Exam

Diversifiable risk

(unsystematic risk) a portion of an asset's risk attributes to firm-specific, random causes; can be eliminated through diversification § Strikes, law suits, regulatory actions, loss of a key account and so forth

Two types of maturity bond based on the issuer's plans to mature the debt:

§ Term bond; has a single, fairly lengthy maturity date (common) Serial bond; has a series of different maturity dates (15 or 20) within a single bond offering

investment

• An investment is simply any asset into which funds can be placed with the expectation that it will generate positive income and/or preserve or increase its value • The rewards, or returns, from investing come in two basic forms 1. Income; periodic interest payments, ordinary share (dividends) 2. Increased value; ordinary shares offer value

Bonds

• Bonds are long-term debt instruments (IOUs) issued by corporations and governments, that offer a known interest return plus return of the bond's principal amount of maturity

Types of Dividends

• Cash dividend; payment of a dividend in the form of cash • Stock dividend; payment of a dividend in a form of additional shares Stock spin-offs

Fixed-Income Securities

• Fixed income securities are investments that offer a fixed, periodic cash payment - popular during high interest rate periods to lock in high returns

CORRELATIONS, DIVERSIFICATION, RISK AND RETURN

• In general, the lower the correlation between asset returns, the grater the potential diversification of risk. ○ The amount of risk that can be reduced by this combination depends on the degree of correlation - only one combination of the finite number of possibilities will minimise risk ○ Three possible correlations - perfect positive, uncorrelated and perfect negative - illustrate the of correlation on the diversification of risk and return • Remember, low correlation between two series of numbers is less positive and more negative - indicating greater dissimilarity of behaviour of the two series.

Ordinary Shares

• Ordinary shares are an equity investment representing ownership in corporation; each share represents a fractional ownership interst in the company.

Low- or High- Risk Investments

• RISK reflects the uncertainty surrounding the return that a particular investment will generate. The broader the range of possible values or returns associated with an investment, the greater the risk. ○ Low-risk investment; relatively predictable and low returns ○ High-risk investment; higher returns but higher loses • SPECULATION offers highly uncertain returns, because of its greater risk, the returns associated with speculation are expected to be greater • SHORT-term investments; mature within one year • LONG-term investments; longer maturities, or like ordinary shares - no maturities at all • DOMESTIC investments; the debt, equity and derivative securities of Australian-based companies and governments • FOREIGN investments; (direct and indirect) might offer more attractive returns

RISK AND DIVERSIFICATION

• Risk can be defined as the variability of anticipated (expected) returns, and it can be measured by the standard deviation. • Holding a collection of many stocks you can achieve a lower degree of variability in the combined returns than by holding just a single one. • Diversification - always invest in more than one financial asset

Exposure to Risk Bonds are subject to a variety of risks (5)

1. Interest Rate Risk; major cause of price volatility in the bond market on fixed-income. Interest rate translates to market risk; the behaviour of IR affects nearly all bonds and cuts across all sectors of the market. 2. Purchasing Power Risk; Inflation erodes the PP of money, and that creates purchasing power risk. Market interest rates on bonds compensate investors for the rate of inflation that they expect over the life of a bond. ○ When inflation is low and predictable, bonds do well, because their returns exceed the inflation rate by an amount sufficient to provide investors with a positive return, ever after account for inflation's effect on purchasing power. 3. Business/Financial Risk; the risk that the issuer will default on interest and/or principal payments (credit risk or default risk). The quality and viability of the issuer. The stronger the position of the issuer, the less risk there is to consider. 4. Liquidity risk; risk that a bond will be difficult to sell at a reasonable price if the investor wants to sell it. Call risk; (or prepayment risk) is the risk that the bond will be 'called' (retired) long before its scheduled maturity date. Issuers often prepay their bonds when interest rates fall - comparable investments aren't just available and replace high-yield bonds to low-yield bonds. The more risk embedded in the bond, the greater the expected return - depends on the characteristics of the bond and the issuer.

