FIN 310 Exam 3

Describe the value-at-risk method for measuring risk.

- Estimates the largest expected loss to a particular investment position for a specified confidence level. - Is intended to warn investors about the potential maximum loss that could occur - Is commonly used to estimate the risk of a portfolio

Assume that the standard deviation of daily returns for a particular stock in a recent historical period is 1.8 percent. Assume that the expected daily return of the stock is 0.01 percent. Estimate the maximum percentage one-day loss based on a 95 percent confidence level.

0.01% - [1.65 X (1.8%)] = -2.96%

Briefly describe the provisions of the Sarbanes-Oxley Act. Discuss how this act affects the monitoring performed by shareholders.

1) Prevents a public accounting firm from auditing a client firm whose employees were employed by the client firm within one year prior to the audit. 2) Requires that only outside board members of a firm be on the firm's audit committee. 3) Prevents the members of a firm's audit committee from receiving consulting or advising fees or other compensation from the firm beyond that earned from serving on the board. 4) Requires that the CEO and CFO of firms that are of at least a specified size level to certify that the audited financial statements are accurate. 5) Specified major fines or imprisonment for employees who mislead investors or hide evidence. 6) Prevents public accounting firms from offering non-audit services to an audit client if the client's audit committee pre-approves the non-audit services to be rendered before the audit begins. The Act prevents accounting irregularities by firms and should improve the ability of shareholders to monitor firms.

CDO (Collateralized Debt Obligation)

A CDO represents a package of debt securities backed by collateral that is sold to investors. A CDO commonly combines a variety of debt securities, including subprime mortgages, prime mortgages, automobile loans other credit card loans. It was a popular means by which a creditor could originate a loan and even service it without lending its own funds.

Explain the use of a balloon-payment mortgage. Why might a financial institution prefer to offer this type of mortgage?

A balloon mortgage payment requires interest payments for a three- to five-year period. At the end of the period, full payment (a balloon payment) is required. Financial institutions may desire balloon mortgages because the interest rate risk is lower than for longer term, fixed-rate mortgages.

Explain the use of a prospectus developed before an IPO. Why does a firm do a road show before its IPO? What factors influence the offer price of stock at the time of the IPO?

A prospectus specifies how the proceeds of the offering are to be used, the past performance of the issuing firm, the risk involved in the firm's business, and the price range in which the shares will be offered.The firm does a road show to promote its offering. That is, it explains to various institutional investors how it will use the funds to support its expansion. The goal of the road show is to convince some large investors to invest in the shares of the firm.The offer price is influenced by market conditions, industry conditions, and the prevailing market multiples (such as price/earnings ratio). Firms prefer to engage in an IPO when market conditions allow for a high offer price.

Why are second mortgages offered by some home sellers?

A second mortgage is often used when financial institutions provide a first mortgage that does not fully cover the amount of funds the borrower needs. A second mortgage complements the first mortgage. It falls behind the first mortgage in priority claim against the property in the event of default.

Identify the factors that affect a stock portfolio's volatility and explain their effects.

A stock portfolio has more volatility when its individual stock volatilities are high, other factors held constant. In addition, a stock portfolio has more volatility when its individual stock returns are highly correlated, other factors held constant. A stock portfolio containing some stocks with low or negative correlation will exhibit less volatility because the stocks will not experience peaks and troughs simultaneously. Some offsetting effects will occur, smoothing the returns of the portfolio over time.

A) How do you calculate the payment on a $100,000 30-year Mortgage with 8% annualized interest? B)What amount of the first payment would go towards the principal?

A) N = 360 (12X30) I% = 8 PV = 100,000 PMT = ? FV = 0 P/Y = 12 PMT = -733.76 B) 100,000 X .08 = 8,000 8,000/12 = 666.67(Interest) 733.76 - 666.67 = $67.1 (Principal)

ARMs (adjustable rate mortgages)

Allows the mortgage interest rate to adjust to market conditions. This gives financial institutions the ability to stabilize their profit margins. Usually ARMs contain a clause with a cap and the ability to switch to a fixed rate within a specific amount of time.

