DIPARTIMENTO DI SCIENZE ECONOMICHE E METODI MATEMATICI
LAUREA MAGISTRALE IN STATISTICA PER LE DECISIONI FINANZIARIE E ATTUARIALI
LINGUA INGLESE
PROF. SSA Paola Gaudio
UNIVERSITÀ DEGLI STUDI DI BARI “ALDO MORO”
2013
TABLE OF CONTENTS
What is Finance.................................................................................................................... p. 3
Why is Finance Important? ................................................................................................. p. 5
Organizational Structure ..................................................................................................... p. 7
Executive Compensation.................................................................................................... p. 9
Securities .............................................................................................................................. p. 12
Capital .................................................................................................................................. p. 15
Mutual Funds ........................................................................................................................ p. 18
Market Efficiency ................................................................................................................. p. 21
Stock Markets ....................................................................................................................... p. 23
Dividends .............................................................................................................................. p. 26
Interest .................................................................................................................................. p. 28
Financial Risk ........................................................................................................................ p. 30
Time Value of Money .......................................................................................................... p. 33
Socially Responsible Investing............................................................................................. p. 34
Banking ................................................................................................................................. p. 36
Insurance .............................................................................................................................. p. 39
The Actuarial Profession ...................................................................................................... p. 41
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WHAT IS FINANCE?
We all have a general idea of what Finance is, but to make sure we are on the same
page, let's let others define Finance for us.
Webster's New World dictionary defines it as:
(1.) money resources, income, etc.
(2.) the science of managing money.
Used in this context it is a noun. It can also be used as a verb in which case it means to
supply or get money for a project.
Of these I like the definition as the management of money.Finance is the most
encompassing of all business enterprises. To understand finance you must know about the
entire business, indeed the entire economy. So for a few minutes let’s step back and
pretend that we never took economics and are new to this earth.
The Financial system (or the economy, your choice) is composed of consumers,
manufacturers, distributors. These groups need money to purchase products and services.
One way of looking at Finance is that it is getting the money to purchase these goods and
services.
Many economists assume that households have excess money and corporations need
money.
(This is obviously a gross simplification. At any given point some individuals have excess
money to invest where others need to borrow. The same is true for corporations and other
organizations, but the simplified model makes things easier for the moment.)
The purpose of the Financial System is to make sure that the money flows to those who
value it the highest (that is those who can put it to the "best" use).
Now
Corporations « Households
(Need money) $ (have money to invest)
Now, these households are not going to just give corporations money. They will demand
their money back at some time in the future and a bit more for the use of their money and
risks incurred etc.
Future
Corporations >> Households
(have money) $ (Want money back)
Everything else we study in finance is just looking at this model in more detail. (Seriously,
EVERYTHING!)
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Let's make it personal.
I remember being asked in second or third grade the key to understanding a book. My
immediate response was to put yourself into the book. The same is true here. If we take a
few seconds now to internalize the subject it will pay large dividends (don't you love
finance humor?) in the future.
If I ask to borrow money from you what do you say? Yes? No? It depends, doesn't it? What
does it depend on? A million things! For example: how much do I want to borrow, what
are the prospects of me being able to repay it, what is my reputation, what am I going to
do with the money, whether you have anything better to do with the money....can you
think of anything else?
The same ideas are true in the financial world. People will not lend, or will require a larger
repayment if they do decide to lend, if there are many things to do with their money, or if
the borrower is going to do something risky with it, or if the borrower has an unsavory
reputation.
If you get that, you will have fun in finance. If you do not understand the example, please
reread it and imagine people asking you for money. Oh, come on, please!!!
(adapted from http://financeprofessor.com/introcorpfinnotes/whatisfinance.htm)
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WHY IS FINANCE IMPORTANT?
This answer has two parts. The first is why Finance is important for the economy
overall. The second is why Finance is important personally.
WHY FINANCE IS IMPORTANT TO THE ECONOMY
From a macro perspective, Finance is merely the practical application of
economics. The Financial System is the means by which an economy allocates
money to its highest valued use. In English, it is how people, businesses, and
governments raise the cash needed to do business.
The goal of any financial system is to make sure that those with good ideas get the
money necessary to implement the ideas. How this is accomplished in a marketbased economy is through the stock and bond markets.
In a market-based economy, investors invest in a firm (by firm here I am merely
simplifying, the "firm" could be a government or organization as well) and the firm
takes the investment and uses it to implement the business ideas.
People do not give money without the expectation of getting something in return.
(However, if you are the sort of person who merely likes to give money away,
please contact me!) If money is given, something is expected back in return. In this
case more money.
The way to get the most money back is to invest in firms that will put the money to
the best use. Of course others know this as well. As more invest with a firm, the
value of the firm's stock rises.
In competition for more money, firms will strive to find better investments. This leads
to economic growth, more jobs, and hopefully a higher standard of living.
WHY FINANCE IS PERSONALLY IMPORTANT
Just like a company, we all need money. We need money to live (food, clothing,
shelter) and we probably want money for a great number of things (concert
tickets, cars, computers, etc.). Thus we need to get money. Finance helps us to
have the money when we need it and even when we want it.
Obviously finance is important if we run our own firm. Here we need to efficiently
manage our resources and know what risks are worth taking. Further, we need to
know how to invest and how to raise money.
Even if you never plan on owning your own business, Finance is still important to
you. Finance teaches us to understand the other side of every transaction. If you
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understand what your employer wants, it is easier to achieve this and hence you
are in a better position for raises and promotions.
That said, few people will now work their entire life at the same firm. This can have
dramatic financial implications. Knowing in advance your financial position and
options dramatically reduces your stress in this time of change.
Taxes can take 40% of what we earn. Making the right investments can cut this tax
burden. This is yet another reason to study finance.
Many people find themselves in financial ruin even though they may be extremely
successful in their field. For example the news is constantly telling us of star athletes
who have gone from making millions to flat broke. Most of these stories could have
been avoided with some basic financial knowledge and financial discipline.
Retirement planning is one of the most cited reasons of why finance is important.
This is because it is so clear-cut. You must invest for your retirement. Knowing how
can prevent needless heartache later.
Ironically, Finance is important because we do not want to have to worry about
money. Marriages are ruined, friendships crushed, and health destroyed over
money worries. I do not want these things to happen to you. Financial knowledge
can help prevent these problems.
(adapted from http://financeprofessor.com/financenotes/introductoryfin/whystudyfinance.html)
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ORGANIZATIONAL STRUCTURE
The three basic types of organizational structures are proprietorships, partnerships,
and corporations.
PROPRIETORSHIP
A proprietorship (or self proprietorship as it is also known) is the easiest type of
organization to form. It is formed by an individual who runs the company without
any separation of his or her personal wealth and that of the firm. An additional
advantage (although it can be disadvantageous depending on tax rates) is that
the money the firm makes flows through to the individual's tax return. This allows the
individual to avoid the concept of double taxation. Finally, an advantage of this
(however slight) would be that the customers know the proprietor is personally
liable which may mean the proprietor would work harder and have a better
quality product.
Disadvantages of this sort of structure are numerous:
1. it is difficult to raise the money necessary to grow the firm
2. the owner cannot easily "cash-out"
3. income flows through the individual's taxes (which may be an
advantage or disadvantage)
4. there is a personal liability for any of the debts of the firm. Thus, if the
business were to fail, or if it were to get sued, the proprietor could be
personally liable and would have to put more money into the
business.
PARTNERSHIP
A partnership is in many ways a group of people forming a proprietorship. The
advantage is still that they are easy to form. A partnership is only good for the life
of the partners. If one dies, or decides to leave the partnership, a new partnership
must be formed.
There are two types of partnerships:
1. General Partnerships - all partners are equally responsible for the firm's
liabilities.
2. Limited Partnerships - allow limited partners to invest in the firm without the
personal liability so long as they do not actively manage the firm. There still
must be a general partner who is personally liable.
CORPORATIONS
The corporation is generally the organizational structure of choice for large firms.
The reasons are numerous. A corporation is recognized in the United States as a
legal entity. This allows for the corporation, and not its investors, to be liable for
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liabilities. This limited liability allows firms to raise money much easier since the most
a shareholder can lose is the amount invested.
Moreover the shares of a corporation are generally transferable. This allows
shareholders to more easily sell their shares.
As legal entities, corporations are taxed. This can be a problem as if the investor
wants to receive a dividend, the company must pay the dividend with money that
has already been taxed. When the investor receives the dividend, (s)he too must
pay taxes on it. Hence the concept of double taxation.
Because of the ease of transferring shares and the limited liability, almost all large
businesses are corporations.
Exceptions
As with anything, we do have some exceptions.
S-Corps are corporations that pass through the earnings to their investors. The
investor must then pay the tax. This gets around double taxation while maintaining
the limited liability benefits of a corporation. Only firms with fewer than 35
shareholders can qualify under the IRS's rulings as an S-Corp. (Note that as a result
of S-Corps, many now use C-Corp to distinguish a normal corporation that does
not pass through its earnings).