Advises the potential investor to take into account the following factors:

1. Investment type and risk; the higher the risk the higher the return 2. Diversification; investing in a range on investments reduces risk 3. Asset Allocation; allocate assets to each asset class (shares, property ect) Your own investment profile; time-frame, attitude to risk, current circumstances and constraints

Process of Trading Shares

1. Place an order with the brokerTwo type of orders: 1. Market orders; an order where the client is prepared to buy or sell a given volume of shares at the current best market price. For every buy order the client is prepared to buy at the lowest ask price, and for a sell order the client is willing to receive the highest bid price 2. Limit orders; an order which specifies the maximum price that which a client is willing to buy shares or the minimum price at which a client is willing to receive to sell shares. In the case of a LO the client specifies a desired trade price in addition to the volume to trade 2. Broker attempts to 'execute' the it. Trade execution requires a broker to find a counterparty; the party taking the other side of the trade. Two ways: 1. They can execute the order on the electronic market operating be the ASC known as the ASX trade. 2. Can trade 'off-market' by contacting the counterparty directly Once a trade has been executed, clearing and settlement takes place. The process by which ownership of shares is transferred from seller to buyer, and cash is transferred from the buyer's account to the seller's account.

Ordinary shares can be issued in several different ways:

1. Public offering; an offering to sell to the investing public a set number of a company's shares at a specified price 2. Rights offering; an offering of a new issue of shares to existing shareholders who many purchase new shares in proportion to their current ownership position. (Own 1% = 100 shares) The new result of a rights offering is the same as that of the public offering; the company ends up with more equity in its capital structure, and the number of shares outstanding increases. 3. Private Placement; the direct sale of a new share issue (or other security issue) to an investor or group of investors to avoid costly processes, offered at a discount to the current market price ○ ASX Listing Rules limit such private placements without shareholder approval to 10% of share capital per annum 4. Stock-spin off; conversion of one of a company's subsidiaries to a stand-alone company by distribution of shares in that new company to existing shareholders. A spin-off occurs when a company gets rid of one of its subsidiaries or divisions (daughter company) ○ It creates new stand-alone company and then distributes all the shares in that company, via a spin off, to its existing shareholders. When they become too diversified and want to focus on their core products

Interest rate arrangements:

1. Simple Interest 2. Future Value; the value at come point in the future of a present amount of money invested at some IR 3. Compound Interest

Economic perspective, there are various 'macro' factors whose effects are very widespread and so are more or less common to all stocks, which means that these factors cannot be removed.

1. The general state of the economy (e.g. booming economy) 2. Interest rates (a rate rise is detrimental to most firs, directly through the cost of funds and indirectly because increased interest rates reduce customers' discretionary incomes - a bigger proportion of their incomes is needed to pay debts such as house mortgages - thus reducing the ability to buy other goods and services.

There are three versions of the dividend valuation model, each based on different assumptions about the future rate of growth in dividends:

1. The zero-growth model assumes that dividends will not grow over time. ○ The capitalised value of its annual dividends; assuming the share has a fixed stream of dividends, dividends stay the same year and year out, and they're expected to do so in the future. ○ Procedure used to price preference shares in the marketplace 2. The constant-growth model which is the basic version of the DVM, assumes that dividends will grow by a fixed/constant rate over time (infinite at a constant rate) ○ Not assumed that the investor will hold the share forever ○ Increase CF (D or g) and or decrease RRR (k) and the value of the share will increase. ○ Best suited to the valuation of mature, dividend-paying companies that hold established market positions - steady not spectacular rate of growth, very predictable growth rates in dividends and earnings ○ Value the market as a whole, determining the expected return on the market for the coming year 3. The variable-growth model assumes that the rate of growth in dividends will vary over time.

Managed funds

; an institution that raises money from fund investors and invests in and professionally manages diversified portfolio of securities or real estate. • Money market managed funds (money funds); are managed funds that invest solely in short-term investment vehicles

Bonds

; less risky and provide higher current income, issued by a wide range of companies so investors can build a diversified portfolio, potential for very high returns on bonds is much limited compared to shares. More stable than shares. Adding bonds to a portfolio will, up to a point, reduce the portfolio's risk without dramatically reducing its returns. Only bought for current income and stability.

Bond Interest and Principle

A bond investor's return is limited to fixed interest and principle payments as long as the investor holds the bonds to maturity. § A bonds coupon is a feature on a bond that defines the amount of annual interest income that the issuer will pay to the bondholder. § The bonds current yield is a measure of the annual interest income that a bond provides relative to its current market price. § The principal of a bond (aka an issue's par value) specifies the amount of capital that must be repaid at maturity. Bonds par value remains fixed over its life

bond

A bond is a negotiable, long-term debt instrument that carries certain obligations (the payment of interest and the repayment of principal) on the part of the issuer.

