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What are derivatives? How can they be used to reduce or increase risk?

A derivative securitys value is derived from the price of another security (e.g., options and futures). Can be used to hedge or reduce risk. For example, an importer, whose profit falls when the dollar loses value, could purchase currency futures that do well when the dollar weakens. Also, speculators can use derivatives to bet on the direction of future stock prices, interest rates, exchange rates, and commodity prices. In many cases, these transactions produce high returns if you guess right, but large losses if you guess wrong. Here, derivatives can increase risk. 2-1

Types of Financial Institutions

Commercial banks Investment banks Financial services corporations Credit unions Pension funds Life insurance companies Mutual funds Hedge funds Exchange traded funds Private equity companies

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Types of Financial Institutions


Investment banks

Help corporations design securities with features attractive to investors Buy these securities from corporations Resell them to savers Examples: Bear Stearns collapsed and was later acquired by J.P Morgan Lehman Brothers went bankrupt

Merrill Lynch was forced to sell out to Bank of America

Commercial banks
Department stores of finance as they serve a variety of savers and borrowers Helped Federal Reserve System in monitoring money supply by checking accounts For example Bank of America, Citibank, Wells Fargo, J.P. Morgan
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Types of Financial Institutions


Financial services corporations

Large conglomerate that combine many different financial institutions within a single corporation

Have diversified to cover most of the financial spectrum


Examples: Citigroup owns Citibank (commercial bank), Smith Barney(an investment bank and securities brokerage organization), Insurance companies, and Leasing companies

Credit unions

Cheapest source of funds available to individual borrowers Cooperative associations whose members have a common bond, such as being employees of the same firm Members savings are loaned to other members to facilitate auto purchases, home improvement and mortgage loans
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Types of Financial Institutions


Pension Funds

Are retirement plans funded by corporations or government agencies for their workers

Are administered by the trust departments of commercial banks and life insurance companies
Invest primarily in bonds, stocks, mortgages, and real estate

Life Insurance Companies

Take savings in the form of annual premiums Invest them in stocks, bonds, mortgage, real estate

Make payments to beneficiaries of the insurance parties


Also offered a variety of tax deferred savings plans for retiring individuals
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Types of Financial Institutions


Mutual Funds

Use savers money to buy stocks, long term bonds, or short term debt instruments

Pool funds to reduce risks by diversification


Bond funds for those who prefer safety Stock funds for those who accept significant risk in the hopes of high returns Funds that are used as interest bearing checking accounts(money market funds)

Invest primarily in bonds, stocks, mortgages, and real estate


Achieve economies of scale in analyzing securities, managing portfolios and buying and selling securities

Exchange Traded Funds (ETFs)

Operated by mutual fund companies


Buy a portfolio of stock, eg. The S&P 500 or Chinese companies and then sell their own shares to public ETFs shares are traded in public markets
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Types of Financial Institutions


Hedge Funds

Similar to mutual funds with few exceptions

largely unregulated as compare to mutual funds and ETFs which are registered and regulated by securities and exchange commission
Mutual funds typically target small investments whereas hedge funds have large minimum investments(often exceeding $1 Million) Organizations that operate much like hedge funds Private equity players buy and then manage entire firm The money used to buy the target companies is borrowed Examples: Cerberus Capitals buyout of Chrysler and private equity company JC Flowers proposed $25 billion purchase of Sallie Mae, the largest student loan company
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Private Equity Companies

Physical Location Stock Exchanges vs. Electronic Dealer-Based Markets

Auction market vs. Dealer market (Exchanges vs. OTC) NYSE vs. Nasdaq Differences are narrowing

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Physical Location Stock Exchanges vs. Electronic Dealer-Based Markets


Physical Location Exchanges

tangible entities, having its own building, allows a limited number of people to trade on its flour and has an elected governing body.
Exchanges are open on all normal working days with members equipped with telephone and other electronic equipment to communicate with his or her firm throughout the world. NYSE is the largest physically located stock exchange A large collection of brokers and dealers connected electronically by telephones and computers that provides for trading in unlisted securities A dealer market includes all facilities that are needed to conduct security transactions The dealer quote the price at which pay for the stock (the bid price) and the price at which they will sell the shares (the ask price) The bid-ask spread which is the difference between bid ask prices, represents the dealers markup or profit
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Over the Counter Market

Stock Market Transactions

Apple Computer decides to issue additional stock with the assistance of its investment banker. An investor purchases some of the newly issued shares. Is this a primary market transaction or a secondary market transaction?

Since new shares of stock are being issued, this is

a primary market transaction.

What if instead an investor buys existing shares of Apple stock in the open market is this a primary or secondary market transaction?

Since no new shares are created, this is a


secondary market transaction.
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What is an IPO?

An initial public offering (IPO) is where a company issues stock in the public market for the first time. Going public enables a companys owners to raise capital from a wide variety of outside investors. Once issued, the stock trades in the secondary market. Public companies are subject to additional regulations and reporting requirements.
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S&P 500 Index, Total Returns: Dividend Yield + Capital Gain or Loss, 1968-2007

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Where can you find a stock quote, and what does one look like?

Stock quotes can be found in a variety of print sources (Wall Street Journal or the local newspaper) and online sources (Yahoo!Finance, CNNMoney, or MSN MoneyCentral).

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What is the Efficient Market Hypothesis (EMH)?

Securities are normally in equilibrium and are fairly priced. Investors cannot beat the market except through good luck or better information. Efficiency continuum
Highly Inefficient Highly Efficient

Small companies not followed by many analysts. Not much contact with investors.

Large companies followed by many analysts. Good communications with investors.


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