Finance 327 Study Guide

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I. Topic 1. Introduction
1. Explain the difference b/w financial assets and real assets. Real Assets: (37%, 1%) Used to produce goods and services: property, plant & equipment, human capital, consumer durable, land, building etc (Material wealth of society: productive capacity, real asset) Financial Assets (debt, equity and derivative): Claims on real assets or claims on asset income. The largest financial asset of U.S. households is: pension reserve (real assets generate net income to the economy and financial assets define allocation of income among investors)  NOT FI (IBM, brokerage) Lehman brother bankruptcy 2008

2. What’s the investment process? Which decision plays a determinant role? Process: asset allocation -> security selection & analysis (TOP-DOWN method). Asset allocation (how much do I have to put in each category) 90 % of the differences in your portfolio is related to asset allocation. Choosing the percentage of funds in asset classes. Security selection & analysis: Choosing specific securities in an asset class. The asset allocation decision is the primary determinant of a portfolio’s return 3. Describe the main players in the financial market(capital resource primary allocated): Business Firms, Households, Governments – can be both borrowers and savers, Financial Intermediaries “Connectors of borrowers and lenders” (Commercial Banks, Investment companies, Insurance companies, Pension funds, Hedge funds), Investment Banks (Firms that specialize in the sale of new securities to the public, typically by underwriting the issue; Commercial and investment banks were separated by law from 1933 to 1999; Post 1999 large investment banks operated independently from commercial banks; In September 2008 end era of “wall street”) (NOT allow most participants to routinely earn high returns with low risk) 4. What’s securitization? (home mortgage) Understand what happened to home mortgage securitization in the recent financial crisis. ADRs Securitization is the process of taking an illiquid asset, or group of assets, and through financial engineering, transforming them into a marketable security. The invention of mortgage-backed securities completely revolutionized the housing,  banking and mortgage business. At first, mortgage-backed securities allowed more people to buy homes. During the real estate boom, many less careful banks and mortgage companies made loans with no money down, thus allowing people to get into mortgages they really couldn't afford. The lenders didn't care as much, because they knew they could sell the loans, and not pay the consequences when and if the borrowers defaulted. This created an asset bubble, which then burst in 2006 with the subprime mortgage crisis. Since so many investors, pension funds and financial institutions owned mortgage-backed securities, everyone took losses, creating the 2008 financial crisis. The intent was to allow banks to sell off mortgages, thus freeing up funds to lend to more homeowners. Therefore, they weren't as careful about the credit-worthiness of the borrower. Second, mortgage-backed securities allowed financial institutions other than banks to enter the mortgage business. This created additional competition for traditional banks, who had to lower their standards to keep the loan volume up. Third, MBSs were not regulated. Traditionally, banks had been highly regulated by governmental agencies to make sure their borrowers were protected. MBSs, and mortgage brokers, were not. II. Topic 2. Risk and Return Concepts

1. What are HPR, APR and EAR? How to calculate them given the data? Holding period return (HPR): HPR=[End Price - Beg. Price + Cash Flow] / Beg. Price
Cash flow: dividends for stocks and coupons for bonds
Annualized percentage return APR=per period rate*number of periods per year, Without compounding (HPR=per period rate) Effective annual rate (EAR), With compounding
2. What are AAR, GAR and dollar-weighted return? When to use AAR...
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