Explain how ADRs enable U.S. investors to become part owners of foreign companies.

American depository receipts (ADRs) are certificates that represent ownership of a foreign stock. They are traded in the United States. U.S. investors can purchase ADRs as a method of investing in foreign securities.

How does the initial rate on adjustable rate mortgages (ARMs) differ from the rate on fixed-rate mortgages? Why? Explain how caps on ARMs can affect a financial institution's exposure to interest rate risk.

An adjustable rate mortgage typically offers a lower initial rate than a fixed-rate mortgage to compensate borrowers for incurring the interest rate risk.Caps on adjustable-rate mortgages (ARMs) limit the degree to which the interest rate charged can move from the original interest rate at the time the mortgage was originated. If interest rates move beyond the boundaries implied by the caps, the mortgage rate will not fully adjust to the market interest rate. Therefore, if interest rates rise substantially, the mortgage rates may not fully offset the increased cost of funds.

Discuss the concept of asymmetric information. Explain why it may motivate firms to repurchase some of their stock.

Asymmetric information may allow a firm's managers to realize when its stock is undervalued, and they may repurchase shares at that time.

Describe how collateralized mortgage obligations (CMOs) are used and why they have been popular.

Collateralized mortgage obligations (CMOs) are mortgage-backed securities that are segmented into classes representing the timing of payback of the principal. Investors can choose a class that fits their maturity preferences.

A share of common stock currently sells for $110. Current dividends are $8 per share and are expected to grow at 6 percent per year indefinitely. What is the rate of return required by investors in the stock?

D1 = D0(1 + g) D1 = $8.00(1 + 0.06) = $8.48 k = (D1/PV of stock) + g k = (8.48/110) + 0.06 = 0.137 = 13.7%

Suppose you know that a company just paid a dividend of $1.75 per share on its stock and that the dividend will continue to grow at a rate of 8 percent per year. If the required return on this stock is 10 percent, what is the current share price?

D1 = D0(1 + g)D1 = 1.75(1 + 0.08) = 1.89 PV of stock = D1/(k - g) = 1.89/(0.10 - 0.08)= $94.5 per share

Describe a lockup provision and explain why it is required by the lead underwriter.

Describe the pressure of the share price at the lockup expiration date. The lockup provision restricts insiders and venture capital firms from selling their shares until a specified period (usually 6 months) after the IPO. Once the lockup provision expires, the insiders and venture capital firms can sell the shares that they own, which sometimes places downward pressure on the price of the stock at that time.

Over the last year, Calzone Corporation paid a quarterly dividend of $0.10 in each of the four quarters. The current stock price of Calzone Corporation is $39.78. What is the dividend yield for Calzone stock?

Dividend Yield = (.10 X 4) / 39.78 = 1.01%

Assume Mess stock has a beta of 1.2. If the risk-free rate is 7 percent, and the market return is 10 percent, what is the expected return on Mess stock?

Expected return = 7% + 1.2(10% - 7%) = 10.6%

Why do firms engage in IPOs? What is the amount of fees that the lead underwriter and its syndicate charge a firm that is going public? Why are there many IPOs in some periods and few IPOs in other periods?

Firms engage in IPOs when they have feasible expansion plans but are already near their debt capacity. The transaction cost (fees) is normally about 7 percent of the gross proceeds received by the issuing firm.Firms prefer to engage in IPOs when business conditions and market conditions are favorable. They avoid IPOs if business conditions are poor, because they do not need funds to expand if the business outlook is poor. Also, when business conditions are poor, the market conditions are weak, meaning that they would have to sell their shares at a low price.

What does it mean to "flip" shares? Why would investors want to flip shares?

Flipping shares refers to selling shares shortly after (such as a day or two) obtaining them at the IPO. Some institutional investors attempt to flip shares to take advantage of an initial return over the first day. IPO performance tends to be unusually high on the first day, followed by a downward drift. Some investors want to earn the initial return and then sell out. They may earn a very high return without tying their funds up for a long period of time.