Limited Liability Companies (LLC) are in some ways the best of both worlds. They
allow for limited liability but also allow the tax benefits of the S-Corp without the
restrictive qualifications of the S-Corp. These are relatively new and only allowed in
certain states. Further, they do not have the rich history of tax and civil law behind
them to set precedence.
(adapted from http://www.financeprofessor.com/financenotes/introductoryfin/organizationstruc ture. html)
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EXECUTIVE COMPENSATION
There are two main things to look at when discussing executive compensation:
1. Form of Pay
2. Level of Pay
It is the level of pay that gets the person to be an employee for your firm. It is the
form of pay that leads to work from the employee. That is, the level of pay gets the
employee in the door, the form aligns incentives and gets the person to do the
work that you desire.
Executives at today's firms are paid much like professional athletes. And like the
pay of professional athletes, executive pay draws a great deal of attention. For
example, in 2000, the median pay in the utility industry was over $2 million (source
Conference Board). (It should be noted that median is the better measure for
examining Executive Compensation than average because averages are driven
disproportionately by outliers).
Executives (and pro-athletes) are paid more than typical workers which draws
both attention and jealousy. They are even paid more (in 1999 62 times more) than
the President of the US.
(http://www.orst.edu/dept/pol_sci/fac/sahr/prceo.htm)
FORM OF PAY
Hourly
Salary
Piecework
Bonus and commission
Accounting
based
pay Market Based pay
SHAREHOLDER-MANAGER CONFLICTS
Shareholders and Managers can fight about many things:
1.
2.
3.
4.
5.
6.
Effort
Time-horizon
Risk (managers are concerned with total risk due to poor diversification)
Empire building
Under-leverage (i.e. lower than optimal debt levels)
Over-retention (i.e. lower than optimal dividends)
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Accounting-based pay is an attempt to reduce some of these conflicts and to
align incentives.
It has the advantage of paying people more for what they control and less
for what is outside their control (for example, a market-wide collapse is
beyond the fault of any manager but a manager with market-based pay
will likely suffer the consequences).
Market-based pay is probably the best for aligning incentives, managerial
interests, and shareholder wealth, this thus lowers shareholder-manager conflicts.
Market-based pay makes up over 50% of CEO pay and is generally responsible for
the headline numbers that we sometimes see.
(www.ExecPay.com)
PYRAMID
Within any given firm the following relationships show which type of pay
predominates.
CEO and Executives
Middle Management
Employees
Market-based relatively more important
Accounting-based relatively more important


Salary relatively more important
The pay at each level may (and generally is) made up of components of each,
but the above shows which form dominates.
LEVEL OF PAY
HOW MUCH ARE THEY PAID?
A lot!
Additionally, CEO pay has been growing much faster than the average worker's
pay.
WHY DO EXECUTIVES GET PAID SO MUCH?
There are many theories.
1. CEO's actions influence a large number of people. Their pay is therefore only
in line with the implications of their actions.
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2. Tournament: CEO pay is the reward for winning the CEO "tournament".
Under this hypothesis, the CEO must be highly paid because so few will win
the award. Thus, the expected payoff must be great enough to offset the
risks and costs.
3. A more cynical view is that CEOs are paid so much because they control
the board of directors who sets their pay.
IS IT TOO MUCH?
In 1974 the Yankees signed “Catfish” Hunter to a $3.75 million five year contract
and everyone was convinced it was the end of the sport. 30 years later players are
making well over $10 million with some MUCH higher. Alex Rodriguez signed a 10
year 275 million contract. And yet baseball continues to pay the big bucks. Much
the same has happened in the business world.
"There's only one small problem with the theory of "greed gone wild." The U.S.
economy is the envy of the world - the only major one to flourish over the last few
years. The question is: Does the U.S. economy grow despite the excesses of CEO
pay? Or does America's philosophy of CEO compensation provide U.S. companies
with a global competitive advantage? "
CEO PAY AND SOCIAL ISSUES
There are observations that by using compensation packages which focus
managers’ attention toward maximizing shareholder wealth, workers are enjoying
greater job and retirement security than are citizens of other developed nations
(Kay, 1998). There are also arguments that the linking of CEO compensation to the
economic performance of the firm has contributed to improving the global
competitiveness of U.S. firms, which, in turn, has improved the economic benefits
for all (Fisher, 1998). From a broader perspective of social issues research, there
have been indications that improved firm economic performance has been
correlated with higher levels of corporate social performance (e.g., Waddock &
Graves, 1997).
(adapted from http://www.financeprofessor.com/488/notes/executivecompensation_levelandform. html)
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SECURITIES
A security is a fungible, negotiable instrument representing financial value.
Securities are broadly categorized into debt securities (such as banknotes, bonds
and debentures) and equity securities, e.g., common stocks; and derivative
contracts. The company or other entity issuing the security is called the issuer.
Securities may be represented by a certificate or, more typically, "noncertificated", that is in electronic or "book entry" only form. Certificates may be
bearer, meaning they entitle the holder to rights under the security merely by
holding the security, or registered, meaning they entitle the holder to rights only if
he or she appears on a security register maintained by the issuer or an
intermediary. They include shares of corporate stock or mutual funds, bonds issued
by corporations or governmental agencies, stock options or other options, limited
partnership units, and various other formal investment instruments that are
negotiable and fungible.
(adapted from http://en.wikipedia.org/wiki/Security_%28finance%29)
EQUITY SECURITIES
CAPITAL STOCK
Capital stock is simply the ordinary shares of stock companies issue to raise money.
The two most common classes of capital stock are common stock and preferred stock.
Holders of common stock exercise control by electing the board of directors and voting
on corporate policy and are on the bottom of the priority ladder for ownership
structure.Preferred stock is a class of ownership that has a higher claim on the assets and
earnings than common stock. Preferred stock generally has a dividend that must be paid
out before dividends to common stockholders and the shares do not have voting rights.
While the dividends on preferred stocks tend to be higher than those of common stock,
they will not appreciate with company growth. However, when viewed over long term
investing, common stocks have historically offered higher returns than preferred stocks.
(adapted from http://www.coxrail.com/q&a/qa01.htm) .(Foxbusiness.com/what’s the difference between)
DERIVATIVES
A derivative security, also known as a derivative stock, is a financial instrument whose
price is dependent on one or a number of underlying financial assets. In itself, the
derivative security is no more than an agreement between two contracted parties to buy
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or sell an asset at a fixed price on or before a date of expiration. The value of the security
is dictated by the value of the underlying asset, which is usually a stock, a commodity, a
bond, currency, interest rates or market indexes.
(adapted from http://www.wisegeek.com/what-is-a-derivative-security.htm)
DEBT SECURITIES
BONDS
A debt instrument issued for a period of more than one year with the purpose of raising
capital by borrowing. The Federal government, states, cities, corporations, and many
other types of institutions sell bonds. Generally, a bond is a promise to repay the principal
along with interest (coupons) on a specified date (maturity).
Some bonds do not pay interest, but all bonds require a repayment of principal. When an
investor buys a bond, he/she becomes a creditor of the issuer. However, the buyer does
not gain any kind of ownership rights to the issuer, unlike in the case of equities.
On the one hand, a bond holder has a greater claim on an issuer's income than a
shareholder in the case of financial distress (this is true for all creditors).
Bonds are often divided into different categories based on tax status, credit quality, issuer
type, maturity and secured/unsecured (and there are several other ways to classify bonds
as well). U.S. Treasury bonds are generally considered the safest unsecured bonds, since
the possibility of the Treasury defaulting on payments is almost zero.
The yield from a bond is made up of three components: coupon interest, capital gains
and interest on interest (if a bond pays no coupon interest, the only yield will be capital
gains). A bond might be sold at above or below par (the amount paid out at maturity),
but the market price will approach par value as the bond approaches maturity.
A riskier bond has to provide a higher payout to compensate for that additional risk. Some
bonds are tax-exempt, and these are typically issued by municipal, county or state
governments, whose interest payments are not subject to federal income tax, and
sometimes also state or local income tax.
(adapted from http://www.investorwords.com/521/bond.html)
BANKNOTES
A bank note is a promissory note issued by a bank. It is payable on demand, sometimes in
the form of precious metals like gold and silver, and sometimes in exchange for assets
such as bonds issued by the bank. Bank notes are considered legal tender, and they are
used in billions of financial transactions all over the world every day. A bank note, in other
words, is currency or money.
(adapted from http://www.wisegeek.com/what-is-a-bank-note.htm)
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DEBENTURES
Debentures are long-term Debt Instruments issued by governments and big institutions for
the purpose of raising funds. Debentures have some similarities with Bonds but the terms
and conditions of securitization of Debentures are different from that of a Bond.
A debenture is regarded as an unsecured investment because there are no pledges
(guarantee)or liens available on particular assets. Nonetheless, a debenture is backed by
the creditworthiness and reputation of the issuer but not by any specific collateral.
