allocation in market economies?
What can individuals achieve by investing savings in financial assets during high-earning periods?
What can individuals achieve by investing savings in financial assets during high-earning periods?
What distinguishes a term repo from a standard repo?
What distinguishes a term repo from a standard repo?
What role do financial markets play concerning risk?
What role do financial markets play concerning risk?
Which of the following best describes federal funds?
Which of the following best describes federal funds?
Why is it unreasonable to expect markets never to make mistakes?
Why is it unreasonable to expect markets never to make mistakes?
What is typically the relationship between the broker's call rate and the rate on short-term T-bills?
What is typically the relationship between the broker's call rate and the rate on short-term T-bills?
Which of the following statements is true regarding repos and reverse repos?
Which of the following statements is true regarding repos and reverse repos?
What effect does a higher stock price have on a firm's ability to raise capital?
What effect does a higher stock price have on a firm's ability to raise capital?
How does the allocation of risk benefit firms seeking to raise capital?
How does the allocation of risk benefit firms seeking to raise capital?
What role does the London Interbank Offered Rate (LIBOR) serve in the financial market?
What role does the London Interbank Offered Rate (LIBOR) serve in the financial market?
How are money market securities characterized in terms of risk?
How are money market securities characterized in terms of risk?
What is indicated by the separation of ownership and management in businesses?
What is indicated by the separation of ownership and management in businesses?
Regarding investors, what characteristic is associated with those who have a higher taste for risk?
Regarding investors, what characteristic is associated with those who have a higher taste for risk?
Why might a bank need to borrow federal funds?
Why might a bank need to borrow federal funds?
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Study Notes
Target Goals for the Unit
- Analyze the investment environment to enhance decision-making
- Solve problems related to risk-return trade-off to optimize investments
- Examine a case in investment and mutual funds for practical application
Learning Outcomes
- Distinguish between real and financial assets
- Explain the importance of financial markets in the economy
- Assess the impact of the 2008 financial crisis on the investment landscape
Real Assets vs. Financial Assets
- Real assets include tangible assets like land, buildings, machines, and knowledge that generate net income.
- Financial assets are claims to income generated by real assets, represented by documents or digital entries, such as stocks and bonds.
- Financial assets enable individuals to hold their claims on real assets and dictate the allocation of wealth among investors.
Types of Financial Assets
- Financial assets are categorized into three broad types:
- Fixed Income: Debt securities promising fixed or formula-based income; examples include corporate bonds and Treasury bonds.
- Equity: Ownership shares in a company with variable returns based on company performance; common stocks do not guarantee dividends, making them riskier investments.
- Derivatives: Financial contracts like options and futures whose payoffs are linked to the prices of underlying assets. Used to hedge risks or speculate.
Role of Financial Markets in the Economy
- Informational Role: Stock prices reflect collective assessments of a firm's performance, aiding capital allocation to firms with the best prospects.
- Consumption Timing: Financial markets allow individuals to save in high-earning periods and consume in low-earning periods, providing flexibility in consumption.
- Risk Allocation: Financial markets enable risk-bearing preferences to be matched with risk-tolerant investors, facilitating capital raising for firms.
- Separation of Ownership and Management: Corporations employ a management structure, separating ownership from daily management, allowing for stability and growth.
- Corporate Governance: Transparency in markets is crucial for informed decision-making; regulations like Sarbanes-Oxley Act enhance corporate governance standards.
The Investment Process
- An investor’s portfolio consists of diverse assets and can be rebalanced to adjust risk and return. Common asset classes include stocks, bonds, and real estate.
Repos and Reverses
- Repos: Short-term agreements where dealers sell securities and agree to repurchase them at a higher price the next day; considered low risk due to collateral.
- Reverse Repos: The opposite of repos, where the dealer purchases securities with an agreement to sell them back later at a higher price.
Federal Funds
- Federal funds represent reserves held by banks at the Federal Reserve, which can be lent on an overnight basis to banks with shortfalls at a determined federal funds rate.
Brokers’ Calls
- Investors buying stocks on margin borrow funds from brokers, who may borrow from banks with immediate repayment conditions.
LIBOR Market
- The London Interbank Offered Rate (LIBOR) is the interest rate major banks charge each other for short-term loans, serving as a key reference rate in financial transactions.
Yields on Money Market Instruments
- Money market securities are typically low-risk, but they are not devoid of risk. The stability of these instruments relies on the creditworthiness of issuers.
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