FIL 241 Midterm: Exam 3

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Finance Insurance and Law
FIL 241
Dalia Marciukaityte

FINANCIAL MARKETS FIL 241 Prof. Dalia Marciukaityte Questions to Prepare for Exams 9. Mortgage Markets 1. What is unique about the nature of mortgage markets? • Mortgage loans are secured by the pledge of real property • Mortgage loans are made for varied amounts- no standard denomination • Issues are usually small family or business entities • Weak secondary market • Traditionally were held by lender • Highly regulated markets and supported by federal government policies 2. What are fixed-rate mortgages? What are their characteristics? • Fixed monthly payment • Mortgage is a lien on the property used as a collateral for the loan • If the contract is broken, the lender may use the property to pay the loan • When mortgage is fully paid, the lien is removed and the borrower obtains a clear title to the property 3. What are adjustable-rate mortgages? What are their characteristics? • Are more acceptable to lenders in high inflation periods • Usually fixed rate for some initial period • Borrower costs vary with interest rate levels • Lender shift interest rate risk to the borrowers 4. How are adjustments made for ARMs? • Borrowers must be provided with 30 to 45 day advance notice of pending rate changes and be allowed to prepay the loan without penalties 5. What are the differences between FRMs and ARMs? • FRM (fixed rate mortgage) the interest rate is set when you take out the loan • ARM (Adjustable rate mortgage) the interest rate may go up or down. Many ARMs start off lower than fixed rate but then they jump up. 6. What are balloon payment mortgages? What are their characteristics? • Relatively low fixed interest rate for predetermined period • After that period, repay the remaining balance or refinance at prevailing rates • Monthly payments are determined using 15 or 30 year period 7. What are rollover and renegotiable rate mortgages? What are their characteristics? • Interest rate is reset to prevailing rates at predetermined periods • Periods between adjustments are longer than traditional ARMs 8. What are interest-only mortgages? What are their characteristics? • Only interest payment in initial years (3 to 10 years) • After the initial period, payments increase so the loan is repaid in full by the end of 30 years 9. What are construction-to-permanent mortgages? What are their characteristics? • For homebuyers who plan to build their home • Land and construction is financed in increments • Only interest payments during the construction phase • When construction is completed, the loan balance is rolled over into one of previously described mortgages 10. What are reverse annuity mortgages? What are their characteristics? • For older people • Borrower against the equity on your home at low rates • The owner of the house receives monthly payments • At the end the house is owned by the bank • Many have lifetime annuity feature 11. What are home equity loans and lines of credit? What are their characteristics? • Allows homeowners to borrow against the equity built up in their homes • Second mortgage if the borrower already has a mortgage on that property • Second mortgages sometimes are used for down payment on the first mortgage to avoid paying for private mortgage insurance 12. What does it take to secure a mortgage loan? • Credit history • Income • Down payment • Mortgage insurance (for borrowers who are unable to make a 20% down payment) 13. What are insured mortgages? What are their characteristics? • Insured and/or guaranteed mortgages are supported by federal and state agencies o Federal housing administration o Veterans administration 14. How do private mortgages work? • Conventional mortgage borrowers with low down payments usually have to buy private mortgage insurance (PMI) • PMI premiums are added to mortgage until the ratio of mortgage to the property value reaches satisfactory levels 15. What are mortgage-backed securities? What are their characteristics? • Develop a secondary market for mortgages • Banks who originate mortgages do not have to hold them on their balance sheet (easier to manage risk) (somebody still has to hold them) • Smaller investors can hold them • Characteristics o Issued in standardized denominations o Issued by either large, well know institutions or insured by such institutions o Usually insured or highly collateralized o Much higher marketability than for mortgages 16. What economic function do mortgage-backed securities serve? Makes it easier for people to invest because it makes, mortgages more liquid 17. What are the types of mortgage backed securities? • Pass-through mortgage securities o Pass through all payments of principal and interest on pools or mortgages to holders of securities • Mortgage backed bonds o Can be issued on pools of old mortgages 18. What is mortgage prepayment risk? • risk that the borrower will repay (call) the debt before maturity • when interest rates decline, homeowners (borrowers) refinance • when interest rates increase, homeowners do not refinance 19. Who are some of the mortgage holders? • Banks • Insurance companies • Pension funds • Government agencies 10. Equity Markets 1. What are the characteristics of common stock? • Ownership in coroporation • Residual (last) claim against the firm’s cash flows or assets • Return is derived from dividends and share appreciation • Voting • Limited liability 2. What are the types of voting? • Vote to elect the member of the board of directors • Cumulative voting (can use all your votes for one director) vs. straight voting • Vote on some major issues • One shar=one vote 3. What are the characteristics of preferred stock? • Fixed dividend o Sometimes adjustable-rate dividend o Cumulative