Normally, Debentures are referred to as freely negotiable Debt Instruments. The Debenture
holder functions as a lender to the issuer of the Debenture. In return, a specific rate of
interest is paid to the Debenture holder by the debenture issuer similar to the case of a
loan. In practice, the differentiation between a Debenture and a Bond is not observed
every time. In some cases, Bonds are also termed as Debentures and vice-versa. If a
bankruptcy occurs, Debenture holders are treated as general creditors.
(adapted from http://finance.mapsofworld.com/debenture/)
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CAPITAL
DEFINITION OF CAPITAL
All assets used by an individual or company to generate income. This can include
cash, property, equipment, and materials. The amount of capital owned by a
company demonstrates its wealth and determines its ability to earn profit.
(adapted from http://www.advfn.com/money-words_term_694_capital.html)
CAPITAL STRUCTURE
In finance, capital structure refers to the way a corporation finances its assets
through some combination of equity, debt, or hybrid securities. A firm's capital
structure is then the composition or 'structure' of its liabilities. For example, a firm
that sells $20 billion in equity and $80 billion in debt is said to be 20% equityfinanced and 80% debt-financed. The firm's ratio of debt to total financing, 80% in
this example, is referred to as the firm's leverage.
MODIGLIANI-MILLER THEOREM
A financial theory stating that the market value of a firm is determined by its
earning power and the risk of its underlying assets and is independent of the way it
chooses to finance its investments or distribute dividends. Remember a firm can
choose between 3 methods of financing: issuing shares, borrowing or spending
profits. The basic idea is that, under certain assumptions, it makes no difference
whether a firm finances itself with debt or equity.
(adapted from http:/investopedia.com/M&M theorem
WHY CAPITAL STRUCTURE MATTERS TO YOUR INVESTMENTS
by Joshua Kennon, About.com Guide
You often hear corporate officers, professional investors, and analysts discuss a company's
capital structure. You may not know what a capital structure is or why you should even
concern yourself with it, but the concept is extremely important because it can influence
not only the return a company earns for its shareholders, but whether or not a firm survives
in a recession or depression. Sit back, relax, and prepare to learn everything you ever
wanted to know about your investments and the capital structure of the companies in
your portfolio!
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CAPITAL STRUCTURE - WHAT IT IS AND WHY IT MATTERS
The term capital structure refers to the percentage of capital (money) at work in a
business by type. Broadly speaking, there are two forms of capital: equity capital and
debt capital. Each has its own benefits and drawbacks and a substantial part of wise
corporate stewardship and management is attempting to find the perfect capital
structure in terms of risk / reward payoff for shareholders. This is true for Fortune 500
companies and for small business owners trying to determine how much of their startup
money should come from a bank loan without endangering the business.
Let's look at each in detail:
Equity Capital: This refers to money put up and owned by the shareholders
(owners). Typically, equity capital consists of two types: 1.) contributed capital,
which is the money that was originally invested in the business in exchange for
shares of stock or ownership and 2.) retained earnings, which represents profits
from past years that have been kept by the company and used to strengthen the
balance sheet or fund growth, acquisitions, or expansion.
Many consider equity capital to be the most expensive type of capital a
company can utilize because its "cost" is the return the firm must earn to
attract investment. A speculative mining company that is looking for silver in
a remote region of Africa may require a much higher return on equity to get
investors to purchase the stock than a firm such as Procter & Gamble, which
sells everything from toothpaste and shampoo to detergent and beauty
products.
Debt Capital: The debt capital in a company's capital structure refers to borrowed
money that is at work in the business. The safest type is generally considered longterm bonds because the company has years, if not decades, to come up with
the principal, while paying interest only in the meantime.
Other types of debt capital can include short-term commercial paper
utilized by giants such as Wal-Mart and General Electric that amount to
billions of dollars in 24-hour loans from the capital markets to meet day-today working capital requirements such as payroll and utility bills. The cost of
debt capital in the capital structure depends on the health of the
company's balance sheet - a triple AAA rated firm is going to be able to
borrow at extremely low rates versus a speculative company with tons of
debt, which may have to pay 15% or more in exchange for debt capital.
Other Forms of Capital: There are actually other forms of capital, such as vendor
financing where a company can sell goods before they have to pay the bill to the
vendor, that can drastically increase return on equity but don't cost the company
anything. This was one of the secrets to Sam Walton's success at Wal-Mart. He was
often able to sell Tide detergent before having to pay the bill to Procter & Gamble, in
effect, using PG's money to grow his retailer. In the case of an insurance company, the
policyholder "float" represents money that doesn't belong to the firm but that it gets to
use and earn an investment on until it has to pay it out for accidents or medical bills, in
the case of an auto insurer. The cost of other forms of
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capital in the capital structure varies greatly on a case-by-case basis and
often comes down to the talent and discipline of managers.
SEEKING THE OPTIMAL CAPITAL STRUCTURE
Many middle class individuals believe that the goal in life is to be debt-free. When you
reach the upper echelons of finance, however, that idea is almost anathema. Many of
the most successful companies in the world base their capital structure on one simple
consideration: the cost of capital. If you can borrow money at 7% for 30 years in a world of
3% inflation and reinvest it in core operations at 15%, you would be wise to consider at
least 40% to 50% in debt capital in your overall capital structure.
Of course, how much debt you take on comes down to how secure the revenues
your business generates are. If you sell an indispensable product that people
simply must have, the debt will be much lower risk than if you operate a theme
park in a tourist town at the height of a boom market. Again, this is where
managerial talent, experience, and wisdom comes into play. The great managers
have a knack for consistently lowering their weighted average cost of capital by
increasing productivity, seeking out higher return products, and more.
(adapted from http://beginnersinvest.about.com/od/financialratio/a/capital-structure.htm)
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MUTUAL FUNDS
Mutual Funds are nothing more than a group of people pooling their money for
investment purposes. Everything else that we see written about with respect to
mutual funds is really just details about how to decide who we should allow to
"manage" our money and how we should keep track and reward those that invest
the money for us.
ADVANTAGES OF MUTUAL FUNDS
1.
2.
3.
4.
5.
6.
Diversification
Lower Transaction costs
Liquidity and divisibility
Better record keeping
Professional management
Marketing (reminds you to invest!)
DO NOT PUT ALL OF EGGS IN ONE BASKET!
Diversification is the idea of not putting all of your money in one spot. It
means holding many types of assets. For example owning shares in many
companies or owning some stocks and some bonds. Diversification lowers
risk since when some assets are up in value, others are down in value.
Diversification, however, can drive up transaction costs for small investors.
Mutual Funds are a solution to this problem. Investors pool their money and
the fund then invests in many different assets. By spreading out trading costs
over a larger investment, the percentage transaction costs are often lower.
Additionally, each investor need not do the research which further saves
expenses.
Most mutual funds (especially open ended funds) allow investors to
purchase (or sell) fractional shares. This divisibility of shares allows investors to
invest set dollar amounts without worrying about the cost of the shares.
Mutual funds also keep track of when people buy and sell. This makes tax
reporting easier. Periodic reports are sent to investors. These lower record
keeping costs.
Some investors need a "kick" to remember to invest. Mutual Funds often
provide that impetus by showing the benefits of investing and also merely by
keeping the fund in the mind of the investor.
While the efficiency of markets (prices are correctly priced) draws into
question the advantages of paying a fund manager to pick stocks, there
are those individuals that believe that managers can invest better than you
and me.
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TYPES OF MUTUAL FUNDS
There are many ways of classifying mutual funds. These range from how the
funds are bought or sold to where the funds invest. It must be stressed that
these categories are not mutually exclusive. Funds can be classified in
several of these categories.
CLOSED-END VS OPEN END MUTUAL FUNDS
Open End mutual funds are ready to redeem or issue new shares at any
point. This is the more popular type of mutual fund. The number of shares is
constantly changing as investors buy and sell their shares. The firm is
generally willing to buy and sell at Net Asset Value (NAV).
The price of closed end funds is set in the secondary markets. In this type of
fund the number of shares is largely fixed and shares are bought and sold
between different investors. This is the traditional investment company. The
firm raises money through periodic security issuances (primary market
transaction) but generally all subsequent buying and selling is done without
the fund's intervention.
TYPE OF INVESTMENT
An alternative way of classifying mutual funds is by the types of assets the
fund buys. Some of the most popular are:
Money Markets
Stock Mutual Funds
Bond Funds
Funds that try to diversify across asset classes as well as within a given asset class
are called Balanced funds. A specific type of this is called a life cycle fund. A life
cycle fund tries to invest in assets that are appropriate for the average investor in
the fund. For example a life cycle fund that targeted young investors would have
riskier growth stocks whereas a fund that targeted retirees would likely have more
invested in government bonds.
Within these broad categories there can be further stratification. For
example: stock fund that invest only in internet firms, or stock funds that
invest only in dividend paying firms.
Funds that specialize within a certain industry are often called sector funds.
These are quite risky as they have not diversified away the industry specific
risks.
