Economics 163: Economics of Investments

University of California, Merced

Professor Jason Lee
Study Guide for Exam 1
This is a rough outline of the topics that we have covered so far as a guide to your studying. I
have organized it to correspond to the chapters in your textbook to make it easier to review. It is
only a rough outline, you are responsible for any material appearing in the lectures whether or
not the topic appears in this study guide. The exam will be a mix of multiple choice questions,
true/false questions and quantitative/graphing questions.

Chapter 1: Investments (Background and Issues)

1. Define investments.
2. What is the difference between real assets and financial assets? What are the three broad
categories of financial assets? Provide examples for each.
3. What are three reasons why financial assets play an important role in the economy?
4. What is the agency problem? Discuss ways in which the agency problem may be dealt with.
Explain how tying stock performance to the compensation of a firms management team may
lead to problems.
5. What is a portfolio? Discuss the difference between asset allocation and security allocation.
6. What is the risk-return trade-off?
7. What is the efficient market hypothesis? Discuss the difference between active management
and passive management. If the efficient market hypothesis is correct should you follow active
management or passive management? Explain.
8. What are financial intermediaries?
9. What are investment banks? Explain the difference between a primary and secondary market.

Chapter 2: Asset Classes and Financial Instruments

1. What are treasury bills (t-bills)? How do treasury bills pay its holders interest? What are
their terms to maturity? What are the advantages of holding t-bills?
2. What is the difference between bid price and ask price of a t-bill? Given a price quote can
you calculate the price of a t-bill and the implied interest it pays?
3. What is a certificate of deposit (CD)? What are some key facts regarding CDs?
4. What is commercial paper? What are some key facts regarding commercial paper?
5. What is bankers acceptance? What are some key facts regarding bankers acceptance?
6. What are Eurodollars? What are some key facts regarding Eurodollars?
7. What are repurchase agreements? What are some key facts regarding repurchase agreements?
8. What are federal funds? What is the interest rate on federal funds called?
9. What is LIBOR? Why is LIBOR important?
10. Which money market instrument offers the lowest yield?
11. What is the difference between a treasury note and a treasury bond? How often are coupon
payments made on treasury notes and bonds? What is the coupon rate? Given a price quote can
you calculate the price of a treasury note or bond?
12. What are TIPS?
13. What are federal agencies debt?
14. What is a Eurobond?
15. What is a municipal bond? What is the difference between a general obligation bond and a
revenue bond? Explain why municipal bonds generally pay a lower yield than other type of
bonds? What is the equivalent taxable yield?
16. What are corporate bonds? Briefly describe the various types of corporate bonds.
17. What are mortgage backed securities? Briefly discuss the difference between conforming
mortgages and non-conforming mortgages.
18. What is a common stock? What rights are enjoyed by shareholders? What is meant by the
term residual claimants? What is meant by the term limited liability?
19. What are dividends? How often are dividend payments distributed? What is the dividend
yield?
20. What is a preferred stock? What are the differences between a holder of preferred stocks
and holders of common stock?
21. What are American depository receipts?
22. What is the Dow Jones Industrial Average? What is meant by the term price-weighted
average? How is the daily percentage change of the Dow Jones Industrial Average calculated?
What are some of the other Dow Jones Indexes?
23. What is the Standard and Poors Corporate 500 (S&P 500)? What is meant by the term
market-value weighted average? How is the daily percentage change of the S&P 500 Index
calculated. What are some of the other S&P indexes?
24. What is the Nasdaq Index? What is the Wilshire 5000 Index?
25. What are some well-known foreign stock indexes? What is Morgan Stanley Capital
International (MSCI)?
26. Why are bond indexes more difficult to compute than a stock index? What are some
examples of bond indexes?
27. What are derivative assets?
28. What is a call option? What is the size of each call option contract? When will the call
option be exercised? What is the relationship between the value of the call option and the price
of the underlying stock?
29. What is a put option? When will the put option be exercised? What is the relationship
between the value of the put option and the price of the underlying stock? What is the premium?
30. What is a futures contract? What is the difference between a long-position and short-
position of a futures contract? What is the key difference between an option contract and a
future contract?

Chapter 3: Securities Market

1. What is the primary market? What is the difference between an initial public offering and
season equity (secondary) offering? What is the difference between a public offering of a debt
issue and private placement of a debt issue?
2. What is an underwriter? What are the duties of the underwriter? What is a prospectus? Why
do underwriters typically underprice the shares of an IPO?
3. What is an advantage of doing a private placement of an equity? What is the disadvantage of
doing a private placement of an equity?
4. What is a direct search market? Give an example of a direct search market. What is a
brokered market? Give an example of a brokered market. What is a dealer market? Give an
example of a dealer market. What is an auction market? Give an example of an auction market.
5. What are the various types of orders found in an auction market?
6. What is the New York Stock Exchange (NYSE)? Who can trade on NYSE? How does an
individual investor trade shares on the NYSE? What is a specialist? What is the settlement date
of trades on the NYSE.
7. What is the NASDAQ? How are trades conducted on NASDAQ?
8. Where does bond trading usually occur? How liquid is the market for corporate bond issues?
9. What are brokers? What is the difference between a full-service broker and a discount
broker?
10. What is a short-sale? What does an investor anticipate will happen to a stock if they engage
in a short-sale? Given a scenario can you calculate the profit (or loss) earned by an investor who
engages in a short-sale? What is the maximum profit from a short-sale? What is the maximum
loss from a short-sale? When might short-sales be limited?
11. What is margin? What is margin maintenance? What is a margin call? If an investor
receives a margin call what can the investor do to address the call? What is the formula to
calculate margin percentage? Given a scenario can you calculate how far the price of a stock
must fall before a margin call is triggered? Explain why margin is popular among investors.
12. Briefly discuss the various regulatory laws that have been passed addressing securities
markets including: Securities Act of 1933, Securities Exchange Act of 1934, Securities Investor
Protection Act of 1990 and Sarbanes-Oxley Act of 2002.
13. What is insider information?

