Introductory finance for economics

#separator:tab #html:true Who are the key players in financial markets?"<ul><li><b>Individuals and Households</b></li><ul><li>Deposit and borrow money</li></ul><li><b>Businesses and Corporations</b></li><ul><li>issuing bonds and shares in order to generate capital</li></ul><li><b>Banks </b></li><ul><li>Facilitate the exchange of money between savers and lenders</li><li>Retail and investment banks must be ring fenced by law </li></ul><li><b>Governments </b></li><ul><li>Governments spend money on public goods financed by debt (gilts) and taxes</li><li>Governments also make laws to regulate behaviour in financial markets.</li></ul><li><b>Regulators </b></li><ul><li>Responsible for ensuring that individuals, businesses, and banks follow the laws set by Governments. </li></ul><li><b>Central Banks </b></li><ul><li>Act as a regulator and set monetary policy</li></ul></ul>" What are the forms of business?"<div><ol><li>Sole Proprietorship</li><li>Partnership</li><li>Limited Corporation </li></ol></div> " What are the differences between a sole proprietorship/ partnership and limtied corporation?"<div>In sole proprietorship/ partherships</div><div><ul><li>A business owned by one person</li><li>they receive all the profits from the business</li><li>Owners have unlimited liability for any debts</li><li>easier to setup but the life of the corporation is limited with the owner </li></ul>In a limited corporation</div><div><ul><li><div>A corporation is a distinct legal entity that is separate from its owners, owners have limited liability</div></li><li><div>In large corporations, the shareholders and the managers are usually separate groups. </div></li><li><div>Ownership of a limited corporation is represented by shareholders. These shares can be easily transferred between owners so the life of the corporation is not limited.</div></li><li>Easier to raise capital</li></ul></div><div><br></div> " How does ownership and control differ in large corporations?"<ul><li>Shareholders delegate decision-making power to managers because it is impractical for shareholders to work at the corporation.</li><li>This creates the agency problem because shareholders and managers may have different interests.</li></ul>" What financial decisions do the managers of firms make? "<div><ul><li>What long term investments should be undertaken? –<b> Investment decision</b></li><li>How will those long-term investments be funded (debt or equity)? – <b>Financing decision</b></li><li>How should the firm’s short-term cash flow be managed?</li></ul></div> <div><br></div>" What is the goal of financial management?<div>To maximise the value of equity for the owners</div> How can firms try to alleviate the agency problem?"<div><b>Managerial compensatio</b>n - tying corporation success to their compensation e.g bonusses or issuing shares to managers.</div> <div><b>Control of the firm</b> - Shareholders elect the board of directors who make decisions about hiring and firing. </div> <b>Corporate governance</b> - Laws, regulations and corporate practices that protect shareholders<br>" What is the balance sheet?It is a snapshop of a business' financial position What are the types of assets and liabilities?<ul><li>Current - lifespan of <12 months e.g cash or trade payables</li><ul><li>Assets can be tangible or intangible (e.g a patent)</li></ul><li>Non current Lifespan of >12 monthsme.g buidlings or long term loans</li></ul> What is net working capital and how is it calculated?"<ul><li>Net working capital = current assets – current liabilities</li><ul><li>It is the liquidity available to a business</li><li>A NWC>0 is needed for a company to run</li></ul></ul>" What is shareholders equity and how is it calculated?<ul><li>Shareholders equity = Total Assets - Total Liabilities</li><li>Shareholders’ equity is how much money the shareholders have in the business</li></ul> What are book and market values and how do they differ?"<ul><li>Book Valuesare accounting values based on International Financial Reporting Standards </li><li>Market values refer to the price at which the asset or liability can be bought or sold</li><ul><li>Market value may be different because assets depreciate in a non linear rate</li></ul></ul>" What are some weaknesses of the balance sheet?<ul><li>Reports book value</li><li>Intangible assets arent included</li></ul> What is the income statement?"<ul><li>It examines a company’s performance over a given period by looking at revenues and expenses</li></ul>" How is income calculated?<ul><li> Income = Revenues- Expenses</li></ul> Balance sheet example"<img src=""paste-a8d9a898e309f81c073f97529b26f1a5bf87ad5c.jpg"">" When are revenues and expenses counted?<ul><li>Revenues are counted as soon as their values are known</li><li>Expenses are counted once the revenue is realised</li></ul> Income statement example"<img src=""paste-f24ef654051c05ac65263b191357424b1a3ef695.jpg"">" What does the cash flow statement show?"<ul><li><span style=""background-color: rgb(255, 255, 255); color: rgb(0, 0, 0);"">Shows the cash that goes into and out of the business and where it goes</span></li><ul><li><span style=""background-color: rgb(255, 255, 255); color: rgb(0, 0, 0);"">Operating, financing, investment</span></li></ul></ul>" What is the cash flow statement broken down into?<ul><li>Operating activities</li><li>Investing activities</li><li>Financing activities</li></ul> How is cash flow from assets calculated?"