LOCATION OF HOLDINGS
Yet another way of classifying funds is where the assets are located. For
example you can have Domestic or International funds. Some of the
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categories here include specific country funds (example the Mexico Fund)
or region funds (for example,Latin America) or even by type of market
(Emerging Market).
One important reason for municipal bond funds is for tax purposes. Interest
earned on municipal bonds is tax-free in the state of the municipality. Thus
an investor in Nebraska that buys a muni-bond issued by the Omaha City
government need not pay state or federal tax on the interest. The interest on
the bond would however be taxable for an investor in New York.
MISCELLANEOUS
Hedge Funds - not a true "mutual fund" but in many ways quite similar. Funds
that take very large bets on various types of investments. DO NOT assume
that a HEDGE fund is low risk (the word Hedge is not correctly used here).
Very low liquidity. Money is generally tied up for at least a year.
Naked Funds - Mutual fund that allows investors to track every trade the
fund manager makes.
Interval Funds - In an effort to remain fully invested, certain mutual funds
only allow withdrawals at certain times.
MUTUAL FUND PERFORMANCE
William Sharpe and Michael Jensen in the mid 1960s investigated Mutual
Fund Performance. They used The Capital Asset Pricing Model (CAPM) and
concluded that on a risk adjusted basis mutual funds did not outperform the
market. Although there have been many subsequent, and more
sophisticated, studies the results have not changed. It does not appear that
mutual fund managers can consistently outperform the market.
The two main reasons why mutual funds cannot beat the market are:


Markets are very tough to beat. This is the basic idea behind the
Efficient Markets Hypothesis. There are many very smart people
trying to beat each other and it is unlikely that anyone can
consistently beat everyone. 
Mutual Funds incur transaction costs whereas market indices do not. 
(adapted from http://www.financeprofessor.com/mutualfunds/mutualfundsmainpage.html)
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MARKET EFFICIENCY
Market efficiency is one of the most controversial topics in finance. On one side of the
debate are most academics and on the other side are many practitioners whose wealth
depends on investor trading.
The debate has gone full circle: from the market cannot be efficient to “well it is
efficient, but there are some chinks in the armor of efficiency.” Market efficiency is
the idea that the market price is right. Thus efficiency comes about as the result of
competition. The many participants are all trying to be the first to get information
that will affect security prices. By trading on this information, the price will quickly
reflect the information. For example, suppose you find out some good news about
a firm. You go and buy the stock. This action drives the price up. If it gets too high
you will sell. This will keep the price at its correct level.
Information and competition are the underlying principles guiding market
efficiency. Think of an asset price being based off of forecasts of future conditions.
(example: the future supply, demand, competition, etc.) These forecasts are
made using the information available in what financial economists call information
sets. The larger the information set, the more accurate the forecasted price
(information is power).
Traditionally, these information sets have been classified into three categories: 1)
past asset price data, 2) information that is publicly available, and 3) private
information. If all past information is incorporated in the price then it should be
impossible to consistently beat the market using technical analysis and the like.
Most studies have found this to be the case although a recent study by Lo,
Mamaysky, and Wang (JF 2000) has casted some doubt on this.
Further, the continued existence of technicians is troubling. However, the gains to
be had using these methods are small. Most believe that this past information is “in
the price” and that technical analysis does not work. If this is the case, the market
is called weak-form efficient. It means that you cannot make money on a
consistent basis using past information. If we expand the “information set” to
include not only past information but also information that is publicly available,
then the market price is “more correct.” If this is the case any attempt to “beat the
market” using publicly available sources (such as financial statements, news
reports, magazine stories, and the like) will likely result in no extra abnormal return.
The ways that this is tested are with event studies and by looking at investors to see
how many are consistently beating the market. Most event studies and the
empirical findings that few investors do “beat the market” are consistent with this
form of efficiency which is called semi-strong form efficiency.
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The final form of efficiency is strong form efficiency. This says that all information
(both public and private) is incorporated into the stock price. This is obviously false
since people trading with inside information do beat the market.
One common error is to prescribe perfection to the markets. Markets are
amazingly good but not perfect. If markets are efficient it does not mean you will
not make money. It only means that you will not earn more than you should earn
for assuming that level of risk. Thus to say beating the market means earning a
return above and beyond the required return for that level of risk. What chinks
exist? As we already have mentioned - programs on technical analysis. Farther
though we have a tough time with “bubbles.” If the market price is the correct
price, how can we explain the bubble in the Japanese market in the late 1980s or
even the Internet bubble in 1998-99? In these incidences the high valuations were
the result of overly optimistic expectations. However, these anomalies are not
enough to throw out the preponderance of evidence that markets are extremely
difficult to beat and that our efforts are generally better spent elsewhere.
(adapted from http://financeprofessor.com/financenotes/lessonsoftheweek/marketefficiency.html)
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STOCK MARKETS
In the US stocks traditionally have sold on both exchanges and over the counter.
An exchange is a central location where buyers and sellers come together to
trade. Many cities used to have their own exchanges - the largest of these was
and still is the NYSE. Many of the other exchanges have fallen by the wayside but
there are still several “regional” exchanges including the Philadelphia Stock
Exchange, the Chicago Stock Exchange, the Boston Stock Exchange, and the
Pacific Stock Exchange .
NYSE
The NYSE is the best known of all stock markets. It is located on Wall Street in New
York City and can trace its roots back to the 1790s when trading was done under a
buttonwood tree.
For most of modern history the American Stock Exchange has been the second
most widely known exchange. It is known as the curb market since it began
trading at the corner of Wall and Hanover Streets in NY city in 1849. It moved into a
five-story building in 1921 and its ticker service became famous for its ability to
transmit 300 characters per minute.
NASDAQ
The Nasdaq is the most famous and largest of the over-the-counter markets. Prior
to the establishment of the Nasdaq, the OTC market in the U.S. was, in the words of
a 1963 SEC investigation "fragmented and obscure." The NASD was given the
responsibility for automating the market. The result was the National Association of
Security Dealers Automated Quotations System. On February 8, 1971 shares were
first traded. From the small beginnings in 1971 as a small network between dealers,
it has evolved into a nationwide computer network able to handle billions of
shares per day.
Due to lower listing requirements, the Nasdaq has traditionally been a launching
pad for newly public firms. As these firms matured then tended to move to the
larger and more reputable NYSE. However, as the Nasdaq grew, this movement
from towards the NYSE has slowed. Many large well established firms have recently
opted to stay on the Nasdaq.
The Nasdaq has been a major success--partially as a result of its technology
orientation and partially as a result of the technology companies that are listed on
the Nasdaq. This has led to increases in market capitalization, trading volume, and
number of firms listed. For example by 1994 it was regularly trading more shares
than the NYSE.
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In 1998 The NASDAQ and the American Stock Exchange merged. The combined
company still maintains the two markets separately, but many speculate that the
AMEX may soon be a memory.
ELECTRONIC COMMUNICATION NETWORKS
In addition to these markets there are many other newer markets. These are small
in size and are almost exclusively computerized networks but are playing a
growing role in after-hour trading as well as institutional trading. These include
Instinet, the Arizona Exchange, the Island, Archipelago, and others. Collectively
these ECNs bring together buyers and sellers and then try to get out of the way.
Instinet is the largest and most widely used of these “small” markets. It was founded
in 1969 and takes no position other than to bring together buyers and sellers. Until
recently, Instinet was available only to large institutional investors. Now however it
is available to smaller investors as well.
The key advantage to these newer smaller markets is the longer hours of trading
available to the investor. Larger institutional traders may get a better price (lower
transaction costs) but generally speaking the key is the liquidity and the ability to
trade after the markets close.
In face of this increased competition the major markets are planning on extending
their own trading hours.
Not to be left without a competitive advantage, Instinet recently announced its
plans to begin trading fixed income securities.
THE BID-ASK SPREAD
You've probably heard the terms spread or bid and ask before but you may not
know what they mean or how they relate to the stock market. The bid-ask spread
can affect the price at which a purchase or sale is made - and an investor's overall
portfolio return. What this means is that if you want to dabble in the equities
markets, you need to become familiar with this concept.
Investors must first understand the concept of supply and demand before learning
the ins and outs of the spread. Supply refers to the volume or abundance of a
particular item in the marketplace, such as the supply of stock for sale. Demand
refers to an individual's willingness to pay a particular price for an item or stock.
The spread is the difference between the bid and ask for a particular security.
The size of the spread and the price of the stock is determined by supply and
demand. The more individual investors or companies that want to buy, the more
bids there will be; more sellers result in more offers or asks.
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On the New York Stock Exchange (NYSE) a buyer and seller may be matched by
computer. However, in some instances, a specialist who handles the stock in
question will match buyers and sellers on the floor of the exchange. In the absence
of buyers and sellers, this person will also post bids or offers for the stock in order to
maintain an orderly market.
On the Nasdaq, a market maker will use a computer system to post bids and offers
and essentially plays the same role as a specialist. However, there is not a physical
floor. All orders are marked electronically.
