Investment Environment Chapter 1 Quiz

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12 Questions

What is the main difference between real assets and financial assets?

Real assets directly contribute to the productive capacity of the economy, while financial assets do not.

What types of securities fall under fixed-income or debt securities?

Securities with a fixed stream of income or determined by a specified formula.

Which type of financial market has a daily trading volume of around $2 trillion in London alone?

Currency market

What role do compensation plans play in mitigating agency problems?

Compensation plans tie the income of managers to the success of the firm.

What is the primary function of financial markets in relation to the economy?

Allocation of risk

How do derivative securities differ from fixed-income securities?

Derivative securities' payoff depends on other financial variables.

What is the main focus of the Sarbanes-Oxley Act (SOX) passed in 2002?

Enhancing corporate governance

Which investment process approach involves determining particular securities to be held first and then asset allocation?

Top-down approach

According to the efficient market hypothesis, what would be the situation in an efficient market?

Neither underpriced nor overpriced securities would exist

What is the main principle behind the risk-return trade-off in financial markets?

Higher-risk assets offer higher expected returns than lower-risk assets

What type of investment process approach focuses more on attractively priced securities rather than asset allocation?

'Bottom-up' approach

Why should one rarely expect to find bargains in the security markets according to the text?

Efficient market hypothesis suggests prices fully reflect available information

Study Notes

Real Assets vs. Financial Assets

  • Real assets are used to produce goods and services, examples include land, buildings, machines, and intellectual property.
  • Financial assets are claims to the income generated by real assets or claims on income from the government, examples include stocks, bonds.
  • Financial assets do not directly contribute to the productive capacity of the economy.

Types of Financial Assets

  • Fixed-income/Debt securities promise either a fixed stream of income or a stream of income determined by a specified formula, examples include corporate bonds.
  • Equity represents ownership share in a firm, examples include common stock.
  • Derivative securities payoff depends on the value of other financial variables such as stock prices, interest rates, or exchange rates.

Financial Markets

  • Currency markets have a high volume of trade, with $2 trillion of currency traded each day in London alone.
  • Commodities markets include trading of goods such as corn, wheat, and natural gas.

Financial Markets and the Economy

  • Financial markets play an informational role in the economy, helping with consumption timing, allocation of risk, and separation of ownership and management.
  • Financial markets can help mitigate potential agency problems, such as through compensation plans, monitoring by boards of directors, and monitoring by large investors and security analysts.
  • The threat of takeover can also help mitigate agency problems for poor performers.

Corporate Governance and Ethics

  • Financial markets have faced scandals, such as Enron, Rite Aid, and HealthSouth, leading to a focus on corporate governance and ethics.
  • The Sarbanes-Oxley Act (SOX) was passed in 2002 in response to ethics scandals, focusing on corporate governance and auditing.

The Investment Process

  • A portfolio is a collection of investment assets, with asset allocation being the choice among broad asset classes (e.g., stocks, bonds, real estate).
  • Security selection is the choice of securities within each asset class.
  • Security analysis involves the valuation of particular securities that might be included in the portfolio.
  • There are two approaches to investment: "top-down" (asset allocation followed by security selection) and "bottom-up" (investment based on attractively priced securities without as much concern for asset allocation).

Markets Are Competitive

  • Financial markets are highly competitive, with risk associated with investments.
  • There is a risk-return trade-off, with higher-risk assets being priced to offer higher expected returns than lower-risk assets.
  • Markets are generally efficient, with prices of securities fully reflecting available information.
  • The efficient market hypothesis suggests that there are neither underpriced nor overpriced securities.

Test your knowledge on the investment environment by taking this quiz based on Chapter One of INVESTMENTS by Bodie, Kane, and Marcus. Questions cover topics such as real versus financial assets, risk-return trade-off, efficient pricing of financial assets, and the financial crisis of 2008.

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