FIN 325

Bond Equivalent Yield (BEY)

BEY of an annual-pay bond BEY= FV of T-bill - Discount Value / Discount Value X 365/days to maturity

Free Cash Flow to the Firm (FCFF)

Cash Flow available for distribution to all investors (stockholders & debt holders) CFO + int(1-t) - fixed capital investment or [FCFF calculated from NI = NI + noncash charged + (Int exp(1-tax rate) - net cap investment - working capital invt.]

Free Cash Flow to Equity

Cash flow that would be available for distribution to common shareholders; = Cash Flow from Operations - Fixed Capital Investment + Debt Issued - Debt Repaid -Differs from the DDM in that FCFE measures what a firm could pay out as dividends, rather than what it actually does pay out

Nonnegotiable CDs

Commercial banks and other institutions offer a variety of savings certificates known as certificates of deposit (CDs). These certificates are available for a variety of amounts and maturities, with higher rates offered as maturity increases. Nonnegotiable CDs are meant to be a buy-and-hold investment, and penalties for early withdrawal are commonly imposed.

stock dividend

Corporation's distribution of its own stock to its stockholders without the receipt of any payment.

Enterprise Value

EV=market value of common and preferred stock+market value of debt−cash equivalents

DDM equation

Estimated Value of a stock

Investment Banking

Financial activities that involve underwriting new security issues and providing advice on mergers and acquisitions. -client advice includes type and features of security, offer price, and timing of sale -underwriting services -coordinates marketing by helping issuer register securities, issue prospectus, and sell securities

MMDA (money market deposit account)

Financial institutions offer MMDAs with no interest rate ceilings. Money market "investment" accounts have a required minimum deposit to open, pay competitive money market rates, and are insured up to $250,000 by the Federal Deposit Insurance Corporation (FDIC), if the bank is insured. Six preauthorized or automatic transfers are allowed each month, up to three of which can be by check. There is no limit on the number of deposits or withdrawals that can be made in person or through automated teller machines (ATMs)

Funds to be invested

Funds to be invested come from assets already owned, borrowed money, and savings or foregone consumption

Reported Earnings

GAAP earnings, the "official" earnings of a company as reported to stockholders and the SEC.

IRAs

IRA assets totaled approximately $8.2 trillion by 2017, which was roughly 31 percent of the total U.S. retirement market.

A corporate bond with a rating of BBB- is considered to be which of the following?

Investment grade

Building wealth through investing can hedge people from...

Investors also seek to manage their wealth effectively, obtaining the most from it while protecting it from inflation, taxes, and other factors.

Negotiable CDs

Issued by a bank in exchange for a deposit of funds, a CD is a liability of the issuer. The deposit is maintained in the bank until maturity, at which time the holder receives the deposit plus interest. However, these CDs are negotiable, meaning that they can be sold in the open market before maturity. Dealers make a market in these unmatured CDs. Maturities typically range from 14 days (the minimum maturity permitted) to one year. The minimum deposit is $100,000.

S&P 500

Market value index of stock market performance covering 500 stocks -all 30 of the DJIA companies are listed on it

consensus forecast

Most likely EPS value expected by analysts

Taxable Equivalent Yield (TEY)

Municipal Bond Yield / 1 - marginal tax rate

Most trading of bonds in the secondary market takes place on

OTC

Zero Growth Rate Case

One of three growth rate cases of the dividend discount model, when the dollar dividend being paid is not expected to change -A dividend stream with a zero-growth rate resulting from a fixed-dollar dividend equal to the current dividend, D0, being paid every year from now to infinity

Multiple Growth Rate Case

One of three possible forms of the dividend discount model, involving two or more expected growth rates for dividends -A dividend stream that is growing at variable rates, for example, g1 for the first two years and g2thereafter

LEAPS (long term equity anticipation securities)

Options with long times to expiration when trading is initiated (up to 3 year maturities currently).

Derivatives

Options, futures contracts

What document summarizes information about a new security issue?

Propsectus

ROA can be described using two different components:

ROA= (Net Income / Sales) x (sales / total assets) ROA= net profit margin x asset turnover

Useful Information about Earnings

Reported earnings are a key factor affecting stock prices; however, it is the surprise element in the reports that often moves stock prices. Surprises typically involve the difference between the consensus analyst forecast and the actual earnings. There appears to be a lag in the adjustment of stock prices to earnings surprises. This has been documented in numerous studies. Surprises may occur because analyst estimates are off target. Alternatively, companies may guide analysts to a slightly lower number than actually expected, resulting in an earnings "surprise." Positive earnings surprises have outnumbered negative earnings surprises by a ratio of three to one. Positive surprises are often attributed to the "earnings guidance game." The size of the surprise is important information, with large surprises leading to larger returns. The best guideline to surprises may be revisions in analyst estimates. If estimates are steadily being adjusted upward, a buy signal is indicated, and if the adjustments are downward, a sell signal is indicated. Investors interested in buying stocks that report bad news and suffer a sharp decline may benefit by waiting a month or two. Chances are the stock will get even cheaper after the initial sharp decline. When estimating stock-price movements, investors must consider reported earnings, earnings surprises, earnings forecasts, and other information contained in the earnings announcement.

Asset-Backed Securities

Represent a claim to a portion of a pool of assets and the return is passed through to investors with different tranches having different levels of risk and return

Russell 3000

Russell 1000 are large-cap stocks ($5.2 billion) Russell 2000 are small-cap stocks ($460 million)

Income Statement

Sales or Revenues -Product Costs Gross Profit -Period Costs Operating Income -Interest Income Before Tax -Taxes Net Income

Equity Securities

Securities issued by corporations as a form of ownership in the business. -voting rights -denote limited liability

government agency securities

Securities issued by federal credit agencies (fully guaranteed) or by government sponsored agencies (not guaranteed)

senior securities

Securities that have a preferential claim over common stock on a company's earnings and in the case of liquidation. Generally, preferred stock and bonds are considered senior securities

fixed-income securities

Securities that pay an equal payment on fixed periods like a bond.

