Investment Environment and Financial Assets

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Questions and Answers

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?

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?

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?

They allow for the efficient management of real assets Signup and view all the answers

What reflects the investors' collective assessment of a firm's performance in financial markets?

The stock prices of the firm Signup and view all the answers

How can derivatives be used in risk management?

To transfer risks to other parties Signup and view all the answers

What happens to the value of equity if a firm is not successful?

It decreases in value Signup and view all the answers

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

Real estate Signup and view all the answers

What distinguishes real assets from financial assets?

Real assets generate net income to the economy, while financial assets do not. Signup and view all the answers

Which of the following is an example of a financial asset?

Stocks Signup and view all the answers

What are the three broad types of financial assets?

Fixed Income, Equity, Derivatives Signup and view all the answers

How do financial markets contribute to the economy?

They allow individuals to hold claims on real assets. Signup and view all the answers

What impact did the 2008 financial crisis have on the investment environment?

It highlighted the risk associated with financial assets. Signup and view all the answers

What does fixed income refer to in financial assets?

Assets that promise a determined stream of income. Signup and view all the answers

What role do investors play when purchasing securities from a company?

They provide funding for the company to acquire real assets. Signup and view all the answers

Which statement exemplifies the risk-return trade-off in investments?

Higher potential returns typically involve higher risk. Signup and view all the answers

What was the most common form of business organization before the Industrial Revolution?

Sole proprietorship Signup and view all the answers

What role does the board of directors play in a corporation?

Hire and supervise management Signup and view all the answers

What is a key requirement established by the Sarbanes-Oxley Act?

Mandatory personal accountability from the CFO for accounting statements Signup and view all the answers

Why is market transparency important for investors?

It ensures that investors can make informed decisions Signup and view all the answers

What happens when an investor rebalances their portfolio?

They adjust the mix of investment assets Signup and view all the answers

Which of the following is an example of an asset class that may be included in an investment portfolio?

Commodities Signup and view all the answers

What is a potential consequence if firms can mislead the public about their prospects?

Disruption in capital allocation Signup and view all the answers

What distinguishes an independent director from other directors in a company?

They are not affiliated with management Signup and view all the answers

What is primarily used as collateral in a repurchase agreement?

Government securities Signup and view all the answers

How do stock prices influence capital allocation in market economies?

They play a major role by directing capital to firms with the greatest perceived potential. Signup and view all the answers

What can individuals achieve by investing savings in financial assets during high-earning periods?

They can shift consumption to times that provide greater satisfaction. Signup and view all the answers

What distinguishes a term repo from a standard repo?

It involves a longer repayment period. Signup and view all the answers

What role do financial markets play concerning risk?

They facilitate the separation of risk preferences among investors. Signup and view all the answers

Which of the following best describes federal funds?

Excess reserves in banks' accounts at the Federal Reserve. Signup and view all the answers

Why is it unreasonable to expect markets never to make mistakes?

No one can predict future performance with certainty. Signup and view all the answers

What is typically the relationship between the broker's call rate and the rate on short-term T-bills?

The broker's call rate is about 1% higher than T-bill rates. Signup and view all the answers

Which of the following statements is true regarding repos and reverse repos?

In a reverse repo, the dealer buys securities and sells them back at a higher price. Signup and view all the answers

What effect does a higher stock price have on a firm's ability to raise capital?

It makes it easier for the firm to raise capital. Signup and view all the answers

How does the allocation of risk benefit firms seeking to raise capital?

It helps ensure each security can be sold at the best possible price. Signup and view all the answers

What role does the London Interbank Offered Rate (LIBOR) serve in the financial market?

It is the rate at which banks lend to each other. Signup and view all the answers

How are money market securities characterized in terms of risk?

They are very low risk but not risk-free. Signup and view all the answers

What is indicated by the separation of ownership and management in businesses?

Often, ownership and managerial responsibilities lie with different individuals. Signup and view all the answers

Regarding investors, what characteristic is associated with those who have a higher taste for risk?

They are more likely to seek high-risk investments. Signup and view all the answers

Why might a bank need to borrow federal funds?

To meet reserve requirements when short. Signup and view all the answers

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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Description

This quiz explores the basics of the investment environment, focusing on the distinction between real and financial assets. It also examines the role of financial markets within the economy and the implications for investment strategies. Prepare to delve into key concepts that affect risk-return trade-offs and mutual funds.