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Conceptaully, What are Financial assets?
Intangible assets that represent a legal claim against the assets and in come of the issuer.
Categories, definition, and an example of financial assets.
- 1. Equity Securities: (e.g. Common Stock)
- represent a residual interest in the corporation; cash flows are paid to
- shareholders in the form of dividends when declared by the corporation’s Board
- of Director.
- 2. Debt Securities: (e.g. Bonds, Notes)
- considered debt securities; investors are creditors or lenders; issuers are
- borrowers (responsible for repaying the principal and interest); cash flows are
- paid to investors (bondholders) in the form of periodic interest payments plus
- repayment of the principal upon maturity of the debt security.
- 3. Derivatives: Financial assets that derive their value from the
- value of a series of “underlying financial assets” (e.g., mortgage-backed
- securities (MBS), asset-backed-securities (ABS).
Pricing of financial assets. (formula and variables)
Po = CFn/(1+k)^n
- Po = Intrinsic value (or “discounted cash flow value”)
- N = number of discounting periods
- CF1….. CFN = Expected cash flows
- k = the investor’s required rate of return
DCF Valuation Process
- 1. Estimate the expected cash flows
- 2. Estimate the investor’s required rate of return
- 3. Estimate the number of discounting periods
- 4. Apply the proper DCF formula to estimate Po
Where are financial assets traded or exchanged?
- 1. Organized Exchanges (e.g. NYSE)
- 2. Over the counter market
- 3. Dealer-to-dealer market (e.g. the “bond market”)
Price-risk transferring innovations
- Innovations that provide market participants with efficient ways to deal
- with price or exchange risk.
Credit-risk transferring innovations
- New vehicles (or financial products) to
- reallocate credit risk.
Financial innovations that result in more liquid markets, provide new sources of funding for borrowers, and allow market participants to legally circumvent capital constraints imposed by regulations.
Financial instruments that increase the amount of debt funding available to borrowers.
Financial instruments that increase the capital base (equity) of financial and non-financial institutions.
Roles of Financial Markets
- 1. Prevent market failure
- 2. Ensure full disclosure and transparency
- 3. Regulate (or monitor) the activities of financial institutions (or financial intermediaries)
- 4. Regulate the activities of foreign participants
Name the Depository Institutions
- Commercial Banks
- Savings and Loan Associations
- Savings Banks
- Credit Unions
How are depository institution funded?
- Non-Deposit Borrowing: Fed Discount Window and Federal Funds Market
- Retained Earnings and Equity Securities
- Issuance of Debt Securities
What services do Depository Institutions offer?
- Consumer Banking
- Institutional Banking
- Global Banking
Who regulates Insurance companies?
- McCarran Ferguson Act 1945
What is the McCarran Ferguson Act 1945?
Insurance is governed by individual states not the fed.
- Insures against the risk of death.
- Insurance company pays designated beneficiaries.
- The risk insured is the cost of medical treatment.
- Insurance company pays medical service provider all or a portion of the
- insured’s medical costs, minus a contractual deductible.
Property and casualty insurance
Insures against the risk of specified damages to various types of property (e.g. cars, houses, buildings, etc.).
- Insures against the risk of litigation, risk of
- Insures against the inability of an employed person to earn income in his or her own occupation (“own occupation disability
There is also “any occupation liability insurance” that insures against the loss of income in any occupation.
Long-Term Care (LTC) Insurance
Insures against the expenses related with long-term care (e.g. care for elderly)
Provide fixed guaranteed periodic payments over a long period of time, normally resulting from a settlement on a disability or other type of policy.
"Guaranteed Investment Contract” (GIC): Similar to a debt obligation issued by an insurance company.
Holders are subject to the same credit risk associated with zero coupon bonds.
Structure of insurance company: Home Office
- Manufacture insurance contracts
- Provides financial backing for the financial guarantees of the contact
Structure of insurance company: Investment Company
Invests premiums collected by the insurance company.