BETA COEFFICIENT

A relative measure of non-diversifiable risk ○ It is an index of the degree of movement of an asset's return in response to a change in the market return. ○ The market return is the return on the market portfolio of all traded shares Deriving Beta from Return Data ○ The relationship between an asset's return and the market return and its use in deriving beta can be demonstrated graphically. Interpreting Betas ○ The beta coefficient for the market is considered to be equal to 1.0; all other beats are viewed in relation to this value ○ Assets beta may be neither negative or positive , but positive betas are the norm ○ Majority of beta coefficients fall between 0.5-2.0 ○ The return of a share that is half as responsive as the market (b=0.5) is expected to change by 0.5% for each 1% change in the return of the market portfolio ○ A share that is twice as responsive as the market (b=2.0) is expected to experience a 2% change in its return for 1% change in the return of the market portfolio. Portfolio betas The beta of a portfolio can be easily estimated using the betas of the individual assets it includes.

ORDINARY ANNUITIES

ANNUITIES are a special kind of multiple cash flows. An annuity is a series of cash flows of equal size that occur at regular time intervals extending into the future.

Corporate Vs. Market Factors

Board of directors weighing a variety of factors in making a decision to pay out dividends: 1. Look at company's earning; profits are vital link to the dividend decision ○ When ordinary shares, the annual earnings of a company are usually measured and reporting in terms of earnings per share (EPS); EPS translates total corporate profits on a per-share basis. It provides a convenient measure of the amount of earnings available to shareholders. 2. Look at growth prospects; company's present earnings will be needed for investment purposes and help finance expected growth 3. How much money the company has 4. Ensure that it is meeting all legal and contractual constraints

EXPECTED RETURN

Calculate the expected cash flow, which is simply the weighted average of the possible cash-flow outcomes (with the weights being the probabilities of the occurrence of the various states of the economy) States in the economy ○ Recession ○ Moderate Growth ○ Strong Growth

Important dates

Directors declare a dividend, they must indicate the date of the payment and other important dates associated with the dividend. • The date of record • Ex-dividend date and payment date • The date of record (or books close date); the date on which an investor must be registered shareholder for a company to be entitled to receive a dividend (holders of record) • Payment date; is the actual date on which the company will mail dividend cheques to the shareholders (payable date) • Ex-dividend date; five business dates before the date of record; it determines whether one is an official shareholder of a company and thus eligible to receive a declared dividend. If you sell before this date

Basic Characteristics of Ordinary Shares

Each ordinary share represents an equity (or ownership) position in a company. • Equity capital (equity securities); is the evidence of ownership position in a company, the form of ordinary shares. • Every share entitles the holder to an equal ownership position and participation in the company's earnings and dividends, an equal vote and an equal voice in management Ordinary shareholders own the company ; no maturity date, they remain outstanding indefinitely

Putting Bond Market Performance in Perspective

Interest rates drive the bond market; the behaviour of interest rates is the single most important influence on bond returns. Interest rates determine: 1. Current income that investors will receive 2. Capital gains/losses that they will incur

Maturity Date

Maturity date; is the date on which a bond matures and the principal must be repaid. The maturity date is fixed, defines the life of a new issue and denotes the around of time remaining for older, outstanding bonds. Such as lifespan is known as an issue's term to maturity.

Market Participants

1. ASX 2. Buying and selling parties 3. Broker; trade execution and settlement services ○ Currently the only participants with direct access to trading on the ASX Trade, charging a 'brokerage commission' ○ Two main types of trading undertaken by brokers: 1. Agency trading; a trade which a broker executes on behalf of a client 2. Principal trading; a trade which a broker executes on their own behalf; investments made for themselves □ House trading; broker sells and buys for their own investment Facilitation; broker takes the opposite side of the trade to the client in order to complete a transaction

The return from an investment can be viewed as coming from 2 major sources

1. Compensation to the investor (Opportunity cost) 2. Risk premium; representing the compensation to the investor for accepting the degree of uncertainty (risk)

The return on investment in ordinary shares comes in two sources:

1. Dividends; payments the corporation makes to its shareholders (interim (6 mo) or final (end of year) basis) 2. Capital gains ; result from selling the shares (or any asset) at a price that exceeds its original purchase price

the total risk of a portfolio investment can be through of as comprising two types of risk:

1. Firm Specific OR company-unique risk (diversifiable (unsystematic) risk - since it can be diversified away) 2. Market related risk (non-diversifiable (unsystematic) risk) as it cannot be eliminated no matter how much an investor diversifies a portfolio of risky assets such as company shares

Three types of call features:

