Financial Markets - Exam #1

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timer Asked: Jan 26th, 2021

Question Description

I'm working on a finance test / quiz prep and need support to help me learn.

This is a Financial Markets class exam that will be held:

On FRIDAY, JAN 29 (PST) from 2:00pm to 2:50pm

I will provide all the course materials for you to practice but this exam definitely requires some prior experience in financial markets.

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Financial Markets (Econ 173A, Winter 2021) Munpyung O Department of Economics University of California, San Diego m1o@ucsd.edu (Part 1) * Please do not replicate or distribute without permission. Financial markets? Financial markets Financial markets, where the financial securities are traded. Munpyung O (UCSD) Financial Markets Part 1 2 / 52 Financial markets? Real Assets vs Financial Assets Financial Assets Real Assets Examples: land, buildings, machines, and intellectual property. Examples: Stocks, bonds, and options. Have productive capacity: produce goods and services. Contractual claims on real assets. Legal claim to future cash flow. Real assets are used to increase the material wealth of an economy. Munpyung O (UCSD) Financial Markets Do not contribute directly to productive capacity. Part 1 3 / 52 Financial markets? Why financial markets? Why do we need financial markets? Munpyung O (UCSD) Financial Markets Part 1 4 / 52 Financial markets? Why financial markets? 1. Time Desynchronizing consumption from income streams across time and states of nature. Consumption smoothing: Financial asset holding permits the desynchronizing consumption and income streams. In timeless world, there would be no assets, no financial transactions, and no financial markets or institutions. Munpyung O (UCSD) Financial Markets Part 1 5 / 52 Financial markets? Why financial markets? 2. Risk The future is, by its very nature, uncertain: An efficient financial system offers ways for savers to reduce or eliminate the risks they are not willing to bear (Allocation of Risk). By permitting economic agents to diversify, to insure, and to hedge their risks, an efficient financial system fulfills the function of redistributing purchasing power not only over time but also across states of nature. Financial markets help us deal with the uncertainty that is inherent in future events. Munpyung O (UCSD) Financial Markets Part 1 6 / 52 Financial markets? Why financial markets? 3. Efficient allocation Financial intermediation: Financial markets are absolutely vital for the proper functioning of capitalistic economies, since they serve to channel funds from savers (surplus agents: economic agents with surplus funds) to borrowers (deficit agents). They provide an important allocative function by channeling the funds to those who can make the best use of them presumably, the most productive. In fact, the chief function of a capital market is to allocate resources optimally. Munpyung O (UCSD) Financial Markets Part 1 7 / 52 Financial markets? Why financial markets? 4. The connection between the financial system and the real side of the economy Financial markets matter for the economy. An example: The financial crisis of 2008. Munpyung O (UCSD) Financial Markets Part 1 8 / 52 Financial markets? Two characteristics: RR Two Big Rs: “RR” 1. Return 2. Risk (uncertainty) – These are the two most prominent characteristics in finance. Risk-Return Trade-off Higher-risk assets are priced to offer higher expected returns than lower-risk assets. Risk and expected return are positively correlated. Munpyung O (UCSD) Financial Markets Part 1 9 / 52 Definitions & Terms Efficient Markets: Markets are competitive Prices quickly adjust to all relevant information. There should be neither underpriced nor overpriced securities. Munpyung O (UCSD) Financial Markets Part 1 10 / 52 Definitions & Terms Portfolio: a grouping or collection of assets 1) Financial assets: stocks, bonds, saving accounts, cash balances, derivatives 2) Real estate: land, building, and things permanently attached to the land 3) Tangible personal or property: gold, art, equipment owned by firms, etc. Munpyung O (UCSD) Financial Markets Part 1 11 / 52 Definitions & Terms Finance: the art and science of managing money 1) Personal finance: managing one’e own money (Individual investor) 2) Professional finance: managing other people’s money (Institutional investor) Financing: raising money 1) Debt financing: borrowing money (with bonds and loans) 2) Equity financing: selling ownership shares in corporation or partnership Munpyung O (UCSD) Financial Markets Part 1 12 / 52 Definitions & Terms Financial instruments (securities): monetary, legal contracts between parties, claims on real assets. 1) Equity instruments (eg. corporate stocks): ownership shares in a business or piece of real property. Holders receive a dividend or share of profit from issuer. 