<div>Cash flow from assets = Cash flow to creditors + Cash flow to shareholders</div>" How is total cash flow calculated?"Total cash flow = Cash flow from operating activities + Cash flow from investing activities + Cash flow from financing activities" Cash flow statement example"<img src=""paste-7953912080acabfcfbb2848a25e402c0b2e89a84.jpg"">" What do liquidity ratios show?"<ul><li>How easily and quickly assets can be converted into cash, showing how easy it is for a company to pay their short-term bills. </li></ul>" How is the current ratio calculated?"<img src=""paste-ea9b5acf6533b7321f272ca9277fceb025653177.jpg"">" What is a good current ratio?>1 as current assets will be more than current liabilities "What is a good quick ratio? <img src=""paste-1b60d24c1d64ce20d135129ede9424961958c698.jpg"">"<ul><li>>1 is great</li><ul><li>This means the company isnt reliant on selling inventory in order to pay off debt</li></ul><li>>0 is needed</li></ul> What do financial leverage ratios do?"Indicate a company’s ability to meet its long-term debt obligation, it is better to be financed with equity rather than debt." "What is a good total debt ratio?<br><img src=""paste-ebea464deac1b8dd95e4302d7041193383ca763b.jpg"">"<ul><li>Ratios>0.5 show a company is financed more through debt</li><li>Ratios > 0.6 are concerning</li></ul> What is the equity multiplier equation?"<img src=""paste-9a2e6cce1dbe66bc364c0b72485ca2500af5762e.jpg"">" What are turnover ratios?"<ul><li>Turnover ratios demonstrate how efficiently a company generates sales.</li></ul>" What is a good inventory turnover?The higher the better<br>Too high the company may be underestimating its sales What is the day sales in inventory and how is it calculated?"How many days it takes a company to sell its stock<br><img src=""paste-c05a23c07b970f9c890e357b93c988eb7ca00b3e.jpg"">" What is the day sales in recievables and how is it calculated?"How many days it takes a company to collect the money its owed in relation to these sales<br><img src=""paste-0dee591504c8c26728f8447139ea8e084694d5d0.jpg"">" What are profitability ratios?"<ul><li>Profitability measures indicate how well a company has performed relative to its sales, assets or equity. (profit)</li></ul>" What is return on assets (ROA) and how is it calculated?"<div>It is a measure of profit per ‘unit’ of asset.</div><div><img src=""paste-d543b1963043a22c6fef8e2b6648b49c71e3b66c.jpg""><br></div>" "What is return on equity (ROE) and what is a good one?<br><img src=""paste-a2bfef898b6576fd36a03c9fbd1713ec2115af5f.jpg"">""<ul><li>A measure of how the shareholders fared during the year, income per shareholders equity</li><li>0.14 is a good number</li></ul>" What is the du pont identity and how is it calculated (the WHOLE sum)?"<ul><li>It can be used to identify what is causing a poor return on equity by breaking a company down into operating efficiency, its asset turnover efficiency, and its financial leverage position  </li></ul><img src=""paste-dcd94c766a3d42bab009cbc781223bd2bdc0c76b.jpg""><br>" What are market value ratios?"Market value measures the value of holding shares in the company" What is the price earnings ratio, how is it calculated and what is a good one"<ul><li>How much investors are willing to pay per unit of current earnings.</li><li>The average on the SNP 500 is £20</li><li><img src=""paste-cd21020912f32c2b79f9d0187482c71e05b1b78d.jpg"" style=""float: left;""></li></ul>" What is a good market to book ratio?"<div><ul><li>A value less than one would suggest the company has not been able to generate value for their shareholders.</li><li>If the value is 1 the market and book value are equal, if it is>1 the firm is overvalued or people think its going to grow</li></ul></div>" How may a company use financial statement information?<ul><li>To evaluate over time</li><li>To comapre</li></ul> Present value formula"<img src=""Screenshot 2023-02-28 at 18.48.09.png"">" Future value formula"<img src=""Screenshot 2023-02-28 at 18.48.42.png"">" Future value of multiple cash flows example"<img src=""paste-a509aa4a878c172e7cafbf649f6986b244ada7c9.jpg"">" Present value of multiple cash flows example"<img src=""paste-b9bea9101c37dfc86e40a7c2e13decb2e708aa3c.jpg"">" What are the 3 ways to evaluate an investment?<ul><li>Net present value (the best)</li><li>The payback rule</li><li>The internal rate of return</li></ul> What is the net present value?"<ul><li>The present value of all cash flows from an investment minus the initial cost of the investment.</li><li>Investments with positive NPVs should be undertaken</li></ul>" How is net present value calculated?"<img src=""paste-3195a508d09482b37324ca3c95af228ebf780110.jpg""><br><div><ul><li>The discount rate, <i>r</i>, is known as the opportunity cost of capital. This is company specific</li></ul></div>" What is the payback rule?"<ul><li>The payback rule calculates how long it will take to pay off the initial cost of an investment.</li><li><div>If the payback period is less than some predetermined limit, then the investment is undertaken.</div></li><li><div>It is biased against long term investments</div></li></ul>" How is the payback rule calculated?"<ul><li>It works by estimating the cash flows in future years and subtracting these one by one from the initial cost, until the initial investment is recovered.</li><li>it doesnt take into account interest rates or time value of money</li><li>It is biased against longterm investments</li></ul>" What is internal rate of return (IRR)?"