1. Freely callable; the issuer can permanently retire the bond at any time 2. Non-callable; issuer is prohibited from retiring the bonds prior to maturity 3. The issue could carry as deferred call; the issue cannot be called until after a certain length of time has passed from the date of issue Call features allow bond issuers to take advantage of declines in market IR. Companies usually call outstanding bonds paying at high rates and their reissue new bonds at lower rates. § Investors who find their bonds called out from under them do receive a small extra compensation called the call premium § The sum of the par value plus call premium represents the issue's call price. This is the amount that the issuer must pay to retire the bond prematurely In addition to call features, some bonds may carry refunding provisions. They're much like call features except one thing: the premature retirement of an issue from the proceeds of a lower-coupon bond

Present value of a single amount

Present value of a single cash flow is the present worth of a payment to be received in the future, taking into account the time flow of money

Secured or Unsecured Debt

Secured bonds are secured obligations, which are backed by a legal claim on some specific property of the issues. Such issues include: § Mortgage bonds; secured by real estate § Collateral trust bonds; backed by financial assets owned by the issuer but held in trust by a third party § Equipment trust certificates; secured by specific pieces of equipment (e.g. airplanes) Unsecured bonds are backed only by the promise of the issuer to pay interest and principal on a timely basis. There is no collateral backing up the obligation, other than good name of the issuer. Subordinated debentures; unsecured bonds with a claim on income secondary to other debentures Income bonds; unsecured debt requiring that they be paid only after a specified amount of income is earned

Types of Investments

Securities or Property • Securities are investments issued by companies, governments or other organisations that represent a financial claim on the resources of the issuer ○ Shares ○ Bonds • Property consists of investments in real property or tangible personal property ○ Real property; land and buildings and which is permanently affixed to the land ○ Tangible personal property; items Direct or Indirect • A direct investment is one in which an investor directly acquires a claim on a security or property (part owner of the company) • An indirect investment is an investment in a collection of securities or properties managed by a professional investor Debt, equity or Derivative Securities • Debt is a loan that obligates the borrower to make periodic interest payments and to repay the full amount of the loan by some future date ○ When companies or governments borrow money, they issue a debt intrument called bonds • Equity represents ongoing ownership in a business or property. May be held as a security or by title to a specific property ○ Ordinary shares • Derivative securities are neither debt or equity. Derives its value from underlying security or asset Share options; an investment that grants the right to purchase or sell share in a company at a fixed price for a limited period of time depending on market price.

The Role of Long-term Securities and Determining Returns

Bonds are liabilities; bondholders are lending money to the issuer - negotiable, publically traded, long-term securities. • Fixed-income securities; debt payments of the issuers are usually fixed. Provide investors with two kinds of income: 1. Current income; periodic interest payments over the life of the issue 2. Capital gains Interest rates and bond prices move in opposite directions; when interest rates rise, bond prices fall and when rates drop bond prices go up.

Time value of money

The idea that money available at the present time is worth more than the same amount in the future due to its potential earning capacity. This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received.

Bank-accepted bill

a bill of change (commercial bill) which the acceptor is the bank ○ Government bills are long-term, government-backed bent securities (riskless) - return is essentially guaranteed. • BABs are short-term debt securities effectively guaranteed by banks ○ Typically have a maturity of up to 180 days ○ 'Zero-coupon' Inflation risk 10-year bonds are long-term government debt securities, they face interest rate risk - the risk is assoiated with the change in value of the bond that arises as a result of a market interest rate change

Call feature

a feature that specifies whether and under what conditions the issuer can retire a bond prior to maturity. The feature is not common in bond issues in Australia.

Effective I.R

IR that accounts for the true amount of interest that is earned on other reinvested interest and principal earned over a year. It is the interest rate which, compounded annually, is equivalent to a given nominal interest rate

Transaction costs

Investors incur transaction costs when buying or selling shares, the main cost is the brokerage pee paid

CALCULATION OF RETURNS USING PROBABILITIES

Probability distributions provide a more quantitative, yet behavioural, insight into an asset's risk. The probability is a given outcome is its chance of occurring. ○ A probability distribution is a model that relates probabilities to the associated outcomes - the higher the dispersion the more risky the asset is § Bar chart - shows only a limited number of outcome-probability coordinates Continuous probability distribution

Present value of multiple accounts

Valuing a single cash flow can be applied to multiple cash flows ○ to find the PV of this cash flow stream, each period's cash flow must be discounted at the IR (r) and then added together

Dividend Valuation Model (DVM)

a model that values a share on the basis of the future dividend stream it is expected to produce; its three versions are zero-growth, constant-growth and variable-growth.