P/S ratio

Stock Price / Sales per Share

P/B ratio

Stock price / Book value of equity per share

Chartered Financial Analyst (CFA)

The CFA qualification is granted by the Association for Investment Management and Research. The CFA designation is a globally recognized qualification in the area of investment and portfolio management.

EV/EBITDA

The EBITDA/EV ratio may be preferred over other measures of return because it is normalized for differences between companies. Using EBITDA normalizes for differences in capital structure, taxation and fixed asset accounting. Meanwhile, using enterprise value (EV) also normalizes for differences in a company's capital structure.

MSCI EAFE

The Europe, Australasia, and Far East Index, a value-weighted index of the equity performance of major foreign markets

Which of the following statements about the NYSE is true?

The NYSE is the oldest and most prominent secondary market in the U.S.

Yield

The basic component investors think of when discussing return is the periodic cash flows (or income) on the investment, either interest (from bonds) or dividends (from stocks). The distinguishing feature of these payments is that the issuer makes the payments in cash to the security holder. Yield measures a security's cash flows relative to some price, such as the purchase price or the current market price

Regulation FD

The federal regulation governing corporate officials who are required to make public (fair disclosure) any information disclosed to analysts or investors -regulates communications between public companies and investment professionals

security analysis

The part of the investment decision process involving the valuation and analysis of individual securities

earnings surprise

The portion of a company's earnings that is unanticipated by investors and, according to the efficient market hypothesis, merits a price adjustment.

underwrite

The process by which investment bankers purchase an issue of securities from a firm and resell it to the public

Capital gains (loss)

The second component is the appreciation (or depreciation) in the asset price, commonly called the capital gain (loss). We will refer to it simply as the price change. In the case of an asset purchased (long position), it is the difference between the purchase price and the price at which the asset can be, or is, sold

listed securities

The securities of companies meeting specified requirements of exchanges and marketplaces

Growth at a Reasonable Price (GARP)

The strategy is a combination of both value and growth investing: it looks for companies that are somewhat undervalued and have solid sustainable growth potential.

Equity Multiplier

Total Assets/Total Equity

Treasury Inflation-Protected Securities (TIPS)

Treasury issues in which the principal amount is tied to the Consumer Price Index to protect the buyer against the effects of inflation

Risk Types

Two general types: ◦Systematic (general) risk -Pervasive, affecting all securities, cannot be avoided -Interest rate or market or inflation risks ◦Nonsystematic (specific) risk -Unique characteristics specific to issuer -Total Risk = General Risk + Specific Risk

Term Structure of Interest Rates

Upward-sloping yield curve -

Variance and Standard Deviation of Return

Variance: (R-Rbar)^2 SD: R-Rbar

Measuring International Returns

[RR x End Value of Foreign Currency / Beg. Value of Foreign Currency] - 1

options contract

a contract under which the offeror promises to keep her offer open to the offeree until a specified date

warrant

a corporate-created long-term option on the underlying common stock of the company. It gives the holder the right to buy the stock from the company at a stated price within a stated period of time, typically several years.

Dividend Discount Model (DDM)

a formula for the intrinsic value of a firm equal to the present value of all expected future dividends

options vs futures

a futures contract is an obligation to buy or sell an asset, whereas an options contract offers the right to do so. The buyer of an option has the right to walk away from the trade if it is not in the buyer's best interest. In contrast, the buyer of a futures contract does not.

Better Alternative Trading System

a global stock exchange operator based in Lenexa, Kansas, with additional offices in London, New York, Chicago, and Singapore

ROE

a key component in determining earnings and dividend growth. Analysts and investors decompose ROE into its critical components in order to identify adverse impacts on ROE and to help predict future trends in ROE =ROA x Equity Multiplier

Dividend Discount Model

a model that values shares of a firm according to the present value of the future dividends the firm will pay Vo=D1/k-g

call provision

a provision in a bond contract that gives the issuer the right to redeem the bonds under specified terms prior to the normal maturity date

dividend yield

a stock's expected cash dividend divided by its current price -dividend per share/stock price

Mortgage Backed Securities (MBS)

a type of asset-backed security that is secured by a mortgage or collection of mortgages

futures contract

an agreement to buy or sell at a specific date in the future at a predetermined price

debenture

an unsecured debt, usually with a maturity of 10 years or more

active management strategy

assumes that investors possess some advantage relative to other market participants. Such advantages could include superior analytical or judgment skills, superior information, or the ability or willingness to do what other investors, particularly institutions, are unable to do -security selection, security analysis, market timing

Personal Financial Specialist

awarded by the American Institute of Certified Public Accountants to CPAs only, requires experience in personal financial planning and a comprehensive examination.

Certified Financial Planner (CFP)

awarded by the Certified Financial Planning Board of Standards, an industry group, requires course work and an examination on financial planning. Holders of the CFP must have three years' experience and adhere to a code of ethics.

institutional investors

bank trust departments, pension funds, mutual funds, insurance companies, and so forth, includes the professional money managers, who are often publicized in the popular press. Institutional investors in the United States hold trillions of dollars worth of assets.

Value of a coupon bond

biggest problem is determining the discount rate or required yield -required yield is the current market rate earned on comparable bonds with same maturity and....