<div><ul><li>The internal rate of return (IRR) is the discount rate that makes the NPV equal to zero.</li><li>An investment should be undertaken if the IRR is greater than the required return (required discount rate).</li><li>It doesnt work for non conventional cash flows</li></ul></div>" how can the current assets trip you up with the quick ratioinventory are included in current assets so they dont need to be subtracted again What are incremental cash flows?"<ul><li>They occur only because of the project being undertaken. </li><li>They are the only cash flows that should be counted when evaluating a project</li><ul><li>So sunk costs arent relevant</li></ul></ul>" What is depreciation?"<ul><li>The loss of value in an asset over time, often as a result of wear and tear</li><li>can be linear or non linear</li></ul>" What is the equation for straignt line depreciation?"<img src=""paste-9747197e3c179b039884ed44b641a524051797a7.jpg""><br>The annual depreciation is equal for each year.<br>The residual value of the good is tracked each year" How is reducing balance depreciation calculated?<ul><li>Multiply by the value by (1-p) for each year</li><li>unless there is a salvage value, then that is the salvage value for the final year</li></ul> How is net working capital for a project calculated?<ul><li>Any excess NWC is invested in the project</li><li>All NWC is recovered at the end</li><li>the initial investment and change acounted as negative </li><li>Recovery is positive</li><li>Total change is the sum of initial, change and recovery for each year </li></ul> What is the procedure for calculating project cash flows"<div><ol><li><b>Revenues</b></li><li><b>Costs/Expenses</b></li><li><b>Depreciation</b> (straight line or reducing balance)</li><li><b>Profit before tax </b>(=Revenues – Expenses – Depreciation) ""including depreciation means companies pay less tax""</li><li><b>Net Income</b> (PBT - tax)</li><li><b>Operating Cash Flow</b> (Net Income + Depreciation) ""depreciation is added back in because it isnt a cash flow""</li><li><b>Total Change in Net Working Capital</b> = (<span style=""color: rgb(0, 0, 0);"">New NWC – old NWC)</span></li><li><b>Capital Spending </b>(Initial spend in year 0 and is there any salvage value)</li><li><b>Net Cash Flow</b> (Operating cash flow + Total Change in Net Working Capital + Capital Spending  ) ""operating, investing, financing""</li><li><b>Investment Criteria</b> (NPV, IRR or the payback rule)</li></ol></div> " Why is it good to analyse NPV?Many of the inputs are just estimates When should a company undertake a project?if most scenarios have a positive NPV What are the types of NPV analysis"<div><ul><li>Base case estimation - based on estimated cash flows</li><li>Scenario analysis - best-case and worst case scenario </li><li>Sensitivity analysis - changing only one input variable and examine how this affects NPV</li><li>Simulation analysis - Vary lots of input variables simultaneously to construct a probability distribution for NPV across many scenarios.</li></ul></div> " Why can tax be written as negative?It can offset the tax bill elsewhere in the business<br>it can also be written as 0 in the exam when profit is 0 Whay are derivatives?"<div><ul><li>Assets tied to the value of commodities</li><li>E.g so you can own oil without physically taking possession.</li></ul></div>" What is the financing decision?"<div>Whether to finance through debt or equity</div>" What activities are undertaken by financial markets?<ul><li>Price stetting and asset Valuation</li><li>Arbitrage -  exploiting different prices in different locations in underdeveloped markets</li><li>Raising Capital - through selling bonds or shares </li><li>Commerical Transactions - In different places with different currencies </li><li>Risk management - A derivative could be used to protect against exchange rate changes in an international transaction </li><li>Investing</li></ul> What is yield?"<div>The income the investor receives whilst owning the asset.</div>" What is capital gain?"<div>The increase in the value of the asset itself, typically this will only be realised when the asset is sold.</div>" What shapes the type of investment investors will make?capital gain vs yield<br>purpose... what is a hedge fund?"<div>These institutions accept money from only a small number of wealthy investors, they have high risk high reward strstegies and are generally less regulated.</div>" what is a pension fund?"They invest the retirement savings of many individuals, they are more risk averse " What is a mutual fund?"<ul><li>These institutions pool the money from an (often unlimited) number of individuals and invest it according to the stated goals of the fund.</li></ul>" What is the difference between the money market and the capital market?"<div><ul><li>The <b>money market </b>refers to debt instruments with maturity of one year or less.</li><li>In the <b>capital market</b>, money is borrowed or lent for a long term through bonds or shares.</li></ul></div> " What is the difference between the primary and secondary market?New securities sold directly by companies or the government  are sold on the primary market whereas the resale of these securities between investors takes place on the secondary market. How do companies issue debt?Through bonds How do bonds and loans compare?"<div>A bond is normally an interest-only loan. The borrower pays interest every period but does not repay the principal amount until the end of the term of the bond.