Efficient portfolio

a portfolio that maximises return for a given level of risk or minimises risk for a given level of return - the financial manager's goal.

Correlation

a statistical measure of the relationship, if any, between series of numbers representing data of any kind ○ Positively correlated; a description of two series that move in the same direction (+1) ○ Negatively correlated; descriptive of two series that move in opposite direction (-1) ○ Correlation coefficient; a measure of the degree of correlation between two series ○ Perfectly positively correlated; describes two positively correlated series that have a correlation coefficient of +1

Annuity due

an annuity in which the first cash flow is to occur immediately - that is, on the valuation date

Inflation-risk premium

an investor who only earns the rate of inflation and not any earned return

Deferred annuity

annuity where the cash flows are deferred for one or more periods. That is, the first cash flow is to occur after a time period that exceeds the time period between each subsequent cash flow

Futures

are legally binding obligations stipulating that the sellers of such contracts will make delivery and the buyers of such contracts will take delivery of a specified commodity or financial instrument at some specific date in the future, at a price agreed on at the time the contract is sold.

Hedge funds

are managed funds that operate in a variety of investment strategies which are generally riskier in nature in order to secure higher returns • Try to limit or 'hedge' the risks that they take

Classified Shares

company issuing different classes of share, each of which entitles holders to different privileges and benefits. • Customarily used to denote either different voting rights or different dividend obligations. (voting and nonvoting rights, dividend or no dividend payments)

Derivative Securities

derive their value from an underlying security or asset. • Options; are securities that give the investor an opportunity to sell or buy another security or property at a specified price over a given period of time. ○ Take advantage of an anticipated change in the price of ordinary shares Futures; are legally binding obligations stipulating that the sellers of such contracts will make delivery and the buyers of such contracts will take delivery of a specified commodity or financial instrument at some specific date in the future, at a price agreed on at the time the contract is sold

Real estate

entities such as residential homes vacant land and income property

Options

are securities that give the investor an opportunity to sell or buy another security or property at a specified price over a given period of time. Take advantage of an anticipated change in the price of ordinary shares

Default risk

the possibility that the borrower will not repay a debt in the future (e.g. government bonds) ○ Relatively 'safe' return ○ Bond markets may vary over time in response to market interest rates ○ Longer bonds more volatile than shorter bonds

DIVERSIFICATION

• TO reduce overall risk, it is best to diversify by combining or adding to the portfolio assets that have a negative (or a low positive) correlation. Combining negatively correlated assets can reduce the overall variability of returns. • Some assets are uncorrelated - there is no interaction between their returns. Combining uncorrelated assets can reduce risk, although not to effectively as combining negatively correlated assets. ○ Correlation coefficient for uncorrelated assets is close to zero and acts as the midpoint between perfect positive and perfect negative correlation.

Risk Characteristics (generally low risk)

○ Inflation risk; the loss of potential purchasing power that occurs when the rate of return on these investments falls short of the inflation rate ○ The risk of default; non-payment - is very low with short-term investments. Does not change much in response to changing interest rates, exposure to capital loss is correspondingly low ○ Disadvantages; low return, average less than the returns on long-term investments Advantages; high liquidity and low risk, inflation and market interest rates

Types of Risk

○ Total risk; a combination of a security's non-diversifiable and diversifiable risk total security risk = non-diversifiable risk + diversifiable risk ○ Diversifiable risk; (unsystematic risk) a portion of an asset's risk attributes to firm-specific, random causes; can be eliminated through diversification § Strikes, law suits, regulatory actions, loss of a key account and so forth ○ Non-diversifiable risk; (systematic risk) the relevant portion of an asset's risk attributable to market factors that affect all firms; cannot be eliminated through diversification § War, inflation, international incidents and political events

What are financial markets?

'Financial markets' can be broadly defined as a complex institutions, procedures and arrangements that facilitate a transfer of funds from one entity in the economy to another. Describes many submarkets such as debt markets, the share market or stock market. ○ One party (investor) transferring funds to another party (the net user of funds) and in exchange receiving a financial asset; a non-tangible asset that entitles the holders to receive a set of cash flows in the future ○ The essential role of financial markets is to bring together the new users of funds in the economy with the new savers of funds ○ FM exist in order to allocate the supply of savings in the economy to the demanders to those savings. ○ Provides the mechanisms through which the forces of demand for funds and supply of funds are brought together. Providers of funds have a claim over recipients of funds for future cash flows, a return for committing finds.

