Here's where you can create more readings for additional extra credit. Don't plagiarize! If you have found a useful link, don't copy the contents here. Instead, put the link on the web readings page. Chapter 1 - Introduction
- Define investments and describe how investments are created in the financial markets
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Investments are the commitment of any resources that over time have the potential for gain. In this class, we usually mean the commitment of money with the hope of making even more money.
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Investing brings together users of funds, usually firms or governments, and providers of funds which are individuals and households. Investments can be created in two different ways. Direct investments are created when the suppliers give money directly to the end user of the funds. In return, the user creates a security, such as a stock or bond which represents some claim on the company's income and/or assets. However, sometimes there are market frictions that make direct investing difficult, such as maturity or denomination mismatches. Indirect investing is when suppliers of funds funnel their money through an intermediary, and the intermediary passes the money along to the ultimate user of the funds. Indirect investment is often done through large portfolios that professionally managed. Sometimes the intermediaries will create a completely different type of security than existed through direct investment (e.g., a share in a mutual fund). Common financial intermediaries include mutual funds, pension funds, insurance companies, and banks.
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There are three major types of securities that are created. Debt securities are a fixed claim on income and assets. Equitysecurities are residual claims on income and assets, and derivatives securities (such as options and futures) derive their value from some underlying asset.
- Discuss some frictions that may occur with a direct transfer and how intermediaries help resolve those problems
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Intermediaries provide an opportunity for investors to pool their resources together and easily purchase securities. These intermediaries are essential to the efficiency of our economy. Maturity, denomination, risk management, transaction fees, etc are all frictions that constrain a typical investor while making a direct transfer. Intermediaries are able to buy securities in large quantities and in-turn sell them to investors on more flexible terms. For example, if you would like to invest $1,000 for 2 years in corporate bonds but the only available investment is a $5,000 bond that matures in 5 years, a financial intermediary is able to offer you the investment you are looking for because your cash is pooled together with many other investors. The fees for such a service are low because of the intermediary’s “economy of scales” (the cost to coordinate a transaction, research the risk of the bond, match your needs with the appropriate investment, etc. are low because the intermediary handles so many transactions).
- Using an income statement, explain the taxation of investment income and capital gains (including the issue of double taxation)
Chapter 2 - Overview of securities
- Walk through a "summary" quote on Yahoo! Finance and describe the information provided
- Differentiate the types of claims on bonds vs. stocks, focusing on the fixed nature of bonds and the residual claim of stocks
- Bondholders have a fixed claim on the assets and income of the company that issued the bond while stockholders have a residual claim on the income of the company that issued the shares of stock. Owning a bond is equivalent to making a loan to that company where as owning a share of stock is equivalent to partial ownership in that company. Bondholders receive a fixed return on their investment based on the interest rate, or coupon rate, of the bond. These coupon payments are generally made semiannually with the principal being returned when the bond reaches maturity, which can be as much as 30 years later. Because bondholders own the debt of the company that issued the bond, they have a priority claim on the company’s assets ahead of stockholders should the company declare bankruptcy. The stockholders’ residual claim, or equity claim, guarantees that stockholders have a right to a share of the company’s earnings after debt obligations are met. This share of the earnings is received in the form of the value of the stock prices and occasionally dividends. The stock price is high when a company is profitable and low when a company is experiencing losses.
- Discussing the rights and benefits of owning stock
- Stockholders’ basic rights include the right to vote, partial ownership, profit, and limited liability. The right to vote is especially important in choosing the Board of Directors who decides the direction of the company. Owning a share of stock means that the stockholder has partial ownership, or a partial equity position, in the company for which the stock was issued. Being partial owners of the company, stockholders are entitled to a share of the company’s profits. This claim on the profits by the stockholders is called residual claim. Even though stockholders are partial owners of the company, each stockholder can only lose as much as he or she invested in the stock. Some of the benefits of stock ownership include the ability to easily buy and sell stocks, transaction costs are low, and market information is widely accessible.
Chapter 3 - Economy
- Explain the natural evolution of events in a typical business cycle - highlight the common relationship between low unemployment / sustainable growth on one hand vs. higher inflation on the other
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To illustrate a typical business cycle, suppose we begin when the economy starts to heat up. When the economy starts to improve, this means that consumers and companies are making purchases. This overall increase in demand for products and services creates jobs, makes unemployment levels decrease, and people are working longer hours (including overtime). Since more people are working longer hours, consumers have more money which ratchets up spending in the economy. As demand increases, there is less "slack" in the economy to a point where we may actually reach maximum capacity and certain items start to become scarce (especially natural resources such as oil). Consequently, the prices for these items increase and general inflationary pressures increase. Lenders begin to increase their interest rates in order to be compensated for increasing inflation. As interest rates increase, consumers stop using credit to purchase big ticket items (e.g., houses and cars) because these items need to be financed. Given the higher debt payments, large item purchases begin to decline and due to the sagging demand workers are laid off in a few industries and unemployment begins to increase and the economy starts to reverse. If things reverse dramatically, the government may be forced to intervene by lowering interest rates to stimulate buying or by increasing spending to increase demand.
- Discuss sector rotation
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Sector rotation is a type of investment strategy that attempts to predict which industries will thrive depending on which stage of the business cycle the economy is in. When the economy is deep in recession or in already in a depression, it is considered in a trough. At this point, consumers are not spending so the demand for money is low. At the same time, the Federal Reserve is likely to keep interest rates low. These factors lead to very low levels of interest rates. Sector rotation tries to find companies that perform best at each stage of the economy. When interest rates are low, the best areas to invest in are equipment, transportation, and construction firms. As the economy is grows (expansion), cyclical industries tend to perform best including big ticket items such as cars, luxury goods such as cigars, technology, and basic materials. When expansion has peaked, the supply of natural resources are strained forcing oil prices and other natural resources higher. Sector rotation would then begin to invest in these types of firms. When the economy starts to contract, sector rotation suggests investing in defensive firms which are less sensitive to economic downturns. Defensive industries include items such as medicine, insurance, tobacco, and diapers.