</div>" What is the face value of a bond?The money that is paid to the owner of the bond at the end of the bond. What is the couponinterest payments, most commonly paid yearly to the owner of the bond what is the coupon rate?coupon/face value What is a bonds maturity?"the date on which the face value is repaid " What is the time to maturity"the number of years <u>left until</u> it is repaid, it changes as time goes on" How does the government borrow money?By issuing bonds Why does the government have a budget surplus every january?"The deadline for self-employed people to pay their self-assessment tax returns is in January" How do the governments interest payments vaary with national debt?"<div>The larger national debt, the higher a government’s interest payments as they must pay more coupons. </div>" What is a discount bond?"A bond that sells for less than its face value because its present valve is below its face value" What is a premium bond?"<div>A premium bond sells for more than its face value because its present value is above face value</div>" How do bond values and interest rates interract"<div>Bond price and market interest rates move in opposite directions because if the bond has a higher interest rate than the market it is worth more. </div>" How is current yield calculated?Annual coupon/current price What is a semi annual coupon and how do you handle themdivide the interest rate an coupon by 2 and multiply the number of years by 2<br>e.g it has a semi annual interest rate of 3 rather than yearly interest rate of 6, a semi annual coupon of 30 instead of yearly coupon of 60 and it has a time to maturity of 40 periods rather than 20 years. What is interest rate risk?The risk to bond owners due to changes in market interest rates, when market interest rates are high the present value of a bond decreases What is the relationship between the present value of a bond and market interest rates?They are inversely related What makes a bond more risky?It’s sensitivity to interest rates What makes a bond more sensitive to interest rates?The longer the time to maturity<div>The lower the coupon rate</div> What is the yield to maturity?The rate for which the selling price of the bond is equal to the present value of the bond.  What are some alternative types of bond?Zero coupon - rate changes based on some index<div>Floating rate</div><div>Income bonds - coupon depends on firms income</div><div>Callable bonds -can be redeemed before maturity date</div><div>Put bonds - bond holders can force the issuer to buy the bond back at a stated price </div><div><br></div> What is default risk?The probability that the bond issuer is unable to pay the face value or coupon of a bond What is default risk premium?Bonds with a higher default risk have a higher yield to compensate for this risk How are bonds rated?AAA, AA, A, BBB, BB, B, CCC, CC, C What bond rating is junk?BB and below How is the risk and yield of a bond related?Riskier bonds have a higher reward What is the difference between nominal and real rates?"<style class=""WebKit-mso-list-quirks-style"">  </style><p class=""MsoSubtitleCxSpFirst"">The nominal rate is the % change in the amount of cash you have.</p><p class=""MsoSubtitleCxSpFirst""><span style=""font-size: 14pt; text-indent: -18pt; -webkit-tap-highlight-color: transparent; -webkit-text-size-adjust: 100%;"">The real rate is the % change in how much you can buy with your cash.</span></p><p class=""MsoSubtitleCxSpLast""><o:p></o:p></p>" What is the difference between nominal and real rates?"<style class=""WebKit-mso-list-quirks-style"">  </style><p class=""MsoSubtitleCxSpFirst"">The nominal rate is the % change in the amount of cash you have.</p><p class=""MsoSubtitleCxSpFirst""><span style=""font-size: 14pt; text-indent: -18pt; -webkit-tap-highlight-color: transparent; -webkit-text-size-adjust: 100%;"">The real rate is the % change in how much you can buy with your cash.</span></p><p class=""MsoSubtitleCxSpLast""><o:p></o:p></p>" What is the difference between nominal and real rates?"<style class=""WebKit-mso-list-quirks-style"">  </style><p class=""MsoSubtitleCxSpFirst"">The nominal rate is the % change in the amount of cash you have.</p><p class=""MsoSubtitleCxSpFirst""><span style=""font-size: 14pt; text-indent: -18pt; -webkit-tap-highlight-color: transparent; -webkit-text-size-adjust: 100%;"">The real rate is the % change in how much you can buy with your cash.</span></p><p class=""MsoSubtitleCxSpLast""><o:p></o:p></p>" What is the equation for the fisher effect?"<style class=""WebKit-mso-list-quirks-style"">  </style><p class=""MsoNormal""><span style=""font-size: 14pt; text-indent: -21.6pt; -webkit-tap-highlight-color: transparent; -webkit-text-size-adjust: 100%;"">R = r + h +rh</span></p><p class=""MsoNormal""><span style=""font-size: 14pt; text-indent: -21.6pt; -webkit-tap-highlight-color: transparent; -webkit-text-size-adjust: 100%;"">Where </span><i style=""font-size: 14pt; text-indent: -21.6pt; -webkit-tap-highlight-color: transparent; -webkit-text-size-adjust: 100%;""><span style=""font-family: Cambria, serif;"">R </span></i><span style=""font-size: 14pt; text-indent: -21.6pt; -webkit-tap-highlight-color: transparent; -webkit-text-size-adjust: 100%;"">is the nominal rate, </span><i style=""font-size: 14pt; text-indent: -21.6pt; -webkit-tap-highlight-color: transparent; -webkit-text-size-adjust: 100%;""><span style=""font-family: Cambria, serif;"">r </span></i><span style=""font-size: 14pt; text-indent: -21.6pt; -webkit-tap-highlight-color: transparent; -webkit-text-size-adjust: 100%;"">is the real rate and </span><i style=""font-size: 14pt; text-indent: -21.6pt; -webkit-tap-highlight-color: transparent; -webkit-text-size-adjust: 100%;""><span style=""font-family: Cambria, serif;"">h </span></i><span style=""font-size: 14pt; text-indent: -21.6pt; -webkit-tap-highlight-color: transparent; -webkit-text-size-adjust: 100%;"">is the inflation rate.