Wilshire 5000 Index

broadest market index (includes all NYSE listed stocks, as well as NASDAQ stocks)

payout ratio

cash dividends declared on common stock/net income -cash dividends / Net Income

Payout Ratio

cash dividends declared on common stock/net income -cash dividends/Net Income

financial assets

claims on some issuer, such as federal government or a corporation -paper (or electronic) claims on some issuer, such as the federal government or a corporation, whereas real assets are tangible, physical assets such as gold, silver, diamonds, art, and real estate

Investment Management

concerned with the management of an investor's wealth, which is the sum of current income and the present value of all future income.

sell-side analysts

cover the actively traded stocks in the United States (some stocks are heavily covered, others are covered by only one or two analysts, and some stocks are not covered at all)

cumulative wealth index

cumulative wealth over time, given an initial wealth and a series of returns on some asset

capital market instruments

debt and equity instruments with maturities of greater than one year

Which of the following statements regarding common stocks is true?

dividends on common stock are at the discretion of the company

prospectus

document issued to possible buyers of a stocks and bonds outlining the financial condition of the company issuing those securities

over-the-counter market (OTC)

electronic marketplace for securities not listed on organized exchanges such as the NYSE

Electronic Communication Network

electronic trading system that brings buyers and sellers together outside traditional stock exchanges

Growth Stocks

emphasize expectations about future growth in earnings -they typically grow earnings/revenues faster than the industry or market -they rarely pay dividends and instead prefer to reinvest excess cash -they usually have relatively high price multiples such as P/E and P/B ratios

buy-side analysts

employed by money management firms (such as pension funds, mutual funds, and investment advisers). These analysts search for attractively priced equities for their firms to buy, and their research is typically available only to their employers

401K

employees contribute a percentage of salary to a tax-deferred plan, and the employer often matches part of the contribution -Tens of millions of American workers contribute to 401(k) plans. At the end of 2018, these and similar tax-advantaged plans held approximately $9.2 trillion in assets. The bulk of 401(k) assets are invested in stocks

Rotation Strategy

executed by an investment manager rotating out of certain asset classes while rotating into other asset classes. Implementing a rotation strategy requires the investor to rely on a variable, or set of variables, to serve as a signal of when to initiate the rotation

Investment companies

financial intermediaries that invest the funds of individual investors in securities or other assets -unit investment trust -open end: money market mutual fund, stock, bond, and income funds -closed end -Exchange-traded funds

When making investment decisions, investors should consider...

foreign markets as well as the U.S. financial environment.

program trading

giving instructions to computers to automatically sell if the price of a stock dips to a certain point to avoid potential losses

Minimum Variance Frontier

graph of the lowest possible portfolio variance that is attainable for a given portfolio expected return -lowest levels of risk for the lowest levels of return

value stocks

have prices that are considered "cheap" relative to earnings, book value, and other measures thought indicative of value -value stocks (1) are believed to trade at a discount to their true value, (2) have relatively high dividend yields, and (3) have relatively low price multiples, such as P/E and P/B

P/E Ratio (Earnings Multiplier)

he ratio of the current stock price to some measure of the firm's annual earnings per share -alternatives to the E in the P/E ratio: -Historical P/E based on the last full fiscal year's earnings (also known as a trailing P/E). -Historical P/E based on the last 12 months of earnings (commonly known as trailing 12 months (TTM), but practically speaking it is really the last four quarters)—also referred to as a trailing P/E. This is the method used by Yahoo! Finance. -Leading P/E based on a forecast of the next fiscal year's earnings. -Leading P/E based on a forecast of the next four quarters' earnings. -P/E based on a combination of the last two historical quarters plus the next two forecast quarters

shadow banking firms

hedge funds, private equity funds, and ETFs

Enhanced Index Funds

index funds that are tweaked by their managers to be a little different. For example, an enhanced fund tracking the S&P 500 could have the same sector weightings as the S&P 500 but hold somewhat different stocks, perhaps with lower P/E ratios

private equity

investments in companies that are not traded on a stock exchange

direct investing

involves securities that investors not only buy and sell themselves but also have direct control over. Investors who invest directly in financial markets, either using a broker or by other means, have a wide variety of assets from which to choose.

ROA

is a fundamental measure of company profitability, reflecting how effectively and efficiently a firm is using its assets

Sell-side analysts

issue recommendations such as "strong buy" that are published and made available to investors

Modern Monetary Theory

macroeconomic theory that describes currency as a public monopoly and unemployment as evidence that a currency monopolist is overly restricting the supply of the financial assets needed to pay taxes and satisfy savings desires

primary market

market for selling financial assets that can only be redeemed by the original holder

A market capitalization-weighted index obtains the current market value of each stock by

multiplying price times shares outstanding

KAO Corporation arranged with Goldman Sachs to issue up to 50,000 shares of its common stock. This method of issuing securities is most likely a

negotiated, best efforts arrangement

Present Value of Growth Opportunities (PVGO)

net present value of a firm's future investments

What is the biggest difference between an option and a futures contract?

options give their holder obligations to buy or sell

lack of investing in generations

over 40 percent of Baby Boomers have no retirement savings at all, and only 25 percent are confident they will have enough money to last throughout retirement.

defined benefit plan

pension plan that guarantees a specified level of retirement income

real assets

physical assets such as gold, silver, diamonds, art, and real estate

PEST analysis

political, economic, social, and technological

Buy-side analysts

prepare research solely to benefit the firm for whom the research was prepared

P/CF

price per share/cash flow per share

Separate Trading of Registered Interest and Principal of Securities (STRIPS)

program lets investors hold and trade the individual interest and principal components of eligible Treasury notes and bonds as separate securities

indirect investing

refers to investors owning securities indirectly through investment companies such as mutual funds and ETFs

Bonds called in are likely to be:

replaced with new bonds that have a lower interest rate

Sustainable Growth Rate

represents the rate at which a company can grow from internal sources, without the issuance of additional securities -ROE x (1-dividend payout ratio)

Chartered Financial Consultant (ChFC)

requires a comprehensive examination and often involves those with an insurance background

defined contribution plan

retirement plan in which the employer sets up an individual account for each employee and specifies the size of the investment into that account -401K

real returns

returns adjusted for inflation

An issue of common stock of which there are already shares publicly held is known as

seasoned issue

marketable assets

securities and financial assets that are easily traded on a market -financial assets that are easily and inexpensively tradable in organized markets

market markers

securities dealers that make a commitment to continuously offer to buy and sell the stock of a specific corporation listed on the NASDAQ exchange or traded in the OTC market