Structure of insurance company: Distributor/distribution component
Basically the sales force responsible for "distributing" the products offered by the insurance company.
Term life insurance
- Insures against death.
- Beneficiaries receive payment upon the insured’s death, as long as it happens within a given period.
- The policy holds no cash value if the insured dies outside the period specified in the policy
Cash value or permanent life insurance
Also called whole life insurance.
In addition to providing term insurance, it builds up cash value, which can be withdrawn or borrowed against by the policyholder.
“Inside buildup” (growth of cash value) is not subject to taxation.
- Participating policies:
- the dividend is based on the performance of the investment portfolio of the
- insurance company. It could exceed, but
- never fall below the minimum guaranteed by the insurance company.
Variable life insurance
- Policy holders can allocate premium payments among various types of investments (typically managed portfolios).
- Performance of insurance policy depends on portfolio performance.
- Cash value and death benefits depend on
- investment results of portfolios.
Survivorship (second to die) insurance
Life insurance policy that pays death benefits when a second policy holder dies.
Typically sold for estate planning purposes.
Definition of investment funds
- Financial intermediaries that sell shares to the
- public and invest the proceeds in a diversified portfolio of securities
Open-end Mutual funds
- Portfolios of securities
- Investors own a pro rata share of the overall portfolio, which is managed by the fund’s investment manager.
- Shares are traded at net asset value
- Share prices are always equal to NAV
- Shares of closed-end funds are initially issued by an
- underwriter and remain constant over time.
- Shares are traded on a secondary market, either OTC or in an exchange.
- NAV is calculated in the same way as open-end funds.
- However, share prices are driven by supply and demand.
- Similar to closed-end funds.
- However, unit trusts typically invest in fixed income securities (bonds).
- The unit trust is created by a sponsor.
- It is then sold to a trustee, who will manage the bond portfolio until the maturity.
- No active bond trading takes place in the unit trust portfolio.
- The units are held until maturity; at which the unit trust will cease to exist.
Sales charge on mutual funds is related to their method of distribution
Front End load
Sales charge that is deducted up front; i.e. when new shares in the mutual fund are purchased.
Sales charge that is imposed once shares in the mutual fund are sold.
Contingent deferred sales charge
Imposes a gradually declining load (or sales charge) on withdrawal.
Define Expense Ratio
Amount charged to mutual fund investors to cover the fund’s annual operating expenses.
Charged by the investment advisor for managing the fund’s portfolio. It is fixed percentage levied on the market value of the fund’s assets.
12-b1 or distribution fee
- the distribution costs of the mutual fund (e.g.
- marketing, distribution, selling costs)
- the costs of
- (1) custody services (holding cash and
- securities in the fund),
- (2) the transfer agent (transferring cash and
- securities among buyers and sellers),
- (3) independent public accountants, and
- (4) director’s fees.
Economic Motivation for Funds
- Risk reduction through diversification
- Reduced transaction costs
- Advantages of professional management
- Variety of investment alternatives (through various types of funds and
- families of funds)
- Payment services by allowing investors to write checks
Securities Act of 1933
Deals with disclosure pertaining to new security issues
Securities Act of 1934
- Regulates securities issuance, exchanges, and
Investment Company Act of 1940
Ensures that investors in mutual funds have sufficient information.
Requires investment companies to produce periodic financial reports.
- Provides tax advantages of mutual funds.
- Prevents mutual funds from changing their investment
objectives without investor approval.
Defined Benefit (DB) Plans
The plan sponsor agrees to make specified (monthly) contributions (or payments) to qualified employees starting at retirement
Defined contribution plans
The plan sponsor is only responsible for making specified contributions into the plan on behalf of qualified participants.
The plan sponsor is NOT responsible for making specified payments to employees upon retirement.
The plan sponsor does not guarantee any specific amount upon retirement.
Hybrid Pension Plans
Defined future benefits but you are contributing.
- Established funding standards for the minimum
- contributions that a plan sponsor must make to the plan to satisfy the pension
- payments projected in the future.