2) Debt instruments (eg. bonds): promises to repay borrowed money. Holder receives interest from issuer (the borrower) 3) Derivative securities (eg. options, futures and forward contracts): the option of obligation to buy/sell some other asset. Value derived from performance of the underlying asset. Munpyung O (UCSD) Financial Markets Part 1 13 / 52 Definitions & Terms Investment: any placement of funds with the expectation of some rate of return. 1) Economic (physical) investment: purchase new plant, equipment or inventory to enhance expected return. 2) Financial investment: purchase securities with expectation of income (dividends, interest) and/or capital gains. Munpyung O (UCSD) Financial Markets Part 1 14 / 52 Definitions & Terms The Investment Process Asset allocation: An investor chooses how to divide investment budget among broad asset classes (eg. stocks, bonds, real estate) since the different types of assets tend to behave differently in response to market conditions. The consensus among finance professionals is that asset allocation is the most crucial decision made by investors. Indeed, various studies have shown that asset allocation accounts for more than 90% of the investment rate of return, while less than 10% originates from particular choices of stocks or bonds. Security selection: the choice of individual securities within each asset class (eg, Apple stocks, Tesla stocks). Munpyung O (UCSD) Financial Markets Part 1 15 / 52 Definitions & Terms Portfolio construction “Top down” : asset allocation −→ security selection “Bottom up”: security selection −→ asset allocation Munpyung O (UCSD) Financial Markets Part 1 16 / 52 Definitions & Terms Two basic investment strategies 1. Passive Management (buy-and-hold): Buy diversified portfolio of securities and hold for a long time. Holding a highly diversified portfolio No attempt to find undervalued securities No attempt to time the market 2. Active management (Buy low, sell high): buy stocks and/or bonds to try to outperform the market on a regular (and short term) basis. Finding mispriced securities Timing the market Munpyung O (UCSD) Financial Markets Part 1 17 / 52 Definitions & Terms Which works best? Small investors: start with a passive approach and broadly diversified mutual funds or market-index ETFs (Exchange Traded Funds). Institutional investors: use active approach, with large staffs to acquire information and analyze individual securities and markets. Modern Portfolio Theory (MPT) and Efficient Market Hypothesis (EMH) suggest that passive is often closest to the optimal strategy. A stronger believe in efficiency (the competitiveness of financial markets) argues for a more passive strategy. Munpyung O (UCSD) Financial Markets Part 1 18 / 52 Definitions & Terms The players in financial markets Households supply funds: lenders Firms demand funds: borrowers Government can be either borrowers or lenders Financial intermediaries: Pool and invest funds Munpyung O (UCSD) Financial Markets Part 1 19 / 52 Definitions & Terms Financial intermediaries Investment companies Banks Insurance companies Credit unions .. . Munpyung O (UCSD) Financial Markets Part 1 20 / 52 Asset Classes and Financial Instruments Financial markets Financial markets, where the financial securities are traded. Munpyung O (UCSD) Financial Markets Part 1 21 / 52 Asset Classes and Financial Instruments Asset Classes & Financial Instruments Munpyung O (UCSD) Financial Markets Part 1 22 / 52 Asset Classes and Financial Instruments Asset classes: A group of instruments (securities) which have similar financial characteristics and behave similarly in the marketplace. Each broad asset class contains many specific security types. Munpyung O (UCSD) Financial Markets Part 1 23 / 52 Asset Classes and Financial Instruments 1. Fixed Income 1. Fixed income Fixed income securities provide investors a return in the form of predetermined fixed periodic payments and eventual return of principal at maturity. eg. bonds (corporate bonds, municipal bonds and international bonds), T-bills, money market instruments, asset-backed securities. value fluctuates due to current interest and inflation rates. The primary risk associated with fixed-income investments is the borrower defaulting. Munpyung O (UCSD) Financial Markets Part 1 24 / 52 Asset Classes and Financial Instruments Munpyung O (UCSD) 1. Fixed Income Financial Markets Part 1 25 / 52 Asset Classes and Financial Instruments 1. Fixed Income - 1) Money market 1) Money market subsector of the fixed-income market. short-term: securities with an original maturity of 1 year or less. debt instruments sold by governments, financial institutions, and corporations to investors with temporary excess funds to invest. This market is dominated by financial institutions, particularly banks, and governments. T-bills, commercial paper, banker’s acceptances, certificates of deposit (CDs), repurchase agreements, etc. highly liquid. relatively low risk. generally trade in large denominations. Munpyung O (UCSD) Financial Markets Part 1 26 / 52 Asset Classes and Financial Instruments 1. Fixed