provision- missed dividends must be paid • Usually, no voting 4. What are the characteristics of convertible stock or bonds? Preferred stock or bonds that can be exchanged for shares of common stock 5. What are the differences between primary and secondary markets? • Primary markets- IPO • Secondary markets- trading by current shareholders 6. What are initial public offerings (seasoned equity offerings)? How are they organized? • Underwritten offering- investment banker guarantees proceeds (or best effort) • Underwriter’s spread- difference between gross and net proceeds 7. What are private placements? • Equity offering to certain investors • EX: shark tank 8. What are right offerings? • A rights offering (issue) is an issue of rights to a company's existing shareholders that entitles them to buy additional shares directly from the company in proportion to their existing holdings, within a fixed time period. 9. What is shelf registration? • Shelf registration or shelf offering or shelf prospectus is a type of public offering where certain issuers are allowed to offer and sell securities to the public without a separate prospectus for each act of offering. Instead, there is a single prospectus for multiple, undefined future offerings. 10. Which secondary market characteristics are important? Why? • Breadth- number of traders • Depth- the size of conditional order to buy and sell • Resilience- ability to attract buyers (sellers) when the stock prices decrease (increase) • Provides liquidity 11. When are the percentage bid-ask spreads wider? • Wider for low priced stocks • Wider for trades of a few shares (normally shares are traded in 100s) • Wider for large block trades • Wider for less frequently traded stocks • Wider for trades where one side has inside information (more risk for dealer) 12. How is equity traded? • Over-the-counter market o For stocks not listed on organized exchanges o Dealer market o NASDAQ (National Association of Securities Dealers; automatic computer-based quotation system) 13. What is the impact of regulations on equity markets? • Securities act of 1933 o Requires full disclosure of relevant information related to a primary issue of securities • Securities Exchange act of 1934: o Established the SEC o SEC administers the Securities act of 1933 o SEC registers and regulates securities exchanges, OTC trading, brokers, dealers o SEC has broad powers over securities industry 14. What are the different types of risk? How are two of them measured? • Total risk (measured by standard deviation or variance • Systematic risk- market risk (undiversifiable) • Unsystematic risk- the type of risk that comes with a company or industry (this is diversifiable) 15. What effect does diversification have on risk? • Diversification reduces risk without reducing returns (averages return) o Works well for passive investing o Can cause problems for active investing 16. What effect does diversification have on returns? 17. What do stock market indexes show? • Choose stocks to be included in the index based on the objectives • Decide initial value of an index • Assign some weight to each stock in the index • Track price changes 18. How are stock market indexes created? 19. How are price-weighted indexes created? • “Buy” one share of each stock in your index; add the prices, the percentage change in the sum represents the percentage change in the index 20. How are market value-weighted indexes created? • “Buy” one share of each stock in your index; add the total market values; the percentage change in the sum represents the percentage change in the index 21. What are the characteristics of Dow Jones Industrial Average (S&P 500)? • Dow Jones o Includes leading companies in their industries o Price weighted index • Standard & Poor’s 500 o 500 largest companies o Market value-weighted index o S&P also has indexes for medium and small size companies 22. How does the stock market react to the news? • Stock market reflects investor expectations about the future cash flows firms will generate and appropriate discount rates • Expected announcements are not news • Market reacts to the difference between the information in the announcement and the market expectation • Behavioral biases- investors can make mistakes 11. Derivative Markets 1. What is a derivative security? • A derivative is a financial instrument whose value depends on the value of the underlying asset • It a contract between two people where one person’s loss is the other person’s gain 2. What are the types of derivative securities? • Futures and forwards • Options (call and put) • Swaps 3. What are the characteristics of derivative securities? • We use derivatives for risk management or speculating • Zero expected return on a well-diversified portfolio of derivatives; you should not add derivatives; no wealth creation • Common risk factors o Interest rates o Commodity prices o Stock market prices o Foreign exchange rate 4. How can you use forward contracts? • Can be used for hedging or speculation, although its non-standardized nature makes in particularly apt for hedging • Forward price- two parties agree today on price • Spot price- observed price at which transaction takes place • Settlement date- specific date which they will be executed • Long position (buyer of the contract, will buy the asset) • Short position- (seller of the contract; will sell the asset) 5. What risk is associated with forward contracts? • Counter party risk. Individuals are exposed to potential loss should their counterpart default on their obligation 6. What are the differences between forward (or futures) and spot markets? • A spot market involves the purchase or sale of a commodity for immediate delivery and payment on the spot date
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