Investment decision making traditionally consists of two steps

security analysis and portfolio management

In general, the ex ante risk-return tradeoff

slopes upward

wealth

sum of current income and the present value of all future investments

Adjusted Earnings

takes net income and adjusts it by leaving out nonrecurring or unusual items

Municipal Bonds

tax-exempt bonds issued by state and local governments

DuPont Analysis

technique of breaking return on total assets and return on equity into their component parts

book value of a corporation

the accounting value of the equity as shown on the books (i.e., balance sheet)

nominal returns

the actual market yields not adjusted for inflation

Federal Reserve

the central bank of the United States in charge of monetary policy

Investment

the commitment of funds to one or more assets that will be held over some future time period.

stock split

the division of each single share of a company's stock into more than one share -stock splits convey positive information about a firm's performance, as successful companies split their stock. Splits generate publicity and that may be helpful in attracting investor interest.

intrinsic value of a security

the estimated value

The MSCI EAFE index proxies for the performance of

the foreign developed equity markets

Passive Management Strategy

the investor does not actively seek out trading possibilities in an attempt to outperform the market. Passive strategies simply aim to do as well as the market

secondary market

the market in which previously issued securities are traded among investors

required return

the minimum expected return necessary to induce an investor to buy a stock, given its risk. Note that it is an expected return, and that it is the minimum rate necessary to induce purchase -The required return, capitalization rate, and discount rate are interchangeable terms in valuation analysis. Regardless of the terminology, it is challenging to determine the precise numerical value to use for a particular stock.

risk-free rate of return

the rate of return on risk-free investments. The interest rates on short-term U.S. government securities are commonly used to measure this rate -proxied by the rate of return on Treasury securities

expected return

the return expected over the next period on one asset relative to alternative assets

exchange rate risk

the risk related to having international operations in a world where relative currency values vary

Industry Life Cycle

the stages of pioneering, growth, maturity, and decline that typically occur over the life of an industry

Fundamental Analysis

the study of a company's accounting statements and future prospects to determine its value -the intrinsic value of a stock is its justified price; it's the price justified by investors' evaluations of a company's fundamental financial variables

Momentum investing

the tendency of stocks that have performed well (poorly) recently to continue to perform well (poorly)

realized return

the total return that occurs over a particular time period

Risk

the uncertainty about the actual return that will be earned on an investment. When we invest, we do so on the basis of an expected return, but there is a risk that the outcome from the investment—the actual (realized) return—will differ from what we expected when we made the investment.

Net borrowings

the value of short- and long-term borrowing by the firm

Bloomberg Dollar Spot Index (BBDXY)

tracks the performance of a basket of 10 leading global currencies versus the U.S. Dollar

blocks

transactions involving at least 10,000 shares

commercial paper

unsecured promissory notes of $100,000 and up that mature (come due) in 270 days or less

Immunization

used to protect a bond portfolio against interest rate risk -interest rate risk composed of price and reinvestment risk -move in opposite directions, offset each other -price risk result of relationship between bond prices and rates -reinvestment risk result of uncertainty about rate at which future coupon income invested -risk components move in opposite directions -favorable results on one side can be used to offset unfavorable changes -portfolio immunized if duration of portfolio is equal to investment horizon -in reality, immunization is not easy to implement; requires frequent rebalancing

Equivalent Annual Yield

uses compounding to turn BEY simple interest rate into a compounded annual rate -EAY=[1 + (FV of T-bill - Discounted Value / Discounted Value )]^(365/days to maturity) - 1

discounted cash flow (DCF) model

values an asset as the present value of all future cash flows from that asset in perpetuity

risk-averse investor

will not assume risk simply for its own sake and will not incur risk unless there is an expectation of adequate compensation for doing so.

American Depository Receipts (ADRs)

"Certificates" created by organizations such as banks; represent ownership in stocks of foreign companies that are held in trust by a bank located in the country where the stock is traded.

Warren Buffett on risk

"be fearful when others are greedy and greedy when others are fearful."

Measuring Return Relative formula

(Price(now) + price (previous) / Price (previous)) + 1

Performance of index funds

-According to Standard and Poor's, over a recent five-year period, 75 percent of actively managed mutual funds failed to outperform the market -for large-cap actively managed growth funds, 79 percent underperformed their benchmark. Notice the astounding results for medium-capitalization funds—96, 94, and 97 percent for the value, blend, and growth categories, respectively, underperformed their benchmarks.

Top-Down Approach

-Analyze the economy/market -Focus on sectors/industries that appear attractive -Analyze and value individual companies

Selecting Optimal Asset Classes

-Another way to use Markowitz model is with asset classes ◦Allocation of portfolio assets to asset types -Asset class rather than individual security decisions likely most important for investors ◦Can be used when investing internationally ◦Different asset classes offers various returns and levels of risk -Correlation coefficients may be quite low

Risk Reduction in Portfolios

-Assume all risk sources for a portfolio of securities are independent ◦This assumption is unrealistic when investing ◦Market risk affects all firms, cannot be diversified away -If risks independent, the larger the number of securities the smaller the exposure to any particular risk ◦"Insurance principle" ◦Only issue is how many securities to hold -Random (or naïve) diversification ◦Diversifying without looking at how security returns are related to each other ◦Marginal risk reduction gets smaller and smaller as more securities are added -Beneficial but not optimal ◦Risk reduction kicks in as soon as additional securities added ◦Research suggests it takes a large number of securities for significant risk reduction

Buying Foreign Bonds

-Attractive because -foreign bonds may offer higher returns at a point in time than alternative domestic bonds -diversification -can be difficult to buy, so most investors buy mutual funs or ETFs that hold foreign bonds -subject to currency risk, but this can be hedged

Basic Financial Statements

-Balance Sheet • shows one point in time: assets, liabilities, stockholder's equity; retained earnings= previous earnings not paid as dividends

Passive Bond Strategies

-Buy and Hold: -no attempt to trade in search of higher returns -laddering can help reduce risk -Indexing: -attempt to match performance of a well-known bond index -Mutual funds, ETFs • Forecasting interest rate changes -notoriously difficult to do accurately -involves tradeoffs -shape of yield curve contains potentially valuable info • Horizon analysis: -project bond performance over planned investment horizon -investor selects bond expected to perform best

Organizational Patterns for Presentations

-Classification: dividing a topic into small categories or main points -Chronological: Presenting topics

