Final Exam Cheat Sheet

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Ch.1 financial intermediation results from economies of scale and the specialization of financial transactions. (banks, inv. companies [mutual & pension funds], insurance companies, credit unions, brokerage firms, investment banks). Inv. banks assist firms in raising capital, create the market for innovative new securities that meet the risk and return demand (CMOs, collateralized mortgage obligations – derivative security that separates the cash flows of a mortgage pool into different classes with different maturities and risks). risk and return are the most important characteristics of financial assets. Another is tax. (high tax-bracket investors would, other things equal, would prefer tax-exempt securities [municipal bonds]). brokered markets (when a bank seeks out investors to purchase an issue directly from the issuing firm, it is acting as a broker) and dealer markets (when an inv. bank purchased and sold a security issue, it is acting as a dealer – profit is the bid-ask spread [ask price is investors’ purchase price & bid price is investors’ sale price, with ask price greater than the bid price]). Both broker and dealer markets require a financial intermediary. auction market is a more advanced market in which all buyers and sellers arrive at mutually agreeable prices (popularity of internet auction market). primary markets (where a security is first sold to investors [IPOs, initial public offerings]) and secondary markets (where existing securities are traded among investors [New York Stock Exchange]). trends: 1)globalization (euro); 2) securitization (CMOs); 3) financial engineering (creation of new securities); 4) faster & more easily accessible information.

Ch.2 money market is the market for short-term securities (T-bills, CDs, Commercial Paper, Bankers’ Acceptances, Eurodollars [$ deposit outside U.S.], Repos [repurchase agreement], Federal Funds, & Call Money. low risk (due to their short lives) and high liquidity (due to low transaction costs) are similarities all these securities have in common. SEE TEXT FOR EXAMPLE OF SHORT-TERM INTEREST RATES AND THEIR DEFINITIONS. T-bill: discount securities (discount, in effect, is the bearer’s interest); rates are quoted using the bank discount method (assumes a 360-day year & simple interest [rather than compound interest]). SEE TEXT FOR EXAMPLE OF CONVERTING THE INTEREST RATE ON A T-BILL INTO BOND EQUIVALENT YEILD. bond equivalent yield (annual percentage yield) assumes a 365-day year. effective annual yield assumes a compounding interest rate. QUESTION, WHICH OF THE THREE RATES IS GENERALLY THE HIGHEST? LOWEST? capital market is market for long-term securities including bonds (Treasury Notes [less than 10 years]; bonds [larger than 10 years]; Federal Agency Bonds; municipal bonds [some interest rates on these bonds are exempt from both federal and state taxes]; corporate bonds [yield quoted on these bonds are typically current yield (annual income divided by the current price of the bond), rather than yield-to-maturity]; mortgage bonds), stocks (common and preferred stock – return from a stock comes from capital gains and dividends. growth stock [high-tech stocks] typically have low dividends and high expected capital gains [thus high prices and high P/E ratios]. value stocks typically have high dividends and low expected capital gains. preferred stocks carry fixed dividends, but firms have no contractual obligation to pay these dividends; they are riskier than bonds, but often carry a lower yield than bonds due to the 70% dividend exclusion tax rule.), and derivatives (primarily options and futures). SEE EQUATION (2.1) AND (2.2) FOR THE RELATIONSHIP BETWEEN TAXABLE YIELD AND TAX-FREE YIELD. price-weighted index corresponds to investing an equal number of shares in each stock (Dow Jones). value-weighted index corresponds to investing a stock in an index in proportion to its total market value (S&P). equally-weighted index...
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