Finance

A loan in which the payments include interest as well as loan principal. An amortized loan is one that is repaid with payments that are composed of both the interest owed on the loan and a portion of the loan's principal. In contrast, a zero-interest loan is one on which interest is not charged, and the payments made to repay the loan will consist only of principal.

Amortized loan:

A value that represents the interest paid by borrowers or earned by lenders, expressed as a percentage of the amount borrowed or invested over a 12-month period. The annual percentage rate (APR) is the cost of borrowed funds as quoted by lenders and paid by borrowers, in which the interest required is expressed as a percentage of the principal borrowed. This rate does not reflect the effects of compounding if interest is earned more than once per year.

Annual percentage rate:

A series of equal cash flows that occur at the beginning of each of the equally spaced intervals (such as daily, monthly, quarterly, and so on). An annuity due is the name given to a series of equal cash flows that occur at the beginning of each of the equally spaced intervals (such as daily, monthly, annually, and so on).

Annuity due

trade instruments that have a maturity period of more than one year. They include securities such as preferred stocks, common stocks, corporate bonds, and long-term bank loans excluding money market instruments.

Capital Markets

Issued by corporations, these unsecured debt instruments are used to fund corporate short-term financing requirements. If issued by a financially strong company, they have less risk. fund their short-term financing needs. Maturities on commercial paper rarely range any longer than 270 days. Risk associated with commercial paper depends on the credit standing of the issuing firm.

Commercial Paper

Issued by corporations, these financial instruments fund their long-term financing requirements. are debt obligations made by corporations to raise money for such purposes as expanding, buying fixed assets, and making other long-term investments. They are riskier than U.S. Treasury notes, bonds, and bills but safer than preferred and common stocks.

Corporate Bonds

are financial cooperatives that are formed and owned by their members. When members deposit their funds with the institution, the monies are lent to borrowing members—based on operational decisions made by the credit union's management. As owners, depositors are entitled to share in the organization's profits. These financial institutions collect deposits from their saving members, and lend the funds to borrowing members. These organizations, calledcredit unions Correct , are owned by their members, which means that they will share in the organization's profits.

Credit unions

Default risk refers to the risk that a borrower will default, which means that the borrower will not make payments as committed. Based on the credit quality and chances of default, ratings are assigned to bonds. The higher the bond rating, the lower its default risk and added default risk premium, thus resulting in a lower interest rate. If a corporate bond has the same maturity and the same marketability as a U.S. Treasury bond, its default risk premium will be the difference in the interest rate offered by the corporate bond and the interest rate on the U.S. Treasury bond.

DRP stands for the default risk premium.

Nick's grandfather loans him $30,000 to start a small coffee shop in the East Village in Chicago. A small startup firm has each of the partners contribute $50,000 in capital to help the company make payroll for the next three months.

Direct Transfers

that is added to the real risk-free rate to compensate for the expected increase in the value of goods and services due to inflation. The inflation premium is calculated based on the expected changes in inflation over the entire life of the security, not the rate of inflation in the past—but you can use past inflation rates to calculate the expected rate of inflation.

IP stands for the inflation premium

California Public Employees' Retirement System (CalPERS) manages pension and health benefits of California public employees and retirees. CalPERS collects money from its participants and creates a pool of assets. It manages these assets by making investments across domestic and international markets.

Indirect Transfers through Financial Intermediaries

xEdu.com is an early-stage start-up company that plans to issue its first public common stock—called an initial public offering (IPO)—in six months. It hires an investment bank to underwrite the issue.

Indirect Transfers through Investment Banks

refers to the capital loss that an investor suffers when the value of a bond decreases due to an increase in interest rates.

Interest rate risk

Some liquid assets can be converted into cash quickly at fair market value, and other assets have different levels of liquidity. Because an investor carries the risk of not being able to sell a security and convert it into cash quickly enough to prevent or minimize loss, a liquidity premium is added to the equilibrium interest rate.