How are the interest rate, the required rate of return on a stock, and the valuation of a stock related?

Given a choice of risk-free Treasury securities or stocks, stocks should be purchased only if they are appropriately priced to reflect a sufficiently high expected return above the risk-free rate.The relation between interest rates and stock prices is not constant over time. However, most of the largest stock market declines have occurred in periods when interest rates increased substantially. Furthermore, the stock market's rise in the late 1990s is partially attributed to the low interest rates during that period, which encouraged investors to shift from debt securities (with low rates) to equity securities.

How do IPOs perform over the long run?

IPOs perform poorly on average when compared to other firms over the long-term period.

Explain the meaning and use of implied volatility.

Investors can derive the stock's implied standard deviation (ISD) from the stock option pricing model. The premium on a call option for a stock is dependent on factors such as the relationship between the current stock price and the exercise (strike) price of the option, the number of days until the expiration date of the option, and the anticipated volatility of the stock price movements. There is a formula for estimating the call option premium based on various factors. The actual values of these factors are known, except for the anticipated volatility. However, by plugging in the actual option premium paid by investors for that specific stock, it is possible to derive the anticipated volatility level. Participants may use this measurement as their own forecast of that specific stock's volatility.

Explain the use of the price-earnings (PE) ratio for valuing a stock. Why might investors derive different valuations for a stock when using the price-earnings method? Why might investors derive an inaccurate valuation of a firm when using the price-earnings method?

Investors can value a stock by applying the industry PE ratio to the firm's expected earnings for the next year. This method implicitly assumes that the growth in earnings in future years will be similar to that of the industry. This method has several variations, which can result in different valuations. For example, investors may use different forecasts for the firm's earnings or the mean industry earnings over the next year. The previous year's earnings are often used as a base for forecasting future earnings, but the recent year's earnings do not always provide an accurate forecast of the future.A second reason for different valuations when using the PE method is that investors disagree on the proper measure of earnings. Some investors prefer to us operating earnings or exclude some unusually high expenses that result from one-time events. A third reason is that investors may disagree on the firms that should represent the industry norm. Some investors use a narrow industry composite composed of firms that are very similar (in terms of size, lines of business, etc.) to the firm being valued; other investors prefer a broad industry composite. Consequently, even if investors agree on a firm's forecasted earnings, they may still derive different values for that firm as a result of applying different PE ratios. Furthermore, even if investors agree on the firms to include, they may disagree on how to weight each firm.

Explain the incentive for private equity funds to invest in a firm and improve its operations.

Managers of a private equity fund typically take a percentage of the profits they earn from their investments in return for managing the fund. They also charge an annual fee for managing the fund. If they were able to improve the business substantially while they managed it, they should be able to sell their stake to another firm for a much higher price than they paid for it. Alternatively, they may be able to take the business public through an initial public offering (IPO) and cash out at that time.

Explain how a mortgage company's degree of exposure to interest rate risk differs from other financial institutions.

Mortgage companies concentrate on servicing mortgages rather than investing in mortgages. Thus, they are not as concerned about hedging mortgages over the long run. However, they are exposed to interest rate risk during the period from when they originate mortgages until they sell them. If interest rates change over this period, the price at which they can sell the mortgages will change.

Mortgage Maturities

Most mortgages have maturities of 30 years, but 15-year maturities are also available.

Suppose that you are interested in buying the stock of a company that has a policy of paying a $6 per share dividend every year. Assuming no changes in the firm's policies, what is the value of a share of stock if the required rate of return is 11 percent?

PV of stock = D/k = 6/0.11 = $54.5 per share

The next expected dividend for Sun, Inc., will be $1.20 per share and analysts expect the dividend to grow at a rate of 7 percent indefinitely. If Sun stock currently sells for $22 per share, what is the required rate of return?