Chapter 4: Mutual Funds

1. What are investment companies? What are some of the advantages of investment companies?
2. How is net asset value (NAV) calculated?
3. What are unit investment trusts?
4. What is the difference between an open end fund and a closed end fund?
5. What are commingled funds?
6. What are real estate investment trusts (REITs). What is the difference between a mortgage
trust and an equity trust?
7. What are hedge funds? Explain how hedge funds differ from mutual funds.
8. Describe the various types of investment policies of mutual funds.
9. How are mutual fund fees typically paid by shareholders? What is a front-end load? What is
a bank-end load? What are 12b-1 fees? What are no load mutual funds?
10. How is the rate of return of a mutual fund calculated?
11. Who pays taxes on the income earned by a mutual fund? What is the turnover ratio?
Explain how a large turnover ratio affects the taxes paid by mutual fund shareholders.
12. What are exchange traded funds (ETFs)? What are some differences between ETFs and
mutual funds?
13. What does the evidence suggest about the ability of a mutual fund manager to outperform
the general market?

Chapter 10: Bond Prices and Yields

1. What is a bond? What is the face value (par value) of a bond? What is the coupon (C) and
coupon rate (c) of a bond?
2. What is the difference between a Treasury note and a Treasury bond? How often are coupon
payments made on treasury notes and bonds?
3. How are prices quoted for Treasury notes and bonds? What is accrued interest? What is the
formula?
4. What are callable bonds? When would it be advantageous for firms to issue callable bonds?
What is the risk to holders of callable bonds? Would a callable bond pay a higher or lower
interest rate than a non-convertible bond? Explain.
5. What are convertible bonds? Would a convertible bond pay a higher or lower interest rate
than a non-convertible bond? Explain.
6. What are put bonds?
7. What are floating rate bonds?
8. What is a preferred stock? What is a key difference between preferred stock and bonds? In
cases of bankruptcy who gets paid first: bondholders, preferred shareholders or common
shareholders?
9. What is the difference between a foreign bond and a Eurobond?
10. Explain why the concept of present value is important in determining the price of a bond?
What is the equation for present value? What is the formula to find the price of a coupon bond?
11. How would you convert an annual interest rate into a semi-annual interest rate? Quarterly
interest rate? Monthly interest rate?
12. What is the relationship between interest rates and bond prices? Would long-term bond
prices or short-term bond prices fluctuate more should there be a change in interest rates?
13. What is yield-to-maturity (YTM)? How do you find the annualized yield (bond-equivalent
yield)? How do you find the effective annual yield?
14. What is current yield? If a bond is selling above its face-value will current yield be greater
or lower than the YTM? If a bond is selling below its face-value will current yield be greater or
lower than the YTM?
15. What is the holding period return for a coupon bond? If interest rates increase will the
holding period return be greater or lower than the YTM? If interest rates were to decrease will
the holding period return be greater or lower than the YTM?
16. What are zero-coupon bonds? What is the relationship between the price of a discount bond
and time? How are discount bonds taxed?
17. What is default risk? How is the default risk of corporate bonds measured?
18. What are bond indentures? What is the purpose of a bond indenture? What is a sinking
fund? What are sub-ordination clauses? Why would bondholders prefer dividend restriction
clauses in a bond contract? What is collateral? What are debenture bonds? Would a debenture
bond pay a higher or lower yield than a collateralized bond?
19. What is a default premium? How does default risk affect the default premium?
20. What are credit-default swaps (CDS)? Explain how the purchase of a CDS could transform
any risky bond into a safe bond? Explain how the growth of credit default swaps led to a
financial crisis in 2007.

Chapter 11: Managing Bond Portfolios

1. What is the relationship between interest rates (YTM) and the price of the bond? Provide an
intuitive explanation for why we would expect to observe this relationship.
2. Is the price of long-term bonds or short-term bonds more sensitive to changes in interest rates
than prices of short-term bonds? What happens to the rate of sensitivity as bond maturities
increase?
3. What is the relationship between interest rate sensitivity and the coupon rate of a bond?
4. What is the relationship between interest rate sensitivity and YTM of a bond?
5. What is the duration of a bond? When would it be useful to know the duration? What is the
equation for finding the duration of a bond? What is the equation for the duration of a perpetuity
(a bond with no maturity)? How would you find the duration of a bond if coupon payments are
made semi-annually?
6. Which bond will have a shorter duration: One that pays an annual coupon payment or a bond
that pays semi-annual coupon payments? Explain why.
7. What is the relationship between interest rate sensitivity and the duration of a bond? What is
the formula that captures the change in price and duration?
8. What is immunization? Why would a bond portfolio manager which to employ the
immunization strategy.
9. Explain how, for an investor who needs a certain amount in the future, changes in interest
rates can lead to re-investment risk. Explain how purchasing a bond whose duration is
approximately equal to the investment planning horizon solves re-investment risk.
10. How does one determine the weighting of bonds in a portfolio to ensure that the bond
portfolio is fully immunized?
11. What is cash-flow matching? What is the advantage of cash-flow matching strategy? What
is the disadvantage of cash-flow matching strategy?
12. When is the duration rule a good approximation for the actual change in the price of bonds
due to a change in interest rates? When is the duration rule not a good approximation for the
actual change in the price of bonds? How is relationship between actual price change and
duration approximation graphically represented?
13. What is convexity? What is the formula for the adjusted duration rule? How well does the
adjusted duration rule approximates the actual price change of a bond due to changes in interest
rates? Why do we care about convexity?