Common Stock Fundamental Analysis

-Discounted Cash Flow Techniques ◦Intrinsic value based on the discounted value of the expected stream of cash flows. ◦Dividend Discount Model ◦Free Cash Flow Model -Earnings Multiplier Approach -Relative Valuation Metrics ◦Emphasizes selecting stocks to buy rather than valuation

Estimating Price Changes Using Duration

-Duration combines coupon and maturity -bond price changes directly related to duration -duration measures approximate percent change in interest rates -modified duration= D* = D/(1+ytm) -D* can be used to calculate the bond's percentage price change for a given change in yield

Analyzing a company's profitability (EPS)

-EPS: culmination of several important factors going on within a company -EPS= ROE x Book Value per share • Book value per share if stockholder's equity / shares outstanding

Calculating Expected Value

-Expected value ◦The weighted average of all possible return outcomes included in the probability distribution -Each outcome weighted by probability of occurrence ◦Referred to as expected return =Sigma (Ri pri)

Payment Methods for Financial Advisors

-Fee-based—may involve a comprehensive financial plan, or specific issues. -Commission-based—plan and recommendations are provided at no charge, with compensation derived from commissions earned from products sold to implement the plan. -Fee-and-commission-based—commissions are often greater than the fees. -Salaried—banks, credit unions, and so forth often offer planning services by salaried financial planners.

Capital Market

-Fixed Income: treasuries, agencies, municipals, corporates, equities (preferred and common) -marketable debt with maturity greater than one year and equity securities, which have no maturity date -riskier than money market securities -fixed-income securities have a specified payment schedule -dates and amount of interest and principal payments known in advance

Measuring Returns

-For comparing performance over time or across different securities -total return is a percentage relating all cash flows received during a given period -CFt + (PE-PB) to the start of period price, PB

Simple Strategy

-Forty percent of the portfolio is allocated to bonds and 60 percent to equity. -This can be accomplished with index funds or ETFs. For example, for the 60 percent equity portion, put 10 percent in the S&P 500, 10 percent in large-cap value stocks, 10 percent in small-cap stocks, 10 percent in small-cap value stocks, 10 percent in international stocks, and 10 percent in REITs. -Over the five-year period starting with the bear market of 2000-2002, this portfolio outperformed the indexes with no additional costs or effort

The Risk-Return Record

-From 1926 - 2010, geometric average annual return was 9.6% for S&P 500 -Arithmetic mean was 11.4% -Standard deviation was 19.9% -Smaller common stocks show greater risks and returns than large common stocks in that period -T-bills showed lowest risk and return

The P/E Ratio

-Important for investors to remember earnings can be defined various ways -Measure of relative price of a stock◦A function of expected dividend payout ratio, required rate of return, expected growth rate in dividends-vary among companies • investor expectations differ • spread between highest and lowest P/E ratio -The higher the expected payout ratio, the higher the P/E ratio◦Growth rate will probably decline, adversely affecting the P/E ratio -Less funds available to reinvest in business -Required rate of return and P/E ratio inversely related -Expected growth rate in dividend and P/E ratio directly related

Asset Allocation

-Includes two dimensions ◦Diversifying between asset classes ◦Diversifying within asset classes -Asset classes include ◦International equities ◦Bonds ◦Treasury Inflation -Indexed Securities (TIPS) ◦Real estate ◦Gold ◦Commodities -Correlation among asset classes must be considered -Correlations change over time -For individual investors, allocation depends on ◦Time horizon ◦Risk tolerance -Diversified asset allocation doesn't necessarily provide benefits or guarantee against loss -Index Mutual Funds and ETFs ◦Investors can buy funds covering various asset classes -Domestic large-cap stocks, domestic small-cap stocks -International stocks -Bond funds -Life Cycle Analysis ◦Varies asset allocation based on age of investor ◦Life-cycle funds (target-date funds) hold various asset classes and the allocation changes as investor ages -No one "correct" approach to allocation

Risk Sources

-Interest Rate Risk ◦Affects income return -Market Risk ◦Recession, war, etc. -Inflation Risk ◦Purchasing power variability -Business Risk -Financial Risk ◦Tied to debt financing -Liquidity Risk ◦Marketability of security in secondary market -Currency Risk ◦Exchange Rate Risk -Country Risk ◦Political stability

Reinvestment Risk

-Interest-on-Interest -Reinvestment Rate Risk: risk that future reinvestment rates will be less than the YTM when bond is purchased -Total dollar return on a bond consists of: -coupons paid -capital gains or losses -Interest Income from reinvestment of coupons

Selecting an Optimal Portfolio of Risky Assets (continued)

-International diversification unlikely to offer as much risk reduction as it has in the past -Markowitz portfolio selection model ◦Assumes investors use only risk and return to decide ◦Generates a set of equally "good" portfolios ◦Does not address the issues of borrowed money or risk-free assets ◦Cumbersome to apply

Bond Valuation Principle

-Intrinsic Value -an estimated value -present value of the expected cash flows -required to compute extrinsic value -expected cash flows, timing of expected cash flows, discount rate or required rate of return by investors

Investment Decisions

-Involve uncertainty -Focus on expected returns ◦Estimates of future returns needed to consider and manage risk ◦Investors often overly optimistic about expected returns -Goal is to reduce risk without affecting returns ◦Accomplished by building a portfolio ◦Diversification is key

Investment Banking Process

-Issuer -Originating Investment Banker -Underwriting syndicate group of investment bankers -selling group of underwriting syndicate + selected retail brokerage firms -Investors

Simplifying Markowitz Calculations

-Markowitz full-covariance model ◦Requires a covariance between the returns of all securities in order to calculate portfolio variance ◦[n(n-1)]/2 set of covariances for n securities -Markowitz suggests using an index to which all securities are related to simplify

Measuring Portfolio Risk

-Needed to calculate risk of a portfolio: ◦Weighted individual security risks -Calculated by a weighted variance using the proportion of funds in each securityFor security i: (wi × oi)2 ◦Weighted co-movements between returns -Return covariances are weighted using the proportion of funds in each security -For securities i, j: 2wiwj × oij