</span><br></p><p class=""MsoNormal""><o:p></o:p></p>" How do you factor in inflation to an investment Discount it by 1+r What is the term structure of interest rates?It tells us the nominal interest rates on default free pure discount (coupon free) bonds of all maturities (INSERT DIAGRAM) What are the determinants if term structureReal interest rate - the cost of not using the money presently<div>Inflation premium</div><div>Interest rate risk premium </div> What is an upwards sloping term structure?When long term interest rates trend higher than short term interest rates (INSERT DIAGRAM) What is a downwards sloping term structure?When long term interest rates trend lower than short term interest rates (INSERT DIAGRAM) What is a yield curveThe term structure of interest rates plotted<div>Maturity against yield</div> How do corporate bonds and government bonds differ in terms of riskGovernment bonds are generally considered default free so they don’t have a default risk premium whereas corporate bonds do.  What impacts yield on the secondary marketInvestors’ perception of risk What is a share?A way a company can raise capital through selling units of equity ownership What is an IPO?An intiial public offering, when shares are first brought to market. An investment bank sets the price and creates a market for the shares What is a DPODirect public offering, when companies offer shares without the help of an investment bank What is a market cap and how is it calculatedIt measures the market value of a company<br>Market cap = number of shares * price per share how does a company get listed on a stock exchange?they must meet the requirements set by that exchange, once listed they can trade on it What is a stock market index?It provides a weighted average of the prices of a selected group of stocks e.g S&P 500 is the 500 largest companies listed on the US stock exchange How can you recieve cash from shares<ul><li>dividends</li><li>By selling the share</li></ul> How is the value of a share calculated when the the price and dividends are known?"The sum of the present values of the dividends and the price you sell the share back for<br><img src=""Screenshot 2023-05-09 at 16.49.51.png"">" How is the value of a share calculated when there is a zero growth rate in profits"<img src=""Screenshot 2023-05-09 at 17.01.55.png"">" How is the value of a share calculated when there is a constant growth rate of profits"It the same as a growing perpetuity (formula given)<br><img src=""Screenshot 2023-05-09 at 17.04.09.png"">" What are some issues with valuing shares based soley on dividends<ul><li>if g>r the model would imply share price is negative, this isnt true</li><li>The evaluation only applies to firms that pay dividends, new high growth firms tend not to make dividend payments </li></ul> How is the value of a share calculated when there is a constant growth rate after some time"E.g You expect to receive dividends of <i>D</i><sub>1</sub>, <i>D</i><sub>2 </sub>and <i>D</i><sub>3 </sub>in Years 1-3 with dividends growing at a constant rate afterwards. <br><img src=""paste-0b445957ed39cf76ec0d514c8e8667a468e10d6d.jpg""><br>" What is a preference share?<ul><li>A share in which the owner is promised a fixed cash dividend every period, forever. </li><li>Dividends must be paid to preference shareholders before they are paid to common shareholders</li><li>If a company misses a payment it accumulates however it doesnt count as a liability</li></ul> Debt vs equity"<img src=""paste-d3213154e9a32c4088f5d2578ac8b0a897591893.jpg"">" What is the security market line?"It shows how much return is recieved per unit of risk, all assets in an organised market fall on this line<br><img src=""paste-8d9da6e8f04596e3c5afbd135911655b771e88f2.jpg"">" How is annual return calculated?"Percentage change in price of an instrument between the year and the year before<br><img src=""paste-8abdc61367e48d6d1094f23539a75c5f8bbed887.jpg"">" How is average annual return calculated?"<img src=""Screenshot 2023-05-09 at 17.26.42.png"" width=""331""><br>r is the return and t is the number of years" How is the variance and standard deviation of an annual return calculated?"<img src=""Screenshot 2023-05-09 at 17.28.15.png""><br><img src=""Screenshot 2023-05-09 at 17.28.37.png"">" How are risk and reward related?The greater the risk the greater the reward  how are historical vs future returns calculatedHistorical returns are calculated using the mean<br>future returns are calculated using expected returns How are expected returns calculated?"<img src=""Screenshot 2023-05-09 at 17.36.19.png""><br>where <i>N </i>is the number of possible states, <i>p<sub>i </sub></i>is the probability of state <i>i </i>occurring, and <i>R<sub>i </sub></i>is the return in state " What is a portfolio and portfolio weights?A group of assets held by an invsestor, portfolio weights are the percentage of a poerfolio held in a particular asset. How can the expected return of a portfolio be calculated?"