Non-diversifiable risk

(systematic risk) the relevant portion of an asset's risk attributable to market factors that affect all firms; cannot be eliminated through diversification § War, inflation, international incidents and political events Because, any investor can create a portfolio of assets that will eliminate all, or virtually all, diversifiable risk, the only relevant risk is the non-diversifiable risk. Therefore, any investor or firm are only concerned solely with non-diversifiable risk.

Shares

if the shares are riskier, the investors should on average earn higher returns on shares than on bonds

Share repurchases

instead of increasing the number of outstanding shares, companies find it viable to reduce the number of shares by buying back their own shares. • Companies repurchase their own shares when they view them as undervalued in the marketplace. • On-market offers; the price must not be more than 5% of the above average of the previous 5 days • Off-market; not within ASX trading rules

Tangibles

investment assets, other than real estate, that can be seen or touched

Stock splits

is a maneuverer in which a company increases the number of shares outstanding by exchanging a specified number of new shares for each outstanding share • Wants to enhance its share's trading appeal by lowering its market price The company gets the desired result; the price of the share tends to fall in close relation to the terms of the split (unless he stock split is accompanied by a big increase in the level of dividends)

Convertible securities

is a special type of fixed-income obligation (bond, note or preference share) with a feature permitting conversion into a specified number of ordinary shares. Convertibles provide the fixed-income benefit of a bond (interest) while offering the price-appreciation (capital gain) potential of ordinary shares

real return

is the amount by which the nominal return for an investment EXCEEDS the rate of increase in the general price level for goods and services in the economy, as measured by the inflation rate. • Thus, the nominal interest rate is the actual interest rate paid or earned and the real interest rate is approximately equal to the nominal interest rate LESS the rate of inflation

Book value

is the amount of shareholders' equity in a company; equals the amount of the company's assets minus the company's liabilities and preference shares. • Commonly used in share valuation • book value can be converted to a per-share basis (book value per share) by dividing it by the number of common shares outstanding.

PV

is the amount that needs to be invested at a rate (r) over (n) periods in-order to generate cash flows (FV)

Market value

is the prevailing market price of the security. Market value indicates how the market participants as a whole have assessed the worth of a share. • Multiply the market price of the share by the number of shares outstanding (market capitalisation)

Par Value

is the stated, or face, value of a share.

Dividend Reinvestment Plans (DRP)

plans in which shareholders have cash dividends automatically reinvested into additional shares of the company. • If the company is good enough to invest in, it's good enough to reinvest in. • Convenient and inexpensive, free from brokerage commissions and most plans allow partial participation. • You must pay taxes on them as though they were cash dividends, treated as taxable income

Nominal I.R

quoted annual interest rate that is adjusted to match the frequency of payments or compounding by taking a proportion of the quoted nominal rate to obtain the actual IR per period. It does not take into account that interest is reinvested and that interest is earned on both principal and reinvested interest.

Preference shares

represent an ownership interest in a corporation that has a stated dividend rate, payment of which is given preference over the ordinary share dividends of the same corporation which has no maturity date

Publicly traded issues

shares that are readily available to the general public and are bought and sold on the open market

Share returns

take into account the price behaviour but also dividend income. In addition to total returns, market performance is broken down into two basic sources of return: 1. Dividends, and; 2. Market returns

Accumulation Index

takes into account both capital appreciation and dividend income when measuring the market return

Risk premium

the additional return expected for taking on additional risk

Investment value

the amount that investors believe a security should be trading for, or what they think it is worth. • Based on the expectations of the return and the risk characteristics of a share • A share has two potential sources of return 1. Annual dividend payment 2. Capital gains that arise from appreciation in market price; by establishing investment value, investors try to determine how much money they will make from these two sources. • Amount of risk exposed by holding the share • The value represents the maximum the investor is willing to pay for the issue

Expected rate of return

the arithmetic mean for average of all possible outcomes where each outcome if weighted by its probability. ○ Return can be expressed in terms of an absolute dollar amount of percentage, it is more common to use a percentage as the measure of return. Percentages allow for comparisons

THE CAPITAL ASSET PRICING MODEL (CAPM)

the basic theory that links together risk and return or all assets. Use CAPM to understand the basic risk-return involved in all types of financial decisions ○ The higher the risk, the higher the required return and the lower the risk, the lower the required return ○ The model can be broken down into (2) parts: 1. the RISK-FREE RATE (the current market yield for Treasury bonds is usually cited as the market's risk-free rate of interest 2. the risk premium (market risk premium)

Yield (or credit) spread

the difference between the rate on company bonds and the rate on government bonds.