Modern Portfolio Theory

-Optimal diversification considers all available information -Assumptions in portfolio theory ◦A single investment period ◦Liquid position (no transaction costs) ◦Preferences based only on a portfolio's expected return and risk -used to tell us how stocks have generally behaved in the past

Financial Adviser demand

-Over 60 percent of affluent Americans with a net worth between $100,000 and $1 million now use a financial adviser -The Bureau of Labor Statistics expects this job category to grow by 27 percent from 2012 to 2022—much faster than the average for all occupations

Portfolio Risk

-Portfolio risk not simply the sum or the weighted average of individual security risks -Emphasis on the risk of the entire portfolio and not on risk of individual securities in the portfolio -Diversification almost always lowers risk -Measured by the variance or standard deviation of the portfolio's return

Selecting an Optimal Portfolio of Risky Assets

-Portfolio weights are only variable that can change in Markowitz analysis -Assume investors are risk averse -Indifference curves help select from efficient set ◦Description of preferences for risk and return ◦Portfolio combinations which are equally desirable ◦Match investor preferences with portfolio possibilities

Risk Premiums

-Premium is additional return earned or expected for additional risk ◦Calculated for any two asset classes -Equity risk premium is the difference between stock and risk-free returns ◦Stocks versus Treasury bills ◦Stocks versus Treasury bonds •Premium is additional return earned or expected for additional risk •Calculated for any two asset classes •Equity risk premium ‐ difference between stock return and risk‐free return •Stocks versus Treasury bills•Stocks versus Treasury bonds

Bond Yields and Interest Rates

-Price for loanable funds • rent paid by borrower to lender • depends on supply/demand -Rates and basis points • 100 basis points are equal to 1% -Short-term diskless rate foundation for other rates • approximated by rate of T-bills -opportunity cost of foregoing consumption -real risk-free rate of interest unaffected by price changes or risk factors -nominal interest rates consist of real rate + adjustment for expected inflation -PPP= $100 at 10% = $110, inflation 4%= (1/1.04) ($110) = $105.60 -IR = rr + ei + rp • equation for all interest rates • rp= all risk premiums -RF= (1 + rr) x (1+ei) - 1

Modern Portfolio Theory

-Provides framework for selection of portfolios based on expected return and risk -Used, to varying degrees, by financial managers -Shows benefits of diversification -The risk of a portfolio does not equal the sum of the risks of its individual securities ◦Must account for correlations among individual risks

Analyzing a company's profitability (ROA)

-ROA: measures profitability • product of net income margin and turnover • Net income margin= net income / sales--> measures a company's earning power in terms of sales • Turnover= sales/total assets • shows how effectively and and efficiently assets are used -ROA= Net Income / Total Assets

Analyzing a company's profitability (ROE)

-ROE: decomposed into two components to product trends • Leverage= Total Assets / Stockholder's equity • ROE= ROA x Leverage • ROE will be larger than ROA for typical profitable company that uses debt to finance some of its assets

PEG Ratio

-Relates P/E ratio to short-term earnings growth rate◦ (P/E) / g -Relating P/E ratio to earnings may be better than P/E ratio alone◦Only a rule of thumb -Different earnings growth rates can be used to calculate PEG ratio

Yield Spreads

-Risk Premiums -Result from different default risks, maturities, call features, coupon rates, marketability, taxes -borrower actions -interest rates -function of variables associated with issue or issuer -inversely related to business cycle

Risk

-Risk and return are opposite sides of the same coin -Risk is the chance that the actual outcome from an investment will differ from the expected outcome -Investors willing to assume large risks may gain large returns, but they may also lose money

Measuring Risk

-Risk arises from variability of outcomes -Variance and standard deviation measure variability -Standard Deviation is simply the square root of the variance

Dealing With Uncertainty

-Risk that an expected return will not be realized -Investors must think about return distributions -Probabilities weight outcomes ◦Assigned to each possible outcome to create a distribution ◦History provides guide but must be modified for expected future changes ◦Distributions can be discrete or continuous

Four reasons why indexing works

-Securities markets are extremely efficient in digesting information. -Indexing is cost-efficient, with expenses much lower than actively managed funds. -Actively-managed funds incur heavy trading expenses. Trading costs can amount to 0.5 to 1.0 percent per year. -Indexing has a tax advantage, deferring the realization of capital gains.

security analysts

-Security analysts are routinely separated into buy- and sell-side analysts. Sell-side analysts issue recommendations such as "strong buy" that are published and made available to many investors, while buy-side analysts prepare research to benefit the firm for whom the research was prepared -Market professionals whose job it is to evaluate and recommend stocks to individual and institutional investors

An Efficient Portfolio

-Smallest portfolio risk for a given level of expected return -Or largest expected return for a given level of portfolio risk -From the set of all possible portfolios ◦Only locate and analyze the subset known as the efficient set -Efficient frontier or Efficient set (curved line from A to B) -Global minimum variance portfolio (represented by point A) -Portfolios on AB dominate those on AC

Correlation Coefficient

-Statistical measure of relative associationij = correlation coefficient between securities i and j ◦ij = +1.0 = perfect positive correlation ◦ij = -1.0 = perfect negative (inverse) correlation ◦ij = 0.0 = zero correlation

Estimating an Internal Growth Rate

-Sustainable growth rate: rate at which company can grow from internal sources -provides benchmark for assessing actual growth -g= (1- payout ratio) x ROE -estimate is dependent on the data period -only reliable if company's current ROE remains stable -what matters is the future growth rate, not the historical growth rate

Impact of Diversification on Risk

-Total risk = systematic (nondiversifiable) risk + nonsystematic (diversifiable) risk ◦Systematic risk is market risk and common to virtually all securities ◦Nonsystematic risk is company-specific risk -Total risk can go no lower than systematic risk -Both risk components can vary over time -Affects number of securities needed to diversify

Major Bond Types

-U.S. government/Treasury securities -government agency securities -federal agencies, such as GNMA -government sponsored enterprises (GSEs) -mortgage-backed securities -municipal securities: general obligation and revenue -generally exempt from federal taxes -corporate bonds