LP refers to the liquidity premium

The longer the maturity of a bond, the higher the risk, thus causing a higher maturity risk premium for long-term bonds.

MRP is the maturity risk premium that reflects the risk associated with interest rate changes.

These financial instruments are investment pools that buy such short-term debt instruments as Treasury bills (T-bills), certificates of deposit (CDs), and commercial paper. They can be easily liquidated. invest in financial instruments—such as T-bills, T-notes, CDs, and commercial paper—that have high liquidity and short maturities. Because the instruments that money market mutual funds invest in are low risk, these funds are considered less risky.

Money Market Mutual Funds

A rate that represents the return on an investor's best available alternative investment of equal risk. The interest rate that represents the return on an investor's best available alternative investment of comparable (equal) risk is the investor's opportunity cost of funds.

Opportunity cost of funds

A series of equal cash flows that occur at the end of each of the equally spaced intervals (such as daily, monthly, quarterly, and so on). A series of equal cash flows that are paid or received at regular intervals, such as a day or a month, is called an annuity. When the cash flows occur at the end of each of the regular intervals, the series is called an ordinary annuity. An example of an ordinary annuity is the 60 monthly payments of $676.65 made at the end of each month to repay a $35,000 loan that charges 6% interest and is to be repaid over five years. If the cash flow were to occur at the beginning of each of the regular intervals, then the annuity would be called an annuity due.

Ordinary annuity

A series of equal (constant) cash flows (receipts or payments) that are expected to continue forever. A perpetuity is a series of equal cash flows that are expected to continue forever. A perpetuity can be considered to be a special type of annuity. While both a perpetuity and an annuity exhibit constant periodic cash flows, the annuity has a definite end date, and the perpetuity does not. Instead, a perpetuity's cash flows are expected to continue indefinitely.

Perpetuity:

returns earned over a given time

Realized Returns

implies that the current market prices reflect all relevant publicly available information. If semistrong-form efficiency characterizes a market, then investors cannot beat the market by making trades based on information reported in today's Wall Street Journal or in a CNN news report, since the information is immediately incorporated in the company's current share price. , the stock price incorporates all current, publicly available information.

Semistrong-form efficiency

The risk associated with a single operating unit of a company or asset

Standalone Risk

implies that current market prices reflect all relevant information, whether it is known publicly or privately. This means that investors (even corporate insiders) will not be able to earn above-average returns, because any information that they may trade on has already been incorporated in the current stock price. Different markets do not exhibit the same level of informational efficiency. As a result, different markets offer investors various opportunities to earn abnormal returns and above-average profits. all information in a market—whether public or private—is incorporated in the stock price. Even insider information is known to market participants, thus minimizing any arbitrage opportunities for a select group of investors.

Strong-form efficiency

or the expectations hypothesis, asserts that long-term interest rates can be used to estimate future short-term interest rates. The pure expectations theory assumes that investors do not consider long-term bonds to be riskier than short-term bonds.

The pure expectations theory

The concept that states that the timing of the receipt or payment of a cash flow will affect its value to the holder of the cash flow. The financial concept that maintains that the timing of a receipt or payment of a cash flow will affect its value is called the time value of money (TVM). The time value of money illustrates that, due to its capacity to earn interest, a cash flow received today is worth more than an identical cash flow to be received on a future date. The exact current value of a future cash flow is a function of the magnitude of the future cash flow, the return required by the owner (recipient) of the cash flow, and when in the future the cash flow will occur.

Time value of money

Backed by the U.S. government, these financial instruments are short-term debt obligations with a maturity of less than one year. They are considered risk-free investments. (T-bills) finance federal expenditures. Sold in denominations of $1,000 up to a maximum purchase of $5 million, T-bills mature in less than a year. They are simple and considered exceptionally safe because the U.S. government backs them.