Income - 1) Money market U.S. Treasury bills (T-bills): A short-term debt obligation backed by the Treasury Dept. of the U.S. government with a maturity of less than one year. – Typical maturities are 13 and 26 weeks, although maturities range from a few days to 52 weeks. – commonly referred to as the risk-free security. The most prominent money market security because it is the safest asset available and because it serves as a benchmark asset. Investors buy the bills at a discount from the stated maturity value. At the bill’s maturity, the government pays the investor the face value of the bill. – The difference between the purchase price and ultimate maturity value constitutes the investor’s earnings. Munpyung O (UCSD) Financial Markets Part 1 27 / 52 Asset Classes and Financial Instruments 1. Fixed Income - 1) Money market Investors do not receive regular interest payments as with a coupon bond, but a T-bill does include interest, reflected in the amount it pays when it matures. income earned on T-bills is exempt from state and local taxes. highly liquid. sold on an auction basis every week at a discount from face value in denominations of $1,000 up to a maximum purchase of $5 million. The greater the discount at time of purchase, the higher the return earned by investors. Munpyung O (UCSD) Financial Markets Part 1 28 / 52 Asset Classes and Financial Instruments 1. Fixed Income - 1) Money market Certificates of Deposit (CDs) a time deposit with a bank. may not be withdrawn on demand. the bank pays interest and principal to the depositor only at the end of maturity. insured to $250,000 by the FDIC in the event of bank insolvency. Munpyung O (UCSD) Financial Markets Part 1 29 / 52 Asset Classes and Financial Instruments 1. Fixed Income - 1) Money market Commercial Paper (CP) A short-term, unsecured promissory note (bond) issued by large, well-known, and financially strong corporations. Denominations starts at $100,000, with maturities of 270 days or less (usually less than 1 or 2 months). CP is exempt from SEC registration requirements. small investors can invest in commercial paper only indirectly via money market mutual funds. less liquid than other money market securities. Munpyung O (UCSD) Financial Markets Part 1 30 / 52 Asset Classes and Financial Instruments 1. Fixed Income - 1) Money market Bankers’ Acceptances a time draft drawn on and accepted by a commercial bank. generally created by a transaction between exporters and importers in different countries. maximum maturity is legally established at 180 days. Munpyung O (UCSD) Financial Markets Part 1 31 / 52 Asset Classes and Financial Instruments 1. Fixed Income - 1) Money market Other money market securities Euro dollars Repurchase agreements (Repos): Sale of a security with the agreement to repurchase the security at a higher price in the near future–short term over night borrowing. Reverse repo (RPs): the mirro image of a repo. Federal funds: short-term lending between banks generally to maintain required reserves. .. . Munpyung O (UCSD) Financial Markets Part 1 32 / 52 Asset Classes and Financial Instruments Munpyung O (UCSD) 1. Fixed Income - 2) Capital market Financial Markets Part 1 33 / 52 Asset Classes and Financial Instruments 1. Fixed Income - 2) Capital market 2) Capital market subsector of the fixed-income market. long-term: securities with more than 1 year in original maturity. liquid low risk (but not as low as the Money Market) Munpyung O (UCSD) Financial Markets Part 1 34 / 52 Asset Classes and Financial Instruments 1. Fixed Income - 2) Capital market The capital (bond) market Munpyung O (UCSD) Financial Markets Part 1 35 / 52 Asset Classes and Financial Instruments 1. Fixed Income - 2) Capital market Treasury Notes and Bonds Maturities: T-notes are issued with maturities up to 10 years; issued for a term of 2, 5, or 10 years. T-bonds are issued with maturities ranging from 10 to 30 years. Notes and bonds differ only in original maturity and are therefore very similar securities. Interest on notes and bonds is paid every six months. Both makes semiannual interest payments called coupon payments. commonly trade in denominations of $1,000. Munpyung O (UCSD) Financial Markets Part 1 36 / 52 Asset Classes and Financial Instruments 1. Fixed Income - 2) Capital market Corporate bonds Issued by private firms Semi-annual interest payments Larger default risk than government securities Options in corporate bonds (chapter 14) Callable: firm has the option to repurchase the bond from the holder at a stipulated call price. Convertible: bondholder has option to convert each bond into a stipulated number of shares of stock. Munpyung O (UCSD) Financial Markets Part 1 37 / 52 Asset Classes and Financial Instruments 1. Fixed Income - 2) Capital market Corporate bonds are similar in structure to Treasury issues, with one important difference: default risk. Because of the default risk, corporate bonds are cheaper (than their respective Treasury counterparts), paying higher yields. The