Foreign Markets

-US equity markets account for a decreasing share of world's stock market capitalization -emerging markets

Calculating Risk

-Variance and standard deviation used to quantify and measure risk ◦Measure the spread or dispersion around the mean of the probability distribution ◦Variance of returns: σ² = - (Ri - E(R))²pri ◦Standard deviation of returns: σ =(σ²)1/2◦σ is expected (ex ante) -Actual (ex post) σ useful but not perfect estimate of future

The P/E Ration continued

-Vary among companies◦Investor expectations differ◦Spread between highest and lowest P/Es typically large -Forward P/E ratio◦Linked to expected earnings growth and risk◦Higher numbers indicate higher investor expectations -Investors often overestimate future growth in earnings -Investors must be increasingly concerned with effect of earnings game on P/E ratio

Portfolio Expected Return

-Weighted average of the individual security expected returns ◦Each portfolio asset has a weight, w, which represents the percent of the total portfolio value

Measuring Bond Yields (continued)

-YTM most commonly used -promised compound rate of return received from a bond purchased at the current price -if held to maturity -coupons reinvested at same YTM -likelihood of meeting second condition is extremely small

Duration

-a measure of a bond's lifetime -stated in years -accounts for the entire pattern -present-value weighted average of the number of years over which invests receive cash flows -describes weighted average time to each payment

Why is Duration Important?

-allows comparison of effective lives to alternative bonds -used in bond management strategies, particularly immunization -direct measure of interest rate risk -measures bond price sensitivity to interest rate movements -this characteristic is most important for bond investors

Intrinsic Value

-an estimated value -present value of the expected cash flows -required to compute intrinsic value -expected cash flows -timing of expected cash flows

Buy-and-hold strategy

-an investor buys stocks and holds them until some future time in order to meet some objective. The emphasis is on avoiding transaction costs, taxable transactions, additional search costs, the time commitment to portfolio management, and so forth. -the average buy-and-hold investor earned 15.3 percent over a five-year period, while the most active traders (turning over about 10 percent of their holdings each month) averaged only 10 percent.1

Convexity

-as changes in required yield increase, modified duration becomes poorer approximation -difference between duration and bond yield curves -refers to the degree to which duration changes as YTM changes as the YTM changes -Convexity largest for low coupon, long maturity bonds, and low yield to maturity

Why Buy Bonds?

-attractive to investors seeking steady income and aggressive investors seeking capital gains -yield appeals to long-term investors -price changes appeal to short-term investors... -Promised YTM is known at time of purchase

Bond Characteristics (continued)

-bond will be worth exactly face value at maturity -until maturity, price changes depending on interest rates -interest rates and bond prices move inversely -bond buyer in secondary market must pay the price of the bond plus accrued interest

Active Bond Strategies

-can be based on: -forecasting interest rate changes -identifying abnormal yield spreads -identifying relative mis-pricing -requires expectations/forecasting -inputs not known at time of analysis

Role of Financial Markets

-channel funds from savers to borrowers -help firms and governments raise cash by selling securities -provide a place where investors can earn a return -help allocate cash to where it is most productive -help lower cost of exchange

Common stocks

-common stockholders are residual claimants on income and assets -par value is face value of a share -book value is accounting value of a share -market value is current market price of a share -aggregate market value is market price per share times number of shares outstanding

K-shaped economy

-companies that are doing well keep doing well -companies that are not performing well continue to not perform well

Building a Portfolio

-diversification is key to optimal risk management -asset allocation is most important single decision -Using Markowitz Principles ◦Step 1: Identify optimal risk-return combinations using the Markowitz efficient frontier analysis -Estimate expected returns, variances and covariances ◦Step 2: Choose the final portfolio based on your preferences for return relative to risk

Duration Relationships

-duration increases with time to maturity but at a decreasing rate -for coupon paying bonds, duration is always less than maturity -for zero-coupon bonds, duration equals time to maturity -duration is inversely related to YTM -Duration is inversely related to coupon

Asset Valuation

-function of both return and risk -historical risk-return relationships useful indicators -no guarantee future will be like the past -also no reason to assume that relative relationships will be much different in the future than they are now -especially useful in the long-run

Industry Analysis Purpose

-help find profitable investment opportunities -part of the three-step, top-down plan for valuing individual companies and selecting stocks for a portfolio -Is there a difference between the returns for alternative industries during specific time periods? -Do firms within an industry show consistent performance over time?

Bond Characteristics

-long-term debt instruments/IOUs -buyer of a newly issued coupon bond lends money to issuer agrees to pay interest and re-pay principal on maturity date -bonds are fixed-income securities -buyer knows future cash flows -known interest and principal payments

Money market

-market in which money is lent for periods of less than a year -negotiable or salable in the marketplace -short-term, highly liquid, relatively low risk debt instruments -issued by governments and private firms -T-bills -Negotiable CDs -Eurodollars -Repurchase agreements -Banker's acceptances

Gross Domestic Product (GDP)

-market value of final goods and services produce by the economy, usually in a year -real and nominal measures -real GDP is single best measure of overall economic activity -increases and decreases directly affect companies -consumption spending, investment spending, government spending and net exports -consumption spending is 70% of GDP

Investing internationally

-may provide higher returns, lower risk -changes in value of the US dollar can increase interest in owning foreign securities -investors can buy individual foreign securities or use investment companies -American Depository Receipts represent indirect ownership of shares of a foreign firm

Business cycle

-monetary policy has an important effect on the economy -increases in money supply tend to promote economic activity -Federal Reserve' impact -sets monetary policy, which impacts interest rate and the availability of money -Estimates vary on economic impact of some policy variables

yield to maturity

-most commonly used -promised compound rate of return received from a

Calculating Duration

-need to time-weight present value of cash flows from bond -duration depends on three factors: maturity of the bond, coupon payments, yield to maturity

Primary Markets

-new securities are issued in a primary market: IPOs versus seasoned new issues; average investors do not often benefit much from IPOs -issue facilitated by investment banker: intermediaries between issuer and investor; buy securities from issuer at a discount, sell them to investors; difference between two amounts is spread

T-notes vs T-bonds

-notes are 2,5 or 10 years; bonds are more than 10 years to maturity -it is common to use the terms "note" and "bond" interchangeably when making general reference to fixed-income debt securities

Bond Price Changes

-over time, bond prices that differ from face value must change -bond prices move inversely to market yields -long-term bond prices fluctuate more than short-term bonds -the change in bond prices due to a yield change id directly related to time to maturity...