STOCK INDICES
There are many ways to measure how the “market” is doing. The most popular in
the US are the Dow Jones Industrial Average and the S&P 500.
There are many differences between the two indices - most notably, the number
of firms. The Dow has only 30 firms whereas the S&P 500 has 500 firms. Additionally
until late 1999 the Dow was made up exclusively of stocks that trade on the NYSE.
There are now two exceptions (Intel and Microsoft that are both Nasdaq-firms).
The major difference in the two indices is in how they are calculated. The Dow is a
price weighted index (a stock index in which each stock affects the index in
proportion to its price per share) whereas the S&P is a value weighted index .
(adapted from http://financeprofessor.com/fin322/notes/stockmarkets.html)
In a price-weighted index such as the Dow Jones Industrial Average, Amex Major
Market Index, and the NYSE ARCA Tech 100 Index, the price of each component
stock is the only consideration when determining the value of the index. Thus, price
movement of even a single security will heavily influence the value of the index .
In contrast, a market-value weighted or capitalization-weighted index such as the
Hang Seng Index and the S&P 500 is a stock exchange index in which a greater
weighting is given to shares of companies that have a larger market capitalization
so they have more influence on index movements than the shares of companies
with a lower market capitalization. Thus, a relatively small shift in the price of a
large company will heavily influence the value of the index.
(adapted from http://en.wikipedia.org/wiki/Stock_market_index#Weighting,
http://www.investopedia.com/articles/ trading/121701.as, and http://glossary.reuters.com/index.php/Marketvalue_Weighted_Index )
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DIVIDENDS
Dividends are payments that firms make to their shareholders. Historically, dividends were
a major portion of returns to stockholders. Since the late 1980s dividends have taken a
back seat to capital gains. After the Enron collapse and the Corporate Governance Crisis
that followed, dividends came back into vogue. Why? It is harder to fake dividends than it
is earning.
There are several types of dividends. Generally, dividends are cash payments, but as we
see with stock dividends it is not always the case.
TYPES OF DIVIDEND
o
o
o
o
Ordinary (or regular) dividends - Regular dividends are paid in cash at
regular intervals. Most firms pay these out quarterly, but there are firms
that pay at other intervals (monthly or annually).
Special (or extra) Dividends - A one-time dividend that is not expected to
be reoccurring.
Stock Dividends - Stock dividends are really mini-stock splits. The
company gives new shares to existing shareholders.
Other types of dividends - These are special benefits such as free cruises
and the like.
DIVIDEND POLICY
Dividend decisions are made by the company's Board of Directors. They are faced with
the decision to pay out dividends or to reinvest the cash into new projects.
In a perfect world, dividend policy would not matter since the return that investors would
earn would be the same as the return that the firm would receive if the cash were
reinvested (this is the idea behind Nobel Prize winners Modigliani and Miller's work in the
field).
However, the real world is not perfect. There are taxes, information asymmetries, and
conflicts of interest. In this world dividend policy may matter. For example, if you think
managers will waste any cash they have, you would prefer larger dividends even though
your taxes will rise.
HOW DOES THE BOARD OF DIRECTORS DECIDE HOW MUCH TO PAY OUT?
The classic work in this area is by Lintner (1956). He found that managers hate to cut
dividends (because investors see cuts as a signal that things are going poorly). Thus once
the Board of Directors decides to raise dividends they want to be sure they do not need to
cut them in the future. This leads to "sticky dividends." Sticky dividends refers to the idea
that dividends track earnings but with a lag since management wants to be sure the
earnings are sustainable.
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DIVIDENDS AND TAXES
Dividends are paid out of earnings. These earnings were already taxed. When a dividend
is received, the investor must pay taxes on the dividend. This dividend is generally taxed as
ordinary income. This double taxation is a big problem when paying dividends.
In many nations the Stock Buybacks can be used as an alternative to dividends. The
rationale behind this is that the investor need not sell. Thus, investors can "time" their taxes.
Further, in many nations capital gains are taxed at a lower rate than is ordinary (dividend)
income. However, if a firm uses stock buybacks exclusively to avoid taxes, the IRS will
intervene and disallow the lower tax.
An additional point is worth noting: corporations that receive dividends can exempt 70%
of the dividend for tax purposes. This is aimed at preventing triple taxation.
Because of the advantage of timing the tax as well as the lower capital gains tax rate,
most people believe there is a disadvantage to paying out large dividends. This view has
really caught on in recent years as firms have not raised dividends but rather reinvested
and/or done stock buybacks.
(adapted from http://financeprofessor.com/financenotes/introductoryfin/Dividends.html)
STOCK BUYBACKS
Share repurchase or stock buyback is the reacquisition by a company of its own stock. In
some countries, including the U.S. and the UK, a corporation can repurchase its own stock
by distributing cash to existing shareholders in exchange for a fraction of the company's
outstanding equity; that is, cash is exchanged for a reduction in the number of shares
outstanding. The company either retires the repurchased shares or keeps them as treasury
stock, available for re-issuance.
Companies making profits typically have two uses for those profits. Firstly, some part of
profits are usually repaid to shareholders in the form of dividends. The remainder, termed
stockholder's equity, are kept inside the company and used for investing in the future of
the company. If companies can reinvest most of their retained earnings profitably, then
they may do so. However, sometimes companies may find that some or all of their
retained earnings cannot be reinvested to produce acceptable returns.
Share repurchases are one possible use of leftover retained profits. When a company
repurchases its own shares, it reduces the number of shares held by the public. The
reduction of the float, or publicly traded shares, means that even if profits remain the
same, the earnings per share increase. So, repurchasing shares, particularly when a
company's share price is perceived as undervalued or depressed, may result in a strong
return on investment.
(adapted from http://en.wikipedia.org/wiki/Share_repurchase)
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INTEREST
Interest is what you earn when you let people borrow your money. Some call it the price of
renting your money. Obviously how much you will rent it for will depend on many things.
We will focus on those things in a few lessons. This lesson will look at how the interest is
computed. Specifically, the differences between simple and compound interest.
SIMPLE INTEREST VS. COMPOUND INTEREST
The difference between simple and compound interest is the difference between night
and day. You will want to remember this simple rule: simple interest grows slowly,
compounding speeds up the process.
Simple interest is interest on the principal amount while compound interest is when your
principle and any earned interest earn interest. If you have invested money into an
account you always want compound interest. Moreover, the relative advantages of
compound interest escalate as your holding period increases.
An example might help simplify things.
Suppose you have $100 to invest. You decide to invest it at the Hog National Bank. It is a
small bank located in the heart of Hazard County. You walk in and speak with the Boss. He
says he will pay 10% simple interest on your $100.
Not knowing he is up to something, you accept the offer and invest your $100. You are all
excited and go home and start calculating how much you will have in the future.
(Investing is always somewhat exciting!)
Ten percent of $100 is $10 so at the end of 1 year you will have the original principle of
$100 + $10 of interest. Still excited you calculate it for the next year. $100 + $10 +10% of the
principle which is still 100. So in year 2 you have $120. Mmm…this is not as good as you
thought. But you keep going, third year you get another $10. Moreover, if you were to
repeat this calculation you would have $10 of interest each year. The reason is that the
interest you earn does not get added to the principle amount so you do not earn interest
on the interest.
Suppose for the time being that there were another bank in Hazard County (or that you
were enlightened enough to invest your money outside of Hazard County) that paid 10%
compound interest. That is they paid interest on both your principle as well as the interest
you have already earned.
The first year you would be no better off: you would still only have 100(1+interest rate)=
100(1.1)= $110.
The difference starts in the second year. Now your interest also earns interest. So you
would end up with ($100 + $10)(1.1)=$121. This equation can be simplified as
Future value = (present value)* (1+ interest rate) number of years remaining
The one-dollar difference does not sound like much, this difference gets very
large over time. Indeed the difference can get very large if there is enough time.
Consider the table below.
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You begin off with $100. In each case the money is invested at 10% annual interest. In the
two columns your total dollar balance is given.
After
Simple Interest
Compound Interest
1 year
110
110
2 years
120
121
3 years
130
133
4 years
140
146
5 years
150
161
10 years
200
259
20 years
300
672
30 years
400
1,744
40 years
500
4,526
50 years
600
11,739
I am sure you agree that it is readily apparent that if you are lending money (and that
really is what you do when you give it to the bank to invest), you would prefer compound
interest. Moreover, you would prefer as many compounding periods as possible since at
the end of each compounding your account is credited for the interest and thus your
interest can start earning more interest.
Stop and think about that for a second. The sooner your interest is credited, the longer it
will work for you. Does it make sense? Think hard. It is a key concept.
(adapted from http://financeprofessor.com/introcorpfinnotes/simplevscompound.htm)
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FINANCIAL RISK
Financial risk is an umbrella term for any risk associated with any form of financing.
Typically, in finance, risk is intimately related to the difference between the actual return
and the expected return (when the actual return is less).
Risk related to an investment is often called investment risk. Risk related to a company's
cash flow is called business risk.