<div><div>by taking the weighted average of expected returns of the respective assets in a portfolio:</div></div><div><img src=""Screenshot 2023-05-09 at 17.42.42.png""><br></div><div><div>Where <i>m </i>is the number of assets in the portfolio, <i>w<sub>j </sub></i>is the portfolio weight of asset <i>j </i>and <i>E</i>(<i>R<sub>j</sub></i>) is the expected return of asset <i>j</i>.</div></div>" What is an equally weighted portfolio?Where money is split equally between assets How is portfolio variance calculated?"<div><ul><li>Compute the expected return for the portfolio in each state of the economy. E(R<sub>i</sub>)</li><li>Compute the expected return for the portfolio. E(R<sub>p</sub>)</li><li>Compute the squared deviation of the expected return for the portfolio in each state of the economy from the expected return for the portfolio.</li><li>Multiply each squared deviation with the probability of the state occurring.  </li><li>Sum the product of each state.</li></ul></div> <div> <table> <tbody><tr> <td></td> </tr> <tr> <td></td> <td><img alt=""A picture containing text, watch Description automatically generated"" src=""clip_image001-1e34614ed01ce3d427fa0173c0b372b7aab58df8.png""></td> </tr> </tbody></table> <br><br></div>" What does the variance of a protfolio measure?<ul><li>Total risk</li><li>Systematic + unsystematic risk</li></ul> How can return be decomposed?Return = Expected return + unexpected return<br>Unexpected return = total risk = systematic risk + unsystematic risk What is the difference between systematic and unsystematic risk?"<ul><li>Systematic risk is (system wide) a risk that affects a large number of assets, it is the only risk rewarded in the market</li><li>Unsystematic risk is a risk that affects a single asset, it can be eliminated through diversification and therefore isnt rewarded</li></ul>" What is diversification?"<div>Anway of reducing an investor’s exposure to one particular risky asset (unsystematic risk) by spreading their capital across multiple assets.</div>" how does diversifiable risk change with the number of assets?It decreases exponentially for the first 10 or so assets, after around 100 assets, the risk is eliminated What is the beta coefficient?<ul><li>It measures the amount of systematic risk present in an asset relative to an average asset</li><li>An average asset has a beta of 1 , riskier asstes have a beta >1 and less risky assets have a beta<1</li></ul> How can the beta of a portfolio be calculated?"<div>As the weighted average of individual asset betas</div><div><img src=""Screenshot 2023-05-09 at 18.10.41.png""></div>" What is the closest thing to a risk free asset?A short term government loan How can the % of a protfolio in a certain asset exceed 100When an investor borrows money to invest What does the slope of the security market line showreward to risk ratio (equation given)<br>Rf = risk free return What is the CAPM"The capital asset pricing model which tells us the expected return on any asset<br>     <i>E</i>(<i>R<sub>i</sub></i>) = <i>R<sub>f </sub></i>+ b<i><sub>i</sub></i>(<i>E</i>(<i>R<sub>M</sub></i>)-<i>R<sub>f</sub></i>)<br><img src=""paste-7afdbe1b5c2afd90ccd7d36cf6cfbde5c8293511.jpg""><br>" What is the difference between regulation and a directive?Regulations are legally enforceable rules in a financial market, a directive is not legally enforceable What should effective regulation do?Promote confidence and stability in financial markets Why is government intervention necessary in markets?"Market failure<p class=""MsoSubtitle""><o:p></o:p></p><div>Externalities - Because it is so connected, negative events in the financial market can impact the global economy</div><div>Asymmetric information -<font face=""Courier New""> </font>Managers may have more information about their company than is publicly available, leading to problems such as insider-trader.</div><div>Moral hazard - Individuals and institutions are more inclined to take risk when they know they will not shoulder the burden</div><div>The agency problem - the divergence of shareholder interests from managerial interests.</div>" What are the costs of regulation?Direct costs of enforcing it<div>Costs to firms for complying</div><div>Effective regulation considers the marginal costs vs marginal benefits </div> What are the types of regulation?"Structural - <span style=""font-size:14.0pt;mso-bidi-font-size:15.0pt; line-height:107%;font-family:"Times New Roman",serif;mso-fareast-font-family: Calibri;mso-fareast-theme-font:minor-latin;mso-bidi-font-family:Arial; mso-bidi-theme-font:minor-bidi;color:black;mso-themecolor:text1;mso-ansi-language: EN-GB;mso-fareast-language:JA;mso-bidi-language:AR-SA"">About what institutions are allowed to do</span><div>Prudential - <span style=""font-family: Symbol;""><span style=""font-variant-numeric: normal; font-variant-east-asian: normal; font-variant-alternates: normal; font-kerning: auto; font-optical-sizing: auto; font-feature-settings: normal; font-variation-settings: normal; font-stretch: normal; font-size: 7pt; line-height: normal; font-family: "Times New Roman";""> </span></span><span dir=""LTR""></span>About the financial position of institutions (avoiding bankruptcy)</div><div>Investor protection - <span style=""color: black; font-family: "Times New Roman", serif; font-size: 14pt;"">– Protection for individuals</span></div>" What are the 3 main policy points in UK regulationIn the 80s there was lots of deregulation <div>In the 90s the BoE got more power</div><div>After the crisis new regulation and committees were introduced</div> How are banks regulated internationally?"The Basel committee of 45 central banks<div>It was established to provide a common framework for regulation globally.