PV of stock = D1/(k - g) k = (D1/PV of stock) + gk = (1.20/22) + 0.07 = 0.1245 = 12.45%

Micro, Inc. will pay a dividend of $2.30 per share next year. If the company plans to increase its dividend by 9 percent per year indefinitely, and you require a 12 percent return on your investment, what should you pay for the company's stock?

PVof stock = D1/(k - g) = 2.3/(0.12 - 0.09)= $76.67 per share

Suppose you bought a stock at the beginning of the year for $76.50. During the year, the stock paid a dividend of $0.70 per share and had an ending share price of $99.25. What is the total percentage return from investing in that stock over the year?

R = (SP - INV) + D / INV = (99.25 - 76.5) + 0.7 / 76.5 = 30.6%

A stock has a beta of 2.2, the risk-free rate is 6 percent, and the expected return on the market is 12 percent. Using the CAPM, what would you expect the required rate of return on this stock to be? What is the market risk premium?

Rj = Rf + Bj(Rm - Rf ) Rj = 6% + 2.2(12% - 6%) Rj = 19.2%

You are considering investing in a stock that has an expected return of 13 percent. If the risk-free rate is 5 percent and the market risk premium is 7 percent, what is the beta of this stock?

Rj = Rf + Bj(Rm - Rf ) 0.13 = 0.05 + Bj (0.07) Bj = 1.142

Sharpe Index formula

Sp = (Rp - Rf) / σp Rp = realized return Rf = Risk-free return σp = Standard Deviation of Portfolio

Explain why the stock price of a firm may rise when the firm announces that it is repurchasing its shares.

Stock repurchases may signal that the firm's managers believe the stock is undervalued, so the investors may purchase the stock based on this signal, and that places upward pressure on the stock price.

What are the risks of investing in stocks in emerging markets?

Stocks in emerging markets are more exposed to major government turnover and other forms of political risk. They also expose U.S. investors to a high degree of exchange rate risk because their local currencies are typically very volatile.

Describe the characteristics of subprime mortgages. Why were mortgage companies aggressively offering subprime mortgages before the credit crisis?

Subprime mortgages were provided by mortgage companies to borrowers who would not have qualified for prime loans. Thus, these mortgages enabled more people with relatively lower income, or high existing debt, or a small down payment to purchase homes. Many financial institutions such as mortgage companies were willing to provide subprime loans because it allowed them a way to expand their business. In addition, they could charge higher fees (such as appraisal fees) and higher interest rates on the mortgage in order to compensate for the risk of default.

January Effect

Tendency for small stocks to have large returns in January.

Why is the 15-year mortgage attractive to homeowners? Is the interest rate risk to the financial institution higher for a 15-year mortgage or a 30-year mortgage? Why?

The 15-year mortgage is popular because of the potential reduction in total interest expenses paid on a mortgage with a shorter lifetime. The interest rate risk is higher for a 30-year mortgage than for a 15-year mortgage, because the 15-year mortgage exists for only half the period.

Describe the dividend discount valuation model. What are some limitations when using this model? (DDM)

The dividend discount valuation model measures the value of a firm as the present value of future expected dividends to be received by the investor. The model can account for uncertainty by allowing dividends to be revised in response to revised expectations about a firm's cash flows, or by allowing the required rate of return to be revised in response to changes in the required rate of return by investors.The dividend discount model may result in an inaccurate valuation of a firm because of potential errors in determining the dividend to be paid over the next year, or the growth rate, or the required rate of return by investors. The limitations of this model are more pronounced when valuing firms that retain most of their earnings rather than distribute them as dividends, because the model relies on the dividend as the base for applying the growth rate. For example, many Internet-related stocks retain any earnings to support growth and thus are not expected to pay any dividends.

Explain how economic growth affects the valuation of a stock.

The firm's value should reflect the present value of its future cash flows. Because earnings are a primary component of corporate cash flows, many investors use forecasted earnings to determine whether a firm's stock is over- or undervalued.

Describe the graduated-payment mortgage. What type of homeowners would prefer this type of mortgage?