CREDIT RISK
Credit risk, also called default risk, is the risk associated with a borrower going into default
(not making payments as promised).
Investor losses include lost principal and interest, decreased cash flow, and increased
collection costs.
Investment risk has been shown to be particularly large and particularly damaging for very
large, one-off investment projects, so-called megaprojects. This is because such projects
are especially prone to end up in what has been called the "debt trap," i.e., a situation
where – due to cost overruns, schedule delays, etc. – the costs of servicing debt becomes
larger than the revenues available to pay interest on and bring down the debt.
MARKET RISK
This is the risk that the value of a portfolio, either an investment portfolio or a trading
portfolio, will decrease due to the change in value of the market risk factors. The four
standard market risk factors are stock prices, interest rates, foreign exchange rates, and
commodity prices:
Equity risk is the risk that stock prices and/or the implied volatility will change.
Interest rate risk is the risk that interest rates and/or the implied volatility will change.
Currency risk is the risk that foreign exchange rates and/or the implied volatility will
change, which affects, for example, the value of an asset held in that currency.
Commodity risk is the risk that commodity prices (e.g. corn, copper, crude oil) and/or
implied volatility will change.
LIQUIDITY RISK
This is the risk that a given security or asset cannot be traded quickly enough in the market
to prevent a loss (or make the required profit). There are two types of liquidity risk: market
liquidity, and funding liquidity.
A security has good MARKET LIQUIDITY if it is “easy” to trade, that is, has a low bid-ask
spread, small price impact, high resilience, easy search (in OTC markets).
A bank or investor has good FUNDING LIQUIDITY if it has enough available funding from its
own capital or from loans.
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With these notions in mind, the meaning of liquidity risk is clear.
Market liquidity risk is the risk that the market liquidity worsens when you need to trade.
Funding liquidity risk is the risk that a trader cannot fund his position and is forced to
unwind.
For instance, a leveraged hedge fund may lose its access to borrowing from its bank and
must sell its securities as a result. Or, from the bank's perspective, depositors may withdraw
their funds, the bank may lose its ability to borrow from other banks, or raise funds via debt
issues.
(adapted from http://www.voxeu.org/index.php?q=node/2566)
OPERATIONAL RISK
An operational risk is, as the name suggests, a risk arising from execution of a company's
business functions. It is a very broad concept which focuses on the risks arising from the
people, systems and processes through which a company operates. It also includes other
categories such as fraud risks, legal risks, physical or environmental risks.
A widely used definition of operational risk is the one contained in the Basel II regulations,
the means by which the European Capital Requirements Directive has been implemented
across the European banking sector. This definition states that operational risk is the risk of
loss resulting from inadequate or failed internal processes, people and systems, or from
external events.
The approach to managing operational risk differs from that applied to other types of risk,
because it is not used to generate profit. In contrast, credit risk is exploited by lending
institutions to create profit, market risk is exploited by traders and fund managers, and
insurance risk is exploited by insurers. They all however manage operational risk to keep
losses within their risk appetite - the amount of risk they are prepared to accept in pursuit
of their objectives. What this means in practical terms is that organizations accept that
their people, processes and systems are imperfect, and that losses will arise from errors and
ineffective operations. The size of the loss they are prepared to accept, because the cost
of correcting the errors or improving the systems is disproportionate to the benefit they will
receive, determines their appetite for operational risk.
DIVERSIFICATION
Most of the forms of risk that we concern ourselves with, financial risk, market risk, and even
inflation risk, can at least partially be moderated by forms of diversification.
For example, a person investing $10,000.00 for one year may desire a gain of $1,000.00, or
a 10% return, providing a total investment of $11,000 after one year. In reality, investing, as
opposed to saving, rarely provides such a neat solution. For example, the average annual
compound return of the broad American stock market over the time period from 1926 to
2006 was just over 10% per year. During that eighty year period though, there were more
than a few times when massive declines in market value were experienced by investors in
that same stock market. From early in the year 2000 through the fall of the year 2002 for
example, the broad measures of market valuation, such as the S&P 500 Stock Index fell
over 50%. For an investor in 2006 to have seen that average compounded 10% return in
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the S&P 500 Index, he or she would have had to invest in 1994. The 10% average annual
rate or return was there, it just took twelve years to see.
(adapted from http://en.wikipedia.org/wiki/Financial_risk)
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TIME VALUE OF MONEY
The first thing that needs to be explained is the concept of simple vs. compound
interest. When we are dealing with the time value of money we are interested in
compound interest. Briefly, compound interest is when your interest earns
additional interest; simple interest is when only the original principle earns interest.
The basic idea of time value of money is that a dollar today is worth more than a
dollar tomorrow. That is you would rather have a dollar now than later, BUT would
rather pay later if possible.
This can be shown in many ways, many people find it easier to understand if they
think in terms of something they already know: food. For example having the
money today allows you to buy some food immediately. Alternatively you may be
willing to forgo current consumption and wait until later to purchase your food.
Thus you could lend your "food money" to another with the promise of being paid
back at some future time. Since you are passing up food today you would
demand a return sufficient to allow you to buy at least as much food in the future
that you are giving up now.
As we do not know the future, any future deal involves risks. For example the
borrower may decide not to pay you back. This is called default risk. Or the
borrower may pay you back but due to rising prices you can no longer purchase
the same amount of food as you had expected to be able to buy (this is called
inflation risk).
As a result of these risks, you as a lender require a higher interest rate to
compensate for accepting the risks. However if you ask for too high of interest
rates you will not find any takers for your loan.
There are two basic concepts that you will need to know. Present Value and
Future value. These can be confusing, but once you get them you will find them
exceedingly useful throughout your finance career.
The two ideas are closely related:
1. Present Value calculations deal with how much something is worth today given
a set of assumptions about the future.
2. Future Value calculations deal with how much money you will have in the
future given a set of assumptions.
If you have that idea down, we can go on and see how these are actually used. I cannot
stress the importance of this enough. These are two of the key things taught in any
introductory finance class.
(adapted from http://financeprofessor.com/financenotes/introductoryfin/timevalueofmoney.html)
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SOCIALLY RESPONSIBLE INVESTING
Socially Responsible Investing (SRI) is a broad-based approach to investing that now
encompasses an estimated $2.71 trillion out of $25.1 trillion in the U.S. investment
marketplace today. SRI recognizes that corporate responsibility and societal concerns are
valid parts of investment decisions. SRI considers both the investor's financial needs and an
investment’s impact on society. SRI investors encourage corporations to improve their
practices on environmental, social, and governance issues. You may also hear SRI-like
approaches to investing referred to as mission investing, responsible investing, double or
triple bottom line investing, ethical investing, sustainable investing, or green investing.
As a result of its investing strategies, SRI also works to enhance the bottom lines of the
companies in question and, in so doing, delivers more long-term wealth to shareholders. In
addition, SRI investors seek to build wealth in underserved communities worldwide. With
SRI, investors can put their money to work to build a more sustainable world while earning
competitive returns both today and over time.
Socially responsible investors include individuals and also institutions, such as corporations,
universities, hospitals, foundations, insurance companies, public and private pension funds,
nonprofit organizations, and religious institutions. Institutional investors represent the largest
and fastest growing segment of the SRI world.
WHAT ARE THE APPROACHES INVESTORS TYPICALLY UTILIZE IN SRI?
Screening, which includes both positive and negative screens, is the
practice of evaluating investment portfolios or mutual funds based on
social, environmental and good corporate governance criteria. Screening
may involve including strong corporate social responsibility (CSR) performers,
avoiding poor performers, or otherwise incorporating CSR factors into the
process of investment analysis and management. Generally, social investors
seek to own profitable companies that make positive contributions to
society. “Buy” lists may include enterprises with, for example, good
employer-employee relations, strong environmental practices, products that
are safe and useful, and operations that respect human rights around the
world.
Conversely, many social investors avoid investing in companies whose
products and business practices are harmful to individuals, communities, or
the environment. It is a common mistake to assume that SRI “screening” is
simply exclusionary, or only involves negative screens. In reality, SRI screens
are being used more and more frequently to invest in companies that are
leaders in adopting clean technologies and exceptional social and
governance practices.
Shareholder advocacy involves socially responsible investors who take an
active role as the owners of corporate America. These efforts include talking
(or “dialoguing”) with companies on issues of social, environmental or
governance concerns. Shareholder advocacy also frequently involves filing
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shareholder resolutions on such topics as corporate governance, climate
change, political contributions, gender/racial discrimination, pollution,
problem labor practices and a host of other issues. Shareholder resolutions
are then presented for a vote to all owners of a corporation.
The process of dialogue and filing shareholder resolutions generates investor
pressure on company management, often garners media attention, and
educates the public on social, environmental and labor issues. Such
resolutions filed by SRI investors are aimed at improving company policies
and practices, encouraging management to exercise good corporate
citizenship and promoting long-term shareholder value and financial
performance.