Stock Dividends

the dividend is paid in additional shares (they have no value). The market responds to such dividends by adjusting share prices according to the terms of the stock dividend. • 10% stock dividend normally leads to a decline of around 10% in the share price. • Relates to imputation credits; only cash dividends carry the credit to the shareholder, the shareholder receives no franking credit from a stock dividend

Standard deviation

the extent of the variability on share prices and dividends indicated by a statistical measure Standard deviation; the most common statistical indicator of an asset's risk is the standard deviation, which measures the dispersion around the expected value. The expected value of a return, is the most likely return on an asset. (EQ 3.14)

Market risk premium

the extra expected return over the risk-free rate demanded by investors to compensate them for investing in the market portfolio because of the higher risk assets.

Historical returns

the observation return earned on the investment in the past. The returns have already happened - they are said to have been 'realised'. Investors makes decision where to place their investment funds are made on the basis of EXPECTED RETURNS or future payoffs on alternative investments - that is, on the basis of what they expect to get back from an investment. the measure of the return earned on a previous investment. Relying on historical data rather than requiring estimation of the probability of occurrence. ○ Holding-period return ○ Regular stream of income, dividend payments, rental income ○ When you receive income from your investment, these incomes should also be accounting for in your return calculation.

Risk

the potential variability in future cash flows. It may be measured by the standard deviation of expected return

RISK MEASUREMENT

the risk and an asset can be measured quantitatively using statistics. 1. Standard deviation 2. Coefficient of variation - can be used to measure the risk of asset returns

Company-unique risk

the risk component that can be eliminated by diversification. Company-unique risk is also known as 'firm-specific' or 'diversifiable' risk or 'unsystematic' risk.

Market risk

the risk component that cannot be diversified away by holding more than one security in the portfolio. Market risk is also known as systematic risk or non-diversifiable risk and is measured by a factor labelled as beta.

Trading Methods

ASX Trade is run by the ASX and used by brokers. ○ ASX Trade can be accessed by ASX-provided ASX Trade Workstation software running on the PC, this feature known as 'open interface' allows brokers to design their own customised computer programs for use in entering orders and obtaining market information Pre-opening and Opening Call Auction ○ From 7am brokers can enter or amend orders on the ASX Trade Normal Trading ○ Orders submitted during the ASX Trade's normal trading hours may execute immediately after they are entered. Highest prices are given the highest priority ○ If a sell order arrives at a price equal to the best standing buy order, a trade will automatically be recognised by ASX Trade. ○ First in first served for the same price ○ Order depth Trade History ○ A list of trades that have occurred during the day for a particular security can also be viewed on the ASX Trade Workstation ○ The Trade History window reports the most recent trade to be executed Closing Call Auction ○ ASX began operating what it called a 'Closing Single Price Auction (CSPA)' at the end of normal trading each day. The CSPA is similar to the opening call. It allows brokers to enter new orders, and retains unexecuted orders from normal trading. These orders are not executed until a time chosen randomly between 4.10 and 4.12pm, when an instantaneous 'opening' occurs and overlapping orders are executed using an algorithm identical to that used to open the market in the morning (for normal trading)

Share Values

Accounting, investment or monetary attribute of a share. Par Value; is the stated, or face, value of a share. Book value; is the amount of shareholders' equity in a company; equals the amount of the company's assets minus the company's liabilities and preference shares. • Commonly used in share valuation • book value can be converted to a per-share basis (book value per share) by dividing it by the number of common shares outstanding. Market value; is the prevailing market price of the security. Market value indicates how the market participants as a whole have assessed the worth of a share. • Multiply the market price of the share by the number of shares outstanding (market capitalisation) Investment value; the amount that investors believe a security should be trading for, or what they think it is worth. • Based on the expectations of the return and the risk characteristics of a share • A share has two potential sources of return 1. Annual dividend payment 2. Capital gains that arise from appreciation in market price; by establishing investment value, investors try to determine how much money they will make from these two sources. • Amount of risk exposed by holding the share • The value represents the maximum the investor is willing to pay for the issue

Bond Valuation: How the Pricing of Bond is Calculated

All bonds (including notes with maturities of more than one year) are priced according to the present value of their future cash flow streams. Bond prices are driven by market yields. That's because in the marketplace, the appropriate yield at which the bond should sell is defined first, and then that yield is used to find the price (or market value) of the bond. Economic forces combine to form the required rate of return (the rate of return the investor would like to earn in order to justify an investment in a given fixed-income security): • Risk-free rate of return • Inflation • Issuer characteristics: ○ Years to maturity ○ Issue's bond rating In the bond market, required return is market driven and is generally considered to be the issue's market yield. That is, the required rate defines the yield at which the bond should be trading and serves as the discount rate in the bond valuation process.