difference in yields is referred to as credit spread. (A credit spread is the difference in yield between two bonds of similar maturity). The probability of default varies across firms of different credit qualities (e.g. countries, industries, guarantees etc.) The probability of default varies over time! Munpyung O (UCSD) Financial Markets Part 1 38 / 52 Asset Classes and Financial Instruments 1. Fixed Income - 2) Capital market Other capital market securities Since 1997, the Treasury has sold Treasury Inflation-Protected Securities (TIPS) which protect investors against losses resulting from inflation; provide a constant stream of real (inflation-adjusted) dollars. International bonds: issued by foreign issuers. Municipal bonds: issued by state and local governments. Mortgage and Mortgage backed securities (MBS) Federal agency debt .. . Munpyung O (UCSD) Financial Markets Part 1 39 / 52 Asset Classes and Financial Instruments 1. Fixed Income - 2) Capital market U.S. fixed-income market ($billion) Source: Security Industry & Financial Market Association, Oct., 2018. Munpyung O (UCSD) Financial Markets Part 1 40 / 52 Asset Classes and Financial Instruments 2. Equity Equity Munpyung O (UCSD) Financial Markets Part 1 41 / 52 Asset Classes and Financial Instruments 2. Equity 2. Equity Unlike fixed income securities, equity securities represent an ownership interest in a corporation. These securities represent a residual claim - after payment of all obligations to fixed income claims - on the income and assets of a corporation. There are two forms of equities, preferred stock and common stock. Most individual investors are primarily interested in common stocks. Munpyung O (UCSD) Financial Markets Part 1 42 / 52 Asset Classes and Financial Instruments 2. Equity Common stocks Ownership share in a corporation. Residual claim: stockholders are the last in line of all those who have a claim on the assets and income of the corporation. Limited liability: the most shareholders can lose in the event of failure of the corporation is the original investment. Munpyung O (UCSD) Financial Markets Part 1 43 / 52 Asset Classes and Financial Instruments 2. Equity Preferred stock Preferred shares generally have a dividend that must be paid out before dividends to common shareholders. Although technically classified an equity security, preferred stock is better characterized as a hybrid security because it has features of both equity and fixed income instruments. – Preferred stock combines features of debt, in that it pays predetermined fixed dividends, and equity, in that it has the potential to appreciate in price. No voting power: holders of preferred stock do not get a vote on company matters. Preferred shares can be converted to a fixed number of common shares, but common shares don’t have this benefit. Munpyung O (UCSD) Financial Markets Part 1 44 / 52 Asset Classes and Financial Instruments 2. Equity ADR (American Depository Receipts): certificates traded in U.S. markets that represent ownership in shares of a foreign company. One of the most convenient and popular ways for investors to buy foreign stocks. ADR holders do not have to transact in foreign currencies, because ADRs trade in U.S. dollars and clear through U.S. settlement systems. Before ADRs existed, if American investors wanted to purchase shares of a non-U.S. listed company, they had to buy the shares on international exchanges. Non-U.S. companies also benefit from ADRs, as they make it easier to attract American investors. Munpyung O (UCSD) Financial Markets Part 1 45 / 52 Asset Classes and Financial Instruments Stock and Bond market Indexes Stock market Indexes Dow Jones Industrial Average (DJIA): a stock market index that measures the stock performance of 30 large companies listed on stock exchanges in the United States. Includes 30 large blue-chip1 corporations Computed since 1896. the second-oldest among the U.S. market indices (after the Dow Jones Transportation Average). Price-weighted average (Example 2.2 and 2.3). Popular but an inadequate representation of the overall U.S. stock market compared to broader market indices. 1 the mature firms that represent the stalwarts of an industry. These well-known, stable, and long-lasting companies are relatively safe investments. Munpyung O (UCSD) Financial Markets Part 1 46 / 52 Asset Classes and Financial Instruments Stock and Bond market Indexes Standard & Poor’s 500 (S&P 500): a stock market index that measures the stock performance of 500 large companies listed on stock exchanges in the United States. Improvement over DJIA in two ways: 1. More broadly based index of 500 firms 2. A capitalization-weighted index2 example 2.4 List of S&P 500 companies: https://en.wikipedia.org/wiki/List_of_S%26P_500_ companies#External_links 2 also called a market-value-weighted index; a stock market index whose components are weighted according to the total market value of their outstanding shares. Munpyung ...
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