The graduated payment mortgage allows borrowers to repay their loans on a graduated basis over the first 5 to 10 years. They level off after a 5- or 10-year period. Homeowners whose incomes will rise over time may desire this type of a mortgage.

Describe the process of bookbuilding. Why is bookbuilding sometimes criticized as a means of setting the offer price?

The lead underwriter engages in bookbuilding by soliciting indications of interest in the IPO by institutional investors, so as to determine demand. The bookbuilding process used in the United States is sometimes criticized because it dictates an offer price that is lower than what some institutional investors would pay.

Explain how the value of the dollar affects stock valuations.

The value of the dollar can affect U.S. stock prices for a variety of reasons. First, foreign investors tend to purchase U.S. stocks when the dollar is weak and sell them when it is near its peak. Thus, the foreign demand for any given U.S. stock may be higher when the dollar is expected to strengthen, other things being equal. Also, stock prices are affected by the impact of the dollar's changing value on cash flows. Stock prices of U.S. firms primarily involved in exporting could be favorably affected by a weak dollar and adversely affected by a strong dollar. U.S. importing firms could be affected in the opposite manner. Stock prices of U.S. companies may also be affected by exchange rates if stock market participants measure performance by reported earnings. A multinational corporation's consolidated reported earnings will be affected by exchange rate fluctuations even if the company's cash flows are not affected. A weaker dollar tends to inflate the reported earnings of a U.S.-based company's foreign subsidiaries. Some analysts argue that any effect of exchange rate movements on financial statements is irrelevant unless cash flows are also affected.The changing value of the dollar can also affect stock prices by affecting expectations of economic factors that influence the firm's performance. For example, if a weak dollar stimulates the U.S. economy, it may enhance the value of a U.S. firm whose sales are dependent on the U.S. economy. A strong dollar could adversely affect such a firm if it dampens U.S. economic growth. Because inflation affects some firms, a weak dollar value could indirectly affect a firm's stock by putting upward pressure on inflation. A strong dollar would have the opposite indirect impact.

Treynor Index formula

Tp = (Rp - Rf) / Bp Rp = realized return Rf = Risk-free return BP = Beta

You discovered that Olmsted Stock is expected to generate earnings of $4.38 per share this year, and that the mean PE ratio for its industry is 27.195. Use the PE valuation method to determine the value of Olmsted shares.

Value = (Expected earnings of IBM per share) × (Mean industry P/E ratio)Value = $4.38 X 27.195Value = $119.114

Explain the difference between weak-form, semistrong-form, and strong-form efficiency. Which of these forms of efficiency is most difficult to test? Which is most likely to be refuted? Explain how to test weak-form efficiency in the stock market.

Weak-form: suggests that security prices reflect recent price movements and trading information. Semi-strong: suggests that security prices reflect all publicly traded information. Strong form: suggests that security prices reflect public and private information. Weak-form efficiency can be tested by searching for a nonrandom pattern in stock prices. If future price movements can be predicted by assessing the past movements, a market inefficiency is detected.

Explain how the maturity of mortgage-backed securities can be affected by interest rate movements.

When interest rates decline, prepayments on mortgages occur because some homeowners refinance with a new mortgage with a lower interest rate. If these mortgages were financed with pass-through securities, the payments will be channeled to the investors that purchased the pass-through securities.

Laddering (Illegal)

brokers encourage investors to place first-day bids for the shares that are above the offer price. This helps to build upward price momentum investors multiplied Google's earnings per share by Yahoo!'s price-earnings ratio.

Spinning (Illegal)

occurs when the underwriter allocates shares from an IPO to corporate executives who may be considering an IPO or to another business that will require the help of a securities firm.

Explain how to estimate the beta of a stock. Explain why beta serves as a measure of the stock's risk.

typically measured by applying regression analysis to determine the sensitivity of the asset's return to the market return based on monthly or quarterly data. Beta serves as a measure of the stock's risk because it measures sensitivity to the market. The higher the sensitivity, the more likely that the stock will perform poorly under adverse market conditions.