Role of Financial Markets

External funds; funds raised from outside sources such as from a bond issue or an equity issue. ○ Borrow money from friends or family and pay back at a later date with no interest ○ Borrow from a bank ○ Sell goods for payment ○ Corporate financing needs will need to either use retained earnings or raise external funds (borrowing or issuing shares to financial institutions, other corporations or individual investors). Financial markets provides a medium for firms to conduct these transactions. Internal funds; funds generated within the company through retaining profits Financial intermediary; an institution whose business is to bring together individuals and institutions with money to invest or lend with other firms or individuals that need money (banks)

Pros and Cons of Share Ownership

Pros and Cons of Share Ownership Shares are owned for the potential for capital gains, for current income and market liquidity. ADVANTAGES: ○ Substantial return opportunities they offer, generally provide attractive, highly competitive returns over the long haul. ○ Ordinary shares returns compare very favourably to other investment outlets such as long-term corporate bonds and Treasury bonds. ○ Shares typically outperform bonds, and usually by a large margin. ○ Shares also provide investors with protection from inflation because over time their returns exceed the inflation rate thus, gradually increasing their purchasing power ○ Easy to buy and sell and transaction costs are modest ○ Minimum investment amount is low  DISADVANTAGES: ○ Subject to various types of risk, including business and financial risk, purchasing power risk, market risk and event risk § Affecting; Share's earnings and dividends, price appreciation and rate of return earned ○ Government control and regulation ○ Foreign competition and the state of the economy that affect price behaviour ○ The earnings and general performance of shares are subject to wide swings, so it is difficult to value ordinary shares an consistently select top performers ○ Selection process is complex because so many elements go into formulating expectations of the share performance ○ Future outcome of the company and its shares are uncertain, and the evaluation and selection process itself is not perfect Sacrifice in current income; the degree of sacrifice that equity investors make in terms of current income. Shares have a long way to catch up to the current income of bonds and fixed-income securities

The structure of the Investment Process

The investment process brings together suppliers who have extra funds and demanders who need funds, come together by a means of a financial institution or a financial market. • Financial institutions are organisations, such as banks and insurance companies, that pool the savings of governments, businesses and individuals and channel them into loans and other types of assets. • Financial markets are forums in which suppliers and demands of funds trade financial assets, typically with the assistance of intermediaries such as securities brokers and dealers. ○ Investments, shares bonds, commodities and foreign currencies • Securities shares ○ Sharemarkets ○ Bond markets ○ Options markets • As new information about returns and risk becomes available, the changes in supply and demand may result in a new equilibrium or market price. Suppliers and Demanders of Funds • Governments (net demander of funds; demands more funds than it supplies because government spending often exceeds tax revenues) • Business (net demander of funds); to support operations; short or long term financial needs • Individuals (net suppliers of funds); put more than out Types of Investors • Individual investors are investors who manage their own funds to achieve their financial goals, concentrating on earning a return on idle funds, building a source of retirement income and providing securities for their families • Institutional investors are investment professionals paid to manage other people's money • Liquidity is the ability of an investment to be converted into cash quickly and with little or no loss in value.

Principles of Bond Price Behaviour

The price of the bond is a function of its coupon, its maturity, and the level of market interest rates. § Inverse relationship between bond prices and market rates: lower rates lead to higher bond prices § Premium bonds; is one that sells for more than its par value, results when market interest rates drop below the bond's coupon rate § Discount bond; sells less than par. The discount is the result of market rate being greater than the issue's coupon rate.

The Role of Short-term Investments

Their primary function is to provide a pool of reserves for emergencies or simply to accumulate funds for some specific purpose ○ Stated rate of interest ○ Discount basis; a method of earning interest on a security by purchasing it at a price below the redemption value (or face value); the difference between what you pay to acquire the asset and what you receive when it matures is the interest the investment will earn