Community Investing directs capital from investors and lenders to
communities that are underserved by traditional financial services
institutions. Community investing provides access to credit, equity, capital,
and basic banking products that these communities would otherwise lack. In
the US and around the world, community investing makes it possible for local
organizations to provide financial services to low-income individuals and to
supply capital for small businesses and vital community services, such as
affordable housing, child care, and healthcare.
(adapted from http://www.socialinvest.org/resources/sriguide/srifacts.cfm)
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BANKING
WHAT IS A BANK?
A bank may be defined as a credit institution. It is an institution which studies, deals in and
guarantees credit. While the bank receives and pays out large sums of money in the form
of deposits, such operations are subordinate to the one great function - that of granting
credit. If we view, then, the bank from this standpoint, its purpose is to facilitate the
exchange of goods without the use of money.
Banking has been developed to meet the needs of business. Hence, the more highly
developed business becomes, the more extensively bank credit is used and the more
important banking becomes in the transaction of business with the use of a minimum
amount of money.
THE FUNCTIONS OF BANKING
The most important functions of banking may be classified as follows:
(1) to assemble capital and make it effective;
(2) to receive deposits and make collections;
(3) to check out and transfer funds;
(4) to lend;
(5) to exercise fiduciary or trust powers;
(6) to issue circulating notes.
Every bank which expects to succeed must first of all prove its value to the community.
The services which a bank performs are so generally taken for granted that the public is
unaware of the real extent of the facilities offered. Banks are equipped to utilize funds, for
either a short or long period of time, safely, and with some profit. Depositors individually do
not enjoy the same ability.
An individual's unused funds are perhaps small in amount, cannot be loaned to
advantage with the assurance of immediate return when desired, and the care of the
money involves worry and risk. The bank, on the other hand, possesses the necessary men,
machinery and experience. By obtaining deposits, each perhaps small in itself, from many
people, it acquires a large reservoir of funds. From this supply, which is constantly being
increased by additional deposits and decreased by withdrawals according to the needs
and circumstances of the depositors, the bank can now make loans and other
investments from time to time.
It is known as a place where loans may be sought, and it is protected in making these
loans of funds which it has had left with it on deposit by the law of averages which usually
operates in such a way that withdrawals and deposits about balance each other, the
normal tendency being in favor of a net increase. By receiving deposits and making
collections the bank saves the depositor much personal effort.
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To receive or deposit in one city a check made payable in another, hundreds or
thousands of miles away, to convert that check in a relatively short time into cash
available for the depositor's use, and all this with no direct assistance from the customer
and at a very slight expense to him or none at all, is indeed service.
In addition to taking care of funds without charge and making collections, the bank
provides the means of withdrawing and transferring funds readily by giving its customer a
book of blank checks. If a depositor owes another man one hundred dollars, the depositor
need not go to the bank, withdraw the cash and pay his debt. He can give his creditor an
order on the bank, which can be presented at the bank in person and the cash obtained,
or it can be deposited in this or another bank. By lending money the bank benefits the
community to the extent that it supplies funds to assist worthy business.
Temporary working capital to assist in the commercial, agricultural or industrial life of a
community is very important. Borrowers logically look to a bank for such assistance and
are thereby saved the necessity of either going without the funds they need or spending
an endless amount of time and effort in negotiating many small loans from individuals.
Note issue, originally a common right of a bank, is now restricted by law to National banks,
Federal Reserve banks and the Government, and is chiefly valuable as a means of putting
additional currency in circulation according to the needs of trade.
There has been such an enormous growth in the business done by trust companies and by
trust departments of banks in the last few years by acting in various fiduciary capacities
that it seems necessary to include this as one of the important banking functions, which
will be more fully discussed a little later.
TYPES OF BANKING
According to their functions, banks may be classified into four chief types, namely,
commercial, savings, trust, and investment.
The deposits of commercial banks are received largely from individuals, firms and
corporations in all lines of business, are repayable on demand, and are mostly invested in
short time loans for commercial business purposes, these loans having a maturity of
perhaps three to six months, and enabling the bank to keep its assets comparatively liquid
and its loans constantly maturing.
Savings banks, which are designed to promote thrift, receive unused, small sums from the
general public, which are left with the banks for future need. These deposits may be
repaid on demand, but since interest is usually paid on deposits, and the bank's
investments are made for a long period of time to enable it to earn a higher interest rate,
the banks are generally allowed to demand advance notice of anywhere from ten to
ninety days of any substantial sums to be withdrawn. This notice of withdrawal may be
waived by the bank if it so desires. The bank may also further protect itself against large
withdrawals by limiting the amount which it will receive on deposit from any one person.
The chief investments of savings banks are approved bonds and first mortgages on real
estate, both probably of long maturity.
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The deposits classified as trust funds are received from individuals, firms and corporations
assigning funds for some trust function, and are repayable and invested according to law
and the conditions of the trust.
Investment banks receive their deposits from well-to-do people who wish their funds held
for investment and which are in due course converted into bonds and other so-called
investment securities.
(adapted from http://chestofbooks.com/finance/banking/Elementary-Banking-AIB/index.html)
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INSURANCE
The basics of insurance are simple - one company offers a guaranteed future
payment for a contracted event. The company offering the guarantee charges a
premium for insuring against the event's occurrence - in doing so, the insurance
company is protecting the client against certain circumstances, say physical
capital loss due to a natural disaster. The insurance company assumes all financial
responsibility associated with the client’s losses.
Where the business gets complicated is in the calculations of premiums. This
involves the use of complex stochastic probability models meant to simulate the
likelihood of a given event’s occurrence. Not all events are created equal, from
an insurance perspective - for some types of insurance a company can
accurately predict the probability of occurrence (say, automobile insurance,
which has such a large sample to study that companies can make accurate
predictions and judgments about demographic groups). For events that are
harder to predict, insurance companies take on greater risk when they issue
policies.
The insurance sector itself is segmented into four distinct sub-sectors: Life Insurance,
Property & Casualty Insurance, Accident & Health Insurance, and Miscellaneous
Insurance.
FORMS OF INSURANCE
LIFE INSURANCE
Life insurance deals with policies that are written to hedge against the risk of
death, accidental death, and in some cases, sickness. In many cases, liability to
the insurer is limited based on cases dealing with suicide, war, riot, and fraud.
PROPERTY & CASUALTY INSURANCE
Casualty insurance deals with policies that are written to hedge against the risk of
unforeseen accidents. Some examples are insurance policies for auto accidents or
losses incurred at sea (Marine Insurance). In general, casualty insurance hedges
against risks associated with liability and crime.
ACCIDENT & HEALTH INSURANCE
Health insurance deals with policies that are written to hedge against the risk of
unexpected or unexpectedly high health costs. Interestingly, the insurer of health
insurance policy can either be from the private sector or the public sector,
subsidized by taxes.
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FINANCIAL GUARANTORS/ASSURANCE
Assurance/guarantor companies provide insurance against default on credit
instruments. They collect premiums to insure bonds against defaults and/or losses in
value through insurance policies generally called "insurance enhancement
products".
(adapted from http://www.wikinvest.com/industry/Insurance)
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ACTUARIES
SIGNIFICANT POINTS
A strong background in mathematics is essential.
Actuaries generally have a bachelor’s degree and must pass a series of
examinations—often taking 4 to 8 years—to gain full professional status.
Competition for jobs will be keen as the number of qualified candidates
is expected to exceed the number of positions available.
About 55 percent of actuaries are employed by insurance carriers.
NATURE OF THE WORK
Through their knowledge of statistics, finance, and business, ACTUARIES assess the risk
of events occurring and help create policies for businesses and clients that
minimize the cost of that risk. For this reason, actuaries are essential to the
insurance industry.
Actuaries analyze data to estimate the probability and likely cost to the company
of an event such as death, sickness, injury, disability, or loss of property. Actuaries
also address financial matters, such as how a company should invest resources to
maximize return on investments, or how an individual should invest in order to
attain a certain retirement income level. Using their expertise in evaluating various
types of risk, actuaries help design insurance policies, pension plans, and other
financial strategies in a manner which will help ensure that the plans are
maintained on a sound financial basis.
Most actuaries are employed in the insurance industry, specializing in either
property and casualty insurance or life and health insurance. They use
sophisticated modeling techniques to forecast the likelihood of certain events
occurring, and the impact these events will have on claims and potential losses for
the company. For example, property and casualty actuaries calculate the
expected number of claims resulting from automobile accidents, which varies
depending on the insured person's age, sex, driving history, type of car, and other
factors. Actuaries ensure that the premium charged for such insurance will enable
the company to cover potential claims and other expenses. This premium must be
profitable, yet competitive with other insurance companies.
Within the life and health insurance fields, actuaries help companies develop
health and long-term-care insurance policies by predicting the likelihood of
occurrence of heart disease, diabetes, stroke, cancer, and other chronic ailments
among a particular group of people who have something in common, such as
living in a certain area or having a family history of illness. Such work of actuaries
can be beneficial to both the consumer and the company because the ability to
accurately predict the likelihood of a particular health event among a certain
group ensures that premiums are assessed fairly based on the risk to the company.