</div><div><p class=""MsoNormal"">Its recommendations are not binding, but it is expected that members will follow these recommendations<o:p></o:p></p></div><p class=""MsoNormal""><o:p></o:p></p>" What is financial market innovation?"<span style=""font-size:14.0pt;mso-bidi-font-size:15.0pt; line-height:107%;font-family:"Times New Roman",serif;mso-fareast-font-family: Calibri;mso-fareast-theme-font:minor-latin;mso-bidi-font-family:Arial; mso-bidi-theme-font:minor-bidi;color:black;mso-themecolor:text1;mso-ansi-language: EN-GB;mso-fareast-language:JA;mso-bidi-language:AR-SA"">the design of new financial instruments or new ways of delivering financial services.</span>" What is securitisation?"<span style=""color: rgb(51, 51, 51); font-family: Inter, helvetica, arial, sans-serif; font-size: 14px;"">Pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations and selling their related cash flows to third party investor</span><br>" "What is a <b><span style=""font-size:14.0pt;mso-bidi-font-size:15.0pt;line-height:107%;font-family: "Cambria",serif;mso-fareast-font-family:Cambria;mso-bidi-font-family:Cambria; color:black;mso-themecolor:text1;mso-ansi-language:EN-GB;mso-fareast-language: JA;mso-bidi-language:AR-SA"">Collateralized Debt Obligation </span></b><span style=""font-size:14.0pt;mso-bidi-font-size:15.0pt;line-height:107%;font-family: "Times New Roman",serif;mso-fareast-font-family:Calibri;mso-fareast-theme-font: minor-latin;mso-bidi-font-family:Arial;mso-bidi-theme-font:minor-bidi; color:black;mso-themecolor:text1;mso-ansi-language:EN-GB;mso-fareast-language: JA;mso-bidi-language:AR-SA"">(CDO) </span>""A security that is divided up into di<span style=""font-family: Cambria, serif;"">ff</span>erent tranches, with di<span style=""font-family: Cambria, serif;"">ff</span>erent levels of risk in each tranche.<p class=""MsoNormal""><o:p></o:p></p>" What is a CDO squaredA security where a load of CDOs are split into tranches and sold to investors What is crowd funding and why did it get popular?"It is a way of financing projects by raising many small amounts of money from a large number of individuals.<div><br></div><div><p class=""MsoNormal""><b><span style=""font-family:"Cambria",serif;mso-fareast-font-family:Cambria; mso-bidi-font-family:Cambria"">Equity-based crowdfunding </span></b>is a type of crowdfunding in which individuals provide cash to a business in exchange for a share of that business.<o:p></o:p></p><p class=""MsoNormal""><o:p></o:p></p><div>It got popular as loans were harder to secure after the financial crisis</div></div>" "What is the <span style=""font-size:14.0pt;mso-bidi-font-size:15.0pt; line-height:107%;font-family:"Times New Roman",serif;mso-fareast-font-family: Calibri;mso-fareast-theme-font:minor-latin;mso-bidi-font-family:Arial; mso-bidi-theme-font:minor-bidi;color:black;mso-themecolor:text1;mso-ansi-language: EN-GB;mso-fareast-language:JA;mso-bidi-language:AR-SA"">democratisation of finance </span>""<p class=""MsoNormal""><font face=""Symbol"">T</font>he process of removing barriers for individuals to access capital markets.<o:p></o:p></p>" What is a financial crisis?"<p class=""MsoNormal""><font face=""Symbol"">A</font>n event in which the value of financial assets rapidly and substantially declines.<o:p></o:p></p>" What is a recessionThe definition varies country to country, Negative GDP growth, or un the UK negative GDP growth for 2 consecutive quarters What was it like before the financial crisis?"<p class=""MsoNormal"">Global stable economic growth, low interest rates and low inflation.<o:p></o:p></p>" What is an asset price bubble?"<p class=""MsoNormal"">A rise in the price of an asset that is not justified by a corresponding rise in the ‘intrinsic’ or ‘fundamental’ value of that asset.<o:p></o:p></p><p class=""MsoNormal"">E.g house prices in the US during the leadup to the crisis</p>" What factors caused the rise in house prices?"<p class=""MsoNormal"">The ‘American Dream’ - Bush Administration housing policy to increase home ownership</p><p class=""MsoNormal"">Regulation of Fannie Mae and Freddie Mac incentivised banks <span style=""color: black; font-family: "Times New Roman", serif; font-size: 14pt;"">to create their own CDOs, pushing securitisation from Government Sponsored Enterprises to the private sector.</span></p><p class=""MsoNormal"">Low interest rates meant increased borrowing from banks and indivisuals<o:p></o:p></p><p class=""MsoNormal"">Reduction in credit lending standards<o:p></o:p></p><p class=""MsoNormal""><br></p><p class=""MsoNormal""><o:p></o:p></p>" What are the main causes of the housing market crash?Rising interest rates meant borrowers couldn't afford mortgage payments<div>Housing supply was outpacing demand. causing prices to fall</div><div>Borrowers couldn't sell their houses or afford to pay the mortgages so defaulted on them</div><div>investors started to make losses</div> Why were CDOs popular"Banks assumed none of the risk from the mortgages<div><span style=""font-size:14.0pt;mso-bidi-font-size:15.0pt; line-height:107%;font-family:"Times New Roman",serif;mso-fareast-font-family: Calibri;mso-fareast-theme-font:minor-latin;mso-bidi-font-family:Arial; mso-bidi-theme-font:minor-bidi;color:black;mso-themecolor:text1;mso-ansi-language: EN-GB;mso-fareast-language:JA;mso-bidi-language:AR-SA"">Investors assumed the risk of the mortgages. But this could be o</span><span style=""font-size:14.0pt; mso-bidi-font-size:15.0pt;line-height:107%;font-family:"Cambria",serif; mso-fareast-font-family:Cambria;mso-bidi-font-family:Cambria;color:black; mso-themecolor:text1;mso-ansi-language:EN-GB;mso-fareast-language:JA; mso-bidi-language:AR-SA"">ff</span><span style=""font-size:14.0pt;mso-bidi-font-size: 15.0pt;line-height:107%;font-family:"Times New Roman",serif;mso-fareast-font-family: Calibri;mso-fareast-theme-font:minor-latin;mso-bidi-font-family:Arial; mso-bidi-theme-font:minor-bidi;color:black;mso-themecolor:text1;mso-ansi-language: EN-GB;mso-fareast-language:JA;mso-bidi-language:AR-SA"">set through Credit Default Swaps, a form of insurance. </span><br></div>" Why was an increasing demand for CDOs bad?"There was increased demand for mortgages to fill these CDOs so they started getting filled with subprime<div><p class=""MsoNormal"">The prevalence of CDOs, CDO-squareds and other financial instruments meant that multiple investors/institutions could be tied to a single mortgage.<o:p></o:p></p><p class=""MsoNormal"">so when house prices fell, decreasing the demand and value of CDOs the impact was great</p></div>" What was the knock on effect of the collapse of the US housing market?"<p class=""MsoNormal"">Investors pulled their money out of financial service firms, businesses became reluctant to invest and individuals and households became reluctant to spend.<o:p></o:p></p>" Where did credit rating agencies fail?They rated CDO tranches incorrectly, they also viewed CDO squareds as more diversified so rated them even more incorrectly How has covid 19 impacted stock prices?"<div><p class=""MsoSubtitleCxSpFirst""><font face=""Courier New"">They fell </font>due to investor uncertainty.<o:p></o:p></p> <p class=""MsoSubtitleCxSpMiddle"">Some sectors such as pharmaceuticals and healthcare had recovered from their losses <o:p></o:p></p> <p class=""MsoSubtitleCxSpMiddle""> Approximately half of industry sectors had recovered, <o:p></o:p></p> <p class=""MsoSubtitleCxSpLast""><span style=""font-family:"Courier New";mso-fareast-font-family:"Courier New""">o<span style=""font-variant-numeric: normal; font-variant-east-asian: normal; font-variant-alternates: normal; font-kerning: auto; font-optical-sizing: auto; font-feature-settings: normal; font-variation-settings: normal; font-stretch: normal; font-size: 7pt; line-height: normal; font-family: "Times New Roman";"">   </span></span><span dir=""LTR""></span>February 2021: News about vaccines lead to investor confidence and the worst a<span style=""font-family: "Cambria",serif;mso-fareast-font-family:Cambria;mso-bidi-font-family:Cambria"">ff</span>ected sectors partially recovered from their losses.<o:p></o:p></p></div>Countries have recovered at different speeds" What was the policy response to covid?Reduced interest rates and stimulus packages How did the pandemic affect the bond (debt) market?Bond prices fell which is odd because they usually act the opposite to shares.<div>Countries and corporations had to borrow a lot of money so their credit ratings fell</div> What was the policy response to the changes in the debt market caused by covid 19"<p class=""MsoSubtitle""><font face=""Courier New"">T</font>he Bank of England, the Federal Reserve of the United States and the European Central Bank all announced large purchasing programmes to stabilise the bond markets.<o:p></o:p></p>" how were different assets impacted by the pandemic?"<span style=""font-size:14.0pt;mso-bidi-font-size:15.0pt; line-height:107%;font-family:"Times New Roman",serif;mso-fareast-font-family: Calibri;mso-fareast-theme-font:minor-latin;mso-bidi-font-family:Arial; mso-bidi-theme-font:minor-bidi;color:black;mso-themecolor:text1;mso-ansi-language: EN-GB;mso-fareast-language:JA;mso-bidi-language:AR-SA"">Silver and gold o</span><span style=""font-size:14.0pt;mso-bidi-font-size:15.0pt;line-height:107%;font-family: "Cambria",serif;mso-fareast-font-family:Cambria;mso-bidi-font-family:Cambria; color:black;mso-themecolor:text1;mso-ansi-language:EN-GB;mso-fareast-language: JA;mso-bidi-language:AR-SA"">ff</span><span style=""font-size:14.0pt;mso-bidi-font-size: 15.0pt;line-height:107%;font-family:"Times New Roman",serif;mso-fareast-font-family: Calibri;mso-fareast-theme-font:minor-latin;mso-bidi-font-family:Arial; mso-bidi-theme-font:minor-bidi;color:black;mso-themecolor:text1;mso-ansi-language: EN-GB;mso-fareast-language:JA;mso-bidi-language:AR-SA"">ered the highest returns. Precious metals are considered ‘safe haven’ assets. </span><div><span style=""font-size:14.0pt;mso-bidi-font-size: 15.0pt;line-height:107%;font-family:"Times New Roman",serif;mso-fareast-font-family: Calibri;mso-fareast-theme-font:minor-latin;mso-bidi-font-family:Arial; mso-bidi-theme-font:minor-bidi;color:black;mso-themecolor:text1;mso-ansi-language: EN-GB;mso-fareast-language:JA;mso-bidi-language:AR-SA""><span style=""font-size: 14pt; line-height: 107%;"">Oil returns in 2020 were negative as it was in excess supply </span><br></span></div>"

Introductory finance for economics

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Introductory finance for economics

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