- Using an example, explain how a decreasing dollar can benefit domestic manufacturers
- A record company sells CDs to stores in the U.S. for $8.00 each. When the company started in 2001, they sold CDs to stores in the United Kingdom for ₤5.60 each (in 2001, $8.00 = ₤5.60). But in the last few years, the dollar has become weaker and weaker against the British Pound. Today the U.S. Dollar is only worth about ₤0.61. The record company doesn’t need to change their prices overseas since they are still able to remain competitive with other UK record labels. This means that they are still selling their CDs in the UK at ₤5.60. And with today’s exchange rate they earn approximately $9.00 per CD sold in the UK (that’s a dollar more than they earn per CD in the U.S.). Because the dollars value fell, this U.S. exporter was able to increase their export revenues by 12.5% with the identical amount of sales. A weak dollar can drastically increase a domestic manufacturer’s profits overseas simply because it takes more dollars to match a foreign currency.
- A very reliable site for checking the most current currency exchange rates, historical exchange rates, etc. is: http://www.xe.com/ucc/
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Also, there is a very large market for investors speculating in future exchange rates. Currency trading is a very popular method of 'investing'. For instance if you follow world news and know that the U.S. GDP if falling much more drastically than European countries, you may decide to purchase Euros today in hope that you can buy U.S. dollars back at a profit after the dollar falls. There are many techniques and theories when it comes to currency trading (much like any other form of trading). One of the most popular websites and markets for such trades can be found at: www.forex.com
- Explain the fed funds market
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The fed funds market is the borrowing and lending that occurs between banks. Banks are not allowed to lend out every dollar they receive from depositors. The Federal Reserve sets standards, called reserve requirements, that every bank must keep a percentage of their deposits in their vaults or in the vault of their regional federal reserve bank at all times in order to ensure that financial transactions can be cleared. Banks that have excess reserves over and above the reserve requirements can earn more interest by lending money to those banks that have reserve shortfalls. Lending excess reserves is called selling fed funds. Much of this activity takes place overnight, meaning that it is a one day contract made only to accommodate the bank with the reserve shortfall. The fed funds rate is the interest rate charged by lending banks in the fed funds market, which is the interest rate is targeted by the Federal Reserve which is considered the primary tool for the Federal Reserve when executing monetary policy.
Chapter 4 - Individual security risk and return
- Introduction to buying on margin and setting up a T-account
- Define dollar and percentage returns, including an illustration that segregates returns into their two components
- Walk through an example demonstrating HPR and then annualize the result using APR and EAR
- Define stock splits and discuss the impact to the number of shares outstanding, the price per share, and the market capitalization of a stock
- Explain the impact of a stock split on a price weighted index and how to adjust the divisor after splits
Chapter 5 - Portfolio theory
- Describe the effects of correlation on the shape of the investment opportunity set
- Using an example of a portfolio with two assets, show how the return of the portfolio is fixed while the risk changes with the correlation
Chapter 10 – Bond Valuation
Chapter 11 - Investment Companies
Chapter 12 – Primary and Secondary Market
- What are the different methods for underwriting new securities sales? What are some of their characteristics?
- There are two standard types of underwriting sales: a firm commitment and a best efforts sale.
- A firm commitment arrangement means the investment bank will purchase all of the shares and is responsible for selling them to investors, therefore shifting the risk to the investment bank. However, the issuing company knows they will get a set amount of money. Firm commitment arrangements are by far the most common type of underwriting contracts. Since the risk lies with the investment banker, the fees charged are significantly higher.
- Best efforts means the investment bank does not commit to buying any shares, but instead simply agrees to put forth its best effort to sell as much as possible. This leaves the risk of not selling all of the shares in the hands of the issuing company. Best efforts sales are typically used by smaller, less-known companies because most underwriters do not want to get stuck with a lot of shares which they cannot sell to investors. Similar to this, in harder economic times best efforts arrangements become more common because more underwriters fear they will not be able to sell shares of any company, even larger, well-established ones. They are afraid of making firm commitments to companies when the demand for stock is low.
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prospectus for COUNTRY Financial.pdf - on Apr 29, 2009 3:07 PM by Ryan Forberg (version 1)
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I've attached a prospectus for the mutual funds that COUNTRY Financial manages. The COUNTRY Growth (CGRAX) fund and the COUNTRY Bond (CTLAX) fund are two funds that I work with on a daily basis and figured this may help to view actual fees and expenses in a prospectus format. The fees and expenses start on page 6. Comparing this to similar funds it looks like these two mutual funds charge a significant more amount of fees. By being an employee at the company I know that these fees are necessary with all the research involved, reporting expenses, investment management, and other operating expenses. By working with the investment managers, these two funds are used heavily at building a particular portflio combined with multiple mutual funds that is highly customizable to the client. I've asked for a hard copy of the prospectus as well and will give that to Prof. Ahlgrim for future reference. They also have more information regarding these two mutual funds on their website at www.countryfinancial.com. These two are also listed on Yahoo! Finance as well. Please let me know if you have any questions about the two funds and I will be sure to answer them accordingly or perhaps have an investment manager provide a little more insight.