Additionally, life insurance actuaries help companies develop annuity and life
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insurance policies for individuals by estimating how long someone is expected to
live.
Actuaries in other financial service industries manage credit and help set a price
for corporate security offerings. They also devise new investment tools to help their
firms compete with other companies. Pension actuaries work under the provisions
of the Employee Retirement Income Security Act (ERISA) of 1974 which sets
minimum standards for pension and health plans in private industry. Actuaries
working for the government help manage social programs such as Social Security
and Medicare.
Actuaries help determine corporate policy on risk, for example, and also help
explain complex technical matters to company executives, government officials,
shareholders, policyholders, or the general public. They may testify before public
agencies on proposed legislation that affects their businesses or explain changes
in contract provisions to customers. They also may help companies develop plans
to enter new lines of business or new geographic markets by forecasting demand
in competitive settings.
Consulting actuaries provide advice to clients on a contract basis. The duties of
most consulting actuaries are similar to those of other actuaries. For example,
some may evaluate company pension plans by calculating the future value of
employee and employer contributions and determining whether the amounts are
sufficient to meet the future needs of retirees. Others help companies reduce their
insurance costs by offering them advice on how to lessen the risk of injury on the
job.
Consulting actuaries sometimes testify in court regarding the value of potential
lifetime earnings of a person who is disabled or killed in an accident, the current
value of future pension benefits (in divorce cases), or other values arrived at by
complex calculations. Some actuaries work in reinsurance, a field in which one
insurance company arranges to share a large prospective liability policy with
another insurance company in exchange for a percentage of the premium.
WORK ENVIRONMENT
Actuaries have desk jobs, and their offices usually are comfortable and pleasant.
While most actuaries work at least 40 hours a week, those in consulting type jobs
may be required to travel and thus work more than 40 hours per week.
TRAINING, OTHER QUALIFICATIONS, AND ADVANCEMENT
Actuaries need a strong background in mathematics, statistics, and general
business. They generally have a bachelor's degree and are required to pass a
series of exams in order to become certified professionals.
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EDUCATION AND TRAINING
Actuaries need a strong foundation in mathematics and general business. Usually,
actuaries earn an undergraduate degree in mathematics, statistics, or actuarial
science, or a business-related field such as finance, economics, or business. While
in college, students should complete coursework in economics, applied statistics,
and corporate finance, which is a requirement for professional certification.
Furthermore, many students obtain internships to gain experience in the profession
prior to graduation. More than 100 colleges and universities offer an actuarial
science program, and most offer a degree in mathematics, statistics, economics,
or finance.
Increasingly, companies are requiring potential employees to have passed the
initial actuarial exam described in the next section, which tests an individual’s
proficiency in mathematics—including calculus, probability, and statistics before
being hired.
Beginning actuaries often rotate among different jobs in an organization, such as
marketing, underwriting, financial reporting and product development, to learn
various actuarial operations and phases of insurance work. At first, they prepare
data for actuarial projects or perform other simple tasks. As they gain experience,
actuaries may supervise clerks, prepare correspondence, draft reports, and
conduct research. They may move from one company to another early in their
careers as they advance to higher positions.
OTHER QUALIFICATIONS.
Actuaries should have strong computer skills and be able to develop and use
spreadsheets and databases, as well as standard statistical analysis software.
Knowledge of programming languages, such as Visual Basic for Applications, SAS,
or SQL, is also useful. Companies also increasingly prefer well-rounded individuals
who, in addition to having acquired a strong technical background, have some
training in business and possess strong communication skills. Good interpersonal
skills also are important, particularly for consulting actuaries.
To perform their duties effectively, actuaries must keep up with current economic
and social trends and legislation, as well as developments in health, business, and
finance that could affect insurance or investment practices.
ADVANCEMENT
Advancement depends largely on job performance and the number of actuarial
examinations passed. Actuaries with a broad knowledge of the insurance,
pension, investment, or employee benefits fields can rise to executive positions in
their companies, such as Chief Risk Officer or Chief Financial Officer. These
generally require that actuaries use their abilities for assessing risk and apply it to
the entire company as a whole. Actuaries with supervisory ability may advance to
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management positions in other areas, such as underwriting, accounting, data
processing, marketing, and advertising. Some experienced actuaries move into
consulting, often by opening their own consulting firm. A few actuaries transfer to
college and university faculty positions.
EMPLOYMENT
Actuaries held about 19,700 jobs in 2008. About 55 percent of all actuaries were
employed by insurance carriers. Approximately 16 percent work for management,
scientific and technical consulting services. Others worked for insurance agents
and brokers and in the management of companies and enterprises industry. A
relatively small number of actuaries are employed by government agencies.
JOB OUTLOOK
Employment is expected to grow much faster than the average for all
occupations. Competition for jobs will be keen as the number of qualified
candidates is expected to exceed the number of positions available.
EMPLOYMENT CHANGE
Employment of actuaries is expected to increase by 21 percent over the 2008—18
period, which is much faster than the average for all occupations. While
employment in the insurance industry—the largest employer of actuaries—will
experience some growth, greater job growth will occur in other industries, such as
financial services and consulting.
Despite slower than average growth of the insurance industry, employment in this
key sector is expected to increase during the projection period as actuaries will be
needed to develop, price, and evaluate a variety of insurance products and
calculate the costs of new risks. Natural disasters should continue to require the
work of actuaries in property and casualty insurance while the growing popularity
of annuities, a financial product offered primarily by life insurance companies, will
also spur demand. Penetration among actuaries into non-traditional areas, such as
the financial services sector, to help price corporate security offerings, for
example, will also contribute to some employment growth.
Consulting firms should experience strong employment demand as an increasing
number of industries utilize actuaries to assess risk. Increased regulation of
managed healthcare companies and drafting healthcare legislation will also spur
employment growth.
Nonetheless, growth may be, to a degree, offset by corporate downsizing and
consolidation of the insurance industry—the largest employer of actuaries. Life
insurance companies, for example, are expected to increasingly shed high level
actuarial positions as companies merge and streamline operations.
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JOB PROSPECTS
Job seekers are likely to face competition because the number of job openings is
expected to be less than the number of qualified applicants. College graduates
who have passed two of the initial exams and completed an internship should
enjoy the best prospects. A solid foundation in mathematics, including the ability
to compute complex probability and statistics, is essential. Experience or skills in
computer programming can also be important. In addition to job growth, a small
number of jobs will open up each year to replace actuaries who retire or transfer
to new jobs.
The best employment opportunities should be in consulting firms. Companies that
may not find it cost-effective to employ their own actuaries are increasingly hiring
consulting actuaries to analyze various risks. Openings should also be available in
the healthcare field if changes take place in managed healthcare. The desire to
contain healthcare costs will provide job opportunities for actuaries who will be
needed to evaluate the risks associated with new medical issues, such as the
impact of new diseases.
Because actuarial skills are increasingly seen as useful to other industries that deal
with risk, such as the airline and the banking industries, additional job openings
may be created in these industries.
EARNINGS
Median annual wages of actuaries were $84,810 in May 2008. The middle 50
percent earned between $62,020 and $119,110. The lowest 10 percent had wages
less than $49,150, while the top 10 percent earned more than $160,780.
According to the National Association of Colleges and Employers, annual starting
salaries for graduates with a bachelor's degree in actuarial science averaged
$56,320 in July 2009.
RELATED OCCUPATIONS
Other workers whose jobs require mathematical and statistical skills include:
Accountants and auditors
Budget analysts
Economists
Financial analysts
Insurance underwriters
Market and survey researchers
Mathematicians
Personal financial advisors
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SOURCES OF ADDITIONAL INFORMATION
CAREER INFORMATION
Career information on actuaries specializing in pensions is available from:
American Society of Pension Professionals & Actuaries, 4245 N. Fairfax Dr., Suite
750, Arlington, VA 22203. Internet: http://www.aspa.org
For information about actuarial careers in life and health insurance, employee
benefits and pensions, and finance and investments, contact:
Society of Actuaries (SOA), 475 N. Martingale Rd., Suite 600, Schaumburg, IL
60173-2226. Internet: http://www.soa.org
For information about actuarial careers in property and casualty insurance,
contact:
Casualty Actuarial Society (CAS), 4350 N. Fairfax Dr., Suite 250 Arlington, VA
22203. Internet: http://www.casact.org
The SOA and CAS jointly sponsor a Web site for those interested in pursuing
an actuarial career. Internet: http://www.beanactuary.org
For general information on a career as an actuary, contact:
American Academy of Actuaries, 1850 M St. NW., Suite 300, Washington, DC
20036. Internet: http://www.actuary.org
(adapted from http://www.bls.gov/oco/ocos041.htm)
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Acknowledgements
This booklet was compiled using a variety of freely available online sources, mostly
www.financeprofessor.com. For didactic purposes, some texts may have been modified
and/or adapted to fit the overall course design. However, at the end of each chapter
there is a link to its original source.
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