US Treasury Bills

implies that current market prices reflect all relevant historical and current information, such as past and current price movements. In this situation, investors will be unable to earn above-average returns simply by examining the company's past and current stock price trends. , the stock price incorporates only past stock price movements and historical information. The release of the earnings report may or may not have an immediate impact on the company's stock price, but the price might eventually adjust to the announcement at some point.

Weak-form efficiency

The difference between the ask price and the bid price

bid-ask spread

involves the transfer of capital among different entities that include individuals, small businesses, banks, financial intermediaries, companies, mutual funds, and other market participants. In a developed market economy, capital flows freely between entities that want to supply capital to those who want it. This flow of capital can be classified in three ways.

capital allocation process

a financial instrument whose value is derived from some other asset, called the underlying asset. Derivatives include options, futures, and forward contracts, and these can be combined with each other or traditional securities.

derivative

does not require all investors to be rational investors. It says that as stock prices deviate from their intrinsic values (because of new information), investors will take advantage of such short-term opportunities. However, some investors will interpret news in a different way and will tend to take reverse actions; that is, if investors are buying a stock that they consider to be undervalued, some investors will sell the stock because they consider it as overvalued, which will drive the stock price to an equilibrium price. The stock price will eventually become equal or close to its intrinsic value.

efficient markets hypothesis

is the process in which derivatives are used to reduce risk exposure.

hedging

determines the ability of investors to beat the market and earn abnormal returns on their investments. If the markets are efficient, they will react rapidly as new relevant information becomes available.

informational efficiency of financial markets

in a Dutch auction is the highest price at which all the shares will be sold. The maximum offer price that WAC can set is $50 if it wants to sell all 500,000 shares through the Dutch auction. Remember that investors who are willing to pay more than $50 for a share of WAC stock would be happy if they had to pay only $50 per share for it.

market-clearing price

consists of the real rate of interest and inflation. In this case, the nominal interest rate is 7.2000%, and the inflation rate is 2.0000%. So the real rate of interest is 7.2000% - 2.0000%= 5.2000%.

nominal interest rate

Consider all risk-free rates as nominal risk-free rates unless otherwise noted. It is the rate on a riskless security that includes an inflation premium for expected inflation. It is calculated as follows: = r* + Inflation Premium = r* + IP

nominal risk-free rate, or quoted risk-free rate rRF

The objective of an IPO is to meet the company's funding requirements by selling stocks at a price so that the market has neither a shortage nor a surplus of securities. If there is more demand for an IPO than supply (creating a shortage), a higher price could have been charged, and the issuer could have raised more capital. Such a deal is referred to as an

oversubscribed offering

refers to equity capital that does not trade in the public markets. Private equity companies make investments in equity securities of private businesses through limited partnerships or as direct ownership interests. The objective of private equity investors is to hold on to their investments in the business until the business can be sold at a profit. Many private equity firms also conduct what are known as leveraged buyouts, in which they undertake a large amount of debt (leverage) that is used to fund a large purchase. hese financial institutions, calledprivate equity companies Correct , are organizations that invest in equity capital that is not traded in public exchanges.

private equity

referred to as the rate that would exist in an inflation-free world on a riskless security. U.S. Treasury securities are considered to be riskless securities, since they are backed by the U.S. government. Considering there is no inflation, the rate on a riskless U.S. Treasury security would be considered as the real risk-free rate. This rate is not static but keeps changing based on the expected rate of return on productive assets traded among investors and borrowers. The real risk-free rate also depends on an investor's time preference for current versus future consumption.

real risk-free rate r*

Although long-term bonds are exposed to greater interest rate risks, short-term bonds face greater reinvestment rate risk; this means that if interest rates are low when short-term bonds mature, an investor might have to settle for a lower interest rate when reinvesting in bonds.

reinvestment rate risk

Market participants speculate to get higher returns, but speculation also increases risk exposure.

speculation

a public Correct market for trading a company's stocks and derivatives.

stock market