Nonmarketable investments

-owned by individuals -represent personal transactions between owner and issuer -owner must open the account, maintain it, close it -in contrast to marketable securities, which trade in impersonal markets -usually very liquid or easy to convert to cash without loss of value -savings accounts and bonds, CDs

Measuring Bond Yields

-premium: price > par value -discount: price < par value -interest payments on bonds usually paid semi-annually -current yield: ratio of coupon interest to current market price; APR% x Current Market Price -does not account for difference between purchase price and redemption value

callable bonds

-provision gives issuer the right to "call in" the bonds from investors -this option is attractive to issuers when market interest rates drop sufficiently below coupon rate -issuer can save money by replacing higher interest-cost bonds with new, lower interest-cost bonds -most T-bonds cannot be called

Realized Compound Yield

-rate of return actually earned on a bond given the reinvestment of the coupons at varying rates -rarely equal to YTM

Bond Ratings

-rate relative, not absolute, probability of default -rating organizations: S&P and Moody's -rating firms perform the credit analysis for the investor, may disagree on ratings -bond ratings and coupon rates are inversely related

Current Yield

-ratio of coupon interest to current market price

portfolio managers

-responsible for making the actual portfolio buy and sell decisions—what to buy and sell and when to place the trade. Portfolio performance is calculated for these managers, and their jobs depend on their performance measured relative to other managed portfolios and to market averages.

Composite Indexes of general economic activity

-series of leading, coincident, and lagging indicators -used to indicate peaks and troughs in business cycle -leading indicators consist of variables such as stock prices, an index of consumer expectations, money supply, and interest rate spreads -coincident indicators consist of industrial production, employment figures, manufacturing activity, and trade sales -lagging indicators of duration of unemployment, bank prime rate, labor costs, and commercial and industrial loans outstanding

Yield to First Call

-some bonds callable after deferred call period -YTM unrealistic for bonds likely to be called -often uses end of deferred call period -substitute number of periods until first call date for and call price for face value

Managing Price Volatility

-to obtain maximum price volatility, investors should choose bonds with the longest duration -duration is additive; portfolio duration is just a weighted average -duration measures volatility which isn't the only aspect of risk in bonds

Analyze economy

-understand economic factors that affect stock prices -use economy-stock market relationship to apply valuation models to stock market -stock market's likely direction is of extreme importance to investors -same analysis can generally be applied to foreign markets; currency changes can affect returns

Corporate Bonds

-usually unsecured and callable -receive payment priority if bankruptcy or liquidation -convertible bonds may be exchanged for another asset at the owner's discretion

The Earnings Game

1. Analysts attempt to estimate what a particular company will earn each quarter. 2. A company may provide "guidance" as to what it thinks earnings will be. Companies may subsequently revise their guidance numbers lower in a series of steps, and the analysts follow by lowering their estimates. 3. This "talking the forecast down" results in the consensus forecast being slightly below the actual expected number. The company now is likely to beat the forecast, which provides a positive earnings surprise. 4. In the past, a positive earnings surprise typically led to stock price increase. Now, however, positive earnings surprises have become commonplace. In most quarters, the vast majority of companies show positive earnings surprises, which means there is less impact from an earnings surprise than in the past. 5. Investors sometimes have to contend with "whisper forecasts," which are unofficial earnings estimates that circulate among professional investors before earnings are announced. Think of these whisper numbers as the analysts' true expectation as opposed to the published consensus number. Some studies suggest that these estimates are more accurate than the consensus estimates.

Which of the following would not be considered a capital market security?

6-month T-bill

EV/EBITDA Ratio

= Enterprise value/EBITDA -EBITDA = recurring earnings from continuous operations + interest + taxes + depreciation + amortization =EBIT + depreciation + amortization

Price of T-bill

=FV x [1 +/- rate x (days to maturity / 365)]

US Government Savings Bond

A Lending money to an organization as an investment, an "IOU". Purchased at a fixed interest rate and period of time.

portfolio

A collection of financial assets -if you own four stocks and three mutual funds, that is your portfolio

Repurchase agreement

A financing transaction in which one firm lends assets to another firm in exchange for cash with a simultaneous agreement to purchase the assets back.

rule of 70

A method for determining the number of years it will take for some measure to double, given its annual percentage increase. Example: To determine the number of years it will take for the price level to double, divide 70 by the annual rate of inflation. -70/RoR= number of years initial investment doubles

Certificate of Deposit (CD)

A savings alternative in which money is left on deposit for a stated period of time to earn a specific rate of return.

Pure Expectations Theory

A theory that states that the shape of the yield curve depends on investors' expectations about future interest rates. -long-term rates are an average of current short-term rates and those expected to prevail over the long-term period; average is geometric rather than arithmetic

Banker's Acceptance

A time draft drawn on a bank by a customer, whereby the bank agrees to pay a particular amount at a specified future date. Banker's acceptances are negotiable instruments because the holder can sell them for less than face value (i.e., discount them) in the money market. They are normally used in international trade. Banker's acceptances are traded on a discount basis, with a minimum denomination of $100,000. Maturities typically range from 30 to 180 days, with 90 days being the most common.

Constant (Normal) Growth Rate Case

A well known scenario in valuation in which dividends are expected to grow at a constant growth rate over time -A dividend stream that is growing at a constant rate g, starting with D0

Coupon Rate

APR% x Face Value

broker

An intermediary who represents buyers and sellers in securities transactions and receives a commission

risk tolerance

An investor's willingness to accept risk when investing